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Vitesse Semiconductor Corporation (NASDAQ:VTSS)

F1Q 2014 Earnings Conference Call

February 4, 2013 16:30 ET

Executives

Ronda Grech - Vice President, Communications & Human Resources

Chris Gardner - Chief Executive Officer, President

Marty McDermut - Chief Financial Officer

Analysts

Quinn Bolton - Needham & Company

Christian Schwab - Craig-Hallum Capital Group

Kevin Cassidy - Stifel, Nicolaus

Alex Gauna - JMP Securities

Operator

Good day, and welcome to the Vitesse Semiconductor First Quarter Fiscal Year 2014 Earnings Results Conference. Today's conference is being recorded.

At this time, I would like to turn the conference over to Ronda Grech, Vice President of Corporate Communications. You may begin.

Ronda Grech

Good afternoon, and thank you for joining us for Vitesse Semiconductor Corporation's first quarter fiscal year 2014 conference call. With us from management today are Chris Gardner, Chief Executive Officer; and Marty McDermut, Chief Financial Officer. Our fiscal first quarter ended on December 31, 2013. Results were reported in our press release issued this afternoon. We also filed our December 31, 2013 quarterly report on Form 10-Q with the SEC today. The press release, along with complete financial information for the quarter and year-to-date are available on our website at vitesse.com.

I'd like to point out that during the course of this call, we'll make various remarks about future expectations, plans and prospects for the company that constitute forward-looking statements for purposes of the Safe Harbor provisions under Section 21E of the Security Exchange Act of 1934. Actual results may differ materially from those indicated by these forward-looking statements as a result of various risks and uncertainties, including those that are detailed in the company's SEC filings. For further information about these risks and uncertainties, please read the company's SEC filings, including our Annual Report on Form 10-K for the year ended September 30, 2013.

I also note that in today's press release, we disclosed non-GAAP financial measures, including non-GAAP income or loss from operations and non-GAAP income or loss, which we will also discuss during this call. Please refer to today's press release for discussions of these non-GAAP financial measures and reconciliation of these measures to the most comparable GAAP.

It is now my pleasure to introduce our CEO, Chris Gardner.

Chris Gardner

Thank you, Ronda. Good afternoon, welcome everyone and thanks for joining us today.

Overall, we are very pleased with the performance in the first quarter of 2014. Our results exceeded guidance in all regards. We grew revenue; we improved margins substantially beyond our plan of 1% per quarter and we managed expenses wisely. Together these accounted for 62% reduction in our operating loss giving us a good start to achieve our target of operating break-even in Q3. While we continue to work within a difficult market environment, we remain confident that we can execute to our plans.

Before I turn it over to Marty, let me provide a brief update on the great progress we made towards our major goals that will drive our growth and return us to sustained profitability in fiscal 2014.

First, we expect to reach $55 million in new product revenue for the year. We had a bit of a slow start just as we did in 2013 and like last year, we expect revenue growth to accelerate in the second half. Second, we expect to attain non-GAAP operating profitability in the third quarter which is supported by this quarter's revenue growth and gross margin improvements. Third, we have already been very successful expanding into adjacent markets to take share. We more than beat our goals to double our design win pace in Internet of Things. This quarter we had wins at more than 15 IoT customers. And we have tripled the opportunities to compare with this time last year. Overall, we had record new product design wins in the quarter at a pace 25% higher than the same quarter last year.

Finally, we are on track with our product developments. In addition to introducing Jaguar-2, our third generation Carrier Ethernet Switch Engine, we launched our new Carrier Ethernet services software package. CEServices is the industry's first field proven turnkey software for Carrier Ethernet service delivery.

With that, let me turn the call over to Marty for details in the quarter.

Marty McDermut

Thank you, Chris. Good afternoon, everyone.

I will start with a review of our first quarter fiscal 2014 financial results followed with comments on our balance sheet and conclude it with our second quarter fiscal 2014 guidance.

For the first quarter of fiscal 2014, total revenue was $27.1 million up $208,000 from the fourth quarter last year is slightly above the high-end of our guidance. IP revenue totaled $2.2 million compared to $420,000 in the fourth quarter. Product revenues totaled $24.9 million down slightly from the $26.5 million in the fourth quarter.

New product revenues totaled $8.9 million compared to the fourth quarter. Excluding our distributors, our top ten end customers in the first quarter contributed approximately 43% of our total product revenues. For the first quarter, there were no 10% direct customers.

Chris will go into more detail on the market breakdown of revenue in the next portion of the call.

In the first quarter, product margin was 57.1% up from 51.8% in the fourth quarter and 3 points above the high-end of our guidance. This is due to a beneficial shift in product mix and customers combined with our aggressive ongoing cost reduction efforts particularly on new products which improved more than 6 points sequentially.

As we have transformed our business, you have seen our margin vary a bit. It's the nature of the beast. For example, relatively small shift from the amount of product sold with higher margins or a decrease in cost let's say $250,000 will have 1% impact on our margins. Together with the positive impact of IP revenue, total gross margin reached 60.6%.

Operating expenses in the first quarter totaled $18.6 million up from $17.6 million in the fourth quarter and comparable to the year ago quarter. Our R&D investment in the first quarter totaled $10.7 million higher than the $9.9 million in the fourth quarter comparable to the year ago quarter. The higher sequential amount is primarily due to the timing of MACs investments.

SG&A expenses for the first quarter totaled $7.9 million slightly higher than the $7.6 million in the fourth quarter that comparable to the year ago quarter. On a non-GAAP basis, first quarter operating expenses totaled $17.5 million compared to $16.6 million in the fourth quarter and comparable to the year ago quarter. Depreciation expense for the first quarter totaled about $400,000. We expect it to be about the same in the second quarter of 2014.

For the first quarter, total stock compensation expense included in cost of goods sold and operating expenses totaled $1.3 million. For the second quarter 2014, stock compensation will be about $.16 million, the increased results from this year's annual grant and the rise in our stock price. Our reported GAAP operating loss for the first quarter was $2.2 million; our non-GAAP operating loss was $861,000. The significant improvement is compared to the fourth quarter and prior year quarter.

For the first quarter, our GAAP net loss was $5.4 million or $0.09 per basic and fully diluted share. On a non-GAAP basis, we had a net loss of $2.4 million or $0.04 per basic and fully diluted share.

Moving on to the balance sheet, at the end of the first quarter, we had a cash balance of $48.4 million compared to the $68.9 million at the end of the fourth quarter and the decrease reflects the repurchase of $13.7 million now its principal of our 2014 debentures last November and cash used in operations. During the first quarter, cash used by operations totaled $4.5 million, if you exclude increases in working capital, operations used $1.6 million.

In the first quarter, capital expenditures totaled $884,000 we expect to total about $500,000 in the second quarter of 2014. At the end of the first quarter, accounts receivable totaled $11.4 million and day sales outstanding was 39 up from the $9.8 million and 34 days at the end of the fourth quarter.

At the end of the first quarter, inventory totaled $12.5 million up $1.9 million from the prior quarter. Accounts payable and accrued liabilities totaled $20.9 million up slightly from the fourth quarter. At the end of the first quarter, working capital totaled $20 million as compared to $69.4 million at the end of the fourth quarter and the decrease primarily resulted from the pay down of the debt in the quarter and the movement of the remaining 2014 debentures due in October of 2014 to a current liability.

Next I will turn into outlook for the second quarter of fiscal 2014. These were estimates based on our current knowledge and are subject to change as such its covered by our safe harbor statement. We estimate second quarter fiscal 2014 revenue will range from $25 million to $27.5 million. Product margins are expected to be between 55% and 57%.

Last quarter, we guided for a product margin improvement of 1 point per quarter through the end of the year. We obviously beat that goal in the first quarter. For the second quarter, we are setting the guidance midpoint at 56% and believe we will improve margins another 1 point per quarter by the end of fiscal 2014. This is slightly higher than last quarter's guidance.

We project total revenue gross margins could be 1 to 3 points higher. GAAP operating expenses including R&D and SG&A are expected to range from $18.5 million to $19.5 million and to arrive at non-GAAP operating expenses back out $1.5 million for stock compensation and amortization expenses.

And with that I will turn the call back to Chris.

Chris Gardner

Thanks Marty.

So I will start today with a review of revenue by market and then provide some analysis on products and customers.

So our Carrier business was $13 million in Q1, which was down 13% sequentially and down about 7% from the year ago quarter. Carrier was 52% of total product revenues. The market is generally not improved over prior quarters; I would characterize it as muted with some occasional upsides which are matched with equal or even larger down size. I don't see any major trends in the market other than no trends.

Our new products in Carrier actually declined modestly in the quarter but we are still up over 90% compared with Q1 2013. New Carrier programs are notoriously slow to ramp and difficult to forecast. We saw a similar slowdown in growth this time last year. We do expect growth to resume in Q2 and accelerate throughout the year.

Enterprise revenue was $11.8 million in Q1 which is 47% of total product revenue increased 2% sequentially and 22% from the year ago quarter. Our growth slowed a bit in the SME segment as a few of our customers particularly HP were impacted by the macro environment. We also experienced some declines in some older signal integrity components that have been selling into the storage market. New products and enterprise grew 7% sequentially and were up 76% on an annual basis. Similar to the Carrier market we expect growth to accelerate in the second half of the year.

IP revenue was $2.2 million in Q1 compared to $420,000 in Q4; the revenue was a combination of existing IP contracts as well as new ones. We booked a new agreement with top tier billion dollar semiconductor manufacturer for IP in the quarter. For longer term, we're keeping our IP guide at 6% to 8% of revenue on an annualized basis. Each quarter we provide a break down of our revenue vintages to highlight the transition of our revenue base from older legacy products to our new product portfolio.

Our older product is about 10% of our SKUs are going through an end of life process that started in early 2012. In Q1 2014 revenue from the EOL products was $3.4 million, which is down $160,000 from Q4. This was a bit stronger than we expected. We continued to guide for EOL revenue declined to below $1 million a quarter by the end of this fiscal year. However, since we now start in a higher level, we expect the decline to be about $1 million or so for quarter over the next two to three quarters.

Our matured product portfolio, which combines hundreds of SKUs, was down $1.5 million in Q1, about 10% sequentially. The weak market environment impacts this portion of our business more than others. As the market environment improves, we expect that our mature products will trend around flat through 2014. Longer term as these products age, we expect them to decline slowly at the rate of 20% to 25% per year. This is a much slower decline than we've seen on our much older EOL products.

This quarter, our total new product revenue was $8.9 million up just 1% sequentially and up 82% compared with Q1 2013. The growth in our new products is coming in waves as it did last year. Customers that showed strong growth in 2013 ramped more slowly from a larger number in 2014. Then we have a second wave of customers, who will drive accelerating growth towards the end of the year. Our new product revenue was well-diversified about 50% coming from our top 10 customers Cisco being the largest and just over 10% of the total. Today we're pretty much tracking your expectations and we do expect to hit the $55 million revenue target we set for the year.

To continue this growth beyond 2015, it's important that we grow our design wins. As a reminder, we increased design wins by 40% from 2012 to 2013. 2014 started even stronger with a record new product design wins in the quarter up 25% year-to-year. Designs typically take from 12 to 36 months to get into production, so most 2013 design wins won't begin to ramp materially until the very end of this year and into 2015. In the past, we've been able to guide out one year our new product revenue growth was about 5% to 10% accuracy. As a result, we're confident the design wins are reasonable proxy for future revenue growth.

Design wins are also proxy for market traction. 2013 was a break through year for attracting new customers to Vitesse. During the year we won first designs at over 100 customers. We accelerated that pace in Q1 2014 adding over 30 new customers in the quarter. The fastest growth was in our new market segment IoT which accounted for over 20% of our total design wins. In addition to adding new customers, we increased our same-store sales. We now have 40 customers with more than five new product design wins each.

Notably there is a common thread between our new customer design wins and our same-store sales, higher margins. We're constantly adding value to our product portfolio in terms of depth and breadth of the product. As a result, the average gross margin on our new product designs has increased about five points over the last 12 months. This is a good indicator that we're becoming more important to our customers. We do see a distribution in margins across our markets. Typically Enterprise is the lowest five to 10 points below corporate average, Carrier is 10 to 15 points above Enterprise and our new segment IoT is five points above Carrier.

IoT is a new growth segment that we identified last year. We're getting tremendous response to our product portfolio and we're on track to meet our three year goal to drive revenues in IoT to 20% of our total. This market is comprised of 100s of customers many of them smaller accounts. In these accounts, our sales team says we don't compete with Broadcom or Marvel, we compete with the distributors. We offer superior products a more complete solution and we can provide better service and support to these types of customers.

In the short-term our business will be driven by opportunities such as ruggedized switches for industrial process control, smart grid energy distribution and monitoring, transportation, security and a host of other applications. But longer term everything in IoT is employed to drive our business even [indiscernible] and some of the other hyper growth segments that were on display at CES in January. All of these will drive the demand for more networking and most of it will be based in Ethernet.

To sustain our growth, we continue to invest in development of next generation products one of our strongest future growth drivers is our new switch engine product portfolio. These products can be deployed very broadly into our Carrier, Enterprise and IoT segments. Revenue in this portfolio grew over 50% from Q1 2013 to Q1 2014. We see this accelerating substantially to over 100% growth in 2014 based on the strength of our design wins [indiscernible] which are up 100% on an annual basis. We are rapidly displacing older solutions such as network processors and more traditional enterprise class Ethernet switches.

This quarter we enhanced our overall switching solution with the introduction of our Carrier Ethernet Services software stack. This software runs on top of our ViSAA switch architecture. CEServices leverages our 10 year history of software development for Enterprise applications. It has been a substantial investment for the company over the last three years. Our new software offering increases the stickiness of our products as customers invest their engineering resources to deploy our solution plus software creates a very large barrier to entry for our competition and long-term it will also help us increase margins.

Together our switch engines and software provide a turnkey solution to develop and deploy equipment for Carrier Ethernet applications including 4G LTE base stations, small cells, backhaul, Ethernet access devices including Carrier Ethernet switches and other appliances. We already have over 40 licensees for this new turnkey solution. As these new designs are deployed we expect to drive both revenue growth and margin expansion.

In closing, let me say that we're very excited about our strong start to 2014 and set a very high bar for the rest of the year. Let me clear that our path this year is not a simple one as we exit our legacy markets to attack new growth markets. Our results showed that we are executing to our plan. We've made excellent progress on all of our goals for fiscal 2014 and we're more confident than ever in our future.

Most importantly we've positioned the company well and as a result we've made substantial market share gains in our primary markets and we'll now further expand our footprint into large adjacent segments. It's clear that our technology and products are the right ones as our market and customer positions continue to strengthen. We expect a build out in 4G LTE including small cell cloud access, business service delivery and IoT with all these strong drives of our growth in the second half of 2014 and beyond.

With that I'd like to end by thanking all of our employees for their continued efforts acknowledge all of our shareholders for their ongoing interest and support.

With that I'll turn it over to Melissa for questions.

Question-and-Answer Session

Operator

(Operator Instructions) And our first question will come from Quinn Bolton with Needham & Company.

Quinn Bolton - Needham & Company

Hi, Chris and Marty, congratulation on a nice December results.

Chris Gardner

Thank you, Quinn.

Quinn Bolton - Needham & Company

I just wanted Chris to -- ask first about the new product ramp obviously a little bit of a pause in the first quarter, if I'm doing my math correctly, it looks like the eight year target of $55 million that you need to do about $46 million in the last three quarters of the fiscal year slightly more than $15 million a quarter that obviously a big step up from the $8.9 million you reported in Q1 -- sorry, the last quarter Q1. Can you talk about your visibility into that ramp whether its depending on a couple of larger design wins moving from trials were closed [ph], production or is that a, a pretty good number of smaller design wins are moving together?

Chris Gardner

Yes, it's really the latter. As I mentioned right now the top 50% of our revenue comes from 10 customers' right so it is fairly distributed. We do have probably half a dozen customers that drive that number pretty hard that grows through 2014 but we also have this kind of second wave of smaller guys that are coming on very strong. I talked a little bit about that last call where there were a number of players in China on the Enterprise side that we're seeing growth.

We expect further ramps from those types of customers but we also start to see new elements coming in some of the 4G infrastructure. We have some good macro cell based stations. We have a couple of pico-cell deployments in the mix. And if you look at our number one new customer both from revenue and design wins at Cisco where we're in a large number of platforms and line cards.

Quinn Bolton - Needham & Company

And maybe following up on that last comment, I think you'd mentioned the Tire-1 OEM customer that did selected you for a network interface device, that was on a fairly fast track and I think you had said last call that there were on schedule to enter production in the first half of 2014. I was just wondering if you could give us any updates on that program or do you still expect to see revenue by the June quarter?

Chris Gardner

Yes. We do expect that that program is on track today. We actually that customer went to early field trials in December. So we negotiated the deal with them and they went to actually got product and started showing that to some of their customers last quarter. We do expect that to go to first customer ship probably in the June quarter.

Quinn Bolton - Needham & Company

Great. And then just last question from me, I know China, especially on some of your Carrier customers, larger Carrier customers in China in the last quarter was expected to be fairly soft, it looks like that that was probably the case given your decline in the mature product. Any signs of life in that China Carrier base or is it still fairly muted in China?

Marty McDermut

Muted is a good word. I think our two big guys were -- one of them was up, one of them was kind of flat and then there is a third guy in China right, the three big accounts for us are Huawei, ZTE and Fiberhome and the two larger guys one was up, one was down and I think Fiberhome is down slightly in the quarter.

Quinn Bolton - Needham & Company

Okay, great. I'll get back into the queue.

Chris Gardner

All right. Thanks Quinn.

Operator

(Operator Instructions) And our next question will come from Christian Schwab with Craig-Hallum Capital Group.

Christian Schwab - Craig-Hallum Capital Group

Hey, great gross margins in the quarter.

Chris Gardner

Thank you, Chris.

Christian Schwab - Craig-Hallum Capital Group

You're welcome. Exact to the previous line of question on new product revenue, if we kind of look at the next quarter's guidance for absolute revenue and if we look at the end of life product, it seems like new product revenues are only going to be up modestly quarter-over-quarter. As we think in that trajectory towards $55 million, is it a latter step in a latter step or is it a big latter step and then flat one?

Marty McDermut

I'd characterize it Christian as more as the traditional hockey stick right. So we will see growth in Q2 but that growth will clearly accelerate in the second half as we said.

Christian Schwab - Craig-Hallum Capital Group

Okay, okay. So just kind of take it up in a hockey stick format it isn't going to -- we don't have lighter side I guess is the question to a big Q3 and then it just kind of stabilizes at that rate?

Chris Gardner

No. We continue to see growth Q3 to Q4 and it's a little far out right now but we would expect certainly that growth to continue maybe not quite at that torrid pace. As I say these things seem to turn on in waves, we saw almost exactly the same thing last year as you recall. We had virtually no growth in one of our quarters and then we saw a substantial growth in the next two.

Christian Schwab - Craig-Hallum Capital Group

Perfect, perfect. Thank you. I don't have any other questions. Just want to make sure I got that right. Thank you.

Chris Gardner

All right. Thanks Christian.

Operator

And our next question will come from Kevin Cassidy with Stifel, Nicolaus.

Kevin Cassidy - Stifel, Nicolaus

Yes. Thanks for taking my question. On your Internet of Things strategy as you have 100s of customers' turns into 1000s of customers, what is the strategy for supporting them, it seemed like your advantage, you are saying right now is, you are giving them direct support. How long can that continue with the longer term strategy?

Chris Gardner

Yes. That's a good question. We are looking at that very hard. So we do have a pretty broad based both wrap [ph] and distribution channel. I think a big part of the difference is that what is a reasonable size customer to us is way, way below the hurdle rate for one of our large competitors. And so, I probably visited 20, maybe 50 of these customers that can't even get through the disti [ph] being served by the large competitors.

So it doesn't scale as you are pointing out to 100s of millions of dollars, it will scale for the next 12 months or so, and we are looking pretty hard at our coverage model. But, I think it's really just a matter of priority, our big friends, or even not that excited about some of the big network in the companies, companies like Alcatel-Lucent and Ericsson are Tier-2 accounts for a lot of these guys they're off chasing Samsung cell phones or Steve Jobs, right. So a completely different view point from their perspective.

Kevin Cassidy - Stifel, Nicolaus

Right. And I think it's an interesting development. And also the gross margin improvement on the new products can you describe that is that mostly yield improvements or what else is happening there?

Marty McDermut

Yes, it's a combination. As I said it's we work real hard on improving the margins on the new products which is where the yields would come in and the cost reduction would kick in. We're also just doing a better job managing the overhead pull a smaller portion but we also, we saw shifts in, we got higher margin clients or customers in there and we also had to shift to just higher margin products at the same time. It's not one item, it's just a number of things that we've been working on that kicked in, in the quarter.

Chris Gardner

Yes. And this is the trend we hope to continue. If you look at our past calls, we talked about the new products taking a little while to get the cost down so we made some good move there. But we also have the carrier product ramp will add to the mix formula that Marty talked about. Then next thing on top of that is higher margin design wins. So as we drive more value with software and other capabilities that will also be pushing our margins out. So we have I think a pretty good plan over the next 12 to 24 months to continue that trend.

Kevin Cassidy - Stifel, Nicolaus

Great. Thank you.

Operator

And next we'll take a question from Alex Gauna with JMP Securities.

Alex Gauna - JMP Securities

Good afternoon gentlemen. Chris you just touched on in terms of investing in software you talked about your Carrier Ethernet Services. I think can you give a little bit more color around either the scale or types of software investments you're making right now or at least the priority ones for this year?

Chris Gardner

Yes. The software is becoming increasingly important in our field right. It's been something that we delivered as an enterprise class provider for many, many years going back more than 10 years. So our software package actually has tremendous amount of investment behind it. As we moved into the Carrier world, Carrier Ethernet is brand new it's an emerging technology and what we found was it that the silicon was being made available by suppliers like us. But the software on top of it was not being packaged together with the silicon. And there are third party providers companies that folks can partner with but it ends up being a two-party solution which is always challenging.

So we started this investment several years ago, we have been growing our software resources very fast with the company. And to put it in perspective we actually had our Carrier Ethernet Services software package graded by an external consultant who look at lines of code, complexity et cetera. They estimated and this was about a year ago so it's probably increased a little bit consent. They estimated that it would take 250 man years to replicate that software code. So you are looking at a very, very dramatic investment 100 engineers for 2.5 years to get this done. And that's the level of product we are deploying that is the level of -- really the barrier to entry that we are putting up against any competitors we want to get in the market.

And here the big value add for us is to getting our customers to market faster because otherwise they have to write the software and obviously that drives tremendous value for them so it does provide incremental margin boost for our whole product portfolio.

Alex Gauna - JMP Securities

Chris, how does that sit in with some of the open source and some of the open Ethernet type of initiatives that are underway in the market?

Chris Gardner

Well, so some of the code that's in there is comes out as open source initiatives and we have to play with some of those initiatives when we provide code out to customers. In other events customers will augment our code with their own and one of the things for example we are doing on our NID-product is, we are enabling that product to be managed by our customer software by providing what's called private NID, so they can effectively manage the device that's running our software just like they manage one of their own pieces of equipment running their own software.

So we effectively then provided very simple way to extend the footprint of equipment into -- further into the access portions of the network with devices like NIDs and EADs.

Alex Gauna - JMP Securities

Got you. One more if I could, and I know its early days, but if some of your customers and partners have been talking about some of the changes in the neutrality and are you seeing any activity along with some of the cloud vendors that might be either improving or changing with the new thinking that's out there around it. Thank you.

Chris Gardner

Yes. That's a great question. That's one of the things I have always told investors you ask me, what are the long-term milestones you look forward for improvement in the business? The simplest is Carrier CapEx, but what will drive in behind that, also drive Carrier CapEx is someway for the Carriers to monetize some of the money that's been made off of their investment. So if you look at Facebook and Netflix and all those guys they are making a fortune off of the ability to have very high bandwidth access and the guys who are providing those networks are not making a ton of money.

I do see that as a trend that will continue. I would sell the story. I can't watch Netflix at my house on a Saturday night because there are too many other people doing the same thing. Eventually, I will get rid of Netflix because I can't watch it. And Netflix will prevent that I think by finding ways to pay for better access and that means CapEx with the networks. So it's a great thing to watch. I think it's a right thing.

Alex Gauna - JMP Securities

Thank you.

Operator

And at this time, there are no further questions in the queue. And I would like to turn the call back over to Chris Gardner for closing remarks.

Chris Gardner

Thank you, Melissa. I would like to thank everyone for joining us today. As we discussed we are very pleased with our strong start to 2014. We continue to feel we are very well-positioned in the market. We are taking share and we look forward to executing on our plan here for the rest of the year. So thank you very much.

Operator

That does conclude our conference for today. Thank you for your participation.

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