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Heidrick & Struggles International, Inc. (NASDAQ:HSII)

Q2 2010 Earnings Conference Call

July 27, 2010 10:00 AM ET

Executives

Julie Creed – VP, IR

Kevin Kelly – CEO

Scott Krenz – CFO

Analysts

Tim McHugh – William Blair & Company

Kelly Flynn – Credit Suisse

Mark Marcon – Robert W. Baird & Co.

Tobey Summer – SunTrust Robinson

Operator

Good day, ladies and gentlemen, and thank you for standing by. Welcome to the Heidrick & Struggles’ Second Quarter 2010 Conference Call. (Operator Instructions) I would now like to turn the conference over to Julie Creed. Ma’am you may begin.

Julie Creed

Good morning, everyone, and thank you for participating in our second quarter 2010 conference call. Participating with me on the call today are Kevin Kelly, our Chief Executive Officer; and, Scott Krenz, our Chief Financial Officer. As a reminder, we’ll be referring to supporting slides that are available on our website at www.heidrick.com, and we encourage you to follow along or print them.

As always we advise you that this call may not be reproduced or retransmitted without our consent. Also, we will be making forward-looking statements on today’s call and ask that you please refer to the Safe Harbor language contained in our news release and on Slide 1 of our presentation.

And now I’ll turn it over to you, Kevin.

Kevin Kelly

Thanks, Julie. Good morning and thank you for joining today’s call. We’re pleased to report very strong results for our second quarter with net revenue and operating income both exceeding in our forecast. Net revenue in the quarter of 126.1 million was up 35.4%, compared to last year’s second quarter and up 10.9% sequentially.

The Americas and Asia Pacific had great quarters. The Financial Services practice increased 85% year-over-year and the Industrial practice grew 20%. As you saw on our release, net revenue from leadership consulting services increased 32% to 8.2 million or 6.5% of total net revenue in the quarter. These results continue to validate our strategy to become a leadership advisory firm.

Slide 3 is a view of our monthly confirmations, or signed contracts, for the executive search and leadership consulting projects. Monthly confirmations in 2010 continue to track well ahead of 2009 levels and have been ahead of our forecast this year.

Slide 4 is a look at quarterly confirmation trends specific to executive search. Second quarter search confirmations were 28.2% higher than last year’s second quarter and 0.6% higher than the first quarter. Every practice contributed to the year-over-year growth but the Financial Services practice was the key driver.

Turning to Slide 5. We ended the quarter with 343 consultants down, 37 compared to the end of last year’s second quarter, and a decline of 24 compared to March 31. During the second quarter, 35 consultants left the firm, 31 voluntarily, this proportionate number of consultants who left in the quarter, about half where from the EMEA region. All the more consultants left and we didn’t expected, we are incredibly impressed with the way our consultants, in many cases less experienced consultants, have responded and stepped up to ensure seamless client service. This validates what we have always believed that Heidrick & Struggles has the strongest has the strongest bench and the best brand in the industry. We place a heavy emphasis in our firm on hiring and developing our people.

We have ramped up our consulting hiring initiatives as well. 11 consultants joined our firm in the second quarter, and 13 others have signed contracts to join. As you know, we don’t often hire consultants form other top tier global firms. We have, but not often. Generally, we like to hire consultants who have deep industry or functional experience or consultants who have demonstrated great success in smaller who we believe will exceed in the Heidrick & Struggles platform.

Our research in past experience is showing that the return on investment is not as attractive for hiring big producers from one of the other top global firms as most require large upfront payments and guarantees. The other firms who are making a lot of noise about their hiring of our consultants but these hires are in effect, they’re different than many acquisitions with high valuations. We prefer to maintain our strategy which we firmly believe we yield a much higher return for our employees, clients and shareholders.

Looking at Slide 6. Productivity, which we define as annualized net revenue divided by the average number of consultants during the quarter, improved by 500,000 to 1.4 million in the second quarter, compared to 900,000 during last year’s second quarter and compared to 1.2 million in the first quarter. We are extremely pleased with the continued productivity gains and continue to believe there is room for us to improve this number.

On Slide 7. The average revenue per search is calculated by a revenue in the quarter, divided by confirmations in the quarter and can therefore be a little confusing as revenue lags confirmations by a quarter. Last quarter, we started providing you with the average revenue per search on a trailing 12-month basis. For the second quarter, average revenue per search for the last 12 months was 102,300, an improvement compared to the first quarter when it was 100,800.

Turning to Slide 8. Operating income in the quarter was 7.6 million and the operating margin was 6%, well ahead of our guidance of 2% to 4%.

Now I’m going to turn the call over to Julie, for an update on some of the key line items. And then Scott and I will go into more detail on our outlook.

Julie Creed

Thanks, Kevin. Our press release and our slide that we posted on the website this morning provides you with all the key financial and operational results of our second quarter and by region, but as usual, I’ll give you some additional color on the other line items on the income statement.

Using Slides 10 and 11, salaries employee benefit expense increased by 21.4 million or about 33% year-over-year. This increase mostly reflect higher performance related variable compensation, which increased 22.7 million compared to last year’s second quarter as a result of higher bonus accruals related to higher net revenue.

Fixed compensation which includes fix salary and employee benefits as well as stock-based compensation expense declined 1.3 million year-over-year. This decline reflects several items. Stock based compensation declined 3.8 million year-over-year, reflecting an increase in RSU forfeitures specific to the second quarter and a reduction in RSUs granted in 2009 in 2010, compared to prior years when a portion of consultant bonuses was paid in a form of RSUs.

The decline in fixed expense also includes a decrease of 1.3 million in deferred cash bonus expense related to lower 2009 bonus accruals because of lower revenue and consultant headcount. These declines in fixed comp expense were offset by an increase of about $2 million related to special recognition awards issued in the second quarter to certain consultants in order to internalize future service to the company.

Despite an increase in salary and employee benefit expense – despite the increase in salaries and employee benefits expense was a 68.2% of net revenue, compared to 69.4% in last year’s second quarter.

Turning to Slide 12. General and administrative expenses increased 4.8 million or 17% from last year’s second quarter. This increase includes approximately 2.5 million related to our global consultant’s conference, the first time in three years that we’ve been able to get our partners together from around the world. This meeting is vital to our collaboration and is an important step in our continued transformation to a practice-driven leadership advisory firm.

The year-over-year increase also includes 2.2 million related to professional fees for the development of our internal search system, process development projects and several other items. These increases, plus a few other smaller items, were partially offset by decreases in premise related cost and depreciation expense of $1.4 million as a result of favorable lease renewals and lease termination.

Moving to Slide 13 and moving down the income statement, I’ll explain the restructuring and impairment charges. During 2Q, one of our subtenants defaulted on its sub-lease in one of our previously restructured offices. As a result, we were advised our estimated remaining obligation for this lease and recorded a restructuring charge of approximately $700,000.

Other operating income of 1.1 million reflects a fair-value assessment of the potential future earn-out payment under the purchase agreement for an acquisition we made in 2009 in Eastern Europe. The assessment indicated that there would not be any future earn-out payment resulting in this $1.1 million adjustment. And net other non-operating expense in the second quarter was 2.4 million. Of this expense, 1.3 million represents exchange gains and losses on cash and other company balances which are denominated in currencies other than the functional currency and are not permanent in nature. The other 1.1 million represents accumulative adjustment for the accounting of our minority associated with our operations in China. In last year’s second quarter, recall that 3 million of the net other non-operating expense is the write up of our investment in visual (CD).

And now I’ll turn the call over to you, Scott.

Scott Krenz

Thank you, Julie. In the first quarter, we reported an operating loss as a result of a number of time recurring and difficult forecast expenses. We were very disappointed but knew that the underlying business was performing as expected. Strong second quarter results, including a sixth quarter of sequential net revenue growth and a 6% operating margin, we enforced our belief that the business is on solid footing.

The Americas and Asia Pacific regions grew 35% and 69%, respectively. The Financial Services practice grew 85%, Leadership consulting 32%, the Education and Social Enterprises practice grew 35% and the Industrial practice grew 20%. Net revenue in Europe grew 15%.

Focusing on Europe for a moment. We note that in addition to Europe’s seemingly slower economic recovery, we lost a disproportionate number of consultants in this region. I will reiterate what Kevin said, hiring is a priority in all three regions, but especially in Europe. In fact, about 50% of our new hires in the second quarter, and about 50% of the 13 new hires made post-second quarter were in Europe.

Slide 15 shows monthly confirmations. Our monthly confirmations continue to trend well above 2009 levels and have been above our forecast. But you can’t pick up a paper without reading about the fragility and the uncertainty of the economic recovery. For example, last week, Federal Reserve Chairman Ben Bernanke told congress that the economic outlook remained unusually uncertain. This, combined with the normally heavy summer vacation schedule and a slightly lower backlog going into third quarter, makes us a bit cautious as to whether we can maintain the same level of year-over-year growth we achieved in the first half of 2010.

Our current forecast is for third quarter revenue of between 114 million and 122 million, or 10% to 18% year-over-year growth. We are estimating a second quarter operating margin of between 3% and 7%. Net revenue is the biggest factor in whether we hit the top or bottom of this range, but also as you know, the mix of consultants who generate the revenue also impacts operating margin.

We are forecasting 2010 net revenue of 460 million to 485 million. We increased the bottom of the range from 440 million to 460 million to reflect the strong first half. After factoring in seasonality and multiple other factors, we decided to tighten the range and to increase the top end of our guidance from $480 million to $485 million. In arriving at this forecast, we expect to see continued strong growth in our Financial Services practice and Leadership Consulting.

We are maintaining our full-year margin guidance of 3% to 5%. The full-year margin continues to be impacted by a number of things. The restoration of employee benefits, the (research) of much needed company initiatives which we postponed in 2009 and the hiring of additional consultants.

Our effective tax rate is highly dependent on the mix of earnings in 40 countries. We anticipate full-year effective tax rate to be approximately 51%. The rate has been primarily impacted by unbenefitted losses in several foreign jurisdictions, mostly in Europe, and by the non-deductibility in some of the cost associated with (dedicating) our former run in office and by the revised forecast of mix of income. As Europe continues to recover and as we get the real estate restructuring behind us, our goal is for an effective tax rate under 40%.

If you turn to Slide 20, cash provided by operating activities was 23.3 million, compared to cash used by operating activities of 19 million in the 2009 second quarter. We ended the quarter with 92.6 million in cash and cash equivalents, up from 81.2 at the end of March and compared to 64.6 million at the end of last year’s second quarter.

We still expect positive operating cash flows during the remainder of the year and strengthening of the balance sheet is still a key goal or 2010. We expect 2010 free cash flow, net of increases in accrued bonuses and capital expenditures of between $15 million and $25 million. Principally because of fit outs required new offices in some of our major markets, capital expenditures in 2010 is going to be higher than our normal 2% to 3% of revenue. We expect 2010 capital expenditures which should be between $23 million and $25 million. But we’ll continue to refine this during the year, based on the timing of leases signed and the start of fit outs.

And with that, I’ll give it back to you, Kevin.

Kevin Kelly

Thanks, Scott. Like so many other companies, we are navigating our way ahead of this recession slowly but surely. In the midst of the worst recession most of us will see in our lifetime and enduring a 220 million one year decline in our net revenue, we made a number of bold and ambitious decisions to become a more formidable competitor and a stronger partner to our clients.

The most significant we made, and cornerstone to our strategy, was to expand beyond executive search to become a Leadership Advisory firm. Clearly we don’t expect a 57-year old executive search firm to transform overnight. But consultant and client feedback supports our strategic vision. As important, the revenue growth that we have achieved over the last 18 months from providing Leadership Consulting services validates that our strategy is working.

Another critical decision was to change our client service delivery model from original focused to an industry practice driven focus. Understanding the business challenges of our clients is a prerequisite for being a great consultant and for earning the distinction of trusted C-level talent advisor.

This is why we organize our firm and global industry and functional practices to focus intently on creating strategic client relationships. Through our practiced focus, we are driving revenue, global branding, hiring, knowledge management and sought leadership.

There is one thing that has not changed at Heidrick & Struggles throughout the years. Our commitment to the core values to make our brand synonymous with best in class, including client service, people integrity, team work and respect.

I’d like to thank our employees for listening to this call and for their commitment and hard work. I’d like to thank our investors and analysts for their continued support.

And at this point, we’d be happy to take any questions that you all might have. Thank you.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Tim McHugh.

Tim McHugh – William Blair & Company

Yes. First can I ask you the comment about the 35 consultants who have left year-to-date? Can you put that in context for us versus last year was only probably an abnormal year, but maybe relative to a couple of years before that, how does that compare to what you’ve seen historically?

Kevin Kelly

Hi, Tim, it’s Kevin. How are you?

Tim McHugh – William Blair & Company

Good.

Kevin Kelly

To put in perspective, we always have this issue after bonus time. And if you look at or go back to, on average, going back to 2005, it was anywhere between 10% to 15% turnover. And on this year, we’re about 15% as well.

Tim McHugh – William Blair & Company

Okay. And then in response to that, what are you doing – you’re mentioning recruiting, ramping up recruiting, are you looking at retention bonuses or getting more aggressive and what you’re willing to pay for sign up bonuses. How’s that going to reflect it.

Kevin Kelly

First of all, I have to correct myself, there’s only 11.1% this year so it’s on the lower end of the range that I gave you. Secondly, a couple of things, one of the things, one of the things that we’re very proud of is that, more so than any other firm, we have truly invested in developing our own people. You would have spend a lot of time using not only resources such as some major business schools, but also internally, developing a (cadre) of individuals who have been able to step up. So we continue to do that around the globe. And secondly, we are hiring and we’ll continue hire in markets where we think there’s definitely a return in investment. We don’t want to get into a game where we’re paying major upfront bonus, et cetera, because given our research, we’ve seen that the return in many cases just isn’t there for three to five years. And third, if you’ll recall from the first quarter earnings call, we have a lot of capacity still on the system. We made it a concerted effort last year to make sure that we hang on a number of consultants who historically have been great producers that have an off year last year. So we still have a lot of capacity on the system and that was again a concerted effort on our parts. So it’s a combination of those three things.

Tim McHugh – William Blair & Company

Are you paying retention bonuses when some consultants are competing off or is that something you are not willing to do and keep on recruiting from you guys?

Kevin Kelly

It depends, Tim. I mean we’re overall; it’s not just one off here, one off there. It’s more of an approach of longer term, working on a long-term incentive program for all of our consultants in the sun. But its’ something that holistically we’ve been looking at for the last 12 months is not only a retention vehicle for key consultants in the organization but also way to have make sure that we are retaining these individuals longer term.

Tim McHugh – William Blair & Company

Okay, great. Thank you.

Operator

(Operator Instructions) Our next question comes from the line of Kelly Flynn.

Kelly Flynn – Credit Suisse

Thanks. Can you give us a sense of how you’re using salary benefits growth year-over-year when compared to revenue growth in the second half?

Scott Krenz

Yes, I mean it’s going to be roughly parallel. We are a business where 80% or so of our cost or salary, a large part of that is variable and is just associated with the production of our consultants. So we will see an increase and at the second half it should be somewhat less than you’re going to see revenue increasing in the second half. We talked about this in the first quarter, 2009 was such an abnormal year. In the first quarter, we saw two things happen and that was we saw – obviously just a step up in normal production by a number of consultants but we also saw an improvement in the overall profitability of the company which increased sort of the proportion they take away of that. So there was a relatively large adjustment and step up in the first half. So it’ll continue to increase our accrual for bonuses will increase in the second half but it will be as quite as steep as we saw on the first half.

Kelly Flynn – Credit Suisse

Okay. Sorry, I’m a bit confused because I thought initially that it would be the same as revenue growth but then later you said –?

Scott Krenz

It’ll grow but I’m looking at the numbers –?

Kelly Flynn – Credit Suisse

So you think you’ll get a little leverage on that line.

Scott Krenz

Little leverage, yes.

Kelly Flynn – Credit Suisse

Okay. Alright, great. In terms of the European consultant departures, I know you spent a fair amount of that already but what was the driver? If you’re going to a little more when you mentioned some competitors kind of making too much noise about taking your consultants but was it that or where there other specific factors that you think you can prevent from occurring going forward.

Kevin Kelly

Kelly, this is Kevin. So I’ll answer that. If you’ll look at what we’ve been doing as a leadership advisory firm, all the CEOs I talked who have gone to this transformation talked about how challenging to is. Given the change in structure, given the change in terms of driving the leadership advisory business that there was going to be a knock on the fact that lose some people who really weren’t long term suited to be in a leadership advisory firm. If you couple that with the fact that the market has picked up and last year was a very difficult year. You have competitors specifically looking at targeting us in China by a market share which isn’t a gain that we want to get into right now. So it’s a combination of things. We’d have some great hires. If you at the backgrounds of the individuals that we’ve hired, again coupled with the individuals that we’ve kept in the organization, we have a great bench, we have great succession planning in place and we’ll continue to invest in the business. It’s a myriad of reasons people leave the organization but our focus now is continue to invest in people that we have as well as look at recruiting great people that are going to fit in longer term with our strategy.

Kelly Flynn – Credit Suisse

Okay, great. Thanks a lot. I appreciate it.

Operator

Our next question comes from Mark Marcon.

Mark Marcon – Robert W. Baird & Co.

Good morning. Just wondering if you could talk a little bit about the longer-term margin expectations as it relates to Europe, obviously there are some transitions that are occurring over there. How long will it take to get up to a decent level of profitability up there?

Kevin Kelly

Mark, it’s Kevin. First what I’ll think, if you get it back a couple of years, we are in the 9% to 11% range, so in average 10%. I think we’re confident that we can go back there. It’s just a matter of the macro-economic environment that we’ve all seen. I mean Europe has been kind of a much more of a challenge and it’s just been slower to recover than the other three regions Scott just mentioned. So we’re confident of in getting the margin back up. And that’s why we want to make sure that we invest now. We’re investing in Central to Eastern Europe, we’re investing in Russia. It was spoken about this before, Germany provides a huge opportunity as that starts to rebound as well as does the U.K. you just have countries like Spain this year that have really fallen off significantly and it’s a matter of time before they start rebounding but its maintaining our client relationships there for the long term and what’s what we’re focused on doing. But again, I think we’re confident in getting up to the 10% plus range.

Mark Marcon – Robert W. Baird & Co.

Okay, thank you.

Kevin Kelly

Welcome.

Operator

Our next question is from Tobey Summer.

Tobey Summer – SunTrust Robinson

Thank you. I was wondering if you could comment on consultant productivity by geography. We had really strong growth in Asia and I was just wondering how things compare on a relative basis. Thanks.

Julie Creed

Sure. Tobey, it’s Julie. It grew across the board. It improved across the board.

Tobey Summer – SunTrust Robinson

Okay. Just a follow-up. Did Asia make more progress than the others in just kind of a road? How much was the flag?

Julie Creed

Yes. A lot of that has to do with the revenue. It’s a calculation so it’s revenue divided by average consultants. So they had great revenue growth so that impacted their productivity.

Kevin Kelly

It’s hard not to. Asia Pacific had absolutely a marvelous first half and a marvelous second half or second quarter of the year. And is bound to be reflected in part of the improvements that are above that as a rest of (inaudible) because as Julie said it’s just a mathematical exercise. But they really did had a number of areas that have record years. First half, a number of other had really, really strong results. Asia has been in the past and continues to be a real, real bite for us.

Scott Krenz

And one way, Tobey, you need to look at this is the average compensation. So if you look historically at Asia Pacific, these would be the other regions, the average level of compensation has been level. So that’s all so bee a benefit to us.

Tobey Summer – SunTrust Robinson

Thank you very much.

Operator

We do have a follow-up question from Mark Marcon.

Mark Marcon – Robert W. Baird & Co.

Wanted to ask about the real estate initiative. With regards to that, you mentioned the total figure in terms of how much it was going to cost for this year, but how much have you spent of that so far and will it be completed by the end of this year?

Kevin Kelly

Let me clarify, Mark, when you say spent, are you talking about the CapEx and the fit outs?

Mark Marcon – Robert W. Baird & Co.

Right.

Kevin Kelly

Because that’s where the expenditure is.

Julie Creed

Yes, and it wasn’t (inaudible).

Kevin Kelly

It’s not over this, though a big hunk of it was. The big offices I think have largely been done this year. One exception to that which we’ve talked about is here in Chicago which is probably going to be the last one we tackle of our big offices. But London, Paris, New York, D.C. are major, major hubs, hubs for have been taking care of them. You’re London, Paris, D.C., New York are all done. Those are completed.

Julie Creed

And if you caught flowing through in Q3 months –?

Kevin Kelly

The full answer is no we’re done yet. Because we’ve taken a view not – we’re not going to restructure property. We’re not going to leave property and abandon it in a market where the sublet market is so weak. So I’ve been letting wheezes run off and handling as a (inaudible). Substantial number of those happen this year but then next year they tend to be smaller offices, the big ones being largely behind us.

Mark Marcon – Robert W. Baird & Co.

And can you talk about the productivity levels of the people that you’re recruiting from other firm? What are you seeing in terms of what they are initially able to do and then as they become part of the system, how quickly they’re able to elevate their games?

Kevin Kelly

I think there’s a mix there, Mark. Because we have some that are new to search, we have some in the leadership consulting area and we have some that are mostly coming. Well not mostly, we have a number coming from boutiques. And what we have seen historically is that the want – there’s consulting crew are at capacity now so they’ll get up the speed quickly. The consultants that are new to search, depending on the area which they operate, could take anywhere from 12 to 14 months to get up the speed. When I say get up the speed it’s pretty much getting close to the average revenue per consultant. And then we see the individual’s (inaudible) really step up and actually increase their revenue from prior organization. So those are the individuals historically we are focused on. So it is pretty much a mix.

Mark Marcon – Robert W. Baird & Co.

And can you also just talk about the China charge with regards to the other, just give a little more color there?

Kevin Kelly

It’s nothing more than an accounting adjustment. We went back and looked at the structure of the business and the minority interest because it’s in a bunch of different pieces and figured out that we had to make a one-time catch up to account for the minority interest there and it’s just an accounting adjustment. It has nothing to do with the business and is not an ongoing issue.

Operator

We do have one more follow-up question from Tobey Summer.

Tobey Summer – SunTrust Robinson

Just curious if you could give us a little color on how long it may take to get down to that 40% tax rate?

Kevin Kelly

The biggest single issue there will be the return to profitability of certain of our overseas subsidiaries particularly in Europe. We keep coming back to that, but that is a major driver because we have some loss countries there where it reduces our income but we get no tax benefit right now. And so really it is that normalization of these overseas subsidiaries principally in Europe and we are probably talking about 12 months to do. That’s the biggest single driver.

Some of the longer term tax initiatives we are looking at have again approximately a 12-month sort of timeframe on to get in place. So we are probably talking about significant progress in 2011 just as the economy in Europe and things improve there and our mix of earnings becomes a little more normal with 2012 sort of looking for the year when we start really seeing the impact of other tax planning initiatives.

Tobey Summer – SunTrust Robinson

On capital deployment, you did cite cash accumulation as a goal for this year, so wondering if you could give us an update M&A opportunities and perhaps your thoughts on share repurchase.

Kevin Kelly

Let me start with the latter one. As I think I have been pretty consistent, this is a year of building up our cash reserves and strengthening the balance sheet. So right now after having come out of a really quite horrendous 2009, that’s our principal focus as opposed to share repurchases. In terms of M&A, we have not specifically commented on that and I don’t intend to change that sort of philosophy. Let’s just say that there are a number of things which will come across our radar screen, we continue to be very cautious in looking at them particularly in this market where it’s a little difficult sometimes to assess valuation of companies, people look back at say 2008 and say, that’s what it should be based on, and we have got 2009 and 2010 being a transition year.

So as you can see, I mean this year we have done one relatively, not relatively very small acquisition, which was a tactical one to really strengthen our office in New Zealand and we haven’t done anything else just because of one, our own caution, our focus on building this business organically and secondly, the difficultly in valuing things right now in the marketplace.

Alright, well, thank you for joining today’s call. I would like to all the consultants across the globe who have continued engage and drive our leadership advisory strategy and I hope that you all have a great. Thanks a lot.

Operator

Ladies and gentlemen, this does conclude the conference. You may all disconnect at this time. Thank you.

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Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

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