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Einstein Noah Restaurant Group Inc. (NASDAQ:BAGL)

Q2 2010 Earnings Call

August 5, 2010 5:00 pm ET

Executives

Manny Hilario - CFO

Jeff O'Neill - President and CEO

Analysts

Nicole Miller - Piper Jaffray and Company

Matt DiFrisco - Oppenheimer & Company

Bart Glenn - DA Davidson and Company

Operator

Greetings and welcome to the Einstein Noah Restaurant Group second quarter 2010 earnings conference call. (Operator Instructions)

It is now my pleasure to introduce your host, Manny Hilario, CFO for Einstein Noah Restaurant Group.

Manny Hilario

Good afternoon and welcome to the Einstein Noah Restaurant Group second quarter 2010 conference call. I am Manny Hilario, Chief Financial Officer. And with me today is Jeff O'Neill, Chief Executive Officer and President.

I will start by covering a few regulatory matters. Please note that during our formal remarks and in our responses to your questions, certain items may be discussed which are not based on historical facts. Such items including statements indicating our belief, trends, plans, expectations, assumptions, anticipation, guidance, projections, estimates and the like should be considered forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. All such forward-looking statements are subject to risks and uncertainties that could cause our actual results to differ materially. For more details, please refer to our news release issued today and to the risk factors in our SEC filings.

And now, let me turn the call over to Jeff O'Neill.

Jeff O'Neill

Thanks, Manny. As this is Manny's inaugural call as our CFO, I want to first publicly welcome him to the Einstein Noah Restaurant Group. Manny is a seasoned financial professional, a great restaurant operator, a respected leader in the industry, and I am pleased to have him as a partner on the business.

Now, with regard to the second quarter, I'd like to begin our conversation with a review of our three key objectives for 2010 and then discuss our execution in relation to them. Overall, 2010 is shaping up to be an exciting year at Einstein Noah on many levels, and I would characterize our performance during the second quarter as generally in line with our expectations and we made progress in a number of strategic areas.

As we started the second quarter, discretionary spending slowed somewhat compared to Q1 and particularly in the month of June as our momentum had been building from Q1 through May. Against this backdrop, we also faced intense price-driven competition from QSR and sandwich chains, especially as it relates to our breakfast daypart.

While much of the competition is focusing on value menus, we see this as a more short-term solution. Instead, we're committed to healthy innovation, fresh baked goodness and a strong line of new products that will build consumer loyalty for the long run.

From the value perspective, we will continue with our successful direct mail and Facebook coupon activity focused on generating trial and repeat purchases against both our new items and our core bagels with our Free Bagel Friday offers.

As noted in our press release, we generated $103 million in total revenues during the quarter, a decline of approximately $900,000. System-wide comp store sales decreased by 1.1%, while comp transactions improved modestly on a sequential basis. This of course is inclusive of the June softness I spoke about.

We also invested in check driving initiative during the quarter to have offset some of the short-term impact of the heavy breakfast value dealing by the competition and are pleased with the results we saw in sequential transaction build during Q2 from this activity.

In terms of our profitability, we realized substantial margin improvement at both the restaurant and manufacturing level. Our supply chain team continues to make advances with year-over-year commodity cost improvements, reduction in freight expenses and savings from a new vendor price verification process.

From an operating perspective, we also made improvements in labor efficiencies and held the line on other operating costs. At our manufacturing and commissary facilities, our teams continue to increase profitability on top of last year's substantial gains in this area. In the end, gross margin held steady at 20% and adjusted EBITDA remained virtually flat at $11.7 million despite the softness of the top-line.

In terms of development, we recently highlighted the growing importance of our franchise and license unit growth with the term franchise first model. Although our Einstein Bros. and Noah's brands consist primarily of company-owned locations, we have considerable experience as a successful franchisor with our 72-unit Manhattan Bagel brand located in the Northeast. We intend to build on our institutional knowledge and significantly expand our franchising opportunities with focus on our national brand Einstein Bros. Bagels.

We're focused on new development agreements and expect to sign as many as 40 to 60 new franchise stores this year. Our current franchisees will also build 12 to 17 new locations in 2010, of which six have been opened as of June 29. As of the end of the quarter, we had a pipeline of 84 franchise locations, six of which have been signed to date.

We look to sign up nine more agreements through the end of 2010. In total, we look to raise our pipeline to somewhere between 90 and 100 restaurants by yearend.

We also have aggressive growth plans in our license channel as well, and already have a robust pipeline to deliver 35 to 45 new locations this year, of which nine have been opened so far with an additional 16 units in various stages of construction. While the unit economics of franchise and licensed stores are different, they both ensure that we drive strong revenue growth and superior ROIs with limited capital outlays on our part.

We will also continue with a healthy base of company store development with 10 to 12 new company-owned store openings this year across our more developed markets of Denver, Dallas, Chicago and Washington DC. Although we are actually increasing the number of openings of 2009 both this year and over the next several, company stores will become a smaller subset of the total Einstein Noah restaurant portfolio as franchised and licensed developments accelerate.

From a consumer perspective, we worked hard to develop a strong pipeline of new products so that we can not only fully exploit fresh baked goodness as a key point of differentiation, but also continue to build our health and nutrition platform. We view bringing new items to market within our core Bagel and breakfast sandwiches as critical in the enhancement of our brand equity.

During the quarter, we launched a new low-calorie product called bagel thin sandwiches aimed at our lunch daypart. We view our bagel thin line-up as both innovative and distinct, and intend to expand this platform with a new line of breakfast bagel thin sandwiches in the next few weeks.

In addition, we recently introduced our next generation of bagel poppers, the Pretzel popper which targets the p.m. snacking locations.

Last month we announced that Einstein Noah became the first quick serve restaurant chain to partner with the Healthy Weight Commitment Foundation. We plan to raise our profile through this partnership, and we'll continue our new lighter side menu with breakfast and lunch items, all under 400 calories.

We have also become the first restaurant chain to partner with Dannon to exclusively feature their Activia yogurt in our new yogurt parfait.

With respect to our coffee business, we're testing a number of items including a premium roast to enhance our credibility and build our coffee mix at the same time. We've continued to focus our catering operation to accelerate growth through the launch of ebcatering.com. We have in place a promotional calendar for the balance of the year, and are pleased with the inroads we've made in tapping the catering side of the business.

And now, for a review of our financial performance I'll turn the call back over to Manny.

Manny Hilario

Thanks, Jeff. Let me start with the key highlights for the quarter. Our cash flow generation continues to be strong as we grew free cash flow by $2.7 million compared to the year-ago quarter.

While net cash provided by operating activities grew by almost 60%, we also made progress in redeeming our Series Z Preferred Stock and reduced our outstanding balance to just $114 million.

In terms of our specific results, total revenue fell slightly to $103.5 million compared to $104.4 million in the second quarter of 2009.

System-wide comparable store sales decreased 1.1% and were primarily driven by a 1.2% decrease in comparable transaction counts, which was offset by a 0.1% increase in average check. Our system-wide comparable transaction trend sequentially improved by 10 basis points in the second quarter 2010 from the first quarter 2010.

Company-owned restaurant sales for the quarter were $94.2 million, reflecting comparable store sales decrease of 2.2% in the quarter. This decrease in company-owned restaurant comparable store sales during the second quarter was partially offset by the addition of six more locations on a net basis compared to a year ago.

Our investments and marketing initiatives were $3.1 million, or $2.1 million higher in the second quarter 2010 compared to the prior year. However, our trial-generating incentives were about the same as the second quarter of 2009 to protect ourselves against the increased competition that Jeff previously discussed.

As a side note, I think it's important to point out that when we referred to $3.1 million marketing initiatives, this goes far beyond the near-term tactics that we are utilizing to build transactions in the period. Rather, our marketing investment encompasses more far-reaching long-term efforts such as building and testing our new product pipeline, customer market research and other areas.

Company-owned restaurant gross profit was 88.5%, down 70 basis points compared to the same period last year. This was primarily driven by our investment marketing, partially offset by strong operating efficiencies to our cost of goods sold and labor initiatives.

Cost of goods sold were 50 basis points favorable as a percentage of restaurant sales at 28.5%. The majority of this improvement was attributable to lower costs in our agricultural commodities, primarily wheat, as well as the impact of our cost initiatives in this area. We are locked in for roughly 85% of our wheat needs for the remainder of this year.

Labor costs improved 130 basis points to 29.1% of restaurant sales due to our continued work on our labor matrix initiative with particular emphasis on managing our players. We also benefit from a decrease in our healthcare benefit costs from 2009, while other operating costs were within 10 basis points of last year at 10% of restaurant sales, rent and marketing costs increased by 230 basis point to 30.8% of restaurant sales; primarily driven by the investment in our marketing initiatives and to a lesser extent rate costs related to new units.

Manufacturing and commissary gross profit grew by $247,000 or 25.3% on $7.3 million of revenues as a result of favorable raw ingredient costs and to a lesser extent labor efficiency gains. Franchise and license revenues grew 17% to $2 million, reflection strong royalty streams driven by the additional 11 net franchise location and 21 net license locations since June 30, 2009. Franchisees and licensees comparable store sales were also up 2.9%.

Our general and administrative expenses held steady at $9 million in the second quarter of 2010 compared to the same period in 2009. As mentioned earlier, adjusted EBITDA remained relatively flat at $11.7 million. Depreciation and amortization expense was $4.5 million for the quarter and we expect depreciation and amortization expense to be in the $18 million to $19 million range for the year.

Taking all of these items into consideration, income from operations was $7.2 million for the quarter down $0.8 million from last year. Interest expense rose to $1.4 million from $1.1 million last year resulting from the additional redemption that began accruing on July 1, 2009 on our unredeemed balance of the series Z preferred stock. As of June 29, 2010, the total series Z and related accrued additional redemption balance totaled $14 million.

Our current estimate of our 2010 annual effective tax rate is 42.6% and it was used to calculate our total provision for income taxes for the second quarter of 2010. Our estimate of cash taxes to be paid remains minimal as we continue to benefit from the utilization of our deferred tax assets. Primarily, our NOL carry-forwards.

On the GAAP basis, net income and diluted EPS available to common stockholders for the second quarter of 2010 compared to 2009 was $3.6 million and $0.21 respectively compared to $6.5 million and $0.39 respectively. However, we believe a more meaningful measure of our performance is reflected in the non-GAAP measures, adjusted net income and adjusted diluted EPS for the second quarter of 2010, which were $3.1 million and $0.19 respectively compared to $4 million and $0.24 respectively in 2009.

Finally, net cash provided by operating activities expanded by 58% to $8.7 million and free cash flow increase by $2.7 million to $4.7 million compared to the second quarter of 2009.

I will now turn the call back over to Jeff from some concluding thoughts.

Jeff O'Neill

Thanks, Manny. Before we go to the Q&A, I'd like to reinforce our mission of accelerating growth in both revenue and units while delivering consistent and reliable growth in EBITDA for our shareholders. To accomplish this, we're running continuing executing our three key initiatives. First, we will build sustainable long term growth by creating more awareness for our brand and by continuing to offer our customers healthy and innovative new products that build on our core bagel and breakfast heritage.

Second, we're focused on discipline cost driven initiatives that will enhance our operational efficiencies in an effort to build a sustainable cost advantage. And third, we're continuing to drive unit growth and realize the full potential of our brands through our franchise first model. We believe we have a competitive advantage in being fresh, fast and fun as no other restaurant brand offers the quality and freshness of a bakery café with the speed of a QSR. With our asset like strategy, development will primarily be through franchising and licensing, while maintaining our strength in company owned units.

On behalf of Manny and myself, we're now ready to answer any questions you might have.

Operator, please open the lines to the Q&A portion of the call.

Question-and-Answer Session

Operator

(Operator Instructions) Our first comes from Nicole Miller from Piper Jaffray and Company.

Nicole Miller - Piper Jaffray and Company

Could you give us some indication in the month how comps were spread between May and June, if we can have the exact number, great; but if not just directionally? And then for July, are things better or off to a later start.

Jeff O'Neill

You know the way I'd look at the quarter is, as we came into the quarter and saw the amount of competition moving into the space, we basically stepped back, saw the value menus out there, saw the launch of our key competitor in the sandwich area come in with subway. And we then, sort of course corrected. So coming out of quarter, I will say that we are at a much better position and let's say we're back on track as we move into Q3, more in line with what we saw in the first quarter.

Nicole Miller - Piper Jaffray and Company

How do you look at, I think I have it right, your company comp is down and the franchise comp is up, is that a function of price or is something else going on there?

Jeff O'Neill

Yes, it's really when you think about a lot of our franchise growth, it's coming in really two areas. It's not unusual for new stores to comp more aggressively than sort of the stores that have been out there for a number of years. Second of all, we're opening up in as we mentioned the tier-1 markets, markets where we're most developed.

And so the expectation is, as we open up more stores, people are more familiar with it. This is why we're going into these stores and that also helps comp. So generally that's what we're seeing the difference between the franchise and company owned stores there.

Nicole Miller - Piper Jaffray and Company

That's helpful, and just a last question, I just wanted to confirm, is that you're 60% locked for all commodities, that 85% locked for wheat?

Manny Hilario

That's correct.

Jeff O'Neill

So wheat's pretty much locked out for the year. And then the other commodities we still have floating, and we continue to close those sort of weekly.

Nicole Miller - Piper Jaffray and Company

And you're locked at 85%, can you give us a dollar amount or I think last time you had said, wheat was close to the $9, a bushel for 2010 versus 10 last year is that still pretty close?

Jeff O'Neill

I can't recall of the top, but we will get back to you on that. That's the number I recall, but we'll do a double check for you Nicole.

Operator

Our next question comes from Matt DiFrisco from Oppenheimer & Company.

Matt DiFrisco - Oppenheimer & Company

Looking at your G&A, gentlemen, is that a sustainable level? It looks like it was very much controlled on a absolute dollar basis being flat with a year ago, is there something in there as far as accruals or timing that might shift into the third quarter we should expect?

Manny Hilario

Relative to G&A, we think that our G&A for the first two quarters of this year is reflective of the run rate of what we think the full annual amount is. Overall for the year to date, that's what we would expect to continue for the remainder of 2010.

Matt DiFrisco - Oppenheimer & Company

Okay. so 19 divided by two for each quarter, so maybe nine-and-a-half for each quarter remaining, so a little higher than what you just did at the ninth?

Manny Hilario

Yes, sounds about right.

Matt DiFrisco - Oppenheimer & Company

Just looking out into 2011 without making you give us guidance here, all of us are following wheat and it's back to, everyone is referring to the '08 days. That was a time when your business had 29% plus percent relative food cost or 29.9%, almost 30%. Can you tell us about what you're selling now and how the business might have changed? Or is it that somewhat of the path had absent taking aggressive pricing, is that direction that where maybe 2011 would go given the current spot price market if nothing changes?

I'm more so not asking what's going on with the spot market in your commentary on that, but has your business changed or is that something that we should look at it from going back two years ago, that's a proxy given where the (inaudible) might be.

Jeff O'Neill

Here's my perspective on that. First of all, this is the topic de jure for the last week or so on what's going on in Russian in the drought. We also know in the conversations we've had with our partners who have helped us on the week by quite well in the last couple of years. The crops in North America that haven't really come out yet but are pending are bumper crops.

So we'll see where this goes long-term. That said, we're always prepared and from my perspective it's so important that we've had this disciplined focus on cost beyond commodities, right across our business. We've got SKU rationalization, we have a very type labor matrix that we have in place now that's driving 1.2 points of operating efficiency. We've got waste management that we're looking at, inventory management at the store level. We put in this contract price verification with suppliers, we have over 250 suppliers and it was tough sort of manually on an excel spreadsheet keeping track of this.

We now have an system in place that triggers every time an invoice comes in that's in correct across those 250 contracts. That's reaping some positives that we've just put in, in the last quarter got up to speed. We've got some freight management that we're looking at. So I would say that well commodities, who knows what's going to transpire; the one thing I will tell you is that the team and myself are much more focused on a cross disciplinary, focused right across the organization that I feel can help us to offset anything that commodities might throw out of.

Matt DiFrisco - Oppenheimer & Company

Okay. And just a last question, Manny, if you can give us an update on potentially how many more remodels we could see in and then a CapEx number I might have missed that, I'm sorry if it's the release? I jumped on the call a little late.

Manny Hilario

I think our year to date CapEx expense is about $8.5 million as we've reported out. I think you could expect a run rate for the rest of the year that's very similar to what you saw for the first half. So I would say about that $17 million to $19 million range on the CapEx.

Matt DiFrisco - Oppenheimer & Company

And then how many remodels in there or do you have left to remodel?

Manny Hilario

We have about 80 restaurants that we still have some pending capital remodels for.

Operator

Our next question comes from Bart Glenn from DA Davidson and Company.

Bart Glenn - DA Davidson and Company

I was just curious in terms of marketing this, specifically what besides the step to drive traffic how do you get out to health message?

Jeff O'Neill

How do we get out the health message?

Bart Glenn - DA Davidson and Company

Yes.

Jeff O'Neill

Yes, we can look at the back half of the year, we're actually casting a little broader based media model so that we can actually look, as we said we need to drive more awareness in our stores. So in the fourth quarter we've set aside a marketing media test and we're just working on those plans right now so that we can build out more effectively to get that awareness up across us.

The mail drops are predominantly focused on the new item. So we do have that out there as generating trial and awareness for us as well through our direct mail pieces.

Bart Glenn - DA Davidson and Company

Just a follow up, how should we think about the ramp and marketing expend as we progress through the year?

Jeff O'Neill

Yes, okay. Well as I've said in the previous calls, we're expecting about $8 to $10 million of marketing spend for the year, that hasn't changed. But when take a look at front half and back half, we really front ended loaded our advertising spend due to a couple of things. One, research, some market research that we put in. We've got a coffee test that we're looking at that we had done extensive work in the first half on, and we've done that research. We are out there with those changes in-field right now, and expect to roll that new coffee platform out through the fourth quarter and into the first quarter of 2011.

We also did considerable amount of testing and research around menu boards, which we will be rolling out come end of October and November across our system.

And then finally, we invest from a research point of view in some market research around the new products that we had in 2010. So a little bit front-end loaded. I would view the back half as more, what I would call more working dollars than development dollars from a marketing point of view. and that's what will be predominantly our plan in the back half of the year.

Operator

Our next comes from (Brian Freckmann from LimeStreet Capital).

Unidentified Analyst

Just want to get a couple of things just cleared up. So it's $0.19 in earnings, and excluding the Series Z its $22. And am I correct that if you actually just take your cash tax number which is about 2%, you get to about $0.33 cents in earnings. Are those three numbers about right?

Manny Hilario

Well I think on our press release we gave you a pro forma on the earnings per share, and we did utilize the equal tax rate that we adjusted for the unusual tax items. So when we did that we were looking at about $0.19 for 2010 in the quarter and about $0.24 in 2009.

Unidentified Analyst

Are you guys using a GAAP tax rate or a cash tax rate there?

Manny Hilario

We are utilizing what our extractive tax rate would be. For instance, for the 2009 item, we adjusted out for the reserve item that we took on the quarter. So therefore what survives there would be more of an effective tax rate to what the run rate would be.

Unidentified Analyst

Right, that's 42%, correct?

Manny Hilario

That is correct.

Unidentified Analyst

But your actual cash tax rate is what?

Manny Hilario

It's very nominal, around 5% to 6%.

Unidentified Analyst

Five to 6%, okay, I can re-compute. Second thing, just to be clear, if you can just quickly go over the number of owned licensed and franchise stores ending the quarter?

Jeff O'Neill

We had 697 stores coming out of the quarter. I think it was around 430.

Manny Hilario

We had 430 company-owned restaurants at the end of the quarter. We had 83 franchise stores, and we have 185 licensed stores for a total of 698.

Unidentified Analyst

Then following up on that your full year guidance is 10 to 12 new company restaurants, 12 to 17 franchise and 35 to 45 licensees. If my math is correct, it looks like maybe you've added four owned, looks like four or five licensed and six franchised. Does that mean the rest of them are really all going to fit in the back half of the year?

Jeff O'Neill

Yes, that's right. You got the numbers right. Right now, in fact when you take a look at that from a license point of view, we've got 16 as well under construction itself in July. So that gives you an idea of how the jump ramps up pretty quickly.

Unidentified Analyst

Pretty sizeable activity in the back half of the year for additional stores. And then just finally, you guys mentioned it, I think one of the analysts previously touched on, the transactions were up and it's pricing that's down. Is that fairly correct?

Jeff O'Neill

That's right. Transactions are, sequentially, they're still down slightly, but when we take a look at what we did for the quarter is we invested in pricing through this couponing activity in order to offset some of the value pricing that was going on. So that would be the difference sequentially between the first quarter and the second quarter. That's what we are speaking to.

Unidentified Analyst

Your comments for exiting the quarter or sort of starting this month, things were looking more like a first quarter which had a positive comp than the second quarter which had a negative comp. (I think) you got any indication?

Jeff O'Neill

Yes, we got it.

Operator

(Operator Instructions) Our next question comes from (Jon Tower from Morgan Stanley).

Unidentified Analyst

Just wanted to follow-up on the new promotions, particularly the bagel thins. I was curious to know how that fared relative to your expectations in the quarter and if any of the marketing dollars were diverted away from the new promotions in order to kind of defend your breakfast?

Jeff O'Neill

First of all, the bagel thin platform we had, we were extremely happy with, and relative to our expectations and our forecast that we had put in, we were about triple the expectations behind that. And when you take a look at the bagel thins to date, they've jumped to our number one sandwich line, which is about 20% of our lunch sandwich category and over 3% of our total menu mix. So pretty significant numbers there.

In the next three weeks or so, we'll be launching the bagel thin sandwiches into our breakfast lineup, and of course that's where our core business is, with close to 65% of our business. So we are quite encouraged and quite excited about the opportunities that we have across our bagel thin lineup.

So in fact, we didn't divert dollars away. I would look at it more this way, John; when we initially came into the year, we would have felt that our marketing dollars would have been spent more I guess equal across the quarters. And what we did is we kind of pulled a little bit of that and poured into the second quarter in order to make sure that we had the right focus and weathered a bit of that bump to head when everybody landed on Q2 all at once in the breakfast space.

Unidentified Analyst

And then just following up on labor side, you guys obviously put some initiatives in place this year. And I just want to know when those will be locked. Is that going to start taking place in the fourth quarter?

Jeff O'Neill

Not really. We did build some labor efficiencies through, kind of got it going in the fourth quarter of last year, kind of end of the third beginning of fourth quarter. But then we've also got some new sort of initiatives in place. And what you're seeing primarily is really a build. The momentum really started in the first quarter of this year, I'd say. So pretty much what you see is what we're expecting to hold through the balance of this year.

Unidentified Analyst

And then just lastly on pricing, obviously as commodities start rising, particularly wheat, how comfortable do you feel with your pricing ability either this year or next?

Jeff O'Neill

I talked a little bit about the menu boards that we've been working on. Two things going on with the menu boards. One is sort of aesthetically or from a marketing or creative point of view, and we really believe that we've got a strong menu board that has just improved on the simplicity. It takes some SKU rationalization or out of it. If you've seen our menu boards, they're robust. And we've looked at making it a little more consumer friendly.

The reason we haven't rolled those out is because we've taken the time to do some real understanding of pricing mix and some variables in that end of it that would enable us to hopefully get a little pricing or at least (tax dollars) to see what's working and what's not working. So a little bit more homework on it I think might come in handy as we go forward.

Operator

At this time, we have no further questions. I'd like to turn the call back over to Jeff O'Neill for any closing comments.

Jeff O'Neill

Just a couple of comments that I'd like to make on sort of where we are at the end of the first half. I am quite pleased with the results and how we course corrected during the second quarter. We get some short-term couponing and trial incentives to offset some of that activity, et cetera, on the breakfast category in Q2, which was quite significant.

We really continue to ensure that we are sequentially increasing those transactions and traffic trend as we go forward. At the same time, we've continued our focus on cost management. And from my perspective, that really paid off in the second quarter as we held a gross profit margin at 20% despite some increased investment in check.

I am very encouraged by the momentum that we've picked up on the franchise and licensing unit growth. We've got a lot of franchisee interest on our business from what I call tier-1 franchisees. The new products are working well. We talked about bagel thins. Our pretzel popper has been a great little addition to our business, because it's a p.m. snacking occasion, getting us in that pretzel location which is a little bit in our DNA. And we are quite pleased with what happened there.

And as importantly, we are back on track as we move into Q3, and we feel like weathered the storm, we course-corrected. And I am happy to see that trends are starting to look more like what we expected and more like the trends we were getting in Q1.

With that said, thank you, operator, and thank you all for the call.

Operator

This does conclude today's teleconference. You may disconnect your lines at this time. Thank you for your participation.

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