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Obagi Medical Products Inc (NASDAQ:OMPI)

Q3 2010 Earnings Call

November 4, 2010 04:30 pm ET

Executives

Ina McGuinness - Integrated Corporate Relations

Al Hummel - Interim President, Interim CEO

Preston Romm - CFO, EVP of Finance, Operations and Administration

Analysts

John Newman - Oppenheimer

Annabel Samimy - Stifel Nicolaus

Scott Henry - Roth Capital Partners

Larry Neibor - Robert W. Baird & Co.

[Mark] - Canaccord Adams

Irina Rivkin - Duncan Williams

Chris Sassouni - Eagle Asset Management

Operator

Greetings and welcome to the Obagi Medical Products third quarter 2010 earnings conference call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. (Operator Instructions). As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Ms. Ina McGuinness. Thank you. Ms. McGuinness, you may begin.

Ina McGuinness

Thank you, operator. Earlier this afternoon Obagi Medical Products released its financial results for the third quarter ended September 30, 2010. If you have not received press release it's available on the investor relation section of the Obagi Medical Products website at www.obagi.com.

This call is being webcast and a replay will be available on the company's website for 30 days. Before we begin, we would like to remind you that today's remarks contain forward-looking statements within the meaning of federal securities laws.

These statements do not guarantee future performance, and therefore, undue reliance should not be placed on them. We refer you to the risk factors contained in Obagi Medical Products' SEC filings for more detailed discussions of the factors that could cause actual results to differ materially from those projected in any forward-looking statements.

All information provided on today's call is as of the date of the live broadcast, Thursday, November 4, 2010, and Obagi Medical Products assumes no obligation to update any such information.

Participating in today's call are Interim President and CEO, Al Hummel, and CFO and EVP of Finance, Operations and Administration, Preston Romm.

With that, I'd like to turn the call over to Al Hummel. Al?

Al Hummel

Thank you and good afternoon, everyone. Let me give a little background since I’m the new kid on the block. I've been a member of the board of Obagi for the past five years and I’m pretty familiar with the operations of the company. In the past few weeks I've been able to work with the employees of the company and I’m pleased to say that Obagi has employees that care about the company, believe in the company and they're dedicated to Obagi's success. It's a very fruitful opportunity to be working with these people.

Today, we reported another solid quarter, including delivering double-digit top line growth of 12%. This was fueled by very strong growth in our Vitamin C line as well as good growth from Nu-Derm and elasticity products.

Our earnings, excluding the incremental additional cost of terminating the Zein Obagi contract, which decision was made after we last talked, and, therefore, not included in our third quarter guidance, our income would have been $2.1 million or $0.10 per diluted share, in line with our third quarter guidance.

Our performance by specific product lines for the third quarter of 2010 compared to 2009 was as follows: Nu-Derm sales increased 14% to $14.9 million. We launched our Nu-Derm continuum program on September 2 as a maintenance regime to encourage continued use of Nu-Derm after the initial treatment phase is completed.

We had meaningful growth from our new and improved CRX systems, which were introduced in the first quarter and which drove awareness of the entire product line. This resulted in sales from the Vitamin C product line increasing 39% year-over-year to $3.8 million.

ELASTIderm sales, which include eye cream, eye gel and decolletage, grew 11% to $2.6 million. We entered an entirely new product segment with our October 15 introduction of ELASTILash. This is an efficacious alternative to other products in the category and has been clinically demonstrated to achieve the appearance of visibly thicker, fuller looking eye lashes. We're excited to enter into this new segment and look forward to reporting our progress.

Sales from our therapeutic products, which include CLENZIderm and Rosaclear, were relatively flat at $1.8 million. Other product categories were up more than 5% year-over-year primarily due to the addition of Refissa, our new tretinoin, which launched in the third quarter last year.

Now, let me review our third quarter performance by geography. Sales from our US business increased over 14% to $23.2 million year-over-year and we were successful in opening 362 new accounts which were up sequentially and indicate that our derm specialty sales force reorganization is operating well. As of June 30, we had 6435 active accounts, a 5% increase from a year ago. Our domestic sales force now totals 120 people, up three from last quarter.

Internationally, product sales were up approximately 14% to $3.5 million due mostly to increased sales in the Middle East and Hong Kong. Both areas are expanding their Medi-Spa businesses. On the other hand, our licensing fee revenue was down approximately 22% to $1.2 million due mostly to the poor economy in Japan.

As you know, we filed a registration statement to sell up to 6.2 million shares of common stock owned by two long-term stock holders, one of which is in the process of winding down the fund. To be clear, these are not new shares and no money will be raised by the company. Please refer to our press release from this afternoon and the S1 on file with the SEC for additional information.

In addition, the board has approved the repurchase of up to $45 million in outstanding stock depending upon market conditions and other factors. In order to ensure the company has needed cash availability for working capital and future growth initiatives we have also entered into a $15 million, five-year term loan to accompany our existing $20 million working capital line of credit.

With that, I would like to turn the call over to Preston to review more of our operating metrics. Preston?

Preston Romm

Thanks, Al, and welcome, everybody, to our call. As Al said, our sales rose 12% to $27.9 million in the third quarter of 2010. This is up from $24.9 million in the third quarter a year ago and year-to-date our net sales rose 12.4% to $82.5 million.

Gross margin for the quarter was 79.3% compared to 78.9% a year ago as we benefited from the January 1, 2010 price increase which was partially offset by a 22% decline in license fee revenue which carries a very high gross margin.

Total operating expenses for the quarter of $19.5 million were higher compared to a year ago due in part to the timing of marketing costs associated with the October 15 launch of ELASTILash, a September 2 introduction of Nu-Derm continuum as well as legal fees of $2 million and the contract termination fees of $888,000 related to the lawsuit, an arbitration demand filed by Zein Obagi ZO skin health.

The termination fees were not factored into our third quarter guidance as the decision to terminate the contract was made after the issuance of our guidance.

Our operating income for the third quarter of 2010, including these expenses, was $2.6 million or 9.3% of sales. This compares to $4.9 million or 19.8% of sales a year ago. Net income for the quarter came at $1.6 million or $0.07 per diluted share. Excluding the legal fees and contract termination costs related to Zein Obagi ZO skin health, which had a negative impact on the per-share basis of $0.08, net income would have been $3.3 million or $0.15 per share. This compares to net income a year ago of $3 million or $0.14 per share.

Our balance sheet is stronger than ever with cash, cash equivalents and short-term investments totaling $45.6 million which is up from $36 million at December 31, 2009 generating $9.1 million of free cash flow.

Now, let me talk about our guidance for the fourth quarter. As we take another look at the economic trends, we see an absence of consistent signs that the economy is improving and noted a drop in aesthetic advertising.

In light of this, we have tempered our expectations for the fourth quarter, putting revenue between $29 million and $29.5 million and diluted earnings per share between $0.07 and $0.09. Please note a couple factors that are included in this guidance.

One, it includes approximately $2 million or a $0.06 negative EPS impact in legal fees for the fourth quarter, the same guidance we gave when we talked last. This also includes up to $2.1 million or a $0.06 negative EPS impact related to the separation agreement with the company's former CEO Steve Carlson, which was not included in previous guidance.

Please also note that we implemented a 4% price increase on January 1, 2010 which drove approximately $1.5 million to $3 million of revenue into the fourth quarter of 2009 making the year-over-year comparison rather difficult. Lastly, this guidance assumes our share count is in the 22.2 million share range.

Lastly, Al and I are in the process of investigating and analyzing initiatives to grow the company. At this time we are focusing on brand awareness, new products and international presence. We look forward to filling you in as we develop the specifics of this strategy.

With that, operator, we'd like to open the line for questions.

Question-and-Answer Session

Operator

(Operator Instructions). Your first question comes from the line of John Newman - Oppenheimer.

John Newman - Oppenheimer

I just wondered if you could give us a sense as to the churn or if there is any churn in your account base over time. I saw that you noted that you had added 362 new accounts during the quarter. I'm just wondering over maybe a 12-month period what do the account additions look like compared to any potential factors that may be sort of dropping out of the economy?

Al Hummel

As you know, we measure churn by an account that hasn't made a purchase in the last 12 months and not surprisingly that's been running higher in '09 and 2010 than it had in previous years because if you go back a year that's 2008 and 2009 in the dross of the economy.

So our churn rate has been averaging 4.5% per quarter plus or minus, which is getting us to about a 17% annualized number in this poor economy. Normally we should see a 10% to 12% churn rate in normal time, so not surprisingly a little bit high. As you indicated, we give you ending active accounts and new accounts so you can calculate what the churn rate is.

The new accounts are across derms, plastics, OB/GYNs and other doctors and after we did a slight reshuffling of the sales team in Q2 we saw a good resurgence of OB/GYNs and derms in the third quarter.

Operator

Your next question comes from the line of Annabel Samimy - Stifel Nicolaus.

Annabel Samimy - Stifel Nicolaus

I'm curious to know about your continuum program, exactly what that entails to maybe keep people on Obagi products a little bit longer than just the three month system. Go into a little more detail there?

Preston Romm

It's a combination of reaching out to doctors and patients, some marketing campaign but it's really -- once you go through the cure phase, let's call it, treatment phase and you've gone through the 13-week period, you don't roll off our product, so we're encouraging people to stay on, less use, less frequent product to stay on the system and it really depends on the specific treatment that you went in for, whether it's melasma or skin pigmentation or wrinkles, depending on what number products the doctor gives you.

It's a concerted effort both on products, not new products but the use of the existing products, and some marketing effort to keep the patients on our systems longer.

\Annabel Samimy - Stifel Nicolaus

You started that September 2, so in the month or so of the quarter, or even up until this point now, what kind of retention have you seen this three-month procedure -- system?

Preston Romm

It's a little early to tell, Annabel. I think we can report on it next time we talk. But it's a little early to say with just four weeks worth of data behind us.

Annabel Samimy - Stifel Nicolaus

Just a little bit curious, the SG&A was a little bit higher. I know that you were talking about how you launched, I guess ELASTILash, and your launch of this continuum program. But I'm a little bit surprised that it is higher. So is there something else in the SG&A -- that's just the legal expenses that are pushing that up higher, as opposed to increased promotional expenses?

Preston Romm

Well, there's $2 million of legal expenses. There's $888,000 of expenses related to terminating the contract with Dr. Obagi. There's kind of launch costs for ELASTILash and continuum and then there is some timing of expenses rolling in from Q4 into Q3 more on the marketing side, which we should see an improvement in the fourth quarter on that.

Annabel Samimy - Stifel Nicolaus

On ELASTILash, where exactly is that going to be reported? Is it going to be in other or is it in another product line?

Preston Romm

It's part of the elasticity family, even though it's not using the copper zinc malonic acid compound. Bit it's part of the elasticity family. We report it in there and at least since it's a new product I think we'll be talking about it a little separately about how it's being adopted into our doctor practices.

Annabel Samimy - Stifel Nicolaus

Were there any inventories from the third quarter for ELASTILash?

Al Hummel

No, that was launched in October.

Operator

Your next question comes from the line of Scott Henry - Roth Capital Partners.

Scott Henry - Roth Capital Partners

Just a couple of kind of speed around questions here -- Preston, I wanted to walk through the guidance, just to make sure I understood it, because there are so many moving parts. I mean, if we look at the first three quarters you did $0.09, $0.14, and $0.10, if you add back what wasn't expected. Then, you look at Q4, which you guided $0.07 to $0.09, but you add back $0.06 for the separation agreement that wasn't expected, which would imply $0.13 to $0.15 in Q4.

If I add all of those up I get $0.46 to $0.48 for the year versus your original guidance of $0.46 to $0.53 so it looks like you just kind of chopped off the top end of the range. Is that right? Am I doing the math correct?

Preston Romm

You are doing the math correct.

Scott Henry - Roth Capital Partners

Nu-Derm continuum, was there any quantifiable stocking in Q3?

Preston Romm

Not really. We gave a lot of the collateral and some product information and training in Q3, so there wasn't really -- there's not really any product stocking to have in the continuum. It's more of an education to get the patients to buy existing SKUs once they come off the 13-week initial period.

Scott Henry - Roth Capital Partners

Then R&D at $1.5 million, was certainly higher than it's been in the past couple quarters. Any reasoning there? Should we think at that going forward to be higher, or look at it as an outlier?

Preston Romm

As we said last quarter, we brought in a new VP and there's a transition period between the old and the new, so there's a couple of little higher salary in there, so I would expect that to continue for a short period of time and then kind of even off.

Scott Henry - Roth Capital Partners

Then a couple of products that I'm just curious where they are now running at that we haven't talked about in a while, Rosaclear and Refissa, What kind of quarterly run rates are those products right now? I would assume they are both around $1 million. Is that fair for a quarterly rate?

Preston Romm

Well, we don't break out individual products within the different categories and, as you see, other is up a little bit year-over-year and that's mostly Refissa.

Scott Henry - Roth Capital Partners

Well I guess ask another way. Are you still seeing kind of organic growth among those products?

Preston Romm

I'd say [amongst the tretenoin] Refissa has really helped out there but the normal [tretenoin] that we sell has done very well. They kind of go hand in hand with Nu-Derm and CNE sales. As you see, the therapeutic line is relatively flat year-over-year.

Scott Henry - Roth Capital Partners

I guess just the final question, giving Al a chance to get involved, when you think about growth initiatives, obviously you don't know what you are going to do just yet. But what are the types of things you're looking at? I mean, are you looking at joint ventures, acquiring products, acquiring companies? I imagine your looking at all of them. But I guess what would be your goal over the next six months?

Al Hummel

I think that we have a number of internal opportunities, just market awareness among not just the doctor but the end user. I think that Obagi has, in part, been pretty quiet relative to the end user. I think there are a number of opportunities that we'll be able to use internet. We're developing our inner circle where people were in pretty good contact with some devoted users.

As I've said before, the product works. It has a wow factor to it and I don't think we've been as good at communicating that to the end user and I think that we will be working hard to do that in the future. I think, as I said, we have people coming to us telling us how good the product is, so using them as a reflector base that would be one area that we will be concentrating on.

Scott Henry - Roth Capital Partners

So I guess my assumption that you were looking at acquisitions, or external factors, may not be totally correct? It sounds like you wouldn't mind continuing to do what you are doing but just doing it better. Is that fair?

Al Hummel

I think that's what we're going to focus on first. I wouldn't discourage the -- if there's a good opportunity that comes along we certainly have the cash and the wherewithal to be able to do it, so I think we'll be exploring external factors as well, new products externally. That will be another area that we'll be concentrating on.

I have a lot of background in terms of product development, so I think that we have an exceptional sales force. We have an exceptional product and if we can augment and extend and/or build on that situation we're going to look for ways to do it.

Operator

Your next question comes from the line of Larry Neibor - Robert W. Baird & Co.

Larry Neibor - Robert W. Baird & Co.

If the focus is going to be on developing internal opportunities, why did you expand your line of credit by $15 million?

Al Hummel

Well, I think that's the focus. It's not the only focus, as I said. We want to be in a position such that if any opportunities come along we're going to take advantage of it. So I think that we'll certainly be opportunistic if we have an opportunity and I think that it shows I think a couple of things.

Number one, it shows the strength of Obagi. The banks have a lot of faith in us, obviously. Number two, it shows that we will maintain our flexibility to take advantage of opportunities.

Preston Romm

I'd add this, Larry. As you know, when you can ask the bank to borrow money you should secure it up because you never know. I'm not saying we're going to have a hard time with money here but if the bank's offering it to us I’m going to take advantage of it.

Larry Neibor - Robert W. Baird & Co.

Are you intending to stay in the same focused business efforts going forward? Not going to change focus?

Al Hummel

I don't anticipate a change in focus.

Larry Neibor - Robert W. Baird & Co.

Did you see some slowdown through the quarter, or through the month of October? It seems as if you're somewhat pessimistic about the fourth quarter? Did you see some change in your business trends over the last three, four months?

Preston Romm

I'd characterize it this way. The second half of the year certainly isn't as robust as the end of the fourth quarter of last year and the first quarter and the bulk of the second quarter were. So I think it's just prudent to kind of level out at the lower end of the ranges we gave earlier, as Scott said, minus some of these unique things that have popped up.

It's certainly tough out there. No one's backing up their numbers. But the feedback we're getting is it's a little tougher now than it was three, four, six months ago.

Operator

Your next question comes from the line of Bill Plovanic - Canaccord Adams.

[Mark] - Canaccord Adams

I just wanted to get your thoughts on product launches going forward and if you see a better opportunity in therapeutic or aesthetic.

Preston Romm

Going back to I think it was Larry's question, we're going to focus in our core business. We seem to do a lot better in aesthetic work but we're going to see what opportunities are out there as we go through this investigative stage. But our brand attributes and our sales force and our doctors lean more heavily towards aesthetic than therapeutic.

[Mark] - Canaccord Adams

Actually, could you give us a little more detail on Nu-Derm continuum? I'm not so familiar with that.

Al Hummel

I think it's a situation that we're recognizing the user base and they are -- the product works so well that, in part, I think they think it's going to work forever. So I think that the campaign here is that we delivered a new pace and we'd like you to keep it and here's a method of doing that.

As Preston has said, there's a reduction of SKUs and it really would depend upon the extent of the damage but I think it's the message that we're providing to both the physician and to the end user that it's important to continue some aspects of your treatment and that way the luster, the shine, et cetera, the rejuvenation continues.

So I think it's a marketing effort focused on reminding both the physician and the end user that we have product opportunities that will continue the quality of the initial treatment.

We found, Mark, in our market analysis with our patients that about 60% plus, once they go through the initial 13-week period, they love the results and they go, "Hallelujah, I'm cured," and they go back to the high-end department store, drug store and start buying more maintenance-type product like sunscreen and moisturizer.

What we want to encourage is the continued use of our products as opposed to somebody else's since they're spending the money anyway. Nu-Derm is a quasi aggressive treatment with tretinoin. Your face turns red and you slough off skin. It doesn't have to be that way. You can use the product less or use less [SKUs] and it becomes more of a maintenance (inaudible) anything else and that's what we're encouraging.

Simple math says stay on the product twice as long, you double your revenue and that's what we're encouraging our doctors and patients to do.

[Mark] - Canaccord Adams

Then finally, just taking a step back and looking at the big picture, Al, when you look at the opportunities in the market, where do you think -- how do you think your views and your perspectives are different from the previous CEO? Where do you see the strengths and weaknesses of the company?

Al Hummel

I think the strengths obviously are the products themselves. They really do work and it's based on science. It's not based on hype. I think that's number one. Number two, as I said earlier, the employees, they really believe in the product. They use the product and they're very happy with the product. I think that is really important because we have a tremendous workforce that really is dedicated to the success of this company.

I think in terms of emphasis, as I said earlier, our discussion with the end user as a customer has been relatively mute and I think that we are a unique product in a category or an area where hype lasts for a short period of time. We see products that are hype. They kind of bubble up and then the hype dissipates and they go away.

Here we have a franchise that we've built on really quality, high-quality scientific progress. I think that story has yet really to be told to a large number of people in the end user market. Now, obviously, we're not Proctor & Gamble. We're not going to go out and buy Super Bowl ads. But I think that there are a number of gorilla marketing campaigns. The internet is a whole new area for campaigning, advertising, et cetera.

As I said, we have letters from women that have written in and said, "You changed my life." I don't think that there are too many other products in the aesthetic category that can say that. We have got to do a better job at transmitting that to our end user.

So I think, number one, there will be a significant emphasis in the future in really just transmitting the truth to our users. As I said, the second thing here is we have a tremendous franchise and there's a hope that we will be able to increase the velocity of new products and/or differentiated products.

Again, it's going to be based on science. So I think that there could be some lumpiness in terms of how many products we can introduce but the goal will be to introduce influential products. Thirdly, I think international, I think that we can potentially do a better job internationally and, again, that's a process. It's not going to happen tomorrow.

For instance, in all the BRIC countries, we are not involved in any of them, Brazil, Russia, India, China and potentially there are opportunities. But I think each of those markets is dependent upon a unique regulatory structure, a unique distribution structure, et cetera, and we're still relatively new in the international arena and we'll be studying those particular opportunities.

So I think we have really three key areas to look at and to invest in to enhance the franchise.

Operator

Your next question comes from the line of Irina Rivkin - Duncan Williams.

Irina Rivkin - Duncan Williams

I wanted to explore the outlook on the aesthetic market a little bit more. There have been reports by other companies of double-digit growth in the aesthetic segments, robustness from several companies, as well as from Estee Lauder and their Clinique product that addresses aging spots. So I was just wondering how come with everyone else doing some well in this segment that you guys are taking a more gloomy outlook?

Preston Romm

Irina, I've seen both pretty robust growth and double-digit growth and I've seen some guiding down and being a little bit more pessimistic, so I've seen it on both sides of the equation. I think a couple things to keep in mind is we have been posting double-digit growth throughout this year as well as last year in the 12%, 13% range, which is still pretty good growth.

The other thing to keep in mind is even with that, about $3 million of product was shipping in the fourth quarter of last year because of the price increase, so comparing last year fourth quarter, this year fourth quarter, although on paper it looks like it's down, we're not projecting a price increase for early this year, early next year, so that kind of mucks up a year-over-year comparison.

Other than that, I think we're posting okay growth in the fourth quarter versus last year and double-digit growth for the quarters one, two, three and four.

Irina Rivkin - Duncan Williams

Then can you update us on the status of the dispute with your R&D guy, the JR Chem dispute that was in the Q?

Al Hummel

I'm not sure I'd go as far as to call it a dispute. We're in discussions with him about continued work and wrapping up work that he is doing now. We don't view that, even if he doesn't do anything, as hampering our future growth potential and we're just in discussions with him.

Irina Rivkin - Duncan Williams

Then I guess I just have one last question which is, of the 362 accounts, would you be able to sort of address what percentage of them were derms or plastics versus gynecologists? Maybe the same question for what percent of the churn is in the core accounts, like the plastic, surgeons, or derms versus the gynecologists and the other non-targeted physicians necessarily?

Al Hummel

I'll have to get back to you on that. We don't have that broken down in front of me. But I do have the information. Actually, our largest growth has been, as a percent, has been the non-derm, non-plastic group but, as you know, in the second quarter we did a bit of a reorganizing moving OB/GYNs and ophthalmologists in to the derm specialty sales force, so the second quarter showed a drop off of new derms and new OB/GYNs and I know we saw other -- I don't know the exact number -- a pick up in the third quarter in both those two areas.

Operator

(Operator Instructions). Your next question comes from the line of Chris Sassouni - Eagle Asset Management.

Chris Sassouni - Eagle Asset Management

Could you talk a little bit about what are some of the leading indicators that you look at, or that you see, that lead you to trimming your estimates for the fourth quarter? Because if I -- and can you also explain sort of the seasonality that exists with your product lines? I would imagine that Christmas is a pretty good part of the season then pre-summertime or is it pretty steady throughout the year?

Al Hummel

On seasonality, the summertime is our lowest quarter because people go off to the beach and they go off and then they come back and see what damage the sun did and they want to look good for the holidays, so the fourth quarter's pretty good.

I mean, we are looking at a sequentially-up quarter in the fourth quarter from the third quarter, so that’s in line with the seasonality. Q1 is down a little bit. Q2 is up a little bit. Summertime is our lowest quarter. Fourth quarter is our highest quarter.

The indicators are really, for us, talking to our accounts and what they're saying as far as foot traffic coming in, procedures that are being booked and how the doctors feel about what the next couple of months look like.

Operator

Your next question comes from the line of Annabel Samimy - Stifel Nicolaus.

Annabel Samimy - Stifel Nicolaus

I just had a quick follow-up question. I just want to be clear. On the guidance that you gave, the $29 million to $29.5 million, that is for total revenues or just product revenues?

Preston Romm

Total revenues.

Annabel Samimy - Stifel Nicolaus

Then on the SG&A -- so the SG&A this quarter had $2 million in legal expenses and you expect that to continue until when?

Al Hummel

Well, right now we're just giving guidance on legal expenses one quarter at a time.

Annabel Samimy - Stifel Nicolaus

The guidance for this quarter is?

Al Hummel

For Q1 it's also $2 million.

Annabel Samimy - Stifel Nicolaus

Did you have any sense when -- and I think -- you already talked about the legal expenses in the first quarter of 2011, maybe?

Preston Romm

Well, the judge has postponed a trial date from February to June. Having said that, I really can't tell you what the legal expenses will look like in the first quarter. I'll have a better sense of that as we get to the first quarter of what activity's happening in that dispute. But right now what we're saying is $2 million of legal expenses for Q4 and $2.1 for the separation agreement for Steve Carlson.

Operator

Thank you. We have no further questions at this time. Ladies and gentlemen, the teleconference has concluded. Thank you for your participation. You may disconnect your lines at this time.

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