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Anaren, Inc. (NASDAQ:ANEN)

F2Q2011 (12/31/10) Earnings Conference Call

January 27, 2011 5:00 PM ET

Executives

Lawrence Sala – Chairman, President and CEO

George Blanton – SVP, CFO and Treasurer

Analysts

Mike Walkley – Canaccord Genuity

Rich Valera – Needham & Company

Marc Balcer – Bluefin

Christian McDonald – Kennedy Capital

Operator

Good day ladies and gentlemen, and welcome to the Anaren Incorporated Q2 Earnings Conference Call. During today’s call, all lines will be in a listen-only mode. Later, we’ll conduct a question-and-answer session and instructions on how to participate will be given at that time. (Operator Instructions) As a reminder today’s conference call is being recorded.

I would now like to turn the conference over to your host, Larry Sala.

Lawrence Sala

Thank you. Good afternoon and thank you for participating in the Anaren fiscal 2011 second quarter conference call. I’m joined again today by George Blanton, our CFO; and Joe Porcello, our VP of Accounting. I’ll provide a brief overview of the results of the second quarter after which George will review the financial highlights and we will then take your questions.

Certain statements made during this conference call will be forward-looking statements. These statements involve risks and uncertainties that could cause actual results to differ materially from those discussed. You are encouraged to review our SEC reports and exhibits to those reports to learn more about the various risks and uncertainties facing our business and the potential impact on our net sales, earnings and our stock price.

Net sales for the second quarter were $43.4 million, up 6% from the second quarter of last year. Robust demand for Wireless standard components continued throughout the quarter resulting in strong revenue growth and improved profitability for the group. In addition, the Space & Defense Group delivered another solid quarter and is experiencing a very active opportunity environment.

Non-GAAP operating income for the quarter was $6.9 million or 15.9% of net sales, up 35% from the second quarter of last year. Strong Wireless standard component sales and a favorable mix of shipments for the Space & Defense Group drove the improved profitability for the quarter. Wireless Group net sales for the quarter were $15.6 million, up 26% from the second quarter of last year, continuing strong demand for standard infrastructure and consumer components drove the increase in net sales from the second quarter of last year. The combination of our recent new product introductions and the expanding deployments of the fourth generation wireless networks are positively impacting demand for our products.

New product and technology development efforts remained focused on expanding our standard component product portfolio. During the quarter we continued to expand our Xinger III, our high power resistor and consumer component product line. In addition, the development of the Anaren Integrated Radio or AIR product line of low power wireless transceiver modules continued and the product line is being positively received in the market. Customers that exceeded 10% of Wireless Group net sales for the quarter were E.G Components, Huawei and Richardson.

For the Space & Defense Group net sales for the quarter were $27.8 million, down 3% from the second quarter of last year. The continuing high quarterly sales volume and a favorable sales mix positively impacted the Group’s profitably for the quarter. Space & Defense Group revenue and profitability for the quarter were negatively impacted by the continuing capacity expansion initiatives in our Unicircuit operation. This initiative should be completed by the end of the current third quarter.

Product and technology development initiatives for the group remained focused on expanding the RAD-hard hybrid electronic module standard component product line for space applications, advancing our RF manifold and hybrid electronic module technologies for radar applications, and the development of integrated microwave assembly technology.

New orders for the quarter were $23.2 million and including contracts for components and assemblies for use in ship borne radar and various satellite applications. During the quarter the Group was selected to receive a contract valued in excess of $20 million from Thales-Alenia-Space for the development and production of integrated beamforming assemblies that will be deployed on the IridiumNEXT satellite payload. The contract is expected to be finalized in the current third quarter.

Space & Defense Group new business environment remained robust due to an increase in the number of satellite based applications. Space & Defense Group order backlog at December 31st, 2010 was $74.3 million. Customers that generated greater than 10% of Space & Defense Group net sales for the quarter were Lockheed Martin, Northrop Grumman, and SRCTec and Raytheon.

George?

George Blanton

The highlights of the second quarter income statement and the balance sheet as of December 31st, 2010 are presented on a non-GAAP basis. These non-GAAP measures are each adjusted from GAAP results to exclude certain non-cash items including equity-based compensation and intangible amortization. The presentation of this additional information should not be considered in isolation or as a substitute for results prepared in accordance with accounting principles generally accepted in the United States. Please refer to our Q2 earnings release for a reconciliation of GAAP and non-GAAP measures

Non-GAAP gross margin was 16.5 million or 38% for the current quarter, compared to 13.5 million or 35.3% for the second quarter of last year. Gross profit as a percent of sales increased 270 basis points from the second quarter of last year due to higher sales levels and a more favorable sales mix for both Wireless and Space & Defense business segments. Wireless standard component sales increased 53% from the second quarter of last year and were partially offset by a decline in the sales of custom assembly products.

Space & Defense shipments were 3% lower than the second quarter of last year. The decline in Space & Defense Group sales was the result of production delays and inefficiencies caused by ongoing capacity expansion and facility renovations at our Unicircuit subsidiary. These declines were partially offset by strong shipments of our counter-IED products, receivers, and satellite products. We expect non-GAAP gross margins to be between 37% and 41% for the third quarter of fiscal 2011.

Investment in research and development was 8.1% of net sales in the second quarter compared to 8.6% of sales for the second quarter of last year. Current R&D spending is supporting Wireless standard component product development as well as a number of projects in the Space & Defense Group and is not expected to decline in the near future although we anticipate increased customer funded non-recurring engineering in the second half of the fiscal year.

Non-GAAP operating income was 15.9% of net sales for the second quarter of fiscal 2011, up 340 basis points from 12.5% in the second quarter of fiscal 2010. The increase was a result of higher sales volume, favorable product mix, and manufacturing efficiencies.

Interest expense for the second quarter of fiscal 2011 was 105,000, compared to 138,000 for the second quarter of last year. We expect interest expense for the third quarter to be approximately $110,000.

Non-GAAP net income was 12.7% of sales or $0.38 per diluted share for the second quarter of fiscal 2011, compared to 8% of net sales and $0.22 per diluted share for the second quarter of last year. The effective income tax rate for the second quarter of fiscal 2011 was 17%. This compares to a tax rate of 34.4% for the second quarter of last year. The decrease primarily resulted from the reinstatement of the federal research and experimentation credit retroactive January 1st, 2010. The projected effective tax rate for all of fiscal 2011, have some one-time events is expected to be approximately 30%. Balance sheet highlights include, cash provided by operations was 2.9 million in the second quarter, capital expenditures were 2.3 million in the quarter, cash, cash equivalents and investments were approximately 71 million at December 31st, 2010, up 3 million from 68 million at September 30th, 2010.

The company repurchased approximately 13,000 shares of its common stock for a total of 229,000 in the second quarter. There were approximately 464,000 shares remaining under the current board repurchase authorization at December 31st, 2010. Accounts receivable were 27 million at December 31st, 2010, down 1 million from September 30th, 2010. Days sales outstanding was 57 days, down one day from last quarter, inventories were 35 million at December 31st, 2010, up 2 million compared to last quarter. The increase was a result of higher business level and delays in two defense programs due to changes in customers requested delivery.

Inventory turnover continues to be strong in our Wireless Group, while Space & Defense inventory turnover slowed due to the delivery delays with the two programs mentioned previously.

Lawrence Sala

Thanks George. For the third quarter of fiscal 2011, we expect comparable sales for the Wireless Group, and an increase in sales for the Space & Defense group compared to our just completed second quarter. As a result, we expect net sales to be in the range of $42 and $46 million. We expect GAAP net earnings per diluted share to be in the range of $0.24 to $0.30, using anticipated tax rate of approximately 30% and inclusive of approximately $0.06 per share in charges related to expected equity based compensation and intangible amortization. Non-GAAP net earnings per diluted share are expected to be in the range of $.30 to $.36 for the third quarter. We will now take questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Mike Walkley from Canaccord Genuity. Your line is open.

Mike Walkley – Canaccord Genuity

Great. Thank you very much. Congratulations on the strong results. And Larry just want to ask a question, you know Ericsson reported they talked about strong demand for new network builds 4G et cetera. Can you update just on the demand for using your 2 and 3 products, I mean flat, sequentially sounds pretty good for what’s usually a seasonally softer March quarter? But we are making updates on demand for those products for 2011, and any comments if you could on maybe why Ericsson, who is so large, fell out of a 10% customer.

Lawrence Sala

They didn’t – just to correct that, we report our sales through Ericsson are through a distribution partner called EG Components in Sweden. And so, we report that is our customer, the actual end use is for Ericsson. So Ericsson continues to be a good 20% of our Wireless sales, as they have been. So just to clear that out. But you know in general, we’ve said since I guess November when we completed our annual purchase negotiations with Ericsson for calendar year 2011 that their forecast for 2011 is very strong relative to even 2010 levels.

We do feel that we saw some of that increase in the last two quarters, as George mentioned our standard component sales were up over 50% annually and in the September quarter they were up 26% sequentially from the June quarter. So we’re seeing this is a tremendous increase. We don’t expect that, that kind of rate will continue but as you said, we still see comparable demand this quarter and order flow remains pretty consistent. So we haven’t seen order flows changing for the last several months and the annual forecast for the year remains very strong. I mean we are always quite cautious that business changes quite quickly, but as we stand today it seems like it’s performing as consistently as we’ve ever seen.

Mike Walkley – Canaccord Genuity

No doubt Larry, and just given that kind of backdrop of strong demand and there has been ongoing component shortages in the industry. Any comments on pricing environment or if these high levels of gross margin in your Wireless business are sustainable for to say calendar ‘11?

Lawrence Sala

Certainly, we’ve negotiated pricing for this year, we wouldn’t expect a lot of deviation from that, it’s a very competitive space. Our customers are constantly concerned about having multiple sources because of historical supply chain challenges, so that’s something we’ve fought for a long time and we will continue to. Our strategy is that continue to have a performance size and cost leading product and to spend our market share, but it’s a constant battle. I don’t think environment changing dramatically positively or negatively.

Mike Walkley – Canaccord Genuity

Okay, great. And the thing at TES it seems like you’re having increasing interest for your AIR product line. I think you mentioned you’ve over 100 customers now trialing the product. Can you give us any update on just how may we should think about the ramp of this product into fiscal 12 and how bigger sales opportunities could become longer term?

Lawrence Sala

Yeah, we’ve said for some time we have little bit of difficulty because it’s such a new space for us with a lot of small customers, so it’s not like there is an opportunity or two that we can hit milestones and have better visibility on. Some benchmarks I guess is we’ve said, I guess all along we thought maybe we do a million dollars in shipments this year and 3 to 5 million next year and we are still – this year might be a bit of a challenge but we are still targeting next year achieving those kind of results and feel that’s very reasonable.

We have actually sampled several hundred customers. We are tracking opportunities that we quoted at those kind of dollar values already, so when we look at annual volumes of the active design activity we’ve got going on it is millions of dollars. So we believe that we are building that kind of portfolio of opportunities that can justify next year’s demands. And I think grossly we would say we think long-term the product line has a potential to double the revenue rate of our Wireless Group and we still believe that, that kind of total sales potential exist for this product line three, four years down the road. So nothing is really changed there. As we’ve gotten product into stock with our distribution partners, which really happened in December timeframe, the number of increase have just increased and our partners are starting to look to get engaged now that they have products on the shelf to sell.

Mike Walkley – Canaccord Genuity

Fantastic. And just to be clear, if this business could double your revenue in that business, your expectations would be it’s a higher gross margin product in the current product line or similar?

Lawrence Sala

It’s similar to our current Wireless standard product line, which is really the margin leader for us as it stands today.

Mike Walkley – Canaccord Genuity

Okay great. Thanks. And then on, just on Space & Defense, very good result, sounds like new orders were up but the bookings were down slightly, can you just kind of walk us through with the expansion going on, kind of how we should think about the near-term, potential lumpiness in this business, and also just to help us think about this large Iridium contract, may be the increased R&D, may be potential and the timing of when that hits tomorrow?

Lawrence Sala

Sure, we’ve just got a lot of business that we expect to book in the second half of the year here. They are all programs that we have either banned, sold source on for a long-long time or like Iridium, where we know we’ve been selected. We are just finalizing some details of contract before we book it. So, on the Iridium side, we’ve only booked the authorization to move ahead, which is less than $1 million of authorization, but we would expect to finalize that contract in the next week or two.

So, we are pretty much settled with that. It will be a fairly substantial impact to our NRE and we have two or three other material development contract that we either already have in-house or we would expect to have in-house by the end of this quarter or so. And with that, we would expect to increase our funded development work by 4 to $6 million or more for the year. So, we can start seeing a lot more people working on funded development work, and coming off of our R&D spending in the Space & Defense Group, as well as some substantial hiring of technical folks that we’ve already put in place in here, for these new projects.

So, that should have some positive impact on reducing our operating expenses. We probably start to see that impact in our fourth-quarter and really start to see it materially in the first quarter of next year, fiscal year. So that is moving ahead well. We are excited about having that new iridium opportunity and that continues. But we have follow on orders for our PRSS contract, our ship borne jammers, some airborne jamming programs that we’ve been on for a decade or more that we all expect to hit over the course of the next four, five months, and still fully expect to have a very positive book-to-bill ratio for our Space & Defense Group by fiscal year end.

Now it is a lumpy business, our customers can push deliveries or orders out a quarter or two because of various issues where we’re not the priority, they have to do some auditing that they didn’t do in the past, but from what we can see we expect to get those things done.

On the Unicircuit side, Unicircuit has been a very positive contributor to our recent business wins, they’re a big part of our approach for the iridium contract, they’re a big part of our EQ-36 business capture. They just play a pretty key role in a lot of the new things that we’re winning and doing. And in order to address the increased demand from our own internal needs we’ve had to expand capability and capacity at Unicircuit. So we’ve gone through a process of moving all the non-manufacturing oriented folks out of the facility into a facility next door and then renovating a lot of what was office space into manufacturing space and brining in new equipment and capability, and that’s been quite disruptive to the facility, it’s caused them to have to reduce their outside order intake so that they could apply their people to putting this new capacity online. It certainly disrupted their production and yields a bit, their ongoing production activity. And mostly we believe that we’re well through it now and should be completed by the end of this current quarter.

We do expect that there will be a likely second phase sometime next fiscal year when we’ll actually expand the footprint of the facility to increase their capacity even further, but the majority of the new process introduction should be completed by the end of this current third quarter.

Mike Walkley – Canaccord Genuity

Okay, fantastic. And one question for George, I’ll pass it on. George your OpEx is already a little lower than expected you must do something NREs coming in, should we think about a stable kind of OpEx level at these levels in totality and given the trajectory along your business units with a 20% operating margin out of the question in the longer term?

George Blanton

I think from an OpEx standpoint Larry had stated that the NRE, funded NRE is going to increase over the next couple of quarters. So I think you’ll see some sort of impact there and so we would expect it to move from an OpEx up to a cost of sales.

In terms of 20% anytime in the near future, I think we’re going to see but it depends on the product mix considerably, so that has a lot to do with it. And I think some of these NRE will help the bottom line but there may be other changes in demand in the future that may offset that. So I think it will be a great goal, we’re striving for it but I don’t see it in the next couple of quarters.

Mike Walkley – Canaccord Genuity

Okay, guys, well, congratulations on all the strong momentum in your business. And I’ll pass it on to next question.

George Blanton

Thanks, Michael.

Operator

Thank you. (Operator Instructions) Our next question is from Rich Valera from Needham & Company. Your line is open.

Rich Valera – Needham & Company

Thanks. Larry, I noticed SRCTec was10% customer of the Space & Defense business. Could you talk about sort of the profile of that business, how long you think the current order last, any prospects for additional business on the same program or others, and – how you think you might handle the transition of off this order, which will probably I guess happen sometime in Q3, Q4 timeframe? Thanks.

Lawrence Sala

Sure. Yeah, I mean clearly for us this project for SRCTec, the current project will end this current quarter. It diminished some last quarter so sales on this program dropped probably 15% last quarter from the rate we were running and they will be down probably 30% again this quarter sequentially and finished in the March timeframe. So this is something we’ve been anticipating and it’s been pretty clear in front of us for the last nine months. From a continuing opportunity standpoint we expect some limited spares business on this program for the next several years as we’ve seen historically, but nothing that we expect to be particularly material for us.

There is a couple of initiatives that are under way as far as additional upgrade opportunities for the installed base, both, the SRC crew system as well as the marine CRVJ systems, and we do have content on both of those initiatives. We don’t have great visibility about timing, but what we do says that these systems are being developed and qualified currently – in the current quarter and to stay on plan, we’re going to production about a year from now and we would have comparable or a little higher dollar content than what we’ve had on these historical applications. For us, it’s the first time that we actually have dollar content on the CRVJ platform, we haven’t had that historically. So, that would be a new opportunity for us and we’re hopeful that those programs continue to be funded and move ahead, but those are upgrades of those existing installed platforms.

From a business transition standpoint, we’re awarded another Fed order last quarter, which is starting to ramp up for us now and we’re filling fairly significantly as the production of the IEV product diminishes as this quarter progresses. We’re expecting continuing follow on orders for our passive ranging technology that should fill in the INET. And then obviously all the new activity with all the space development IridiumNEXT and some military communication satellite projects that we have kicking off will fill in.

So, our expectation is we should see a fairly elegant transition on the revenue side. We may see some negative impact on the margin side, because we got a very mature production going on that runs fairly efficiently and we’re starting up three or four smaller initiatives that are really in the beginning stages. But we’re we’ve got good visibility of the revenue opportunity.

Rich Valera – Needham & Company

That’s a very helpful color. Thank you. On the Unicircuit transition wondering if, George, if you could quantify how much of an impact that had on the gross margin in the just reported quarter and how much you think it might have in the current quarter?

George Blanton

Yeah, we’re probably looking at a percentage point there in the current quarter, it’s going to recover – not recover but it will start to move out of this transition phase next quarter and be, I’ll say, fully pulled back to where they were in the fourth quarter.

Rich Valera – Needham & Company

Okay, that’s helpful. And Larry, any reason you didn’t mention EQ-36 when you were talking about the transition, the revenue continuity as you sort of pay that uncertainty as EQ-36 ramping as expected?

Lawrence Sala

No, I mean just timing, EQ-36 won’t be ramping up in the April, May timeframe. Certainly in fiscal ‘12 we expect EQ-36 to be a significant incremental growth program for us. But in the near term transitioning out of IED and into other things between the third and fourth quarter, we don’t expect EQ-36 to happen that quickly, that’s the only reason I didn’t mention it. But from our total revenue impact fiscal year to fiscal year we would expect EQ-36 to have a very positive impact for us, because we said for a long time we expect it’s transitioning from kind of a $5 million a year program for us to more like a $10 plus million a year program for us.

Rich Valera – Needham & Company

Sure, that’s helpful. Okay, that does with me. Thanks guys.

Lawrence Sala

Thank you. Welcome.

Operator

Thank you. Our next question comes from Marc Balcer from Bluefin. Your line is open.

Marc Balcer – Bluefin

Larry, I just wanted to see if you could characterize the Space & Defense new business opportunities you’ve discussed, to what extent is this really a maturity, the opportunities you’ve been tracking or are you also seeing kind of a very front end of the formal resale of opportunities that have started little bit down the road?

Lawrence Sala

Yeah. Well, it’s certainly broken into segments. Obviously, IridiumNEXT is a segment and an opportunity kind of bringing up itself. We have captured the first beamforming contract. We’ve said for some time we’re pursuing a contract that’s also quite significant, it’s not quite as large as the beamforming contract, but for the switching network that goes onboard the same satellite payload. So, combined, that’s a fairly substantial business opportunity for us.

Then, in addition to that there is a number of military communication satellite opportunities. We’ve participated on AHF program for a number of years and that program looks like it has substantially larger future for us than we had originally anticipated. We believe there is a variation of that system also being that will be deployed where we will have a comparable opportunity. And then we’ve been selected for the next generation of this type of communication satellite technology.

So all told, we would expect over the course of next six months contracts for variations for all of those opportunities that totaled something on the orders may be $15 million of opportunity this year between just kind of follow on production and development work for next generation systems.

And then beyond that segment our M.S. Kennedy operation, which really builds kind of standard power management building blocks for any type of spacecraft application whether it’s a commercial application or a military application, we’re just seeing a very robust global marketplace. Now, big programs like in GPS III are somewhat of a driver, but just general demand for space craft and their RAD-hard Power Management technology has continue to increase over the last two and a half years since we’ve been together and they’re projecting – continue to project a very positive business environment. So, all the opportunities seem to be – seeing positive momentum for us.

Marc Balcer – Bluefin

Great. Thank you. And then you’ve mentioned two programs with delays in delivery day, I don’t know if that’s related to – you’ve mentioned two programs last quarter as well they the same or can you elaborate on that?

George Blanton

Yeah, no nothing special of interest, same couple of programs, these had a couple of customers who wanted to move deliveries into calendar ‘11 that we’ve had – previously had in our plans to ship in the end of calendar ‘10 here. So, most of that’s already shipped out the door today as we speak and we’re back on kind of normal delivery rates to them. So, yeah just their desire to adjust delivery dates to help them manage inventory through year-end and into the next calendar year.

Marc Balcer – Bluefin

Great, and it’s kind of a re-ask, but I think you had expected the Wireless business to be down sequentially and it was up, you know maybe I’m just looking to hear, but anything specific that you can point to or whether that’s just strength of the standard business?

George Blanton

You know I was just gaining courage, I guess (inaudible) here to say that it’s going to be flat this quarter after seeing this consisted strong demand. So, nothing special. Last – the September quarter was up so significantly sequentially we just weren’t confident it was sustainable even though forecast remained strong, but now that we’ve gotten through another quarter and continuing strong order flow and continuing strong forecast. We’re more confident to say that this is sustainable, yes.

Marc Balcer – Bluefin

Great. Thank you.

George Blanton

Yeah.

Operator

Thank you. And I show one more question in queue, Chris McDonald of Kennedy Capital. Your line is open.

Christian McDonald – Kennedy Capital

Good evening. Thanks for taking my questions. I’m wondering if you could put some numbers around the revenue impact of the Unicircuit transition and just you mentioned that there was some normal outside business that they couldn’t pursue due to that transition.

George Blanton

Yeah, it was about a million dollars of impact that we’ve seen. If you combine the impact of them taking outside business and the difficulties to trying to support our continuing production each year it’s grossly about I’d say about a million dollars impact in the quarter there.

Christian McDonald – Kennedy Capital

Okay. And then those two programs that were where the customers requested delivery delays, was that a meaningful impact as well in the quarter?

George Blanton

Yeah, something of the same order of magnitude, a little less, but comparable order magnitude. So, that was kind of the buffer of achieving the high end of our guidance versus kind of coming in the middle of our guidance. So, we had some expectations to be in the middle of our guidance expecting softer Wireless performance, but ended up there because of softer Space & Defense.

Christian McDonald – Kennedy Capital

Okay. And Larry you mentioned some of the opportunities that MS Kennedy is now seeing in RAD-hard Power Management. Is that a function of some of the investment that Anaren has made since the acquisition on upgrading them as Kennedy capabilities, or these more longstanding capabilities in program relationships that have existed at MSK?

Lawrence Sala

I’d love to take more credit for Kennedy, but I really think it’s just they positioned themselves exceptionally well over the last five years. They have a partnership with Linear Technology, where they have an exclusive supply arrangement here in the U.S. for taking their RAD-hard semiconductor products and putting them into standard packages and offering them as qualified standard components. And that’s been a very successful initiative and they’ve just done a great job of building out their product portfolio. Some of the investment we’ve made has helped get them a better capacity and some automation to be a little more consistent in their production, but they deserve 98% of the credit, we might take the 2% for that.

Christian McDonald – Kennedy Capital

Okay and then you mentioned some potential, further upgrades to the IV jammer area, I don’t know, maybe I’m premature in even asking this, but with those program plans will this be a similar situation where nearly the entire installed base is upgraded or maybe you could just kind of walk through potential magnitude of what the upgrade might entail?

Lawrence Sala

Yeah, that’s difficult for us to really predict. I guess our expectations would be as far as quantity goes, it would be substantially less than the last upgrades, because there just won’t be as many systems still deployed. So, our best guess and plans are that for the crew work that we’ve done, it might be half the size of the last upgrade that we performed, but if we’re successful on the CRVJ side that would be relatively comparable in size, so another goal-round that about the same size as the last one that we’ve just, in the process of completing, is probably our best guess what this will be.

Christian McDonald – Kennedy Capital

Okay. Thanks a lot.

Lawrence Sala

Sure.

Operator

Thank you. I show no other questions from the phone lines.

Lawrence Sala

Great. Well, we greatly appreciate you taking the time and we look forward to speaking with you again next quarter.

Operator

Ladies and gentlemen, thank you for your participation on today’s conference. This does conclude the program and you may now disconnect.

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