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Exactech, Inc. (NASDAQ:EXAC)

Q2 2011 Earnings Call

August 3, 2011 10:00 AM ET

Executives

Bill Petty – Chairman and CEO

David Petty – President

Joel Phillips – CFO

Analysts

James Sidoti – Sidoti & Company

William Plovanic – Canaccord Genuity

Jeff Johnson – Robert W. Baird

Jim Quentin – Barrett & Company

Operator

Welcome to the ExacTech, Incorporated Second Quarter 2011 Earnings Conference Call. (Operator Instructions) I would now like to turn the conference over to Dr. Bill Petty, CEO of ExacTech. Please, go ahead.

Bill Petty

Thank you, Doug, and welcome everyone to our ExacTech Conference Call. I will begin by reading the SEC disclaimer. This release contains various forward-looking statements in the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934.

They represent the company’s expectations or beliefs concerning future events of the company’s financial performance. These forward-looking statements are further qualified by important factors that could cause actual results to differ materially from those in the forward-looking statements.

These factors, among others, include the effect of competitive pricing, the company’s dependence on the ability of third-party manufacturers to produce components on a basis which is cost-effective to the company, market acceptance of the company’s products, and the effects of government regulation. Results actually achieved may differ from the expected results included in these statements.

For the second quarter of 2011, ExacTech’s revenue was $51.7 million which represents a 9% increase over $47.6 million in the second quarter of 2010. The net income decreased 9% to $2.7 million which represents $0.21 per diluted share compared to $3 million or $0.23 per share in the same quarter last year. Excluding the compliance expenses of $1.5 million, net income for the quarter increased 13% to $3.7 million or $0.28 per share.

The segment performance for the quarter is as follows our Other Products revenue remained flat at $7 million. Just as a reminder, our Other Products includes our cement line, instrument sales; things of that type.

Our Knee Implant revenue was up 7% to $20.7 million. Hip Implant up 15% to $8.4 million. Biologics and Spine revenue was down 13% to $6 million and Extremity Implant revenue increased 36% to $9.7 million.

Now to look at the picture for the first half of the year. In the first six months, the revenue was $105.1 million which is an increase of 9% over the $96.7 million for the first six months of the previous year.

Net income for the first six months was down 9% to $5.7 million or $0.43 per share compared to $6.3 million and $0.48 per share for the first six months of 2010. Again, excluding the compliance expenses of $2.7 million, the net income for the first six months increased 12% to $7.4 million or $0.56 per share.

The Product segment revenues for the first six months were $13 million for Biologics and Spine which is a decrease of 8%; $42 million for Knees, an increase of 4%; $16.4 million for Hips, an increase of 18%; and $19.1 million for Extremities which is an increase of 35%.

Our Biologics-Spine lines remain in the doldrums with the main challenge being in Biologics. We are initiating new programs to better educate the market regarding the value equation for ExacTech’s bone growth and cell therapy product.

We have abundant documented excellent clinical effectiveness data related to these products and our plan is to use that more effectively in convincing our customers that those products provide excellent results for their patient.

We are pleased that in what remains a challenging environment, revenues for our other product lines continued to grow with Knees up 7% for the quarter, Hips up 15%. Our Extremities product line continued to lead the market with 36% growth for the quarter.

I’m now going to turn it over to David Petty, who will give a little more information about the comparison between domestic and outside the U.S.

David Petty

Again, happy with the results of the second quarter, and I just want to point out that we have been taking advantage of the investment that we made. We began discussing investments in the channel outside the United States about six quarters ago. We made those investments throughout 2010 and the first half of this year.

And we’re pleased to report that in fact those investments are paying off, particularly in the European market and also in the Japanese market where we are now starting to realize results with the clearances of some of our hip products in second half of last year and are really starting to do very well in the Japanese market.

Now, Jody Philips is going to give some more information about the operational and financial results.

Joel Phillips

Good morning, everyone, and thanks for joining us for the second quarter call.

The second quarter results were largely in line with our expectations as we entered the quarter. Our gross margins continued to expand on a year-over-year basis to 68% during the quarter as compared to 65.5% in the second quarter of last year.

As was the case in the first quarter, the expansion in the gross margin was primarily due to a larger percentage of our outside the U.S. sales being in direct market and is therefore somewhat offset by higher operating expenses, specifically in our sales and marketing expense area.

The 21% increase in sales and marketing expenses during the quarter was largely attributable to a full quarter of expenses in our new European direct operations as compared to the same quarter of last year. As we progress through the third and fourth quarter, we expect the increases in sales and marketing expenses to be significantly lower as these direct operation expenses have now annualized.

The 40% increase in G&A expenses during the second quarter was primarily due to the increases in the compliance spending, which increased from $400,000 in the second quarter of last year to $1.5 million in the second quarter of this year. And again, that was largely in line with our expectations.

We anticipated that the compliance spending would be heavier in the first half of 2011, and therefore, we are projecting $1 million in compliance spending for the third quarter but again that is a relatively fluid number that is quite difficult to project.

At this time, we are maintaining our estimate of $5 million in compliance spending for the full year 2011. As a result of these operating activities, our operating profit dropped to $3.9 million from $5.1 million in the second quarter of 2010 and again, the large driver here was the $1.1 million increase in compliance spending as well as the costs from the direct selling operations outside the United States.

As we look to our updated guidance for the second half of the year, we have tightened up our ranges on both the revenue and the EPS projections due to the first half of the year performance although our base expectations remain intact.

Specifically, in the third quarter, we are projecting a 7% to 11% top-line revenue growth at $45 million to $47 million, which factors in the softness of the U.S. joint market as well as the uplift that we get from the direct operations transition compared to the third quarter of 2010.

From an earnings guidance perspective, for the second half of the year, the key drivers to our performance will be the U.S. sales growth as well as the compliance spending that we are projecting at $2.1 million for the third and fourth quarters collectively.

From a balance sheet perspective, total inventories increased $1.9 million during the second quarter and our credit line borrowing increased $1 million during the quarter and this was largely consistent with our expectations due to the roll-out of new products as well as increased presence in a number of markets where we are direct outside the U.S. We expect inventory and credit-line increases to now moderate as we turn modestly cash-flow positive in the second half of 2011.

Looking at our accounts receivable, our accounts receivable actually decreased by $500,000 during the second quarter although our day sales outstanding on a year-to-date basis expanded from 67 to 70 and that was primarily due to the outside-the-U.S. mix where we typically have somewhat longer payment terms.

That is all of the prepared comments that I have at this time and again, thanks for joining us this morning and we look forward to your questions. Doug, we can go ahead with the questions now.

Question-and-Answer Session

Operator

Thank you, sir. (Operator Instructions) And our first question comes from the line of Jim Sidoti with Sidoti & Company. Please, go ahead.

James Sidoti – Sidoti & Company

Good morning. Can you hear me?

Bill Petty

Yes.

Joel Phillips

Yes, Jim.

James Sidoti – Sidoti & Company

Very, very good international quarter. Now, is that primarily direct sales at this point or is there still some stocking involved there?

Bill Petty

That number really does not include stocking to any significant extent. It is really, as I mentioned a moment ago, being driven by both the European market growth where we’ve made some investments in the last six quarters, as well as starting to hit our stride a little bit in Japan with hips as well with knee.

James Sidoti – Sidoti & Company

Yes. Okay. And then on the Biologics side, I know during the quarter there were some more studies that questioned I guess the initial claims or Infuse, the initial studies when Infuse was approved. Is there any – do you have the ability to use that to your advantage to help people switch over to Europe biologics?

Bill Petty

Well, Jim, we let surgeons and hospitals make those decisions. Our goal and our plan is to demonstrate the efficacy of our product, which we think stands up very well against other products, and the specific one you mentioned, much better priced to the hospital.

I’m not going to be critical of the Infuse product. I actually think it’s a product that does work. I think the issues related to there, the recent information and what’s been (inaudible) et cetera, are really related to maybe little aggressive use in certain kinds of applications.

So, again, we think our products stand up very well (inaudible) as a result and that is what we will continue to push, and as I mentioned in my opening remarks, we have a fair amount of data that demonstrates that, which is usually very powerful as you present that to surgeons and hospitals.

James Sidoti – Sidoti & Company

All right. And Jody, it sounds like you’re going to start to generate some cash, the back half of the year. I guess a few questions there. Is that a churn do you think continues going into 2012? And will the cash be used to pay down the lines?

Joel Phillips

I think the impact in the second half of this year will be relatively modest. We do kind of expect to reach the inflection point. Hopefully we’ve reached it now. As we look to 2012, I think there’s actually more of an opportunity to be more materially cash flow positive.

We have ramped up a number of significant instrument sets both with Hip and Knee, and we’re well-equipped now to support significant growth over the next six quarters. And yes, to the extent we are cash flow positive, it will be used to reduce our credit facilities.

James Sidoti – Sidoti & Company

Okay. Then just the last question, can you just give us an update on what products you’ll be releasing in the back half of this year?

Bill Petty

Sure. I’ll start with the Extremities line and just remind you that we have already launched this year the Platform Fracture Stem as well as the Proximal Humerus Fracture Plate, and now we’re following that in the second half of this year CTA Humeral Heads and a Posterior Augment Glenoid, as well as an Augmented Reverse Baseplate.

So I think really the thing there, Jim, is really we’re trying to stay ahead of the technology curve with respect to staying ahead of the competition with superior products to sustain the momentum in the Extremities line. We feel very good about this sequence and series of plus notches there. We will continue to get mileage out of our Logic Posterior Stabilized Knee, which is now in the fields in a significant way.

Then during the course of this quarter we’ll be launching the Logic Rotating Bearing Knee in the European market, and we feel good about the prospects for that. We also will begin a pilot launch or initial clinical experience with the Logic Cruciate Retaining version of the Logic system in knees.

And in Hips, we are going to be gaining use of the Revision Acetabular System during the third quarter, and then prospectively by the beginning of the Q1 of 2012 we’ll be adding line extensions both to our Crown Cup in the Acetabular side as well as the Element Hip Stem.

In Spine, we are launching the Octane PEEK Cervical Interbody System as well as the Gibrault Cervical System, and then probably in the first half of next year the Proliant Sacroiliac System. I did overlook the Proliant Pedicle Screw System, which is launching currently.

So we have a succession of three major systems that are internally developed in the Spine, which will complement the Silverbolt System, which you know we bought from VertiFlex last year.

James Sidoti – Sidoti & Company

That’s it?

Bill Petty

That’s all, Jim.

James Sidoti – Sidoti & Company

All right. So Jody, even with the launch of all these new systems, you think you’ll be cash flow positive?

Joel Phillips

Again, I want to manage expectations here. We’re expecting to reach an inflection point. We have been significantly cash flow negative in the first half of this year. I don’t think we’re going to start producing a lot of cash, but we should cease being cash flow negative in the second half of 2011 and all of these launches are factored into that projection.

James Sidoti – Sidoti & Company

Great. Thank you.

Bill Petty

Thank you, Jim.

Operator

Our next question comes from the line of Bill Plovanic, with Canaccord Genuity. Please go ahead.

William Plovanic – Canaccord Genuity

Hey, great. Thanks. Good morning.

Bill Petty

Hi, Bill.

David Petty

Morning.

William Plovanic – Canaccord Genuity

Hi, guys. Bill, on the international, it’s just with Japan I mean was it more the direct ops in Europe really drove it? And how much was the contribution from Japan? And actually, Jody, how much did FX help you out in the quarter?

Bill Petty

I’ll let David talk about the market, then I’ll talk about the FX.

David Petty

So really if you want to drill down for this to the details the big drivers in the growth were in Europe specifically the major investment we made in Spain as well as Japan. Those were the main ones.

And I’d said a moment ago that the gratifying thing about what’s happening in Japan is that we’re really moving both the Hip and the Knee line in a meaningful way. And our team is actually ahead of their own internal Knee plan year-to-date which is wonderful and doing very well on the Hip also. And of course, those are profitable markets for us so it helps the whole picture.

Bill Petty

The total FX impact for the second quarter was $1.3 million so if we look at the total growth excluding that it was 6% worldwide.

William Plovanic – Canaccord Genuity

Okay. And then, help me understand on the Biologics is it fair to say that the weakness is a domestic issue at this point?

David Petty

Absolutely, Bill. We do sell some Biologics outside the U.S. but the vast majority is the domestic sales.

William Plovanic – Canaccord Genuity

And then where – I know you don’t want to get into too much color but was Spine up sequentially?

Bill Petty

It was not up sequentially from first quarter to second but the first half was pretty strong.

William Plovanic – Canaccord Genuity

Got you. And then...

Bill Petty

And Bill, just let me make one point about that which is that for reasons related to the FDA clearance we did not launch two of the Spine products we intended to launch in the second quarter. They’re cleared now and we are launching currently.

William Plovanic – Canaccord Genuity

Okay. So it might have been just...

Bill Petty

I think just to paint that picture a little more thoroughly, I think what people need to understand about where we are with the Spine is that with those product launches that I referenced earlier, along with the Silverbolt, what that really means is that we can begin to attract a higher quality sales person or sales agent and that’s part of our strategy. And I think we do feel very good about this plan going forward.

William Plovanic – Canaccord Genuity

I think it really was a pretty good quarter and I’m sure that the decrease in biologics year-over-year is masking some of your domestic growth in your other lines.

So I’m trying to – do you feel with Biologics it’s stabilized yet? Or what do you need to get it to stabilize? And what’s really on, is this a transition to signed distribution on the Biologics? What’s really causing this drop off because I think we finally annualized some issues and it was looking like we were getting, about to get back on track, and now it’s kind of, it’s starting to go down again.

David Petty

We have annualized some issues. I think there are a couple of things that work. We were talking internally actually today about the reality of some of these biologic sales are added to procedure cross or what’s their revision, joint procedure, or a variety of other procedures.

And perhaps there’s a little bit of an economic push back happening with biologics when they’re considered accessories or additions to a standard type of surgical case. So there’s maybe an effect there though we can’t prove that.

The bottom line though, is that maybe with the excitement of things like all the shoulder launches and the new knee products and hip products and so forth that perhaps we’ve taken our eye off the ball with respect to focus in the field sales organization.

We did have a summer sales meeting with our domestic sales team two weeks ago and put a lot of effort into refocusing the team on the biologics efforts and certainly taking advantage of any market opportunities that may be out there with respect to identifying the clinical efficacy of our products as we said already on this call.

So I guess what I can say about it is we don’t accept it the way it is. And we will change whatever we need to change to get to the point where that is not holding us down but rather carrying us forward with respect to growth.

William Plovanic – Canaccord Genuity

I mean to throw it in there, if I just cut the numbers up, the math tells me that your domestic hip and knee was probably down a little year-over-year. I would assume that a lot of the biologic uses in those procedures as well. So a decrease there would spill over into a decrease for biologics.

Bill Petty

Yeah. I mean the market as you know is slightly down in hips and knees and our experience is similar to the market, maybe slightly better. And yes, to the extent that hip and knee procedures in the market in general are down, that can hold us back.

Certainly, things like adding the cell therapy or so-called PRP product to a total knee procedure, which we’ve done very effectively in the past, if we’re getting economic pressure there and procedures are down, then that’s a double effect, right? So we actually have some very specific strategies to turn that around.

William Plovanic – Canaccord Genuity

Okay. And then that leads to the last question. Not to be the dead horse, capital neutral in the back half, the major new product introductions and instrument set bills and all that are pretty much factored in, so as we go into 2012 and the new product cycles start to slow a bit, and because they’re out in that market, you’ve built instruments, we actually should see the cash flow turn positive or release their tip in the deck down.

Bill Petty

That’s accurate.

William Plovanic – Canaccord Genuity

Great. Okay. Thanks, guys.

Bill Petty

Thank you, Bill.

Operator

(Operator Instructions) Our next question is from the line of Jeff Johnson with Robert W. Baird. Please go ahead.

Jeff Johnson – Robert W. Baird

Thank you. Good morning, guys.

Bill Petty

Good morning.

Jeff Johnson – Robert W. Baird

Hey, David, I wondered if I consult with you. Just you went through the litany there of all the new products and as always a very impressive pipeline. You mentioned the ceramic or the Crown Cup anyway, what’s the status on the ceramic version there on U.S. approval? I know it was pending. I just haven’t seen anything come through.

Bill Petty

The Ceramic – this is Bill speaking, Ceramic we had was approved under a PMA and it remains approved. We are doing post-market surveillance, which is required by the FDA.

Jeff Johnson – Robert W. Baird

Okay. Maybe I misunderstood the assumption last time, Dr. Petty. I thought the Ceramic Crown Cup was pending U.S. approval.

Bill Petty

Well, right.

Jeff Johnson – Robert W. Baird

There’s got to be a buyer.

Bill Petty

So that still is pending. We did launch the Baylock-Delta-Sumrell heads earlier this year and we do have a version of the Crown Cup with ceramic outside the U.S. and you’re right. The U.S. is still pending clearance.

Jeff Johnson – Robert W. Baird

Still pending on that. Okay. No, that’s helpful. Thanks. I just wanted to update my tables there. A couple other things. David, you brought up the PRP issue and maybe some of the economic sensitivity there and I know you’ve done extremely well on the knee side with that.

How much maybe is that impacting the Biologics business or is it more on the Bone Healing side that really is the issue at this point?

David Petty

It’s both. It’s both. The DVM line is feeling some pressure and then specifically, we’ve had a few instances where the PRP used in conjunction with Solemays the surgeons got pushed back from hospitals and they actually – they stopped in a couple of instances that I’m thinking of.

Now, we do have data that we’re putting together which actually demonstrates that it’s an economic advantage to the hospital when you consider the total procedure cost, the hospital stay, transfusion rate, et cetera. And I think maybe we haven’t been as effective as we could in making those economic claims to hospital administration. And that’s one of the key points in our strategy going forward to turn it around.

Jeff Johnson – Robert W. Baird

Yeah. And where do you think, I guess, PRP use is going. You read about it a lot in the press and even in some of the journals. It seems as if there’s some big believers, there’s also some controversy on whether or not it’s beneficial. Is this – and Dr. Petty, maybe you can weigh in more on this, is it a treatment, do you think, that’s going to continue to grow in acceptance across the industry?

Bill Petty

Well, first of all, let me say I’m biased, because, as most of you know, I operate with my son one day a week. He lets me come in, so I keep my hand in surgery a little bit, and we’ve now been using PRP, actually knee, shoulders and hips for about three years now, and I can say that our experience is the differences are remarkable, both from the standpoint of early patient satisfaction, early recovery, but also the cost issue. I mean, some surgeons don’t use drainage anyway, but we no longer use drainage.

We haven’t given a transfusion and we can’t think of how long. So that’s the economic part, okay. So that’s Bill Petty’s personal opinion.

When you look at the literature, as you just described, you certainly can get mixed reviews. And I think one of the things that we’re facing is there’s PRP, there’s PRP, there’s PRP, and unfortunately, when it’s published in the literature, though they say what versions they use, they don’t always give the efficacy of the platelet concentration. And I think there’s little question that, with certain systems, you do not get adequate platelet concentration, and therefore probably make little difference or no difference.

And then you read literature where it’s well-described and they use a system which has been demonstrated to provide substantial platelet concentration, and that’s where you see the good results.

And as you know, there’s now literature both from the U.S. and from Europe that shows substantial improvements in all the parameters that I just mentioned, from my personal experience. So that’s why it’s so hard to just compare one study to the next.

Your question to me was, did I think it was going to continue to see increased usage? And my answer to that is yes. But I think we’re going to have to really understand that, our surgeons are going to have to understand, that there are differences in the systems that are out there. And if you want to use it, you need to be sure you’re using an effective system.

Jeff Johnson – Robert W. Baird

All right, great. That’s very comprehensive and helpful. Thanks. And last couple of questions I guess. I know VertiFlex got a warning letter on Silverbolt I think it was just Dynamic Stabilization. That has no impact on anything you guys own at this point, is that correct?

David Petty

That was a data disclosure from December of last year and something that was dealt with prior to our acquisition of those products. That was...

Jeff Johnson – Robert W. Baird

Okay, great.

Joel Phillips

FDA disclosure.

Jeff Johnson – Robert W. Baird

Okay. And Jody, just on the guidance side, I hear what you’re saying on knee, higher – or the $5.1 million in compliance costs and that’s partly impacting guidance. But on your x compliance cost guidance being trimmed here from a midpoint of a $1.14 to $1.10, so that’s a $0.04 trim there, what’s really impacting this cut to guidance on an x compliance cost basis?

Joel Phillips

Okay. I think you’re referencing the top end of the range. We kept pretty much the bottom end of the range intact, so our...

Jeff Johnson – Robert W. Baird

Yeah, I was looking at the midpoint, I’m sorry.

Joel Phillips

So, really the top end of the range, the reason it was just adjusted is just due to kind of where we ended up in the second quarter, being kind of the middle of the range. And with the current U.S. market trends being a little bit less than what we thought they would be at the beginning of the year, those are kind of the two variables.

Jeff Johnson – Robert W. Baird

All right. And I guess – so, if that’s – it’s not impacting your revenue guidance, but it is your earnings, so essentially your expected mix of business is just shifting a little more towards the o-U.S. stuff and away from the U.S. stuff that would be more profitable? Is that the way to think about it? So that’s why it doesn’t have a revenue impact but it does have a little bit more impact at the earnings line?

Joel Phillips

That’s correct. Again, as compared to our beginning-of-the-year guidance, we’re expecting a little bit more o-U.S. business relative to the U.S. business than what we originally expected.

Jeff Johnson – Robert W. Baird

Okay. That’s what I thought; I just wanted to make sure. And then last question for me, just conceptually, as we turn into 2012, and I know visibility for anybody in orthopedics is tough, even right now, but thinking about 2012 a second, when we think about your European business, how has it been performing I guess, if we try to exclude out the revenue benefit of just going direct as opposed to selling into your distributors?

Has your volumes – just I guess any metrics you can give us to help us think about conceptually what might happen in 2012, what’s the benefit of this kind of just the higher ASP that you’re recognizing on the P&L for those products once that’s anniversaries through at the end of the year?

Joel Phillips

I think maybe the big picture you’re looking for there is at what point do we get back to and/or above the profitability that we had in those markets as part of the transition. And I think it’s turning out that that’s basically a two year proposition and we’re probably 12 to 15 months into that now.

So while we are profitable in those markets currently, we’re not back to the levels of profitability where we were before. We have an opportunity in 2012 and we would expect to be there kind of in the 24 month window.

Jeff Johnson – Robert W. Baird

Right. All right. That’s helpful. Thanks, guys.

Joel Phillips

Thank you.

Operator

Our next question is from the line of Jim Quentin with Barrett & Company. Please go ahead.

Jim Quentin – Barrett & Company

Hi, Jody. How are you?

Joel Phillips

Good morning, Jim.

Jim Quentin – Barrett & Company

Can you hear me okay?

Joel Phillips

I can hear you great.

Jim Quentin – Barrett & Company

I just have one question today. I may not be an intelligent question but all these compliance expenses and so forth, do these ever go away or is there any time limit on it? Or what’s the story on that?

Joel Phillips

Here’s our plan. Currently our DPA is for one year. The anniversary date is December 7. During the DPA, we have had a monitor which includes five or six attorneys who review a lot of what we do spend a lot of time looking at ExacTech. In addition to that, we have had three major consultants and some other let’s say not quite as major consultants to help us in all of the policy and procedure work, record keeping work, documentation work.

So if the government ever comes calling again we have excellent records on everything that we’ve done and why we’ve done it, et cetera.

Both of those costs, we would expect to be vastly reduced or go away completely when our DPA is terminated. We will of course have ongoing compliance costs. And though we haven’t discussed it internally, my personal opinion is that once those extraordinary costs go away, we will no longer break it out and it will just be the expenses within the company.

And that means running our own compliance program, probably occasional consultants as we need them and things of that type. So do we expect the high cost to be reduced? The answer to that is yes and when that occurs, we will no longer break.

Jim Quentin – Barrett & Company

Okay. When you say yes, does that mean that will terminate or reduce by December 7, 2011?

Joel Phillips

The answer to that is yes. And I think probably not December 7, 2011 but December 31, 2011, after the fourth quarter, that will be the last time we will break them out and from then on, they will just be included in our SG&A.

Jim Quentin – Barrett & Company

Okay. Thanks very much, Jody. Great quarter. Okay. Thank you.

Joel Phillips

You’re welcome.

Operator

(Operator Instructions) And I’m sorry. No further questions in queue. I’d like to hand the call back over to management for closing remarks.

Bill Petty

Thank you, Doug. Thanks to all of you for your interest. Excellent questions today and we look forward to working hard to rewarding your interest and confidence in ExacTech. Thanks and have a great rest of the week. Bye-bye.

Operator

And ladies and gentlemen, this does conclude our conference for today. We’d like to thank you for your participation and you may now disconnect.

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