Cosi, Inc. (NASDAQ:COSI)
Q4 2015 Earnings Conference Call
March 24, 2016 5:00 PM ET
R. J. Dourney - President and Chief Executive Officer
Miguel Rossy-Donovan - Chief Financial Officer
Tony Brenner - Roth Capital Partners
Arieh Coll - Coll Capital
William Meyers - Miller Asset Management
Thomas Bundock - Ram Partners LP
Good day ladies and gentlemen, and welcome to the Cosi Fourth Quarter 2015 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will be given at that time. As a reminder, this conference is being recorded.
I would now like to hand the meeting over to R. J. Dourney, President and CEO. Please go ahead.
R. J. Dourney
Thank you, Karen. Good afternoon everyone and thank you for joining the call today. I’m here with our CFO, Miguel Rossy-Donovan, who will kick us off on the call with our regular required disclosures. Miguel?
Thank you, R. J. and good afternoon everybody. We encourage you to follow along with the PowerPoint presentation that is available at www.getcosi.com. We will begin with Slide 4 shortly. In the meantime, I’ll get yourself situated if you have not done so already, I will go ahead and go through our required disclosures.
Please be advised that during the course of today’s call management will make forward-looking statements regarding future events, including the future financial performance of the company. These forward-looking statements are made pursuant to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements involve risks and uncertainties that could cause actual results to differ materially from those projected. You are cautioned not to place undue reliance on forward-looking statements would speak only to the date of today’s call March 24, 2016.
More information about factors that may cause results to differ from the projections made in these forward-looking statements can be found in Cosi’s filings with the Securities and Exchange Commission, including its annual report on Form 10-K for the year ended December 28, 2015 and the subsequent 10-Q quarterly reports, especially in the sections titled risk factors. The company disclaims any obligation to publicly update or revise any forward-looking statements to reflect events or circumstances that occur after today’s date.
With that, let me pass it onto our President and CEO, R. J. Dourney to kick us off. R.J.?
R. J. Dourney
Great, thanks Miguel. This afternoon we’re going to walk everyone through three areas. First, we will detail the process in place to eliminate cash burn by mid 2016. The second is to review the strategy to ensure the foundation is laid for growth in 2017 and beyond, and finally how we’re going to get there. Management has implemented key initiatives, which are preserving and protecting cash. The first of these initiatives deployed at the end of 2015 reduced our G&A dollar expenditure, increased the results generated by the team, and has raised team morale and participation.
Our focus on revenues is straightforward. Increases in guest, trial as well as positive impact to the guest intent to return are linked to three areas. Speed has a competitive advantage, our continually improving quality of operations in our digital marketing strategy. Unit-level and profitability were steady gains are tied to the work of our unit-level employees.
The support center team, operations leadership, and an incentive plan remodeled after Chick Fil A. These initiatives have brought us to the inflection point where we have accelerated the trajectory of our legacy portfolio restaurants towards profitability, a trend we are continuing to see in 2016. And in our franchise system, with a legacy franchisees are profitable, the model is established and the growth pipeline is being fueled.
Moving to Slide 5, and the progress we have made reducing our cash burn shows a steady trajectory towards turning cash flow positive in 2016. We improved margins, reduced capital projects, and decreased G&A. Additionally the Cosi team did more than deploy a reduction in G&A that would help us achieve profitability. We involve the entire support center team and established a plan, where not only would each of them take on a more responsibility, but they would share in the upside.
In the past, we have shared management’s commitment to linking the success of the shareholders with our team success. Over the past few months with the support of Cosi’s Board of Directors, we have extended our incentive plan to all members of the support team where they receive restricted stock awards. Fewer people doing more, but with a lot of upside to their financial performance of the company and the value we generate for shareholders.
The team is coming up with tremendous ideas for making Cosi profitable and keeping our aspiration of becoming the best restaurant company in America in our sites, initiatives including one great idea where the operations and support center team can receive a $500 bonus for coming up with a profit-generating idea, passionate, talented people achieving more.
Slide 6 shows the trend line continuing with an increase in sales driven by traffic increases and improved operations execution continuing through period to – of 2016. But I think it’s important for us to look back before we look forward. We were on a roll coming out of 2014 into early 2015. Traffic was up, trial was up, and then we’re seeing the head of wall. We immediately dug in and identified the root causes of this issue and with discipline implemented corrective action.
During the time when we saw the decrease in traffic, we had deployed a series of initiatives that cause us to lose sight of one of our strengths, making speed, and what we call ease of use, a competitive advantage. Simply put the process should do be nothing short of pleasant for the guest every time they come to Cosi, from how and where they order to the font size on the menu boards, every step should do two things.
First, we should steer the guest towards our most craveable menu items, because here is what we know. If we can get you to try items like the signature salad or a tomato basil soup, we have you hugged.
The second is the process should be easy, so pleasant that when you walk out, you’re looking forward to your next visit. This has always been one of our competitive advantages here in Boston, and it will become a strength for Cosi system-wide.
The Cosi team has been testing our reduced menu, easier to read, that steers you to the craveable items on the menu. It is easier for the hourly employee to execute and easier to – for managers to manage. Early results of the test are showing traffic is up and costs are down, and the guests and our people are happy with the changes. With discipline, we will roll this out system-wide.
Late in 2015, the new operations leadership team came together and did a phenomenal job pushing the Hearthstone model deeper into the legacy restaurants. Operations quality continues to improve based on consumer feedback and traffic trends. The improvements are tied to great people or talented in achieving superior results. Two of our new regionals are former Hearthstone team members; Christine Anderson and Stan Lauren, who have deployed to other parts of the country and are breeding our commitment to excellence.
Others are a long time Cosi leaders like Ricardo Ruiz who are completely committed to the direction of the company and are achieving outstanding results and still others like Mike Battle are new to Cosi on our leading their teams to greatness. I couldn’t say that you a year ago, but I can now, passionate people taking a disciplined approach and relentlessly pursuing greatness.
Last year, we began a digital marketing campaign to attract new and elapsed users. The short answer to, did it work is, yes. We invited the guest back and they continue to return. The plan for 2016 is to continue the strategy as cash flow permits. It’s not a cheap date, but the results are worth the effort and expense.
Miguel will now take us through the financial performance for the fourth quarter, the full-year, and the progress we have made in making our restaurant portfolio more profitable across all quartiles. Miguel?
Thanks R. J., my pleasure and hello, everyone, again. We have a lot to cover, so let’s dive right in. For your reference, we are on Slide 7.
I’ll start with this. The financial performance of our restaurants is improving at a faster pace that it has been in the past. In fact, our restaurant portfolio generated $1.3 million more in cash in the fourth quarter, or 670 basis points more versus the same quarter last year.
I’m going to run through the restaurant’s financial performance executive summary rather quickly. So if you’re interested to dive in a bit deeper, or if you have any questions, I’m happy to do so in the Q&A.
But let’s start with sales. Company-owned net restaurant sales for the quarter of $23.6 million increased by $4.9 million, or 26.5% when compared to the same quarter last year. Now this increase was driven by four things.
First, the addition of the 13 Hearthstone restaurants in the second quarter. Second, the $1 million increase in sales from the non-comparable base. And third, a $0.1 million increase from the comp store base. These increases were then offset by a $0.6 million decrease results from closed restaurants.
R. J. talked about comp sales results earlier. So I’m not going to rehash of those, but will add additional color to period one and period two of 2016. In period one, specifically, there was an estimated unfavorable impact of weather at the end of the period, and we estimated that to be anywhere between 1.5% and 1.7%, which based on our approximations bring the normalized comp sales for the period to an approximate range of 1% to 1.2%.
In period two, we had the opposite. We experienced a favorable impact of this year’s weather versus last year. And we estimated the impact of this event to have been approximately somewhere between the range of 3.6% to 3.8%, bringing the weather adjusted number for period two to an approximate range of 1.7% to 1.9%.
One I think, I’ll say about the sales impact of the weather events. The thing that is the most encouraging to me is, when you refer back to Slide 6, which R. J. talked about, those numbers actually indicate that the trajectory that we started in – after the third quarter of 2015, continues the pace of – and the momentum continues and we continue to be at par and some types ahead of the fast-casual segment.
Okay, so let’s get back to the cost now. As you see we experienced material decreases in every category, especially in prime costs, so let me touch on those. At a high-level, cost of goods sold improved by 310 basis points, due to operational improvements and purchasing benefits realized in 2015 that were still in the process of being initiated or had not been initiated at that time in 2014.
Labor costs improved by 310 basis points as a result of initiatives implemented this year to address the management and hourly configurations of our restaurants, which was offset somewhat by the unfavorable impact of wage increase in some markets, which was mitigated by these initiatives to drive efficiencies and productivity by reconfiguring our labor.
Turning to Slide 8, the main point here is that the cash flow improvement realized in the fourth quarter 2015 made up 100% of the total improvement in fiscal 2015 versus prior year.
Let’s walk through the main drivers and variances here. Similar to the quarter, restaurant sales increased $13 million, or about 17.3%, and these are mostly driven again by the acquisition of the Hearthstone units in the second quarter of 2015. This accounted for about $3.4 million of the increase that was a $1 million favorable impact from the comp restaurant base and a $3.5 million impact from the non-comp base. And this is all offset by a decrease of $5 million from closed restaurants.
Also similar to the quarter, all cost categories improved versus the prior year, though at a slower rate than in the quarter, highlighting the sharp increase in costs in the latter part of 2014, and the efforts to correct the economic model throughout 2015, especially in the second-half of the year. Again, I’m happy to discuss any questions that you may have during the Q&A.
But in the meantime, let’s move onto Slide 9. Okay, so in Slide 9, I want to here unpack a little bit more for you how these improvements that I just talked about at a high-level in financial performance in our restaurant portfolio has played out in the four quartiles within our portfolio.
Let’s start with taking a look at what transpired as we compare each quarter in 2015 by quartile to the same quarter last year. The bottom line here is first that we realized significant improvements in the third quarter across the first, second, and third quartiles.
Second, here is another side of the inflection point we keep talking about. All quartiles improved materially in the fourth quarter when compared to last year. This is led by the fourth quartile where we committed to aggressively reduce the historical cash burn and by the second quartile where we committed to keep moving them towards more profitable levels.
Third, the third quartile has improved their cash flows versus last year every quarter in 2015. And finally, these improvements are accelerating in 2016 for all the quartiles.
More importantly as R. J. mentioned earlier, we reached an inflection point in the fourth quarter and we have changed the trajectory of all quartiles towards profitability with improvements across the Board in each quartile. That combined with the fact that these improvements versus prior year accelerated in 2016, gives us the confidence of the turnaround that’s happening.
Okay, so let’s turn to Slide 10, where we will quickly review the improvements in financial performance across the four quartiles now sequentially quarter-over-quarter in 2015. The main and very encouraging point here is that, we have also seen a positive improvement, improving trend quarter-over-quarter since the second quarter of 2015 across the portfolio.
In particular, I’d like to point your attention to the fourth quartile, which represents our most and profitable restaurants. And I also want to point you back to the remarks we made during the third quarter earnings call, the last time we were together. At that call, we stated our commitment to address this group of restaurants urgently and aggressively by either number one, moving them towards profitability fast, or number two, exiting some of them. We moved quickly on both fronts.
First, we identified the economic model corrections that needed to be aggressively implemented and we did and we are continuing to do that. In fact, most of the reason we are seeing the rapid improvement in the fourth quartile is, because we acted with urgency and the units responded, and I want to stress that the units responded.
Second, we identified the pool of restaurants that we should exit and we have been doing that. We closed two. Two more will close within the next 45 days, and we expect to close four to five more by year-end. We have been actively negotiating with landlords and in some cases with third parties, who might acquire the locations. However, it is taken a bit longer than we had originally anticipated.
We are going to be disciplined and we are going to make sure that there is no adverse impact of costs and our ability to move forward, especially given the movement we are seeing across the quartile, a lot of these units are responding. When you consider the improvement in this quartile versus where they were in the first quarter, they have reduced their cash burn by 1,000 basis points and by 510 basis points in the fourth quarter alone.
Now, let’s be transparent and look at the Hearthstone and – the Hearthstone portfolio and the top two quartiles. As you can see in the table, the first quartile continues to generate respectable cash flows. The second quartile turned positive earlier in the year and is maintaining profitable level. And the Hearthstone restaurants continue to produce the strongest results. However, the performance across all three took a slight step back from where they were in the third quarter after having had two straight quarters of improving trends.
There are three reasons behind this, none of which are cost management issues. First, Hearthstone quartile one and quartile two restaurants carried most of the burden on cost of goods sold related to the impact of discounts from promotions launched in the fourth quarter to invite new guests into our restaurants.
Second, these promotions also had an unfavorable impact on other operating costs in these quartiles, where the expenses booked. Promotions also impacted, sorry, in addition to that second in some instances we invested in training and development for managers to strengthen the bench in our strongest quartiles.
And third, restaurants in these quartiles also carried a heavier load of management development initiatives related to ensuring that as we grow that strength of the management teams and the hourly employees, we absolutely secure that we’re investing in our staff’s ability to continue on their own increasing the velocity of the improvements going forward, as opposed to doing that when they’re under the microscope. So we feel that all of these three investments were very positive and we’re seeing the benefits in 2016. I assure you that we are safeguarding our best assets, as we aggressively improve those that have underperformed.
Every Monday without fail, Willy Nicolini, our VP of Operations, the Regional Directors and I meet for as long as it takes to review every units P&L. We start by taking – by talking about how to make our strong units stronger? How to transfer those winning standards to our biggest opportunity restaurants? And then create actionable plans to improve those underperformers. We are focused on developing our people, so that the wins we achieve, as I said earlier can be sustained when not under the microscope, that’s very important.
Finally, we’ve created a – an environment where managers are empowered to think like owners. With this in mind, we created, tested, and have now implemented a profit-sharing plan for our managers system-wide. Now, R. J. spoke about that earlier, but it’s also relevant here. It’s changing our culture. It’s driving results, and it’s life-changing for managers.
Finally, I want to point your attention to Slides 11 and 12, where we have outlined the non-GAAP reconciliation for both the quarter and for the full-year. There are two things I want to focus on here very quickly.
First, G&A. We entered – we ended the year 2015 at $12 million versus $12.4 million last year. However, on a cash basis, we spent $10.6 million in G&A related uses of cash. As R. J. mentioned, we restructured our support systems and functions and entered 2016 with a $2.6 million savings versus cash uses in 2015.
Second, I want to point your attention to the asset impairment charges of $1.4 million related to stores that we expect to close, or are considering closing as a result of our portfolio profitability initiatives.
Third, in the fourth quarter, we also realized the benefit of $1.5 million in taxes. This was the result of getting partial release of our valuation allowance as a result of the benefit of Hearthstone’s deferred tax liability, post acquisition, which allowed us to realize the benefit due to goodwill.
Okay. So with that let me hand it back to R. J. and keep this going. R. J.?
R. J. Dourney
Great. Thanks, Miguel. Everyone should be getting the picture. The team is in place and the plan is causing us to realize improvement. The trajectory continues on a path we need to see in order for Cosi to turn cash flow positive in mid-2016. We do not need to make staggering gains at the unit level to turn cash flow positive, rather keep the trajectory going as it is currently.
Going to Slide 13 and our 2016 strategic focus, we have now spoken about generating cash and increasing transactions. Growing the franchise business begins with our franchisees being profitable. This has been an intense focus of the Cosi team over the past year and the legacy franchisees profitability is happening. Can a new or existing franchisee generate the same four-wall cash flow and return on investment, as Hearthstone or the Costa Rican franchisee, they can, and it’s our job to show them how.
Step two, is our financial help. Great franchisees have the right to expect us to have be on solid financial footing.
Step three is ensuring the right partners join us. We announced a few weeks ago, the signing of the development agreement in Panama with our Costa Rica franchise partner. Refranchising some of our company restaurants is a tool we will use to help great franchise partners join our system. We continue to meet with three groups with this goal in mind and I expect at least one agreement this year.
Aramark, Sodexo encompasses URS division of franchisees with Cosi now and all have units open. We have just approved another unit with Sodexo. We have what they need, a great concept for their clients and a model that makes money. This foundation of 12 plus franchisees healthy and growing will be in place in 2016. Our culture is truly the Bedrock out of what makes us successful. So we’re clear this means attracting, developing, and retaining a superior team that achieve great results and live our values. This team aspires to be the best restaurant company in America.
We’re accomplishing this by treating our people with respect, stretching them to grow and actively developing them. But there are two sides to our culture that need to be understood. Yes, we are passionate about creating a positive environment for our people encouraging them. But this comes with an expectation that we be the best. We aspire to be the best in the industry and this passion and commitment will help set us apart.
No secret that Cosi struggled in New York City, while we had some great real estate, we had not operated at a high level and we were losing money in the market. Led by Willy Nicolini, our VP of Operations and Christine Anderson, we changed the culture in New York and the results have been impressive, marketing did their part and the profit sharing plan was tested here. Now six months later, Cosi in New York is rivaling Boston for top box performance. This is become a case study internally for where this can go.
Last point before we move to Q&A. This has been a turnaround story. And like with any successful turnaround story, we have had to make adjustments to the plan. We do it with discipline and without concern for staying a course simply, because we said something. We adjust and move forward in the best interest of our shareholders, and our people. This is a strong team intensely driven for results.
Operator, please open this up to questions.
[Operator Instructions] Our first question comes from the line of Tony Brenner from Roth Capital Partners.
Thank you. A couple of questions, I just like to be clear on what to expect from your G&A expense as reported it was just under $12 million in 2015, so the cash amount was…
R. J. Dourney
$7 million, $8 million – we’re expecting $7 million, $8 million.
It was somewhat close and you indicate that the run rate is $2.5 million less than that, so and projecting for 2016. Is it reasonable to expect versus that $12 billion also at least $2.5 million less since for the full-year, is that…?
R. J. Dourney
Yes, Tony, how are you? Yes, a good question, I should have made that clear. At the third quarter earnings call, we stated a goal to drive the 2016 G&A costs down to anywhere between $7.5 million and $8 million. We actually were able to reduce those costs and have already done so, by $7.8 – $27.8 million. So we basically have given the cash…
That’s cash, that’s not – you’re reporting G&A, right?
R. J. Dourney
That’s right. The next step is you add to that the non-cash, which we approximate to be about $1.3 million.
Okay. Second, question…?
R. J. Dourney
In the release R. J. it implies that the franchise system will grow in 2017, I think earlier it had been suggested that existing franchisees would open at least eight new restaurants this year 2016, is that no longer expected?
R. J. Dourney
No Tony, it’s still the case. The legacy – we haven’t changed our 2016 guidance on franchise growth.
And the two stores that are about to close or both lease terminations?
R. J. Dourney
Could you on the other side, you expect to close during the year? Could you talk a little bit about what impact that will have on your quartile performance? Just how much of a drag those four, five stores actually were?
R. J. Dourney
Yes, I don’t think we want to give anymore guidance, Tony, other than they are drain. And while, Miguel, went through the four quartiles and talked about the list that we’re seeing, we’re adjusting them in a case-by-case basis, but that’s all the guidance we’ll provide right now. Thanks.
Okay. Thank you.
R. J. Dourney
Thank you. And our next question comes from the line of Arieh Coll from Coll Capital.
Hi, good afternoon, gentlemen. I’m glad to see that your hard work is showing tangible results and wish you the best luck going forward.
R. J. Dourney
Thanks, Arieh. Thank you.
Regarding your menu, can you clarify as to in the test you had, how many sandwiches and salad are being reduced or eliminated in the menu from a number of, let’s say, 40 down to 30? And as a result of that what sort of impact in same-store sales have you had in the test stores?
R. J. Dourney
Yes. So, Arieh, in total we’ve reduced that menu by about 20%. The melt category has gone, and we’ve additionally removed a handful of other items. I will tell you that we’re happy with the comps that we’re seeing in these restaurants. They’re above the rest of the market. But I’d tell you, it’s still pretty early for us to start during in our particular number, but the numbers are healthy.
Okay, great. Thank you.
R. J. Dourney
Thank you, Arieh.
Thank you. And our next question comes from the line of William Meyers from Miller Asset Management.
Hey, thanks. Could you tell me, if the new chips credit card systems have been installed in all your restaurants?
R. J. Dourney
Pardon me, can you repeat the question please?
Yes. The credit card systems that now have the higher security, because their chips in the credit cards, are you now equipped to handle all of that in all the restaurants?
R. J. Dourney
No, we are not.
Okay. Then do you have a plan that you can share with us?
R. J. Dourney
I can share a specific plan, but I can tell you that we’re evaluating it and we’re still in the same camp as others, where we’re evaluating how much that might slow down the transactions and dispute initiatives that we have in our restaurants. So that’s all I can say at this point.
That’s fine. And then my other question was, you talked about improved digital marketing. Could you talk about the kind of model you’re using in your digital marketing? Is that a Groupon type model or some other model?
R. J. Dourney
No, no. It’s a good question. So here is the good news. Our consumer base is millennial, they’re Internet savvy. And so a lot of the ways that they participate in social media is – it’s the evolution that we’re seeing in digital marketing. So we have a way of replicating our core base of users based around our Cosi card users that replicates their image and then we’re able to go into a trade area, for instance, where we have a restaurant and push digital marketing to people that look like our users in that particular trade area. So it’s a little – it’s very driven on targeted marketing to demographic and psychographic specifics and it’s working.
R. J. Dourney
Yes. Thank you.
Thank you. [Operator Instructions] Our next question comes the line of from of Thomas Bundock from RAM Partners.
Hi. How are you to-night?
R. J. Dourney
Good to see some progress.
Thank you. Thank you, Thomas.
I’m curious as to whether you track the loyalty program that you have – the Cosi card in the different quartiles, in other words, there – if I look at the Slide 9, I see a dramatic difference between the quartile, the AUV and the third quartile and the Hearthstone and the third and fourth quartile. So I’m wondering is there – have you looked at the degree to which people participate user Cosi card in the first quartile versus the third and fourth quartile for example…?
R. J. Dourney
Have you measured that in anyway?
R. J. Dourney
Yes, Thomas, that’s a great question. So we get pretty granular with this information. So we’re looking at it from – everything from the number of cards that are activated to the loyalty level of those participants, and how that relates to the quartiles in that each of those restaurants falls into.
We have another vehicle that we use as well for gathering data, but absolutely and that then ties back and it’s fed back to our operations team, so that they can address issues, because it’s exactly what you would think. The restaurant that has higher initiation of Cosi cards, higher use and more loyal guests, those of the restaurants that are more profitable and are running at higher average unit volumes, you’re right.
R. J. Dourney
Thank you. And we also have a follow-up from the line of Arieh Coll from Coll Capital.
R. J. Dourney
Regarding the Chick-Fil-A profit sharing arrangement you might not be comfortable giving exact details, but can you give just embellish a little more about what kind of incentives there are and what I’m trying to understand is what sort of change in behavior you’ve seen specifically in terms of employees being proactive, retention being better and maybe be even easier to hire new hourly employees?
Thank you. This is a great question. I’ll be happy to take that on. So essentially the plan is grounded on the concept of flowing through incremental sales, it’s ambitious, it’s balanced and it’s self-funded. And we tested in the New York City back in October and we were able to see an incredible return immediately both in terms of the movement and the progress that R. J. talked about earlier, but also in terms of what you mentioned in terms of the culture, and motivation, and involvement.
We’ve rolled that out, we saw that almost immediately. I think that there were two reasons for that, people have heard about the New York test and they were excited about it. And then when it was rolled out, they actually felt the empowerment. And the most amazing thing happened that in my opinion, they actually were – literally my phone was ringing off the hook with them wanting to get trained, with them wanting to understand all of the ins and outs of the P&L, with them wanting to challenge where costs are coming from. And honestly as a CFO and for my team in financial and partnership with operations that was the second most incredible outcome besides the fact that there were just jazzed about it.
Okay, great. And what’s the timeline or rolling this out to the rest of the chain?
It’s been rolled out.
Oh! it has, so it’s been in place since when?
We rolled that out at the beginning of the year.
Okay, great. Thank you and best of luck with that.
Thank you. And that concludes our question-and-answer session for today. I would like to turn the conference back over to Cosi management for any additional comments.
R. J. Dourney
Thanks, Karen. Cosi management is focused on eliminating cash burn by mid-2016. We provided you with a review of the strategy to ensure, we have laid the foundation for growth into 2017 and beyond. And finally we shared with you the details of how we’re going to get there.
Thank you for your time today. And more importantly, thank you for sticking with us during the challenges of the past and we really look forward to talking to you on our Q1 call. Thanks.
Thank you. Ladies and gentlemen, thank you for your participation in today’s conference. This does conclude the program. And you may now disconnect. Everyone have a good day.
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