Government Properties Income Trust (GOV) on Q2 2016 Results - Earnings Call Transcript

| About: Government Properties (GOV)

Government Properties Income Trust (NYSE:GOV)

Q2 2016 Earnings Conference Call

July 28, 2016 11:00 AM ET

Executives

Christopher Ranjitkar - Director, IR

David Blackman - President and COO

Mark Kleifges - Treasurer and CFO

Analysts

Michael Carroll - RBC Capital Markets

Bryan Maher - FBR Capital Markets

Jamie Feldman - Bank of America Merrill Lynch

Operator

Good morning and welcome to Government Properties Income Trust Second Quarter Financial Results Conference Call. This call is being recorded. All participants will be in listen-only mode. [Operator Instructions] At this time for opening remarks and introductions, I would like to turn the call over to the Director of Investor Relations, Mr. Christopher Ranjitkar.

Christopher Ranjitkar

Thank you and good morning, everyone. Joining me on today's call are President, David Blackman; and Chief Financial Officer, Mark Kleifges. They will provide insight about our recent accomplishments and results for the second quarter. They will then take your questions.

First, please note that a transcription, recording and retransmission of today's conference call are prohibited without the prior written consent of the company. Also today's conference call contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 and other Securities Laws. These forward-looking statements are based on GOV's present beliefs and expectations as of today, July 28, 2016.

The company undertakes no obligation to revise or publicly release the results of any revision to the forward-looking statements made in today's conference call, other than through filings with the Securities and Exchange Commission, or SEC, regarding this reporting period. Additional information concerning factors that could cause those differences is contained in our filings with the SEC, which can be accessed from the SEC's website or the investor section of our website at govreit.com. Investors are cautioned not to place undue reliance upon any forward-looking statements.

And finally, we will be discussing non-GAAP financial metrics during this call, including normalized funds from operations, or normalized FFO. A reconciliation of these non-GAAP figures to net income and the components to calculate cash available for distribution, or CAD, are available in our supplemental operating and financial data package, which again can be found on our website.

Now I will turn the call over to David Blackman to begin our quarterly discussion. David?

David Blackman

Thank you, Christopher. Driven by continued strong leasing activity, Government Properties Income Trust announced solid second-quarter results today. We increased both normalized FFO per share and cash basis NOI while also maintaining high occupancy across our portfolio. As of June 30, GOV owned 72 properties in continuing operations, containing 11 million square feet that were located in 31 states in the District of Columbia. At quarter end, consolidated occupancy was 94.2% and same-property occupancy was 94.4%.

GOV's weighted average lease term, based upon annualized rent was five years as of June 30. The U.S. government remains our largest tenant and, in aggregate, our government tenants contributed 92.7% of our annualized rent at quarter end. Consistent with trends from recent quarters, we remain active in leasing during the second quarter, dominated by lease renewals with government tenants. Consolidated leases totaled more than 566,000 square feet for a weighted average lease term of 10.1 years, a 4.4% average roll-up in rent, and leasing capital commitments of $1.96 per square foot per lease year.

Most of the square footage leased during the quarter was with government tenants, which included four executed leases for approximately 515,000 square feet that resulted in a 4.7% average roll-up in rent, a weighted average lease term of 10.7 years, and leasing capital commitments of $1.92 per square foot per lease year. While most of our government leasing this quarter was with state governments, we remain encouraged that our dialogue with the U.S. government continues to be for longer dated lease extensions. As in past quarters, we continue to engage tenants in early renewal discussions to get ahead of future lease expirations.

As an example, we entered a 292,000 lease renewal this quarter with the Georgia Department of Transportation that was a 2019 lease expiration. The lease was extended 10 years beyond its natural expiration date for a 13.2 year new lease term. We also rolled up rent 12.4%, and our leasing capital commitment was $1.86 per square foot per lease year.

Moving on to our capital recycling and investment activity, as previously disclosed, our property in Falls Church, Virginia, remains under agreement to sell. The contract price is $13 million, excluding closing costs. During the quarter, the buyer concluded its due diligence and now has its earnest money deposit at risk. Closing remains subject to obtaining certain zoning entitlements and is still expected to occur no later than the first quarter of 2017.

Last week, we sold our 35,000 square feet office property in Savannah, Georgia, for $4 million. In connection with the sale, GOV provided $3.6 million in seller financing. As of today, we do not have any other properties marketed for sale, but continue to evaluate the portfolio in an effort to identify additional dispositions. We also continue to evaluate potential acquisition opportunities for buildings that are majority leased to government tenants. Potential acquisitions tend to be suburban office properties located in markets where GOV already has a presence. Although we do not have any potential acquisitions under agreement today we maintain an active pipeline and are reasonably confident that GOV will win its fair share of opportunities over time.

As with past earnings calls we will continue to provide insight into our expiring leases for the next 24 months. As of June 30, we have leases contributing approximately 24.5% of GOV's annualized rent and covering approximately 2.2 million square feet that are subject to expiration. Based on our latest tenant discussions we currently expect tenants contributing 1.23% of annualized rent to vacate during the next 24 months. This compares to 1.85% of annualized rent categorized as to vacate the previous quarter.

Reconciling the two quarters, tenants contributing 79 basis points of annualized rent vacated properties during the first quarter, as expected, while we added three new tenants contributing 9 basis points of annualized rent to the list this quarter. Note that the math is not perfectly reconciled due to a change in our aggregate annualized rent from the end of the first quarter to the end of the second quarter.

The tenants we have identified to be at risk of downsizing or vacating increased from 3.43% last quarter to 3.51% this quarter. The new at-risk tenants include two nongovernment firms that occupy less than 5,000 square feet in the aggregate. Other than these two immaterial additions, our at-risk list has not changed from the prior quarter. As a reminder, these figures are the best information we have available today based upon our dialogue with tenants. As negotiation with our tenants evolve we expect our disclosures to evolve as well.

Similar to our tenant retention rate, which we believe will remain above the tenant retention rate for our suburban office peers, we believe the level of insight that we are providing about our lease expiration schedule demonstrates best-in-class disclosure practices. Both tenant retention and attracting new tenants to our buildings remain significant areas of focus for GOV, which is underscored once again by our robust leasing results this quarter.

I will now turn the call over to Mark Kleifges to provide more detail on our financial results.

Mark Kleifges

Thanks, David. I will begin with a review of our property level performance for the second quarter of 2016. When compared to the second quarter last year, GOV's rental income grew by approximately $1.9 million to $64.1 million. On a same-property basis, our second-quarter GAAP rental income declined by $193,000 year-over-year to $61.9 million, and same-property cash rental income increased $1.1 million year-over-year to $62 million.

Consolidated quarter net operating income, or NOI, increased by $1.3 million or 3.4% year-over-year to $39.6 million. Consolidated cash basis NOI for the second quarter increased by $2.4 million or 6.6% to approximately $39.4 million. Our consolidated GAAP and cash NOI margins for the 2016 second quarter were 61.7% and 61.6%, respectively.

From a same-property perspective, our GAAP NOI declined slightly by $111,000 or 0.3% year-over-year to $38.2 million, while our cash basis NOI increased by $1.1 million or 3% to $38.2 million. Our same-property GAAP NOI margin was 61.7% and our same-property cash basis NOI margin was 61.6% for the 2016 second quarter. Normalized FFO for the second quarter was $43.4 million, which is up from $42.4 million for the 2015 second quarter. Normalized FFO per share for the 2016 second quarter was $0.61, an increase of $0.01 or 1.7% from the 2015 second quarter.

Adjusted EBITDA was $48.9 million for the 2016 second quarter. It includes approximately $12.5 million of cash distributions received from our SIR investment. We paid a $0.43 per share dividend to shareholders during the second quarter, which equates to a normalized FFO payout ratio of approximately 70.5%. We spent $2.6 million on recurring building improvements and $7.7 million on tenant improvements and leasing costs in the 2016 second quarter. As of quarter end we had approximately $23.9 million of unspent leasing-related capital commitments and, as a result, we expect our TI and leasing commission spend to remain at these higher levels for the remainder of 2016.

Turning to our balance sheet and liquidity, our adjusted EBITDA-to-interest expense ratio for the quarter remained strong at 4.7 times, and total debt-to-gross book value of our real estate and the market value of our SIR investment was 46.1% at June 30. During the quarter, we issued $310 million of 30-year senior unsecured notes at an interest rate of 5.125%. We used the net proceeds of the issuance to repay all amounts outstanding under our $750 million revolving credit facility.

Operator, that concludes our prepared remarks. We would like to open the call up for questions, please.

Question-and-Answer Session

Operator

[Operator Instructions] The first question comes from Michael Carroll with RBC Capital Markets. Please go ahead.

Michael Carroll

David, can you give us some color on the two pending asset sales? And was there a reduction in the contract price on those sales? And why was there a reduction there?

David Blackman

Sure. Yes, let's start with the Falls Church, Virginia property, which is under agreement for $13 million. We did reduce the price on that as a condition of the buyer concluding its due diligence. They found certain things in their diligence process that required them to need to reduce price in order to maintain their return. And as you know, we've been -- this is our third buyer on this particular property. So we thought if we could get a higher amount of earnest money deposit at risk that it would be worth reducing the price in order to have the money at risk. So we agreed to that.

On the Savannah property, we also had a small reduction in the purchase price -- or the sale price on that asset. Again, it was a diligence finding from the potential buyer. We actually considered letting that property fall out of contract and remarketing the asset. But when we went back and reassessed who the potential buyers were for that property, all of them were going to redevelop asset into a hotel. And since we started the marketing process on this property, about 2,500 new hotel rooms had been announced in Savannah. So we thought we would probably not achieve a higher price by going back to market. The buyer had concluded its due diligence and was prepared to close. So we thought the right thing to do was to accept the lower price and move forward with the sale.

Michael Carroll

Okay, great. Thanks for the color. And then, Mark, with regard to the committed but unspent leasing costs right now that you mention in your prepared remarks, are there any specific leases that these costs pertain to? And how long will it take to deploy that capital?

Mark Kleifges

The $23.9 million that I mentioned in my prepared remarks really relates to the majority of the leases that we've entered into over the last, say, 1.5 year, 2 years. In terms of how that money is going to be -- the timing of actually spending those commitment dollars, we don't have complete control over that. Our tenants have some control, but our current estimate is that between $11 million and $13 million of those commitments will be spent during the remainder of 2016.

Michael Carroll

And is it fair to assume that TIs and LCs will trend higher in 2017 also?

Mark Kleifges

Well, we have -- we've got another, I think -- if you look at the rest of this year, we've got a little over 0.5 million square feet expiring the remainder of this year. So there will be some costs associated with that, the majority of which I would think will be incurred in 2017. And then we've got additional expirations next year. So I think -- I don't know if I would say they trend higher than this year, but they will be on the higher side of where we've been historically.

Michael Carroll

Okay, great. And then last question, I know this isn't an issue for 2016, but in 2017, it looks like GOV might need to pay an incentive fee to the external manager. How should we think about that's going to be recorded on the P&L? Will that be amortized throughout the year? And will that be included in your normalized FFO calculation?

Mark Kleifges

Yes, the way our thinking has evolved around how we will handle an incentive fee, if there is one, is we will measure the incentive fee at the end of each quarter and record a proportional amount of the estimated fee in that quarter's G&A expense. When it comes to calculating normalized FFO, what we would do is we would add back that expense that's in G&A during the first three quarters of the year, and then include the actual expense amount in the fourth quarter when one, we know if any fee is actually due for the year and we will be able to calculate what the fee is. And the reason we've decided to take that approach is just due to the volatility in that expense amount throughout the year. It just would make our normalized FFO number somewhat meaningless and non-comparative between quarters.

Michael Carroll

Okay, great. Thank you.

Mark Kleifges

Yes.

Operator

[Operator Instructions] Our next question comes from Bryan Maher with FBR & Company.

Bryan Maher

Good morning, guys.

David Blackman

Good morning.

Bryan Maher

Can you give us a little bit of an update on the acquisition environment, and particularly as it relates to pricing that you're seeing, and what the depth of the pipeline is that you are looking at? I know you don't have anything under contract at the moment. But can you give us a six to 12 month view of what you are seeing out there?

David Blackman

Sure, Bryan. This is David. We have probably six or seven potential opportunities in the pipeline today. I would say they are a little more heavily weighted towards states' leased buildings than they are federal leased buildings. Probably in aggregate, it's probably $150 million, $175 million in total value. Cap rates would range anywhere -- and this would be the kind of acquisition cap rate that we disclosed. They are going to range anywhere from, call it a 7% cap rate to maybe a 9% cap rate, depending upon whether it's a state or federal lease deal and what the average remaining lease term is.

We think that there are a couple of deals in that pipeline that we've got a pretty good chance of being competitive on. But there clearly are some in the pipeline that don't work for our current pricing expectations and we will probably pass on those. But it's a decent pipeline of opportunities to look at today.

Bryan Maher

That's really helpful. And then, look, I have read some of my competitors' reports on you guys, and it seems like there is some question out there related to GOV's ability via RMR to re-lease certain space that comes available, which having covered many of the RMR entities and RMR itself, and knowing your 30 year track record, I just really find that questioning to be somewhat unreasonable. Can you give maybe the listeners some color as to the back story of RMR and its 30 year history of successfully re-leasing assets? I think that would be really helpful to many on the buy side. Thanks.

David Blackman

Sure. Let me make sure I understand the question, Bryan. You want us to give some color on our ability to lease assets as leases expire or we have vacant space. Is that correct?

Bryan Maher

That's correct. Just because of stuff that I've read related to some people questioning your ability to keep these occupancies at the level they've consistently been at.

David Blackman

Sure. It's a good question and I appreciate the opportunity to provide some color. I guess there is several different ways to look at that. I think, one, and let's just talk about GOV particularly, if you look at our occupancy historically over the last three or four years, we've maintained a pretty high occupancy. This company's occupancy has never dipped below 90%. We have bumped around 94% to 96% for the last several years, and we have had -- we routinely have 7% to 15% of our revenue expiring in any one year. So, we wouldn't be able to obviously maintain high occupancy like that if we didn't consistently renew leases or bring new tenants to place.

I think, again, speaking specifically about GOV, we've had some relatively large vacancies across the portfolio that we have re-leased in a relatively short amount of time period. One example would be our property in Rockville Pike that the FDA moved out of. That was about 110,000 square feet of vacancy in what is somewhat of a weak market. And within a year, we were able to backfill 100% of that space with another government tenant and we think we will probably be able to grow that tenant in the building, and they will ultimately end up taking more space than what the FDA occupied.

A second example would be a building we own in Atlanta, Georgia, in Executive Park that the CDC occupies, and they vacated. And within about 12 months, we were able to backfill that building 100% with Emory University. The other -- in some of these cases, the FDA is an example, we have lost tenants due to them outgrowing our buildings and us not being able to accommodate their growth. So, that's one of the reasons where we've had some vacancies.

But we routinely across the RMR companies, we are leasing 1 million square feet of space a quarter. We have very good relationships with brokers across the country. And I think when you look at senior housing properties, trusts, select income REIT and GOV on a combined basis, all of our companies have done a good job of maintaining high occupancies. So I don't know, did that help answer your question, Bryan?

Bryan Maher

Yes, it does. I just want to grasp how big RMR is and how you have 400 professionals who are pretty much all the time leasing up buildings. So I think that anything out there on you might have some short-term vacancies is a bit hard to stomach. That's all.

David Blackman

Yes, I appreciate that comment.

Bryan Maher

Thanks.

Operator

The next question is from Sumit Sharma with Morgan Stanley. Please go ahead.

Unidentified Analyst

This is Vikram with Sumit. David, can you maybe just give a sense of the relative acquisition opportunities, how competitive you are, pricing, et cetera? And maybe just from an accretion standpoint, compare and contrast between Select Income, GOV, etc., since you manage the broader acquisitions for the RMR group?

David Blackman

Sure. As I said, we have a pretty decent pipeline of potential opportunities today. It's six or seven potential opportunities; $150 million, $175 million in value; relatively broad range of cap rates, probably from around a 7% to maybe as high as a 9%. I think today what we are looking to acquire at GOV would be buildings that give us an acquisition yield at 8% or maybe above, where we have -- it's a stabilized building that doesn't have any near-term lease expirations, and buildings where there is not a tremendous amount of building capital.

So what we are trying to find are buildings that are accretive, both on an FFO and an AFFO basis. And we think we can do that, that 8% to 9% range, and provide a good spread over our weighted average cost of capital.

The government lease market tends to be a more narrow leasing market -- or, excuse me, not leasing, I'm sorry. The acquisition market tends to be more narrow than what you would find for Select Income REIT. Just simply there are less buildings on the market to buy that are majority leased to government tenants. From a Select perspective, Select has maybe a slightly lower weighted average cost of capital today, has the ability to buy assets on an accretive basis anywhere from maybe 7.5 and above. But there is a pretty good pipeline of potential opportunities that are suburban office, strategic to tenants, with long weighted average lease durations or industrial buildings.

You sometimes have to look at a number of deals before you find one that is within the pricing range that makes sense for your cost of capital, but they are out there. And I think our perspective is it's more important to be patient and buy the right buildings than to rush and try to grow the companies.

Unidentified Analyst

Okay. And just on your prior comment about maintaining occupancy through a long time frame or through the cycle in a relatively narrow band, just going forward, it seems like your same-store cash NOI trajectory has improved over the last few quarters. Can you just maybe look out, given some of the leasing comments and what you are seeing out there over the next 2 to 3 years, what are your expectations? Do you think this 3% range is sustainable from here on?

David Blackman

Let me make sure I understand the question. As we look out two to three years, do we think we will continue to be able to grow same-property cash NOI and maintain high occupancy?

Unidentified Analyst

Yes. I mean just on cash NOI specifically, because it's obviously -- if I look back the last five quarters, there have been several periods where it has been negative. And the last two quarters it has ramped up towards 3%. So I am just looking out, given mark to market, the opportunities you are working on the leasing front, I am just trying to get a sense of how you view the trajectory of cash NOI.

David Blackman

It's very difficult to provide great color out two or three years. I think what I would do is maybe point to the headwinds with the U.S. government that we have been dealing with over the last really three years. If you go back and look, there have not been approved budgets. The U.S. government has been doing short lease renewals, and just simply kicking the can down the road. We are getting to a point where the U.S. government is now more focused on long-dated lease renewals, which we find very positive.

We think we will have approved budgets going forward, which will allow the agencies to create longer-dated housing plans. And we should be able to grow the weighted average remaining lease term across our portfolio. We think that's very positive in that the longer our weighted average lease term, the less average lease expirations we will have in any one given quarter, which will allow us to better spread out our leasing capital.

We also think that, as we look at leasing spreads, just like this quarter where we had 4.4% average roll-up in rent, we should be able to continue to have flat to maybe slightly up increases in rent. It really depends on the economy and whether it continues to remain a more landlord-friendly leasing environment than a tenant-friendly leasing environment.

Unidentified Analyst

Okay. Thank you.

Operator

The next question is from Jamie Feldman with Bank of America. Please go ahead.

Jamie Feldman

Thanks. So the move out there 1.23%, can you talk about your leasing prospects to backfill that space?

David Blackman

Yes, Jamie, let me take a look at the list real quick. And some of these are a little bit far out. And maybe the way to look at this is more on what are some of the larger blocks of space. Because what we have in most of these, we have relatively -- we have -- a lot of these are -- well, all of these are actually less than 1% of rents, so it's a lot of smaller spaces. Probably our largest space is a 38,000 square foot bay in Buffalo, New York. And that is a fourth quarter move-out. So, we have -- we've ramped up our leasing efforts on that. There are a handful of prospective tenants in that market that we are beginning to have dialogue with.

We have hired both government leasing brokers as well as nongovernment leasing brokers to give us the best opportunity to find tenants. And I think our building is reasonably well-positioned in that market to be successful. It may take us 12 months to find the right tenant. It may take us 12 months to find two or three tenants to replace that one tenant. But we think that we are doing the right things in terms of making the space presentable and providing brokers adequate incentive to show the space, and that that will help us be successful. So, we are optimistic that we have pretty good prospects to backfill this space. And I would say that's across all of our potential move-outs across the portfolio.

Jamie Feldman

And this is -- the number you gave is over the next 24 months?

David Blackman

It's the next 24 months, yes.

Jamie Feldman

Okay. And then would you say a year downtime sounds about right for most of those spaces, just like the Buffalo space?

David Blackman

I think some can be long time [ph]. Yes, I will give you an example. We have -- if I look at the size of the square footage of our tenants vacating over the next 24 months, we've got a lot of spaces that are 1,600 square feet, less than 1,000 square feet, 3,000 to 4,000 square feet. Those types of spaces really shouldn't take as long to lease, because you don't have to find large tenants. Of the 130,000 square feet of space the vacates represent, we have one 38,000 square foot space, a 40,000 square foot space, and a 20,000 square foot space. So those are the ones that will take a little bit longer to lease. In some cases we might be able to do it in less than a year. In others, it may take a little bit longer than that, depending upon the market.

Jamie Feldman

And then when you talk about the 3.51% of a downsizing risk, how is that calculated? Is that of the total lease, a certain percent of that you think will go away? And then if you were to handicap that -- well, first I guess I will let you answer that question.

David Blackman

So, what we do on our at-risk category is we include 100% of the revenue for a building if we think they are at risk of downsizing or vacating. So it's capturing 100% of that, and in many cases, these are potential downsizing risks that probably would be more of a 20% to 25% of the total loss. And that is assuming we don't roll-up rent.

Jamie Feldman

Okay. And this is all for 24 months? Okay. And then, can you talk about on your new leases what kind of rent bumps you're getting? Because I think the delta between straight-line rent and -- or GAAP and cash is narrowing? What's the leasing environment like right now for rent bumps? And then as you are thinking about -- you had mentioned potentially more long-dated lease renewals and the government getting more active, do you think you'll start to see rent bumps in leases or these are going to be flattish leases still?

David Blackman

I think that's a very difficult question to answer, because every lease is a little bit different. Every market is a little bit different. For the government leased buildings, there are some buildings where we have a lot more negotiating strength than in others. Particularly buildings where there are high security parameters or less options for the government to relocate out of our properties. So, I think you're going to see, across the portfolio, a mix of roll-ups and you're going to see some roll-downs. I think what we had said over the last -- what we've said, that over the next 12 months or so, we would expect our rents to be flat to slightly up.

I think that's consistent with our specific portfolio. I would say that the market generally has become a little bit more landlord-friendly than tenant-friendly. But again, I think it depends a lot on markets and you have to look at what the individual market's overall vacancy factor is as you try to make that assessment.

Jamie Feldman

It sounds like you're talking about market rent. I was thinking more about contractual rent bumps in the leases.

David Blackman

Oh, okay. Well, as we've talked about on numerous occasions, the U.S. government leases are flat, so we don't have contractual rent bumps. What we have is the right to grow operating expenses based upon a change in CPI. And if you think about where CPI has been over the last couple of years, it's been pretty modest. We have some rent bumps in our state leases and in some of our nongovernment leases, but when you think about the U.S. government representing over 70% of our rental income, and those leases are flat, we are not going to show a lot of internal growth from contractual obligations.

Jamie Feldman

Okay. And I guess what I was asking before is, as you're coming back to the negotiating table, and the government sounds like they want to sign longer leases, any chance that that might change? Or that's pretty much how they are going to do things and will continue to do things?

David Blackman

I don't have any expectation that the government is going to start agreeing to contractual increases in their rent. I think that's the way they've always done it and I think it would be unreasonable for us to project to the market that we would get anything different than that.

Jamie Feldman

Okay. All right, great. That's very helpful, thank you.

Operator

We have no more questions in the queue at this time. This concludes our question-and-answer session. I would like to turn the conference back over to Mr. Blackman for any closing remarks.

David Blackman

Thank you, operator, and thank everyone for joining us on today's call. I look forward to seeing you as we go to conferences and when we are out in the market. Thank you.

Operator

Thank you for attending today's presentation. The conference has now concluded. You may now disconnect.

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