InfraREIT's (HIFR) CEO David Campbell on Q2 2016 Results - Earnings Call Transcript

| About: InfraREIT (HIFR)

InfraREIT, Inc. (NYSE:HIFR)

Q2 2016 Earnings Conference Call

August 3, 2016, 11:00 am ET

Executives

Brook Wootton - Director, IR

David Campbell - CEO

Brant Meleski - CFO

Analysts

Greg Gordon - Evercore ISI

Steve Fleishman - Wolfe Research

Brian Chin - Bank of America Merrill Lynch

Operator

Good morning and welcome to the InfraREIT Second Quarter 2016 Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions]. After today's presentation, there will be an opportunity to ask questions. [Operator Instructions]. Please note this event is being recorded.

I would now like to turn the conference over to Brook Wootton, Director of Investor Relations. Please go ahead.

Brook Wootton

Thank you, Denise. Good morning and welcome to InfraREIT's 2016 second quarter earnings conference call. Joining me today are David Campbell, Chief Executive Officer and Brant Meleski, our Chief Financial Officer.

Before we begin, I would like to make everyone aware of certain language contained in our Safe Harbor statement. The company cautions that certain statements made during this call are forward-looking and are subject to various risks and uncertainties. Actual results may differ materially from our projections and expectations. These risks and uncertainties are discussed in our reports filed with the SEC.

Our forward-looking statements represent our outlook only as of today. We disclaim any obligation to update these statements except as may be required by law.

In addition, during this conference call, we will make reference to certain non-GAAP measures. A reconciliation of these non-GAAP financial measures, are available on the Investor Relations section of our website.

I will now turn the call over to Brant Meleski.

Brant Meleski

Thank you, Brook, and thanks everyone for joining us this morning. We are pleased to report positive results for InfraREIT's second quarter and the first half of 2016. I will open the call today with a review of our financial performance and then turn it over to David to discuss our guidance, and the Sharyland rate case.

I would like to direct your attention to the supplemental slides that we posted on our website this morning. Slide 3 summarizes our key financial metrics for the second quarter. Lease revenue grew 15% while adjusted EBITDA grew 12% relative to the second quarter of last year. Cash available for distributions and non-GAAP EPS were consistent with 2015.

Slide 4 covers the same metrics for the six months ended June 30, 2016. For that period, lease revenues grew 15% and adjusted EBITDA grew 11% relative to the first six months of 2015. Cash available for distribution increased 3% while non-GAAP EPS decreased 2% compared to the six months ended, June 30, 2015. All four metrics were in line with our plans for 2016.

Turning to Slide 5, we see net income increase 4% during the second quarter of 2016 versus 2015, driven by the 15% increase in lease revenue, offset by an 18% increase in depreciation expense, and a 32% increase in interest expense. Depreciation increased based on assets placed in service relative to last year and the increase in interest expense is a result of higher outstanding debt during the quarter as compared to the prior year, along with higher interest rates due to the $400 million of floating rate debt that we termed out during December of 2015.

Slide 6 covers net income for the year-to-date period ended June 30, 2016. Net income increased significantly due to a 15% increase in lease revenue and the elimination of approximately $45 million of IPO related expenses. Higher lease revenues reflected the underlying growth in our asset base driven by footprint capital expenditures.

The increase in lease revenue was partially offset by higher depreciation and interest expense, both of which were in line with expectations for the quarter and year-to-date period.

Interest expense increased by $3.5 million compared to the prior year. The increase in interest expense was primarily the result of the December 2015 debt transaction that I mentioned earlier, along with an additional $100 million of debt that we issued in January of 2016. Increased levels of interest expense will continue throughout the year and is incorporated into our guidance.

Slide 7 lays out the comparison of non-GAAP EPS in the second quarter of 2016 versus 2015. As I've mentioned on previous calls, we believe non-GAAP EPS helps to inform investors and analysts when comparing InfraREIT's valuation to other utilities using PE multiples. This metric is defined as GAAP EPS plus adjustments for straight line rent and percentage rent revenue recognition, along with any other one-time adjustments. In the second quarter of 2016, non-GAAP net income was $18.2 million compared to $18 million in the second quarter of 2015. Non-GAAP earnings per diluted share was $0.30 for each of the period.

As expected, Sharyland's revenue during the second quarter did not exceed the breakpoint for recognizing percentage rent for GAAP purposes. So no percentage rent revenue was recognized. The difference between the cash received and the quarterly lease payments associated with percentage rent and GAAP revenue is reflected in the row described as percentage rent adjustment. This row includes an adjustment of $6 million compared with an adjustment of $6.1 million in the second quarter of last year.

We also adjust for the difference between the base lease payments received and revenue recognized in the second quarter and their GAAP accounting for straight line rent in the row marked base rent adjustment. This row includes an adjustment of $3 million compared with an adjustment of $3.1 million in the second quarter of 2015. Together, the add-backs for percentage rent and straight line rent equaled $9 million in the second quarter of 2016 compared with $9.2 million in the second quarter of last year.

Turning to Slide 8, we review non-GAAP EPS for the six months ended June 30, 2016, non-GAAP net income was $37 million compared to $35.9 million in the first half of 2015. The percentage rent adjustment was $13 million compared with a $12.6 million adjustment in first half of 2015. Together the add-backs for percentage rent and straight line rent equaled $19 million in the second quarter of this year compared with $17.7 million in the first half of last year.

Slide 9 covers the calculation of cash flow available for distribution or CAD building up from net income of $9.2 million in the second quarter of 2016. We make the same adjustments for straight line rent and percentage rent that we make when calculating non-GAAP EPS, but then we adjust for a few other items. First, we add back the non-cash, cash amortization of deferred financing costs of $1 million; second, we add back non-cash equity compensation of $228,000; third, we deduct non-cash income of $1.1 million, primarily consisting of AFUDC and other funds; and finally, we deduct $11.4 million, which is the amount of capital expenditures required to offset depreciation during the quarter and maintain our net assets at a constant level.

In total, these adjustments bring our second quarter CAD to $18.3 million which is consistent with the same period of 2015. Our CAD per share this quarter was $0.30.

Slide 10 covers the same calculations CAD for the six months ended June 30, 2016. We start with net income of $18 million in the first half of the year compared with a loss of $27 million during the first half of 2015. We add back deferred financing costs of $2 million compared to $1.8 million and non-cash equity compensation of $520,000 compared to $308,000 in 2015. We also deduct non-cash income of $2 million in 2016 compared to $1.5 million in 2015.

Lastly, we deduct our capital expenditures to maintain net assets of $22.5 million in 2016 compared to $19.2 million last year. This build-up results in CAD of $37.6 million in 2016 compared to $36.5 million during 2015.

CAD per share was $0.62 for the first half of the year compared to $0.60 for the first half of 2015.

Slide 11 lays out InfraREIT's liquidity as of the end of the quarter. We ended the quarter with approximately $287 million of available liquidity and our long-term debt totaled $721 million.

On Slide 12, I would like to point out that our growth and financing strategy has remained consistent since our IPO. Our strategy is to grow our dividends per share through investments in footprint projects and the acquisitions of T&D assets. As we have described, we expect to fund our footprint project capital expenditures through the end of 2018, without issuing additional equity, while continuing to target our consolidated credit metrics of 60% debt to total capitalization and 12% adjusted FFO to debt.

Now I will turn the call over to David.

David Campbell

Thanks, Brant, and good morning everyone. Turning to Slide 13, and as Brant noted, we are pleased to report solid results for the second quarter and first six months of 2016. Revenue and adjusted EBITDA continue to increase in line with expectations reflecting growth in our core service territory.

We invested more than $63 million in infrastructure improvements in the second quarter enabling Sharyland to support customer load growth and help to provide safe and reliable service to Sharyland's customers.

The second quarter also saw some important steps for Hunt's development projects. The Cross Valley transmission line was placed in service in June. Like the Golden Spread transmission line, which came online earlier this year, Cross Valley is currently owned and operated by Sharyland. The proposed Southline Transmission project in Southern New Mexico and Arizona also made significant progress during the second quarter. Both the Western Power Authority and the Bureau of Land Management issued records of decision for the project, so the key federal permits are now in hand.

The open solicitation process for Southline closed at the end of June. The process resulted in indications of interest from a diverse set of counterparties with the total submittals exceeding the projects capacity.

Currently the indications of interest are being reviewed and evaluated to determine the optimal go forward commercial framework for this large and promising development project.

As described on Slide 14, Sharyland has filed a system-wide rate case with the PUCT on April 29, 2016. We are working closely with the Sharyland team as the rate case advances. This month, the PUCT is expected to rule on a set of threshold legal and policy issues related to the regulatory framework for Sharyland and SDTS which is InfraREIT's regulated subsidiary. The topics will include among other items, whether and how to regulate the leases between Sharyland and SDTS, whether these entities should be regulated separately, and evaluating the validity of the PUCT's 2008 order that initially approved the restructure.

Consistent with the terms of that 2008 order, InfraREIT has operated in our current REIT structure through several PUCT proceedings including the Sharyland rate case that settled in January 2014. Our structure has demonstrated its resilience and effectiveness to more than five years of rapid growth and expansion. We continue to believe that it is an advantage structure for funding power, infrastructure assets and leverage the strengths of our tenants Sharyland Utilities.

InfraREIT and Sharyland have been and continue to be engaged in constructive discussions with the PUCT staff and intervenors about the go forward regulatory framework. These discussions have focused on developing an approach for administering rate cases and regulating leases in a manner that is acceptable to key stakeholders and consistent with REIT rules and PUCT regulations.

Following these initial discussions, we expect other issues such as the allowed return on equity, capital structure of the income tax allowance, the cost of debt, and other economic items to be addressed over the remaining course of the rate case.

Slide 15 highlights our forward outlook. We are reaffirming our 2016 guidance for several key metrics for both CAD per share and non-GAAP earnings per share, our forward outlook remains in a range of $1.15 per share to $1.25 per share for 2016. We continue to expect annualized dividends in 2016 to be $1 per share.

We are also reaffirming our predicted 2016 capital expenditure range of $220 million to $240 million. However as a result of our interim quarterly review with Sharyland, for 2017, we are revising our capital expenditure forecast to a range of $235 million to $280 million, a decline of $15 million on the low-end. Similarly for 2018, we are expanding the range to $135 million to $220 million, a decline of $35 million on the low-end. As a result, our 2016 to 2018 capital expenditure range is now $590 million to $740 million.

The primary driver of the wider range in our capital expenditure forecast is associated with the higher level of uncertainty about customer load growth in our West Texas service territories and resulting impacts of 2017 and 2018. As we noted previously, the growth in our West Texas service territory is heavily dependent upon oil focused upstream, midstream, and related activities.

While Sharyland continues to see new drilling and related activities in the region, the relative focus on infill drilling and the pace of activity in Sharyland's footprint have informed a wider band and a lower end of the range in Sharyland's forecast for potential growth and reliability focused investments.

These changes are reflected in the base footprint CapEx forecast shown on Slide 16. This slide also incorporates the slight increase to spending on synchronous condensers in 2018. We are now expecting to add a third condenser with the majority of the capital investments after 2018 outside the forecast period. The proposal for the third condenser will go to ERCOT review but will not require a CCN.

The other major project detailed on Slide 17 is the addition of the second circuit to our transmission loop in the Texas Panhandle will require a CCN. The PUCT is expected to review the CCN request at its August open meeting. Both the second circuit and the first two synchronous condensers have target online dates in 2018.

On the low-end of the base footprint CapEx range has widened. We continue to believe that we are in a attractive position and foundation for growth in West Texas. Leading oil producers continue to highlight the strategic importance and concentration of ongoing investment activity in the Permian Basin.

Sharyland will continue to monitor closely the West Texas activities of upstream and midstream providers and the resulting impact on our expected investment levels. We will have more information on expected capital expenditures later this year after Sharyland completes their annual bottoms up financial planning process. This process typically wraps up in the late summer, early fall.

Given the commodity dynamics and impact be on your growth in our service territories, going forward we expect to establish wider ranges throughout your CapEx forecast. Working with Sharyland we will also continue to monitor potential new win developments in the Texas Panhandle as the project backlog continues to expand, we expect that this will create new interconnection opportunities and related investments to ensure the reliability and stability of the transmission group.

As noted on Slide 15, we are reaffirming our three-year CAGR range of dividends per share of 8% to 10% for 2015 through 2018. The 8% to 10% growth rate outlook reflects the targeted CAD per share payout ratio of 80% to 90%. The changes to the range of 2017 and 2018 capital expenditures do not impact this outlook, but it may have potential impact beyond 2018. Of note with respect to the rate case, the 2015 to 2018 outlook for dividends per share assumes and is subject to continuity and lease treatment and a range of regulatory outcomes that are consistent with the rate Sharyland requested in its April filing package including continuation of the income tax allowance at historical levels.

We expect to provide CAD per share and dividend per share guidance beyond 2018 after resolution of the rate case.

Important element of InfraREIT's growth strategy is the acquisition of transmission projects developed by Hunt, our development partner.

Slide 17 highlights the areas where Hunt is focused. Two of these projects, the Golden Spread and Cross Valley transmission lines came online earlier this year and are currently owned and operated by Sharyland. InfraREIT expects to have the opportunity to reengage in discussions about the potential acquisition of the Golden Spread, Cross Valley projects at a later date as market conditions evolve.

In addition, we are monitoring the potential integration of Lubbock Power & Light or LP&L into the ERCOT market. As we have previously described the municipal utility in Lubbock submitted an application to join ERCOT last year. If approved, the transmission integration solutions may involve touch points with the Sharyland system and thereby create potential transmission opportunities for Hunt or for Sharyland. LP&L's application was discussed at the PUCT July open meeting, during which the commissioner has asked ERCOT and SPP to evaluate the cost benefits and technical considerations associated with LP&L's request.

Ultimately the PUCT will be the decision maker on LP&L's request and for any follow-on decisions regarding which transmission interconnects would be required.

In combination we expect the Golden Spread, Cross Valley, and new development projects such as Southline and LP&L interconnections, if acquired, will be important elements from increased growth strategy, complementing the growth in our core service territories.

In closing, we had another positive quarter and we remain on track for a solid 2016. We are confident in the fundamentals of our business and we believe the long-term dynamics in our target markets remain compelling and attractive.

Thank you again for your interest in InfraREIT and we will now open the call to questions.

Question-and-Answer Session

Operator

Thank you. At this time, we will begin the question-and-answer session. [Operator Instructions].

And your first question will come from Greg Gordon of Evercore ISI. Please go ahead.

Greg Gordon

So will the threshold issues that are going to be discussed in this preliminary order, will they come in a regularly scheduled meeting later this month. And if so, when are the dates for those meetings?

David Campbell

Thanks, Greg. So this is David, the next open meeting is August 18. So the commission may take up the threshold issues and the preliminary order at that meeting. We're currently engaged, as I mentioned, discussions with PUCT staff and intervenors around a potential approach that may impact the schedule of PUCT hasn't indicated precisely when they will make a decision but the next open meeting which it could be taken up is August 18.

Greg Gordon

Great. As I think about this -- and I think about the two potential sort of extreme outcomes of this threshold policy issue order the most -- the least extreme is that the commission determines that they are going to regulate leases as tariffs but in a way that doesn't really change the underlying sanctity of the lease payments in terms of their IRS eligibility as revenue and the worst is that they say we treat leases as tariffs which means that we reserve the right to change them at anytime even midcourse during the lease in which case there is a risk that the IRS would then see these leases as no longer qualifying revenues and thus jeopardize your REIT eligibility; is that a fair or unfair sort of explanation of the two extreme outcomes and where do you -- what is your goal and the dialogue you're having with the staff on the outcome?

David Campbell

Thanks, Greg. It -- I think that's a fair characterization of the extremes. The demos and the details and the sort of thing and the details can be pretty intricate, so it's painting it in simplified picture though it is hard because it's coming out of the details. But at the end of the day, we are working and having constructive discussions with staff and intervenors to develop an approach that it's consistent with all the applicable laws and regulations, so REIT rules and regulations, as well as the PUCT regulations, and PURA, that's Texas regulatory law. And it works for everyone and matches those requirements.

So we have to work those details as we have described, the leases reflect the regulatory parameters that are in place when the leases are signed and lease supplements reflect any changes to regulatory parameters and when leases are expiring and new ones are put in place when they're extended, the new regulatory parameters are reflected. So there is no doubt that the leases that we have track rate case outcomes over time and we own regulated assets, so the profile of our economic return reflects the regulated nature of our business.

So we're within that underlying context of the general consistency, we are working through the details now in the process, we are not done, so we have got to work through the details.

Greg Gordon

Okay, great. With regard to Southline, the update sounds encouraging. If the project is ultimately commercially viable what type of -- I'm sure you may not be able to get too much specific here but what timeframe are we looking for to go from sort of commercially viable to actually constructed and would that that gets constructed at the Hunt level by Golden Spread and Cross Valley or would that be and then you would have to transact in order to bring that into the InfraREIT family; is that correct?

David Campbell

Yes Greg that's correct. So it's -- I do think it was a promising quarter getting the two records a decision, working through the open solicitation, there are still important steps to go through in the commercialization process but when this would be an opportunity, so it is not reflected in the guidance we have now and very, very likely it will be outside the forecast period or came in. But as you noted all the costs associated with the development effort and really managing the process through financing and construction but very likely it would be an Hunt camp. So then it would be opportunity that we would evaluate once it's further down and then de-risk further.

Greg Gordon

Great, thank you guys. Have a good one.

David Campbell

Yes and I will add, it is a project that Hunt developer is obligated to offer to InfraREIT. It's on the list of what we call ROFO project.

Greg Gordon

Yes, understood. Again, thanks. Have a good morning.

David Campbell

Thank you, Greg.

Operator

The next question will come from Steve Fleishman of Wolfe Research. Please go ahead.

Steve Fleishman

Yes, hi, good morning. I just wanted to clarify that the tax treatment is not part of the threshold issue discussion?

David Campbell

Good morning, Steve. That's correct; the tax treatment is not on the list of issues in the threshold issues that were -- that have been briefed and that are covered in the preliminary order, so all economic issues effectively will be addressed in the next phase.

Steve Fleishman

Okay. And I guess because of schedule some on the price we don't know when we are going to get intervenor testimony on the ROE and tax issues and things like that?

David Campbell

We know with certainly that schedule was when the schedule issues came up, the schedule was debated, so I suspect that ALJ's lot of scheduling conference after the next open meeting soon within next few weeks and reset the schedule but as of now, as it's not our firm schedule, so they will break it.

Steve Fleishman

Okay. And then I want to go back to something, you said about the kind of long-term capital plan and I think you said that in the future you suggest it will be even a wider range of capital when you kind of give us three-year plan like it already seems pretty wide. So I'm just is that really true and kind of why is it so? Why there have to be such a wide range; is it really that variable?

Brant Meleski

Steve, it's Brant, good morning. I will take that one. It is a -- we have widened the range over time since the IPO and what we are -- what we are realizing is commodity prices has moved around over the course of the first 12, 18 months is that we are seeing more variability in our capital expenditure forecast especially as you go out into the future. Less so in the current year for the next 12, 15 month period but as you go out in time we are seeing more variability there than we see other utilities have in the industry.

And I think that's -- we think that's driven by a couple of factors, one is the fact that a significant portion of our total rate bases invested capital has been invested and placed in the ground over the course of the last five or six years. And so we do not -- it's a relatively young system, we are not dealing with a large system that is 50, 60, 80 years old that has a lot of replacement CapEx, the majority of our CapEx really is driven by going from reliability needs.

And so as there are changes in the economic activity in especially West Texas whether that's driven directly by oil company activity or the knock-on effects of that activity, we are seeing more variability even within a year forecasting for out years in 2017 and 2018 then we may see elsewhere in the industry and because of that instead of having the risk of up and down swings in CapEx quarter-to-quarter based on what we are hearing from customers as to their new connection -- new customer growth or load growth, we are looking and what David indicated in his prepared is just moving to a wider range in our year two and year three CapEx forecast to try to capture those movements. So we do not have as many quarter-to-quarter swings.

Steve Fleishman

Okay. And when we look at the segments, is it more in the distribution or the transmission where the variability is showing up?

Brant Meleski

It's a combination of both and if you dig into the details on the slide that we provided in our slide deck, you will see that especially in 2018, the lower end of the range was reduced in both transmission and distribution. Transmission is driven both by what I'll just describe as wholesale activities, larger customer needs but is also driven by the expansion of the distribution network. And so if distribution is expanding in certain areas then you need to add a substation or private transmission lines to support that distribution activity. So it is a function in both parts of our business.

David Campbell

Steve, this is David. All I will add is the -- I mean, in posting to your question a little while it seems a wider range and you see for others not relative to place where I work and some of these utilities you cover where they may have underlying growth in 0% to 2% range. In West Texas load growth was compound annual rate of 15% from 2011 to 2015. So five-year CAGR 15%, so what we're seeing particularly there is a lot of reliability in system related investments that was mapped out and predictable like informed CapEx guidance and CapEx we've seen in 2015, 2016 and largely up to 2017.

But in the out years it will depend on the ongoing pace of that growth and where and how much producers continue to invest in related ministry of investments that follow and obviously producers give a pretty good view on their current year CapEx movement in a forward year but they are not giving 2018 forecast outside of where the prices are.

So we are trying to be sensitive, we are signaling that those dynamics impact the out year outlook in particular that will narrow as we get closer to the timeframe. So appreciate the question.

Operator

[Operator Instructions].

The next question will come from Brian Chin of, Bank of America Merrill Lynch. Please go ahead.

Brian Chin

Just going back to the threshold issues, is there a particular chain of events that needs to happen with regards to getting a sense of whether the IRS is okay with whatever approach comes out of the process. So for example do you need to have discussions with PUCT and staff and have the commission approve a particular approach on the lease revenues and how they qualify for REIT status? And then you go to the IRS or is it the concurrence set of discussions that you can have with the IRS such that by the time PUCT approval happens, you have a pretty good sense that IRS is okay with the way things are moving. Can you just give a little more color there?

David Campbell

Well, Brian it's a good question. I think the area in which we are focusing is an approach that works within the context of what's known in terms of IRS rules and regulations in our PLR. So seek to have a through our discussions, developer framework that works for the full set of applicable laws and regulations in other words you don't have to go back to the IRS, supposed scenarios in which you might have to go back to the IRS but the framework in which we're targeting, we think we can get to.

But again we have to work through the details, it is one in which we can develop an approach that is consistent with REIT rules and regulations and also works with Oncor and PUCT regulations rather than having any other dialogue that obviously gets hard to match up those timelines. So our goal is to try to do something works within current rules and we are honestly with lot of excellent tax advice and information on how to approach things.

But to your broader point working through the details will be an important piece of this. So it's a lot of this will be how it's implemented and how we work that through and that's where we are -- the discussions that are taking place now and I'm sure will continue over time.

Brian Chin

So I guess I should take from your response that an active dialogue with the IRS in your opinion isn't necessary because you understand where those parameters lie and that we should not expect an active IRS approval of whatever approach is determined in the future going forward; is that the right interpretation?

David Campbell

Brain, it's certainly what we are going to seek to achieve through the discussions that's right. And we don't know how the -- how it will play out or I guess the scenarios in which we would need to have an active dialogue with the IRS. But what we're going to seek to achieve is to work within the current parameters in regulations and not need to have that iterative dialogue.

Brian Chin

Got it. And then going back to the CapEx set of questions, I can appreciate that there is a sort of moving set of sensitivity here to the economic outlook and the energy outlook. Is there sort of a general oil price range that is consistent with the current CapEx forecast like $50 a barrel, $40 a barrel just to give us a sense of where the current CapEx spending level is calibrated too?

David Campbell

Brian, I wish it were that straightforward. There is a general link -- I do think there is certainly more robust outlook from the producers when prices were in the $50 plus range but there has been a couple earnings calls and other ongoing even some today and the course of week where there are still some plans to add rigs.

For us it's -- we are not a direct distributor or an indirect so it's a -- not a first order or second order. So it depends a lot of where the producers actually choose to drill where that activity takes place so, it's generally linked but we can't tie it as explicitly as, you would like to see in as we would. So, it's a -- I think that we track them I'm sure, they way the producers are commenting on their relative plans and where their growth plans accelerate and they certainly signal things get, they take the higher levels of activity at $50 and beyond but this is not an easy way to map that with a number for us in terms of CapEx. There is a lot of -- there is the same level of activities since specifically where it is.

Operator

And at this time with no additional questions, we will conclude the question-and-answer session. I would like to hand the conference back over to David Campbell for any closing remarks.

David Campbell

Perfect well we know that it's a very busy earnings day today and a busy season. So thanks again for your interest in InfraREIT. Have a great day. That will close.

Operator

Ladies and gentlemen, the conference has now concluded. Thank you for attending today's presentation. You may now disconnect your lines.

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