[Operator]: The question-and-answer session will be conducted electronically. If you would like to ask a question please do so by pressing the “*” key followed by the #1 on your touch-tone phone. If you are using a speakerphone, please make sure your mute function is turned off the allow your signal to reach our equipment. We will proceed in the order that you signal us, and we'll take as many questions as time permits. Once again, please press “*”, #1 on your touch-tone phone to ask a question.
Gordon Hodge, Thomas Weisel Partners
[Q - Gordon Hodge]: Hi, good afternoon. Just a couple of things. One, it is this looked as though, based on the high level of free trials in the quarter, that a lot of the sub adds may have come towards the end of the quarter, and that would be consistent with the fact that you raised guidance at the very end of the quarter rather than at your analyst day. I'm wondering if could you comment on that or it was decline in ARPU, was that more related to a mix issue with the lower price plans in there? And then also the disk purchases look rather low in the quarter. At least low relative to the other quarters. You've got much higher users now. I'm just wondering if you're enjoying economies there, or is it just sort of a one-off situation in the quarter. Thanks
[A – Barry McCarthy McCarthy]: Hi, Gordon. It's Barry, thanks for the questions. I heard three of them. One about the timing of sub growth, one about ARPU, and one about content purchasing.
[Q - Gordon Hodge]: Yes.
[A – Barry McCarthy]: Well, with respect to sub growth we had quite a bit of momentum coming into the quarter and you see in that part in our earnings release in the mix of free versus paid subscribers. The update in the guidance was as much about the settlement as it was about an update on the business, but since we were updating people about the settlement, we felt compelled to give you the full picture. With respect to ARPU, it has declined and not reflects the continued popularity of the lower price plan, which are also contributing to the improvement in gross margin in part as Reed mentioned, then lastly, you're right, disk purchasing was down in the quarter by quite a bit, it was about 13% of revenues. We'll see a slight, which is low historically, as you know, we've been in the high teens. We'll see a slight increase probably next quarter by a couple hundred basis points maybe, something in, let's call it the mid teens, 15%, 16% range. So the personalization software that we've been developing and integrated into the website has been working quite well for us, as we mentioned, that is contributing to the decline in purchasing and to increased margins.
[Q - Gordon Hodge]: So some of that is that sustainable, it sounds like, in terms of the lower purchasing.
[A – Barry McCarthy]: Well, it's extending into Q4 below historical levels, and we'll see after that.
[Q - Gordon Hodge]: Terrific. Then just, I guess, I didn't really ask the question very well, on the subscriber adds, did you notice an appreciable change when blockbuster took prices up in terms of an acceleration in the adds of subscribers and is that continuing into Q4? It would appear that it is, but,
[A – Barry McCarthy]: Gordon, there's no question that the blockbuster price increase helped, but there was no inflection point in the quarter. For example, the price that they actually did but the week that they actually increased prices, it's as much also helped by their lack of marketing and general weakening state which affects the service level, it affects the marketing and it affects the pricing. So all of those factors combined make for a weakened competitor and for a stronger competitive environment for Netflix.
[Q - Gordon Hodge]: Terrific. Thanks.
[Operator]: Glen Reid from Bear Stearns.
[Q – Glen Reid]: Yeah, hi. Just quickly following up on the ARPU question, is it still the case, or maybe could you kind of elaborate more just on the dollar contribution or the gross profit contribution, between your say your 999 plan and your 17.99 plan. Are they still roughly equivalent some is that really the case? And I guess the second thing, there's been some talk, in the last few days about a blockbuster-Amazon partnership that's sort of been going around. I'd love to get your thoughts on that in terms of how it might affect your business. Thanks.
[A –Reed Hastings]: Glen, it's Reed. I'll take the second part and let Barry do the first part. We've heard the same rumors but then we've been hearing them for nine months. So this' anything really different happening there, and I think what we've shown is blockbuster spent about $300 million trying to compete against us, and we've held together and, in fact, you know, accelerated our business, returning a substantial profitability, looking at great profit streams next year, so would it have to be, another $300 million investment to knock us off our momentum in some slight way at smaller levels we wouldn't feel it. So we look at it and say very unlikely to see again, again the key thing is not whether there's partnership of advertising, it's whether there's another round of $300 million of investment, and we look at that and say it's fairly unlikely, that we're just too far ahead for them to be willing or able to do that.
[Q – Glen Reid]: So would that mean that you wouldn't necessarily feel compelled to revisit your sort of marketing spending caps that you've kind of laid out?
[A –Reed Hastings]: Well, let me separate it again in the two cases. One case, which is blockbuster, can do anything they want if they're not able to spend another $300 million, there's almost no chance that they will make an impact against us.
[Q – Glen Reid]: Sure.
[A –Reed Hastings]: If, for some reason, they've got another 300 million to invest, either through partnership or anything else, and they choose to invest it through on-line we think it's highly you know likely, given the port return on their current investment, but that would ratchet up the competitive environment and we would have to respond in a variety of ways. So that always stands out there, I think a very low percentage chance because they've already spent $300 million there in a weekday. We've accelerated where our distance between them and total adds that grown over the last year. So that kind of double down thing is always possible but extremely unlikely.
[Q – Glen Reid]: Okay.
[A –Reed Hastings]: Barry, the ARPU question.
[A – Barry McCarthy]: I think the question was about the comparability between the plans around contribution margin, which is gross margin less the fulfillment cost. And we had previously said they were roughly equivalent, and we still like what I'll say about it today, we like the economics quite a bit. You can see the increased profitability in the plans reflected in the increasing gross margin of the business.
[Q – Glen Reid]: Okay. Thank you.
[A – Barry McCarthy]: It's not as specific as you like, I know, but I think directionally it answers your question.
[A –Reed Hastings]: Sure, thanks.
[Operator]: Heath Terry from Credit Suisse First Boston.
[Q – Heath Terry]: Great. Actually, I was just wondering if could you go maybe a little bit more in-depth on what you are feeling these days about the possibility of any kind of new trend into the space, specifically Amazon, he is special as you're looking at what they doing in Europe, and then also if could you talk strategy evolving around the launch of your video download service and certainly understand the thought process behind that. As you look at potential investments for growth, does international and possibly revisiting some of the plans that you had previously about international make any sense from where you sit?
[A –Reed Hastings]: Heath. If Amazon DVD rental service in the U.K. were a roaring success and taking the country by storm, I think everyone would be more concerned about their likelihood of entering in the U.S. Given what we know about Amazon's DVD rental service in the U.K., that it's appreciably behind video Island and love film and behind blockbuster in the U.K., number four in the market, the prospect of Amazon expanding relatively on successful initiative is fairly small because they're a very thoughtful, rationale player. So always possible, don't see anything that indicates' likely again because they're in the market. If they were, motivated enough they would have entered earlier this year and a small entry like they've done in the U.K. where they're still number four a year later would be inconsequential to us. Next you asked about downloading. Anything specific? I could go through what I said on the script but we tried to give a good explanation there, which is, the TV channels have a lot of the content locked up exclusively, that's why Comcast, movie link, apple, and us don't have much content. That will shift over time, and it's unfortunate, and the consoling factor is that the larger we get, the bigger profit base and the bigger subscriber base we have when that content eventually is available for licensing, and when it is, it will be available to everybody just like music is.
[A –Barry McCarthy]: Did that hit your question?
[Q – Heath Terry]: Can you hear me.
[A –Reed Hastings]: Yeah.
[Q – Heath Terry]: Okay no, actually what I was asking about when I mentioned downloading was less actually about downloading but with your decision not to do downloading. Like I said, I completely understand the strategy there, or to hold off and downloading until it makes more sense for you. Does that put you in a position to maybe revisit some of the international expansion plans that you had previously does that make sense from where you said?
[A –Reed Hasting]: We'll continue to invest in downloading as appropriate, but obviously lighter than we would if we had launched. In terms of international its something that we look at from time to time and the way that we approach it is the core business profitable enough that we can afford the investment in international and still deliver on our 50 to 60 million earnings guidance for next year and the 50% growth there after. So we look at it as it's international is one way put it to the growth, another way is invest in marketing in the U.S. We trade those off against each other, so nothing imminent, but it is something that we continue to look at. You want to add anything to that Barry?
[A – Barry McCarthy]: We don't feel like we're missing any opportunities internationally, as we watch by way of example the U.K. market develop. It's developing slowly. The economic proposition appears to be challenging, and there are some small and competitors who are capital constrained who are battling each other to a draw at the moment, it seems.
[A –Reed Hastings]: And the U.S. is growing so fast we look at it and say 20 million subscribers in the next five years, will concentrate on the U.S. for the most part, and grab that 20 million, serve them.
[Q – Heath Terry]: Catch him Thank you.
[Operator]: Safa Rashtchy Piper Jaffray
[Q – Safa Rashtchy]: Hi this is Safa Rashtchy. What is driving the decrease in SACA is that where do now its penetration increase or is that the sharing music cues with friends? Can you just give us more color on the decrease in SAC?
[A –Reed Hastings]: SAC has stayed amazingly stable over the last two years between $35.0 and $38.0. So, in the middle of, the big blockbuster storm, it only moved up to $38.0. So, the macro look has been enormously stable. It's more efficient till down this quarter to do with effectiveness of our program, the weakening competitive environment, continued improving execution in scale. One of the things that we shared in our analyst day is that if you look in our more developed markets, such as the bay area. It's not that SAC has skyrocketed as we gone the deeper penetration, it's that SAC is actually less. So as we grow we're getting scale economies and in the bay area we estimate our SAC between $25.0 and $35.0 per subscriber. In other words, appreciably less than international average. So that portends really well for us as we get to those kinds of 10% penetration levels across the nation.
[Q – Safa Rashtchy]: Thank you.
[A – Barry McCarthy]: Reed made a great case for why it is that we should be forecasting a lower SAC and we're not, so let me try to at least articulate our thinking so that walk away from the call imagining that we've sandbagged our plan here, which really isn't our intent. In each of the last two quarters we have expected SAC to come in higher and depart from the trend. We have spent aggressively and made, what, in respective proven to be relatively conservative assumptions with that response rates on some of the spending we have done. I think from a planning perspective, that's the right approach, because in the alternative, if we fall behind, and we overshoot on SAC, there's no way to meet the plan numbers, we'll get crushed. So that's the approach we took the last two quarters. We're going to continue to take that approach as we begin to bring some new advertising vehicles more heavily into the mix, and until we've got a consistent history that shows we should be more aggressive in our assumptions that about response rates we will continue to be relatively conservative.
The reason we've changed our approach on the guidance through '06 by not giving a range but given you as below which we will not fall, which I characterize as the bottom of the range, because our goal is to spend the marketing dollars and we made very well be more productive in terms of yield from the SAC perspective in which case subs will be considerably higher than we have been forecasting, and that's just fine but you should have the comfort knowing that we'll be in a $50 to $60 million range for income on a pretax basis next year regardless of what happens from our growth perspective. And, of course, historically that hasn't been the case we overshot one subscriber growth, because we were managing to a SAC number, we have, I'll say, overshot from marketing spending and it came out of the bottom line.
[Q – Safa Rashtchy]: Thank you.
[Operator]: Youssef Squali, Jeffreys.
[Q - Youssef Squali]: Yeah thank you. Hi Beary, Hi Reed, two questions first I am trying to understand why they switch to the fixed market and budget strategy at a tame when your competitor is weaker and when you can grow fastest, why has the focus changed to profitability?
[A – Barry McCarthy]: We said fixed marketing, not small marketing, so if you look at our report you'll see we spent about $33 million in marketing up from low 20s in Q2. So don't interpret us we're backing off at all. We are pushing the growth a level hard or we're doing it in a way where we can feel very dependable in terms of delivering our earnings.
[A – Reed Hastings]: Yes in the range of as a percent of revenue, about 15% on low side I think and 24% on the high side in the Q1 time frame when sub growth has really been rocking. The latest quarter we were 19%. I think you can expect us we are sitting in the 19%, 20% range. So we feel like we've put the hammer down on spending and we have taken advantage of all of the scale economies in the business that have contributed to increased profitability. I think we made the argument last quarter, and invested it in incremental marketing. So we share the same view that you do, which is that this is an opportune time to pursue growth in the presence of a weakened competitor, the and we are.
[Q - Youssef Squali]: Will you be playing with promotional discounts or introduce lower prices, say, for instance, 799 as a plan?
[A – Barry McCarthy]: Well, we may test a number of different things, Youssef, and we'll give you an update if any of them work and we can be confident of their success, but of course, it will be smart for us to test many different things.
[Q - Youssef Squali]: Okay and lastly, I guess, Barry McCarthy, and you guys pushing back the download service, would you still be spending 1% to 2% of your revenues on R&D as you said before?
[A – Barry McCarthy]: Well, if we don't spend it on downloading, we're going to reinvest in incremental subscriber growth and marketing, provided, of course, that the marginal acquisition cost per subscriber still works within the framework of our economic model, and I think it will. So if it's not going into downloading we invest in the market and we'll drive for faster growth. Now, one more word about this investment of marketing and faster growth. Over the long run, I think we will have a more valuable enterprise on a net present value basis. Since each sub is profitable over their life, the sooner we bring in a sub, the more valuable the enterprise is going to be, and the faster we'll drive bigger profits if not in the current quarter then in the next couple of years. So it's good for the business and I think it's good for investors.
[Q - Youssef Squali]: Makes sense. Thanks a lot.
[Operator]: Dennis McAlpine, McAlpine and Associates.
[Q - Dennis McAlpine]: Thank you and good afternoon. Couple of clarifications, could you say what that postage assumption was for next year? Was it 37 to 39?
[A – Barry McCarthy]: Yeah, $0.02 each way, Dennis, so they discuss already in back so two plus two, four cents.
[Q - Dennis McAlpine]: Okay. And then when you talked about the purchasing being down, I think you said 14% or, so did you increase the rev share, and what do you see happening to rev share going forward, particularly as you go into Hi-Def DVD?
[A – Barry McCarthy]: Dennis, there's a slight increase in rev share but it really different kinds on which studios have the hot films of the quarter and now we are, let share with them as suppose to any strategic evolution. In terms of Hi-Def, DVD none of that has been worked out so it may be more or rev share or may be less rev share and we will get a chance to talk to the studio sort it out the plans from up around and pricing of Hi-Def, as you know that perhaps not all of the investors do conduct expected time is middle to late next year in terms of the launching of the first movie following on the launch of play station 3, potentially of HD-DVD, depending on the format.
[A – Reed Hastings]: I want to make a correction. I think I heard we retail a rev share was up slightly. Rev share it was actually down in the quarters. So if the content cost across the aboard, we are actually important contributors to increase profitability because of some of the things we're doing from a personalization standpoint on the website.
[Q - Dennis McAlpine]: Can you update us where you are with the Tivo arrangement given what you are talking about down loading is that down, where those, that still proceeding, or what's happening there?
[A – Barry McCarthy]: Yeah there's no work going on right now. We love those guys, and we just don't have any content. So there's not really any point of doing anything at this point.
[Q - Dennis McAlpine]: One last thing. You were willing to put Wal-Mart out of its misery by taking over its operation. Would you consider doing the same thing for blockbuster?
[A – Barry McCarthy]: Now I think it would be a potential significant FTC issues there. So it not clear that we will be able to be in a pre desire to, so for now works very well for us because we having them in the market, creates a lot across, we grow the market category, we've done very well since they've been in, so may be in our interest to actually have them stay as, you know, a relatively not strong balance sheet and be in the business in a small way. So we're not particularly eager for anything to change over there.
[Q - Dennis McAlpine]: Very good. Thank you.
[Operator]: Jim Friedland, SG Cowen
[Q - Jim Friedland]: Thank sir first the quick question on the tax rate assuming you have to start booking taxes even though they're non-cash. If you exclude the stock-based comp impact should we just use a 40% rate and then the second question is on usage. On a like for like basis have you seen any different usage patterns with the lower price plans and is usage still continuing to sort be flatsish to slightly down on the core three DVD plan? Thanks.
[A – Barry McCarthy]: Jim, with respect to the tax rate I'd use a 42% number. Overall, usage has come down significantly, not on a normalized basis, which reflects the shift in plan mix. Historically, Q3 has been a heavier period of usage than either Q2 or Q4 on a normalized basis. And the last thing I'll say about usage which is in answer your question directly, but tells you roughly how we're feeling about the level, usage in the quarter was almost exactly, within 100th of a disk where, we expected it to be. And we're liking the current usage levels.
[Q - Jim Friedland]: Okay I think that’s the best of all thanks.
[Operator]: Doug Ernst, Hudson research.
[Q - Doug Ernst]: Good afternoon. Daniel Ernst, but thanks for taking the call. Two questions if I might. Could you give us an estimate what you think cash flow is for 2006 based on your assumptions for beginning to pay taxes during the year? And then secondly, kind of looking at your guidance for the year in subs and also for your longer-term goals of 20 million, if I look back over the last five years or so you've touched 8, 9 million homes already, kept 3.6 million of them. Are you seeing in your gross homes that you touched, two, three years ago to be (indiscernible) 47:52, and coming back and trying service, or you getting your growth from new subscribers? Thanks.
[A – Reed Hastings]: Daniel, it's Reed. I'll take the second part and leave the first part to Barry McCarthy. We're seeing the growth all around of people who come back to the service and new people, and so, for example, in the San Francisco bay area, we've continued to see net adds, so you're looking at gross adds we mentioned, coming in the figure of total people touched, but ultimately what drives the P&L is net adds so we put a lot of focus on, now watching trends and that. And in the bay area towards nationally, we've seen an acceleration in net adds, I talked about it nearly tripling from a year-ago in terms of net adds, and in the bay area we're still seeing an acceleration of net add. And if you think of the S curve of growth in terms of can’t understand at what point will we saturate we're still on the first half of that S curve where net adds is still accelerating and I will see that one going for ever eventually net adds will still stop increasing and we will continue to grow but at a constant rate, like DirecTV, which grows by about a million and a half a year of net subs over the last ten years. So again, our net adds are still accelerating, so we still haven't even hit the halfway mark in the S curve of growth and even in the bay area where we're 11% of households, the net add rate is still growing. So that's what gives us the confidence in talking about those very large numbers such as 20 million subscribers in the 2010 to 2012 period. And I turned Barry McCarthy handle the quick as the question.
[A – Barry McCarthy]: The question was with regards we could give about free cash flow in ‘06 and what (indiscernible) 49:38 was due to the impact of taxes. We don't provide free cash flow guidance for '06. And the answer to the second part of the question is there will be no impact on free cash flow from taxes. It's entirely a GAAP accounting issue. At some point we'll make the determination that it's likely that the business will consume on a go forward basis that roughly $125 million in NOL’s that we expect to finish the year with at a 42% tax rate that will translate into something like if we booked it all of at one time that is $53 million one-time gain that will get run through the P&L. And then for accounting purposes we appear to be a fully taxed entity, and so it will affect the GAAP net income number we report but for so as the IRS is concerned, we'll continue to consume that $125 million NOL even after the business becomes profitable for tax purposes, and that will happen at a different time than does it for GAAP purposes, primarily because of the treatment that has to do with the stock options expensing.
[Q - Doug Ernst]: Okay, understood. But will that give me the cash flow guidance could you give me range of Capex for '06?
[A – Barry McCarthy]: No, we don't give Capex guidance, either, sorry.
[Q - Doug Ernst]: Okay thanks.
[Operator]: Frank Gristina with Avondale Partners.
[Q - Frank Christina]: Thanks two questions. I apologize that if you answered this already but the phones were over choppy. In terms utilization did you give a stat as to whether or not it was up or down year-over-year?
[A – Barry McCarthy]: Utilization of Disk usage.
[Q - Frank Christina]: Oh, thank you Sorry. Did you give the stat as to whether or not it changed year-over-year?
[A - Barry McCarthy]: It's down year-over-year.
[Q - Frank Christina]: And in the past you've sometimes given a percentage. Can you give us a ballpark there?
[A – Barry McCarthy]: No.
[Q - Frank Christina]: Okay. And then the other question is, with regards to the cash flow it seems like that you had an atypical decrease accounts payable, and I was just curious what that was, that's historically risen. If you could give us some color there.
[A - Barry McCarthy]: Yeah, we think about the combination of AP and 52:03 (indiscernible) expansion AP with a quite a bit in the current quarter. It's primarily related to a decrease and content purchasing.
[Q - Frank Christina]: Okay. Thanks very much.
[Operator]: Gordon Hodge, Thomas Weisel Partners.
[Q - Gordon Hodge]: Yeah, sorry, but here's one on the whole notion of tipping the stores. Curious if you think you're pretty close to doing so and if so would that, cause you to be really aggressive, at least on a short-term basis, I guess to test that hypothesis that you can do in the and would you then be cut prices, for instance, or more be aggressive in a particular regional area, would that be the other way you to think about a test of the,
[A - Barry McCarthy]: No Gordon, remember that the stores have five and ten-year leases, so you can't get short-term, let's run aggressive pricing for summer and, change the flavor of the market. So it's really of long-term trend and what we're seeing in the bay area video stores closing, and a number of block busters closing that's the positive trend for but again, it will play out over five years because the lease has come up they just get non removed. I think to get out of the leases. So, you know, that's the real constraint, and, let me rather losing money because of low sales in those stores will it high penetration. So by continuing to drive penetration up, we continue to lower their efficiency in the stores and you see that in the earnings about competitors or lack thereof, and you think that will be a continuing trend going forward as we grow.
[Q - Gordon Hodge]: So this isn't a sharp change it your track on your part in terms tinkering with prices more. That’s more gradual?
[A - Barry McCarthy]: You know really the price were we seen is, the elasticity is substantial but we'll only do the price if the elasticity is enough that we end up at the same or better place from an earnings point of view.
[Q - Gordon Hodge]: Great. Thank you.
[Operator] Derek Brown, Pacific Growth Equities.
[Q - Derek Brown]: Thank you. My question kind of relates to the how guys anticipate the mix of subs coming in by the various price plan, I mean that based on kind of the general framework you guys are giving for '06 is it seems like there's quite a bit coming in at the lower end, and I'm wondering if that's by design or by accident or people rotating from current price plans downstream at all?
[A - Barry McCarthy]: We're pretty agnostic in terms of the different price plans what. we do want to do is get subscribers on the plan that makes sense for their profile because then they're more like to stay with us, and that's part of why our retention has been improving, churn dropping is we're doing a better job of getting someone that's a very casual movie person to be on the 999 program and someone who is a very heavy-duty movie person to be on our $24.0 four-out program. So when you match the (indiscernible) 55:21 person they're more likely to stay with you for a long time. As you mentioned before the gross profit dollars, profound pretty similar across the plans, which allows us to be agnostic. So we really don't try to, for example, we have a free trial for all of the plan. If we wanted to steer people we could have a free trial just on one or two of the plans what we found is that on balance it works better to let people choose the plan that makes sense for their life, so other than the revenue the other factors, if you take it down to the gross profit line you get much more stable.
[Q - Derek Brown]: Right thank you.
[A - Barry McCarthy]: To say this while giving way on a revenue per disk basis we really like what we're seeing in the business.
[Operator]: Glen Reid, Bear Stearns.
[Q - Glen Reid]: Just again real quick on the tax issues, just so I'm clear, there is no cash tax impact, it's really a GAAP tax, and we should be modeling 42% starting when?
[A - Barry McCarthy]: Yes, I think 42% is as good an assumption as any other, and it's not a tax issue, it's a bookkeeping issue for GAAP purposes. The timing is uncertain. I think the bid and the ask is somewhere between the fourth quarter of this year, which I think is probably unlikely, but within the realm of possibility, and the outer limits I would say the third quarter of next year, assuming that we're operating the bottom line along the lines of our forecast.
[Q - Glen Reid]: Okay.
[A - Barry McCarthy]: It's about developing and conveying to our auditors and us collectively reaching the conclusion that there's more than a reasonable likelihood that we will be able to utilize in future periods the NOL’s that we've accumulated.
[Q - Glen Reid]: Okay. And then one other question, just back to the marketing issue. Have you guys sort of found any particular marketing, whether it's TV, Internet that's become more effective, less effective, and how do you think you'll sort of proceed with your marketing strategy, you know, based on what you've seen in terms of effectiveness?
[A – Reed Hastings]; Well, we're getting better and better as we get bigger in terms of our on-line buying, in terms of our TV buying, print, radio, direct mail, all the vehicles that we use, and any channel can work depending on its price. So by having multiple channels we're able to be very diversified mix, so if pricing drops in one area, we'll tend to pour little more money into that pricing rises in another area we'll shift money out of it. In that way we have a very flexible and diversified platform for our acquisition spending.
[Q - Glen Reid]: Okay. Thanks.
[Reed Hastings co founder and CEO] Great. Thank you to everybody on the call. Look forward to talking with you in another quarter.
[Operator]: That does conclude today's conference call. You may disconnect at this time. We do appreciate your participation.
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