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Dresser Rand Group Inc. (NYSE:DRC)

Q3 2007 Earnings Call

October 31, 2007 8:30 AM ET

Executives

Blaise Derrico - IR Director

Vince Volpe - President, CEO

Mark Baldwin - CFO

Analysts

Geoff Kieburtz - Citigroup

Ole Slorer - Morgan Stanley

Kevin Pollard – JP Morgan

James West - Lehman Brothers

Robin Shoemaker - Bear Stearns

David Anderson - UBS

Roger Read - Natexis Bleichroeder

Thad Vayda - Stifel Nicolaus

Glenn Primack - Broadview Advisors

Operator

Good morning, ladies and gentlemen and welcome to theDresser-Rand third quarter 2007 earnings conference call. (OperatorInstructions) I will now turn theconference over to Blaise Derrico, Director of Investor Relations.

Blaise Derrico

Good morning, all. This call is open to the public. It isbeing webcast simultaneously at www.Dresser-Rand.com and will be temporaryarchived for replay. A copy of the news release we issued yesterday isavailable our website, as are the slides we will be using today during ourpresentation. We will let you know when to advance the slides as we deliver ourprepared remarks.

Please turn to slide 2. The statements made during thisconference call that are not historical facts may be forward-lookingstatements. Forward-looking statements involve risks and uncertainties that maycause actual results or events to differ materially from those expressed orimplied in such statements.

In addition, this conference call contains time-sensitiveinformation that reflects management's best judgment only as of the date of thelive call. Dresser-Rand does not undertake any ongoing obligation, other thanthat imposed by law, to publicly update or revise any forward-lookingstatements to reflect future events, information or circumstances that ariseafter this call.

Further information concerning issues that could materiallyaffect forward-looking statements, including our financial performance, can befound in Dresser-Rand's periodic filings with the SEC.

Now, I will turn the call over to Vince Volpe, President andCEO.

Vince Volpe

Good morning. Thank you for joining us today and welcome toDresser-Rand's earnings conference call. With me today are Mark Baldwin, ourChief Financial Officer; and Blaise Derrico, Director of Investor Relations. Today,I will start with a few opening comments and Mark will follow me with adetailed discussion of our third quarter results.

Please turn to slide 3. Our net income for the third quarterwas about $21 million or $0.25 per share. Consistent with our prerelease onOctober 3, there are two items which affected our third quarter results.

First, the work stoppage at our Painted Post facility in New York State reducedour net income by approximately $13 million after tax, or $0.15 per share. On August 3, 2007, the representedemployees at our Painted Post facility in New York State imposed a work stoppage as aresult of our being unsuccessful in reaching a new agreement.

As the work stoppage persists, we continue to executesuccessfully our contingency plan. This plan includes a complement of temporaryworkers, augmented by newly hired permanent workers, employees from the unionwho have chosen to return to work, and extended subcontracting. As the numberof temporary workers declines, our costs will reduce to the point that shouldthe work stoppage persists through 2008, we believe the results for the yearwill not be materially impacted.

The second item which affected our third quarter results wasthat aftermarket parts sales did not recover as quickly as had been previouslyforecast. This was principally due to the continuing slow pace of orders fromtwo national oil company clients. Recently, we've begun to see signs ofrecovery. I will have more to say about this situation in a moment.

Please turn to slide 4. As to other third quarterperformance metrics, I will mention a few. Sales increased 25% compared to thecorresponding period last year. Bookings were 3% higher than last year's thirdquarter. Our backlog grew 48% to a record level of approximately $1.7 billion.Our operating income was $36 million, including the impact of Painted Post workstoppage, which we estimate reduced our operating income in the quarter byabout $20 million and margins by about 400 basis points. Our operating cashflow for the first nine months of the year was $188 million, which was morethan double that of the corresponding nine-month period last year.

We are also pleased to report on a couple of other positivedevelopments that occurred earlier this month of October. Next slide, please.First, we signed an alliance agreement with Repsol YPF, one of the world's tenlargest private oil enterprises. Repsol has operations in 29 countries with thebulk of its assets located in Spainand Argentina.The agreement covers sales of all Dresser-Rand products and services. Weestimate the value of the agreement over the next two years of be approximately$100 million.

Under this alliance agreement, we have been awarded an orderin August for the Tarragonarefinery worth approximately $13 million, and in October, we secured two ordersvalued at approximately $20 million for the Petronor expansion at the Bilbao,Spain refinery.

Repsol's planned refinery expansion reflects the continuedstrength of the refinery market globally, particularly as it relates toexpansion in the European sector. There are more planned refinery projectswhere we believe we are well positioned to supply mission-critical rotatingequipment.

Next slide, please. Second, in October we booked an order inexcess of $46 million for compression equipment to be supplied on an offshoreplatform in Asia Pacific. We will supply two DATUM turbo compressor trains forexport gas and pipeline service. This is continued evidence of the strength inthe new unit market for upstream Over the past 12 months, bookings for projectsin the upstream market have represented nearly a third of our total bookingsfor all markets.

Next slide, please. Total bookings for the last 12 monthswere approximately $2.1 billion or 26% higher than the same period a year agoand 60% higher than two years ago. Approximately 50% of our bookings in thelast year were for downstream applications, principally in refining. New unitbookings were especially strong and totaled $1.3 billion, an increase of 46%compared to the 12 months ended September 30, 2006. Aftermarket bookings were up 4%.

As previously mentioned, aftermarket bookings in 2007 havebeen temporarily impacted by changes in the procurement process and the delayin budget appropriations for certain national oil company clients.

Turn to our next slide, please. The bar chart in the upperleft-hand corner of this slide shows the bookings trends for the two nationaloil company clients that have slowed their order patterns due to processchanges. As you can see, bookings for the first nine months of 2007 wereapproximately $43 million lower than the corresponding period in 2006.

As previously reported, at one of the national oil companieswhich we've labeled NOCA, budget issues have impacted their ability to placeorders. At the other, which we've labeled NOCB, process changes have increasedthe time from request for quotation to purchase order from weeks to months, dueto the additional approvals that are now required and the additional officelocations involved in the process.

At the time of our second quarter conference call, we hadsaid that we expected to see both national oil companies return to more normalbooking and shipment levels. While this was not the case, bookings for thesetwo national oil companies started to improve in the third quarter, totalingabout $20 million, up from $14 million in the first half of the year, so wehave seen some recovery in the order trend. We continue to believe that theseshortfalls in aftermarket bookings involving these two national oil companiesare just timing delays and not lost market share.

The bar chart in the lower lefthand corner of this slideshows bookings for the first nine months of 2007 compared to the correspondingperiod in 2006, excluding the two national oil company clients. The point ofthis bar chart is that if you were to adjust for these two clients, bookingsfor all other clients are actually up 8% year over year.

Turn to slide 9, please. We do have some good newsconcerning one of these national oil company clients. We're currentlynegotiating a three-year blanket purchase agreement initially valued atapproximately $50 million. The agreement would cover all aftermarket parts andservices and would help streamline transacting business. We expect to sign theagreement this quarter. In light of these developments, we believe thataftermarket sales shortfall will be at least partially recovered in the fourthquarter.

Turn to slide 10, please. Our backlog at the end ofSeptember was at a record level of $1.7 billion or 48% higher than the year earlierperiod and 101% higher than two years ago.

Breaking it down into our two business segments, new unitbacklog of $1.5 billion is up 62% versus a year ago, and the aftermarketbacklog is up about 4% to $294 million. Our strong backlog gives us very goodmomentum going into the fourth quarter and next year. I will have more to sayabout outlook in a moment.

First, I'd like to turn the our call over to Mark Baldwinfor some more details about our third quarter financial results.

Mark Baldwin

Thank you, Vince, andgood morning, everyone. Please turn to slide 11. Sales for the third quarter of2007 of $389 million were about 25% higher than the third quarter of 2006. Newunit sales of $194 million were higher than the third quarter of '06 by about$80 million, reflecting the shipment of a few large orders, including turbocompressors installed on a large FPSO vessel.

Aftermarket sales of $195 million or essentially flat withthe corresponding period last year. Sales were lower than what we hadanticipated earlier in the quarter, due in part to the slower than expectedpace of orders from two of our national oil company clients, as Vince hasrecently discussed.

Turn to the next slide, please. As Vince mentioned earlier,we reported net income for the third quarter of $21 million or $0.25 perdiluted share. However, as you can see on this slide, if you were to adjust ourGAAP net income for the estimated impact of the Painted Post work stoppage,adjusted non-GAAP net income would have been approximately $34 million or $0.40per diluted share.

Turn to Slide 13, please. Operating income for the thirdquarter of 2007 was $36 million, including the impact of the work stoppage,which we estimate reduced operating income by approximately $20 million.

There are two components of this estimated $20 millionimpact. First, there are higher costs of approximately $10 million, whichprincipally relates to the use of temporary replacement workers. Second, weestimate that there was about $10 million of margin related to sales that havebeen deferred.

As you can see on this slide, if you were to adjust ouroperating income for the impact of the work stoppage, adjusted non-GAAPoperating income would have been approximately $56 million compared to $48million for the corresponding period in '06.

Turn to slide 14, please. Again, if you were to adjust forthe impact of the work stoppage, the adjusted non-GAAP operating margin of13.3% compares to 15.6% for the corresponding period in '06. This 230 basispoint decrease was principally due to lower margin new units representing ahigher portion of total revenues in '07 compared to '06. New unit revenues increasedto nearly 50% of total revenues compared to only 37% in 2006.

Next slide, please. Our new unit operating margin decreasednearly 380 basis points to 6.2%. The decrease in operating margin wasprincipally attributable to the work stoppage at the Painted Post facility,which we estimate reduced margins by approximately 300 to 350 basis points.

Next slide, please. Our aftermarket operating margindecreased 430 basis points to 22.1%. The decrease in the segment's operatingmargin was primarily attributable to the impact of the work stoppage at thePainted Post facility, which we estimate reduced margins by approximately 400to 450 basis points.

Turn to Slide 17, please. In August of 2007, we amended ourrevolving credit facility. The amendment increased the size of the facility by$150 million to $500 million. It lowered the borrowing costs 50 basis points,and extended the maturity date by approximately three years.

At the end of the third quarter, our liquidity wasapproximately $491 million and consisted of about $184 million in cash and $307million of available borrowings under our bank credit arrangements.

Next slide, please. Net cash provided by operatingactivities for the first nine months of the year was about $188 million. Thiscompares to $92 million in the first nine months of '06. The increase ofapproximately $96 million was principally from favorable changes in workingcapital and higher operating earnings.

With respect to the working capital changes, the change in accountsreceivable since year-end provided cash of approximately $77 million in thefirst nine months of 2007, compared to $44 million in the first nine months of2006. Inventories, net of progress payments, grew $53 million in the period asour business continued to grow. Inventories grew nearly $43 million in thefirst nine months of '06. Customer advances increased approximately $72 millionin the period, compared to an increase of approximately $12 million in thefirst nine months of 2006.

Turn to Slide 19, please. As you can see on this slide, networking capital has been reduced by more than $100 million to a negative numberover the past 12 months, despite higher business volume. This improvement inour net working capital reflects our diligence in collecting progress paymentsand advances from customers, consistent with the terms of our contracts. Thetiming of billing and collection of these advances has improved. For example,the sum of progress payments and customer advances increased to 94% of ourgross inventory value at the end of September of '07, compared to 74% at theend of '06.

Next slide, please. While we anticipate sustaining somelevel of this improvement in net working capital, quarterly fluctuations in ourbusiness may at some point drive us back to the 5% of sales target in thefuture, depending upon the growth and timing of new unit bookings. As you cansee on this slide, net working capital in the range of 5% of sales is a morenormal level for our business.

Next slide, please. In terms of investing activities, weused approximately $18 million of cash for the first nine months of '07, $10million for capital expenditures and $8 million for the acquisition of theGimpel valve business in April. This compares to investing activities using $13million in the first nine months of '06 for capital expenditures. We also used$140 million of cash in the first nine months of 2007, principally to pay downlong-term debt.

Turn to slide 22, please. You can see on this slide thesignificant reduction in our total debt. Since the end of 2004, we've reducedtotal debt by a little more than $450 million. Next slide, please. We ended thethird quarter with a net debt to capital ratio of approximately 17%, and netdebt to our last 12 months' adjusted EBITDA was less than 1 times.

As you know, our growth strategy includes acquisitions.While we have nothing to report at this time, we are continuously evaluatingpotential targets. For more information about our results for the thirdquarter, please refer to our 10-Q which we filed last night with the SEC.

With that, I will now turn the call back to Vince for someclosing comments and to moderate our Q&A session.

Vince Volpe

Thank you, Mark. Turn to slide 24, please. I will wrap upour prepared remarks with a few comments about our business outlook. Demand forour products and services continues to be strong. Our backlog is extended into2008 with more than $1.1 billion of our September 30, 2007 backlog scheduled to ship beyond this year.

As for our earnings outlook, we expect the fourth quarteroperating income to be in the range of $85 million to $105 million, including apotential curtailment gain of between $8 million and $12 million. We currentlyestimate that the impact of the work stoppage on fourth quarter results will beapproximately three-quarters of the third quarter impact. This is due toongoing reduction in our dependence on the relatively high cost temporary workforce due to hiring of permanent replacement workers and extendedsubcontracting.

With respect to earnings per share in the fourth quarter, wecurrently estimate that it will be in the range of $0.58 to $0.73 per share.This assumes interest expense of approximately $8 million and an effective taxrate of 36.5%. These fourth quarter results should bring the full year 2007operating income to a range of $205 million to $225 million, including thecurtailment gain of $8 million to $12 million.

The curtailment gain would essentially offset certain otherunusual charges recorded this year of approximately $10.2 million, including aprovision for the Maersk litigation, service unit expenses, and workers' compensationexpenses related to previous years' payment information provided to us byIngersoll-Rand earlier this year.

Turn to the next slide, please. As to our outlook for 2008,we currently expect significant improvement compared to 2007. While we have notcompleted our 2008 plan, our current thinking is that consolidated revenuesshould increase on a percentage basis by 15% to 20%. New unit revenues shouldincrease on a percentage basis by 25% to 30%. Consistent with previousguidance, operating margins should be in the low double-digit percent of sales.

Aftermarket revenues should increase on a percentage basisby high single-digits, consistent with the growth we've experienced in theaftermarket over the past six years. Operating income should increaseapproximately 40% over 2007 operating income guidance range of $205 million to$225 million, reflecting the continuing benefit of operating leverage, costcontrol and no material impact of the work stoppage, should it continue intonext year.

Interest expense is expected to be approximately $32million. We are now estimating our effective tax rate for 2008 to beapproximately 35% to 36%. Finally, diluted shares outstanding are expected tobe approximately $86 million.

Next slide, please. As mentioned during my opening remarks,I will now comment on the status of the work stoppage at our Painted Postfacility in New York. We are intothe 13th week of the work stoppage involving approximately 400 representedemployees. Since work stoppage commenced on August 4, 2007 the parties have met on several occasionswith the assistance of a federal mediator from the United States FederalMediation and Conciliation Service, and there has been virtually no change ineither parties' pre-strike position on any of the major areas of disagreementwhich lead to the work stoppage.

As a result, we've been implementing a contingency planwhich includes hiring permanent replacement workers, substantially increasingsubcontracting of components and parts, and reducing costs associated with thework stoppage. Our contingency plan, though somewhat higher in cost thanoriginally planned is, we believe, working effectively as designed. As to thecurrent status of the plan, we currently have working in the plantapproximately 180 temporary replacement workers consisting of skilledmachinists, assemblers and support personnel provided through a firm thatspecializes in replacement workers during strikes.

We've begun the process of hiring permanent replacements.The number of permanent replacements and bargaining unit employees who havechosen to return to work currently stands at 75. Additionally, another 25applicants have been offered employment and are expected to begin training inearly November, bringing the total in-plant permanent work force toapproximately 100. We expect to further increase the permanent replacementworkers with continuous recruiting. Throughout this recruiting process, we'vemaintained a strict adherence to our high quality standards for new employees.Those standards are focused on safety, quality, professional behavior,productivity and customer responsiveness.

We continue to extend subcontracting to our supply base withagreements being negotiated. Currently, we've subcontracting approximately 35%of our labor hours. By year end 2007, we estimate that the supply chain willhave replaced the work of approximately 150 people.

We are producing products to our high-quality standards andhave met most of our new unit delivery commitments to date. Production capacitywill ramp up as we continue to execute our contingency plan and increasinglyshift from temporary employees supplied by the replacement company to permanentreplacements and short-term subcontracting to long-term supply chain agreementsfor the purpose of shortening delivery cycle times.

In the event that the work stoppage continues into 2008, ourcurrent best view is that over time, we will turn to our pre-strike cost levelsand therefore, we do not expect a material impact on our full year results.

Before we open this to question-and-answer, I will take amoment to put the Painted Post situation into perspective. For many years, thelegacy contract language and benefits in Painted Post have increasinglydiverged from what has occurred in mainstream corporate Americaand indeed within most of Dresser-Rand.

Said differently, over the past several years, themanagement and union negotiating teams have not dealt proactively with thechanges necessary for an improved operation needed for long-term, globalgrowth. During the past two years, the company has attempted to work with theunion to effect the appropriate changes in a way that would be win-win for bothemployees and the company, including an offer to avoid the necessary strikepreparation and split the savings among the employees in the form of a bonusfor everyone. The union rejected this and all other suggestions we made.

This company is not seeking a contract which creates thelowest-cost labor force in the industry. If we were, we would have made thedecision to vacate our principal places of manufacturing in New York State. Infact, it could be argued that we should be spending money and resources ondoing just that rather than enduring this strike.

The fact is, however, that with an improved, moderncontract, we believe that we can compete effectively as a company, make strongreturns for our shareholders, and maintain a significant manufacturingfootprint here in the United States.We will persist in implementing the needed changes in all of our facilities.

Last year, we negotiated two competitive contracts: one inour Wellsville, New York facilityand one in out Burlington, Iowafacility. These contracts contained a great deal of change. As a result, overthe past year we have launched significant investments in both facilities,including added manufacturing capacity and investing in new equipment.

The Burlington, Iowaplant has increased its employment by 12%, and the company is making newinvestments in the facility. In Wellsville, we have moved new products into theplant and increased the workforce by almost 40%, from 285 when the contract wassettled to over 400 folks today.

While the increased workload has brought its share ofchallenges, our employees are focused on improving these operations for thelong term. This is a good example of what is still possible in the United States with a modern, effective, efficientand forward-looking working labor contract.

We continue to be firm in our commitment to achieve thechanges identified for Painted Post and for all of our facilities to operateeffectively in today's global business environment. We believe we're doing theright thing for our shareholders, for our employees, for our customers, and forthe communities in which we do business.

Thank you for your attention. At this point, we will openthe line for questions.

Question-and-AnswerSession

Operator

Your first question comes from Geoff Kieburtz - Citigroup.

Geoff Kieburtz - Citigroup

Could you explain a little bit the other income line in theresults today?

Mark Baldwin

Other income for the third quarter was $5.6 million. $5.2million of that is the gains we had on our cash that is held in affiliatesoffshore. The weak dollar creates a gain when we're holding that cash offshore.Almost all of that $5.6 million is the result of currency gains.

Geoff Kieburtz - Citigroup

As a consequence, not really something we could forecastvery effectively?

Mark Baldwin

If you can forecastthe dollar, you can, Geoff.

Vince Volpe

Let us know how that goes, Geoff. That's why we normallyfocus our comments on the operating income line.

Geoff Kieburtz - Citigroup

But a little seriously, if the dollar were to weaken infuture periods by a similar amount to what it did this past period, is this thekind of impact we can expect?

Mark Baldwin

Geoff, we are actually looking at trying to bring some moreof that money home, despite the prognosis that the dollar may weaken more. So,I would not expect, even if the dollar were to continue this decline, to havethat. We do want to bring more of it home. We are a dollar-based company and ifthe dollar does get stronger, it could go the other way. There are accountingimplications to that, Treasury implications to that. I don't want to get intothat at this point in time.

Geoff Kieburtz - Citigroup

On the fourth quarterguidance of $85 million to $105 million operating profit, if I understood youcorrectly, Vince, that's inclusive of $8 million to $12 million in FAS 106gains?

Vince Volpe

Correct.

Geoff Kieburtz - Citigroup

So if we excludedthat effect, because it didn't sound from your comments that that was a reallyhigh probability scenario, correct?

Vince Volpe

No, we believe thatwe will incur that gain this quarter, Geoff.

Geoff Kieburtz - Citigroup

Oh, you do?

Vince Volpe

Yes, but we're not100% sure, and so we want to make sure that we keep it on everyone's screen sothat if it does move out, we will let you know and you'll understand the effectof that.

Geoff Kieburtz - Citigroup

My original question was, if we took the gain out of thepicture, should we interpret the guidance as $85 million to $93 million ofoperating profit?

Vince Volpe

That sounds like theright math.

Geoff Kieburtz - Citigroup

What triggers the FAS 106 gain?

Vince Volpe

There's a long answer to that. It is complex and I can'tspeculate on all the different pieces of it, but as I said before, we believethat is something that will occur in Q4.

Geoff Kieburtz - Citigroup

I think I heard you say that in your '08 outlook youcontinue to believe that new unit margins should be in the low double-digits.Is that correct?

Vince Volpe

Yes. We've beensaying this for the last couple of years, Geoff, that we thought we would getto high single-digits this year and then crossover in 2008 into the low double-digitrange. That looks now, with a lot of our backlog now in place that looks likethe case. I think even on the last quarter call, I alluded to the fact that wewould have more information for you on this call because we just have a betterview on our backlog next year.

Geoff Kieburtz - Citigroup

That's really what's driving it, is pricing improvement inthe backlog?

Vince Volpe

Yes, There are three things that go on, so however you dothe math, the way that it fundamentally works out is we try and focus ourmaterial gains on offsetting inflation, material productivity gains, whichallows the pricing to flow through.

Geoff Kieburtz - Citigroup

You mentioned a couple of contract wins there, on the Repsolcontract specifically. Could you tell us how much of that is incrementalbusiness from Repsol, and how does it breakdown between aftermarket and newunit?

Vince Volpe

This is mostly newunits. What we've booked so far is mostly new units, all but probably about $3million we think would be new units. Now, the way to think about Repsol is thisis terrific for us. Repsol has been a good customer in the past but they justhaven't been all that active, and so you've been from one year to the next on the new unitside, in a zero to $10 million mode. Maybe there was a year where it was morebut on average I would say it was probably less than $10 million. So now, youcan see that there's a significant step up in terms of what we've alreadybooked.

Now, just to be clear on this, we booked that first tranchein August of about $13 million. That's actually steam turbine business, so thatis in our backlog as you look at 9/30. The other about $20 million, we bookedthis month of October, so you actually haven't seen it show up yet. That is forthe turbo compressor business and reciprocating compressor business.

By the way, reciprocating compressor is that will be builtat Painted Post.

Geoff Kieburtz - Citigroup

You do expect $100 million of orders over two years?

Vince Volpe

Correct, that'scorrect.

Operator

Your next question comes from Ole Slorer - Morgan Stanley.

Ole Slorer - Morgan Stanley

Just going back on the fourth quarter guidance again, so if Iunderstand you correctly, we take out the gain from the high end, the loss fromthe low end to get to a gain-free guidance. That would imply a midpoint in thattype of guidance in the low 60s per share, versus current expectations of 58,so marginally ahead. Would that be the right way to look at it?

Mark Baldwin

The right way to look at I, the operating income guidancewas $85 million to $105 million with the curtailment gain. If you take themidpoint of that curtailment gain, the operating income would be $75 million to$95 million. Then just work down.

Ole Slorer - Morgan Stanley

Sorry, I misunderstood your previous comment. So on thatbasis, the midpoint in the guidance, excluding the curtailment gain, is thesame as the First Call estimate, right?

Mark Baldwin

I'm not sure what theFirst Call number is right now. I am talking operating income, Ole.

Ole Slorer - Morgan Stanley

But translate thatthrough to EPS.

Mark Baldwin

Then that is what it works out to, because the operatingincome guidance, without the curtailment gain, is $75 million to $95 million.

Ole Slorer - Morgan Stanley

So you knock off the midpoint in the operating income.

Mark Baldwin

And with all the other guidance, that should give you theright EPS. I have not done that math though.

Ole Slorer - Morgan Stanley

I think it works out at 59 or so, above expectations. Solooking at the $10 million of deferred revenues, up to $20 million, when wouldwe expect to recover that? Is that all coming back in the fourth quarter, or issome of that also delayed beyond that?

Vince Volpe

Well, I think the wayto look at it, Ole, is a fair amount of it is going to come back, okay? Intotal, whether it all comes back from the Painted Post piece or whatever orit's because of the aftermarket increase in the bookings and our oil companyclients, if you look at the total year, if you adjust for the strike, you willsee that we are getting pretty darned close on a total year guidance to whatwas sort of at the low end of our range but pretty darned close to the rangethat we originally provided at the beginning of the year. That should give youa sense that a significant portion, we believe, of the aftermarket shortfallwill actually be recovered.

As far as the curtailment gain, by the way, I want to justmake sure everybody thinks about this over the course of the year. It's logicalfor you to make a fourth quarter adjustment of that, but let's not lose sightof the fact that we had about $10.4 million of extraordinary costs in thebeginning of the year related to the Maersk litigation from 1998, the workers' compclaim from Ingersoll-Rand which dates back a couple years, and then the exitunits, the service units that were part of selling the last tranche of stock tothe public markets.

When you add those three things together, you get about$10.4 million, I think, or $10.2 million. You can sort of use that as you thinkabout the curtailment gain which comes back in the other direction and justforget about any adjustments certainly on a full-year basis.

Ole Slorer - Morgan Stanley

I just wanted to understand the math behind it. Looking intonext year on your guidance, pretty punchy numbers there in terms of revenues onthe new unit side. Can you talk a little bit about the type of pricing powerthat you think you have, given that you are seeing strong demand from all ofyour end user areas?

Vince Volpe

Ole, this is not the first time you've asked me thequestion.

Ole Slorer - Morgan Stanley

Every quarter I suppose. As long as you have 4% or 5%margins net of D&A, then I will continue to ask that question.

Vince Volpe

Yes, it's a fair question. I think it will continue to rollalong at the same trajectory we've seen it over the past couple of years. It'sa gradual thing in our business because we strive to push pricing from one jobto the next, not just on a yearly basis.

Ole Slorer - Morgan Stanley

You're still doingthat with all the stuff you are delivering in '08/'09?

Vince Volpe

Yes, you will seecontinued expansion in the margins.

Ole Slorer - Morgan Stanley

Same rate, 200 basis points?

Vince Volpe

Again, we haven't given you specific numbers at this point.What we've said is we will be in that low double-digit return on sales numberfor units next year.

Operator

Your next question comes from Kevin Pollard – JP Morgan.

Kevin Pollard - JP Morgan

I had a couple ofquestions around your new units. First of all, if I look at your ending backlogof a little over $1.4 billion and your number of a little over $1.1 billion thatis supposed to ship in '08 and beyond, can I infer from that that you'relooking for a big number close to $300 million in the fourth quarter?

Vince Volpe

Yes.

Kevin Pollard - JP Morgan

Quite a bit scheduled to ship there. Then if I look atwhat's left, relative to go out in '08 and beyond, assume a 14-month lead time. It seems like therevenue guidance up 25% to 30%, while very good for sure, it actually seems alittle conservative. Can you walk me through your thinking there?

Vince Volpe

Well, I think there'stwo pieces of it, Kevin. One is we talked 14 to 16 months is what we've beensaying, but there is an issue of mix in there. If you get a couple of projectsthat have extended testing, full load, full pressure testing, Class 1 typetesting, those will extend out beyond that timeframe just because of thetesting requirements.

So we give you broad guidance of 14 to 16 months but theactual number moves around depending on the mix of business. So we have takenthe actual mix of business that we have. We have obviously more visibility thanyou do, so we don't need to just use statistics. We actually look at ourbacklog and looked at the delivery dates, and we think that 25% to 30% is afairly good number.

All that being said, I would not say, at this point in time,we would be looking to overstate that growth either, though.

Kevin Pollard - JP Morgan

Let me just ask the question this way then. If youexperience continued, strong bookings in the early first half of '08, it'scertainly possible that number could prove to be conservative.

Vince Volpe

Yes, but unlikely because what happens is by the time you'reinto '08, anything you're booking that's got a fairly short cycle time, ninemonths or less, is probably pretty small: single-stage turbines, high-speedseparable resets, and they don't really amount to that much in terms ofrevenue. Any of the big stuff that's going to move the needle in terms of thetop line is going to be into '09.

Kevin Pollard - JP Morgan

It seems like I recall the last conference call you said youexpected second half of '07 bookings on the new unit side to be in the $500million to $600 million range. Obviously, you're on track based on what you sawin Q3. Do you still think you are there again in Q4?

Vince Volpe

Yes, I do.

Kevin Pollard - JP Morgan

So, a similar levelof bookings?

Vince Volpe

Yes.

Kevin Pollard - JP Morgan

If I can switch over to the strike just will quickly, you'vedone it sounds like a really good job of replacing a lot of the strikingworkers and outsourcing. If the strike were to end in before year-end, how doyou deal with the 400 striking employees plus the 100 new permanent workers,especially in light of the fact that you've outsourced 150 jobs? How does thatall play together?

Vince Volpe

Well, there's a couple of pieces to this. First of all, thepeople the we've hired as permanent replacement workers stay because we hiredthem as permanent replacement workers and so, they stay. So that's the firsttranche.

The variables that we have, then are what's left. Also, welook at what has been subcontracted. The subcontracting piece, and this is sortof a subtlety that I don't always do a good job making. There's subcontractingand then there's outsourcing, okay? When you make a decision that you're goingto outsource something and put it out of the facility forever -- theoreticallyforever -- you go and you sign long-term supply agreements and that workbasically never comes back.

The subcontracting piece you have some flexibility on and sosome portion of that, we're going to look at the workforce. We will bring thebest performers back first. When we think that we've got the right mix ofcontinued outsourcing and subcontracting and the right mix of good,high-performance employees, then that's what we will do.

The short story is that at this juncture in time,unfortunately there is little expectation that all 400 folks that are out aregoing to come back.

Kevin Pollard - JP Morgan

In terms of the guidance that you've given on the marginside, does that assume that the strike ends and the new cost structure is inplace or would there be some potential upside as that strike gets resolved?

Vince Volpe

Well, I'm not sure that there's much the of a swing eitherway, I think we would save a little cost. But let me just first of all say oneother thing in terms of the answer that I've provided you. What I should havestarted with is that we have a very clear understanding of the legalrequirements around what we've done so far. In fact, our chief negotiator is alabor attorney, okay? So we are very focused on making sure that not only do wedo the ethical thing but we also strictly follow the legal requirements interms of evaluating how and how many folks to bring back.

Now, far as the strike is concerned, if we were to settle --which based on what has happened so far, I've got to tell you is unlikely --but if we were to settle here miraculously short term, say by the end of theyear, and we were able to bring everybody back, there would basically be somecost avoidance around the temporary workforce that we have today.

The temp workers are the once that are most expensive, theones that we've hired through this outside firm. So that might make a change,but it's really not going to move the needle that much one way or another,which is why we basically represented that we don't think that there's going tobe any real material cost impact on 2008.

What will be different is how we get the work done. So, Iwouldn't look for too much upside any more than we're looking for muchdownside, if it doesn't get resolved.

Operator

Your next question comes from James West - Lehman Brothers.

James West - Lehman Brothers

When we think about the replacement workers and particularlythe new 25 that you've made offers to and that will enter training hereshortly, how long is the training process? Should we be concerned about, Iguess, new labor entering your facilities that weren't union people comingback?

Vince Volpe

Well, a couple ofgood questions all embedded in that one. First of all, first and foremost,nobody will come into this facility without the proper safety training, (a). (b)Thekind of people that we're hiring from the outside are people that have theaptitude or the experience already to do what our folks that were there weredoing. We have about a four-week training period, after which we expect thesepeople to be productive.

James, depending on who they are, their level ofproductivity could go from 50% or 100%, or some other number, from zero to100%, I guess. What we will see is, in some cases, people after the four weeksare pretty much good to go. In other cases, it will ramp up a little bit moreslowly, but we're not talking about years year, okay?

I mean, I don't mean to minimize what our folks in-househave done for us all these years, but the reality is that if you have theaptitude and you are a trained machinist, you will learn how to machine ourtype of equipment fairly quickly and you will learn the idiosyncrasies of themachine tool you work on and all those other things.

So, there will be a bit of a ramp-up time, but we've bakedall of that into the guidance that we've provided. We've also baked in therunning down of the cost, if you will and we've done a significant out of workaround this before we represented and continued to represent that. We don'tthink that the impact should the strike persist will be material on ourfinancial results next year.

James West - Lehman Brothers

Switching gears, you announced back I guess a couple weeksago that you obtained some technology from TransCanada. Could you provide somemore details on that technology, how that gives you a competitive edge and whatthat could mean for your business?

Vince Volpe

What we have is ejector technology in our gas enginebusiness and so the play here, I think it's fundamentally environmental; someefficiency improvements also. I wouldsay that while we are delighted with that, that is not something singularlythat's going to move the needle, James. It's just one of those things we have.

If you think about our growth in the aftermarket over thelast six years, we've been growing, even with this year and the problems we'vehad with those two clients, we're growing about 8% a year. The way you do thatis by doing all of the things we talked about before, not the least of which islooking at adding or developing a variety or an array of additional aftermarketretrofits and upgrades. This really falls into that category.

So this is not something that's going to be a line itemwe're going to report about and say oh, wow, this has moved the needlesingularly. It's just another one of a cadre of initiatives that we'velaunched. This one happens to be through a license agreement. Many of these weactually develop ourselves and then others we think will come to us throughacquisitions, which we continue to focus on.

James West - Lehman Brothers

So on the acquisition front, how is the hunt going foradditional aftermarket acquisitions?

Vince Volpe

Well, the hunt is on. We have a fair amount of targets andwe are at different stages in different discussions right now, so until you getto the end and you have a conclusion on any of these, it's hard to provide toomuch guidance, but we are working at it copiously, James.

Operator

Your next question comes from Robin Shoemaker - BearStearns.

Robin Shoemaker - Bear Stearns

Vince, in the past you've articulated an aftermarketstrategy of increasing the aftermarket share on your own equipment, and alsogetting a larger share of the aftermarket on competitors' equipment. I justwondered what kind of progress you've made on those two fronts?

Vince Volpe

Well, I think theguidance that we provided was we thought we would pick up about another 2percentage points of share this year on our own equipment, plus or minus,Robin. Then as it relates to the applied technology initiative, which is workingon other people's equipment, I don't have the number right here to disclosetoday but I believe that through the nine months of this year, we've alreadysurpassed the bookings of last year for the full year. So it continues to movealong nicely. Last year, we booked $52 million on other people's equipment, sothat will frame it for you.

Robin Shoemaker - Bear Stearns

On the new unit backlog, I believe you said one-third wasupstream. What percentage is mid and downstream, roughly?

Mark Baldwin

Downstream is aboutbetween 45% and 50% and then midstream is a little more than 10%, and we haveother, which is fundamentally the government business, which is the highsingle-digits.

Robin Shoemaker - Bear Stearns

Is it still broken out roughly 50% North Americaand 50% international?

Vince Volpe

I don't have thatnumber right with me, but I will tell you this early that it may be, but itlooks like it's starting to move offshore. I mean, if you look at Repsol goingforward, if you look at Repsol as a booking coming in October, that's all forEurope.

By the way, as we look at the Repsol business, so far, weare only talking about Spainwhere we've had bookings and some other assets, including in South America. So we are excited about that.

For 2006, about half of it was North Americaand on a trailing 12-month basis, it looks like we are in the low 40% now. Soit is moving offshore, Robin.

Robin Shoemaker - Bear Stearns

I think on the last conference call you indicated youthought you might book as much as $100 million of new unit orders for LNGprojects in '07. Is that likely or are there some delays you are experiencingthere?

Vince Volpe

Well, it looks likethe delay, we're starting to experience the delays that we were somewhatconcerned about, even from last year. so I think this is probably the righttime to say that my view has changed from probably to unlikely booking thisyear.

The good news is we theoretically don't need them to bebooked this year. The other good news is that the projects that we are workingon or are engaged in, they haven't been decided and they haven't goneelsewhere. So we are still engaged and we're still waiting, and so that is inthe category of probably at this point going to move out into next year.

Operator

Your next question comes from David Anderson - UBS.

David Anderson - UBS

Most of the questionshave centered around the new unit side. I just want to ask a couple ofquestions on your aftermarket. If I look at your guidance for next year, youare showing high single-digit growth for aftermarket revenue. It looks likegrowth has been moderating there over the last couple of years. Can you justarticulate maybe a little bit more as to what's going on there? Is there somesort of trend in here that I'm not quite understanding?

I know you talked about the NOCs and the impact. I assumethat you're taking that into account there, and so I guess if you could walk methrough how you get to that guidance, and also what kind of upside you might belooking at there?

Vince Volpe

First of all, I think the aftermarket business was flat from1990 to 2000; compound annual growth rate flat; 0.4% I think was the number.But even inside of those periods, you could see fluctuations anywhere plus orminus $50 million. it still would bounce around and that's because we have alot of clients. We have close to 8,000 or more discreet order numbers or orderscoming in for aftermarket. While we don't have 8,000 clients, this is a verydecentralized business, so BP doesn't adopt strategy. It could be Texas City buys a bunch of parts but the North Sea doesn't; so there's a lot movement up and down so when we lookat forecasting in the aftermarket we've got to do it on statistics.

So if we look at this year and we bake in the bookingsnumbers, which clearly are flat based on these two NOCs, our view is that we'regoing to project a compound annual growth rate consistent with what we'veachieved from 2000 to 2007 inclusive, where we did start to grow that businessin a systemic fashion and we did it by doing some of the things that we'vetalked about in the past, creating demand, working on other people's equipment,doing a better job our own market share.

At this juncture in time sitting here at the end of Q3, itis impossible to know what each of these clients is going to do in detail.We've opted for going back to what has statistically been our run rate over thelast five or six years, Dave. So, could there be upside to that? Yes, therecould be but I couldn't speculate what there is.

You know, there could also be downside to it, right, becauseyou can get that much fluctuation. So we feel like the high single-digit numberat this point in time, is the most reasonable guidance to give. I reallywouldn't shade it one way or another at this point in time.

David Anderson - UBS

A big chunk of that is on the refining side. We've talkabout this a little bit in the past. But have you seen any kind of changes interms of their maintenance schedules? If I read between the lines a little bit,you are expecting them to go back to more of the historical ordering patterns?I mean, have you seen any change from now to when you look to next year comparedto over the last couple of years?

Vince Volpe

Dave, not a heck of a lot. Bythe way, from one year to the next, the upstream business can actuallyprovide on a percentage basis, even though we have more units installed inrefining, on the upstream side oftentimes there is more extensive aftermarketwork being done because you are out on a platform; you are in a non-controlledenvironment in terms of gas properties.

The gas properties coming out of the well are not aggressivedry gas like what you get when you get in a refined process. So actually, Iwouldn't focus on refining aftermarket activity as the only thing that drivesthe aftermarket.

The other thing is that really with respect to the new unitbuying patterns, if you don't overhaul your unit every three years, you'regoing to be “pay me now or pay me later”. We did see that in the past and Ican't remember what year it was anymore, but in the late '90s, people triedthat and it really didn't work. Then they had sort of catastrophic failures. Soinstead of putting $200,000 or $100,000 worth of bearings, seals and consumableparts into a machine, they ran it too far and they wrecked the rotor and theywere into six or seven times that number easily.

I really don't see a big change in terms of the buyingpatterns across the spectrum of the aftermarket, which is why we are pegging itat sort of the traditional growth rate we've seen over the last five to sixyears.

David Anderson - UBS

Looking at the margins, you were talking about the impact ofthe strike and the NOCs on the margins in the third quarter. If I add that backin, the margins were quite strong on the third quarter. If I look going towardsto '08, I heard your comments of a couple hundred basis point improvement onthe new unit side. I'm just wondering. If I add that back in on the thirdquarter of little bit lower numbers, would you expect all-in operating marginsto expand in '08? Can you give me kind of a rough sense of how much you'relooking at?

Vince Volpe

I can repeat what Isaid before. You are right. If you adjust on a full-year basis for the strike,you will get something higher than we are reporting. Now, Mark has done themath for you on Q3 and year-to-date. So you'll get a number that is not farfrom what you were expecting, Dave, for the year way back when, when we talked aboutit.

The other thing that I supplied you with today so thatpeople didn't get confused adding stuff in and out, I didn't say it was Xamount of basis point improvement year over year because I thought I wouldconfuse everyone. What I said was use low double-digit operating margins for'08.

So I'm kind of getting you right to the answer rather thanconjecturing on how many basis point you add to an adjusted or a non-adjustednumber. I would just reiterate that guidance hasn't changed for two years. Youknow, it's what we said we were going to do, folks. We said we're going to getto high single-digits in for the full year of '07 and that we would crossoversort of the magic 10% line into '08 and get stronger margins, low double-digitsin '08.

Then the other thing I have once again reconfirmed a coupletimes is that the pricing continues to be strong and I reaffirmed to Ole on hisquestion that we continue to ramp up. I think you've got enough to triangulate.

David Anderson - UBS

No, I understand, butyou're just talking about new units though, right?

Vince Volpe

I'm sorry. Was I not clear?

David Anderson - UBS

No, I was asking forboth and I guess I was really asking about the aftermarket, is really what wasgetting at. Are you expecting expansion in aftermarket margins as well?

Vince Volpe

I think that thereshould be marginal expansion in the aftermarket, Dave. I think principallybecause the more units that you put through the factories, and we build theparts in the same factory, you're going to get some help there. So we're not ona big pricing crusade on the aftermarket; we are real happy with our margins. Wewill press where we can, but what will happen to the margins is basically abenefit of the units being a bigger part of the mix.

Operator

Your next question comes from Roger Read - NatexisBleichroeder.

Roger Read - Natexis Bleichroeder

I'm just trying tounderstand, in your further commentary on the Painted Post deal, the $10million of margin related to deferred sales that didn't come through in the thirdquarter. Is that new units only, or aftermarket only, or a combination of thetwo? I'm just trying to understand what might have been the lost revenue in thequarter.

Mark Baldwin

In our Q, you will see that we did take a shot at disclosingthat $20 million. We didn't break it down in terms of the deferred sales. Ofthe $20 million, $11 million to $12 million is in the aftermarket area, and $8million to $9 million was in the new units. Now again, that includes the costof the temporary workers and the deferred sales.

Roger Read - Natexis Bleichroeder

So, if I am lookingat deferred sales and I assumed a 50-50 split, you're talking about maybesomewhere between a $30 million and $50 million loss of revenue in the quarter,or deferred revenue in the quarter?

Mark Baldwin

I would say that's reasonable, but the lower end of thatrange, though.

Roger Read - Natexis Bleichroeder

In terms of the process of getting through the strike atPainted Post, whether these guys settle or don't settle, what would be theexpectation on getting that $30 million back, and also the expectation of howcosts may come out?

I mean Vince, you said from an '08 basis for the full yearnot a material impact, but clearly you would expect to have a declining butmaterial impact Q1, maybe even Q2 before you would be on maybe a full run ratewith whatever settlement you get in the back half of '08?

Vince Volpe

Let me help you understand a little bit the trend here,Roger, and these are legitimate questions. We have not disclosed what I amgoing to tell you here. We have disclosed about a $20 million impact so far. Wesaid that would be reduced by about 25% in the fourth quarter, so that startsto give you a sense of the size of the problem for the year.

If we look at out-of-pocket costs and deferred costs for thequarter, it was about 50-50. When we look at the fourth quarter that will shiftso you're going to see about the same one-time costs between Q3 and Q4. Butdon't forget, Q3 was only two months of strike; Q4 is three months. So on aper-month basis, that number is starting to come down. So you start to see theone-time ramp down.

On the deferred side, when we look at the loss or thedeferred impact, if you will, we think that $10 million will come down byperhaps more than a factor of three. So what that means is you are improvingyour throughput in terms of the impact on the sales side of the equationalready and you can see how the costs are starting to ramp down.

Beginning in the first quarter, Roger, we're going to stillhave temporary workforce people, and they will ramp down and somewhere in thesecond quarter I think we probably get to zero. So it will continue to rampdown, but that number is not really a material number when you look at the bigpicture and everything else we're doing in the business.

So yes, there will be some impact in the first of the year,principally in Q1, due to the temporary work force, and that will ramp down.

Roger Read - Natexis Bleichroeder

Following on some of the questions you guys have had aboutacquisitions, if you don't find substantial acquisitions, you're paying down alot of you debt, building some cash here. Vince, how do you ultimately look atthe potential for a dividend, share repurchase, something along those lines?

Vince Volpe

Well, I don't think adividend would be something we would consider at this point in our history. Wefeel like it may be too early to do that, and fundamentally, what we want to dois reinvest in our business because we think that will give us the greatestshareholder value. Good acquisitions are the best way to do that and anotherway to do that to create shareholder value is clearly to buy back stock.

So I would now rule that out, Roger. We just haven't gottento that point yet. No decision has been made and so we need to leave it inlimbo now, but I should tell you that it is something we would consider.

Operator

Your next question comes from Thad Vayda - Stifel Nicolaus.

Thad Vayda - Stifel Nicolaus

Just a quick one on these procurement agreements. What levelof comfort do you have that there really hasn't been any demand destructionassociated with the time it has taken to renegotiate these? I mean, what arethe NOCs using now to satisfy their aftermarket requirements?

Vince Volpe

Thad, could yourepeat your question, please? The volume was a little low on us, sorry.

Thad Vayda - Stifel Nicolaus

Regarding these procurement agreements with NOCs, what givesyou comfort that there has actually not been an element of demand destructionassociated with the time it has taken to renegotiate these?

Vince Volpe

I understand the question. Because they need these parts, theyare not buying stuff just to have it; they are buying it because they need it.These are aftermarket parts. So itwouldn't be how you think about traditional demand destruction where it gets soexpensive to build a facility that the economics are gone. This is equipmentthat's already running, needs to continue to run. They need these parts; theycome to the OEM. That's us. So we believe it's fundamentally a question oftiming. They are not going and buying these parts from anybody else.

Thad Vayda - Stifel Nicolaus

That was my question, not demand destruction, just sort ofmarket share loss.

Vince Volpe

Right, right.

Thad Vayda - Stifel Nicolaus

The guidance range for the fourth quarter, what is thesingle largest variable between the low end and the high end?

Vince Volpe

I would say it'sswing in aftermarket sales because that's where most of the margin is. We'vegot our new unit equipment booked in there. If a unit gets pulled in or getsslipped out, it's not going to matter all that much probably to the overallearnings side. I think we've got to ship our parts into our services work. Theyare still book-and-ship; we still have to get orders and turn them around andship them. They're always is in a quarter. What I would say is the levels thatwe are forecasting are very similar to what we achieved last year. So it lookslike doable numbers.

Operator

Your final question comes from Glenn Primack - BroadviewAdvisors.

Glenn Primack - Broadview Advisors

If we go back to the D-R Avenue project and the growth thatyou've seen so far in applied technology bookings, do you think as you moveout, are you comfortable putting a growth rate on just that piece over the nextthree to five years? Because it seems like you've made incredible progress andif I look into '08, potentially north of 10% of aftermarket could come fromjust that Applied Technology piece.

Vince Volpe

obviously internally we do, but we don't put a growth rate,we don't publish a growth rate on Applied Technology, other than to say that webelieve we have the organizational structure and that we are continuing tobuild that structure, by the way, which you'll see. A big part of our SG&Aincreases have been around building that structure. It's a great investment,though.

Glenn, we're going to continue to drive that business. Itwouldn't surprise me for you to be able to draw a straight line through thelast couple of points here. You have them already, and we ought to see thatkind of growth in applied technology. That will not be enough to continue togrow at the rate that we've indicated, though. We need to also work on ourupgrades and retrofit business; we need to look at entering the kind ofagreements we have with TCPL on the ejector technology. We have to look atmaybe small bolt-on service acquisitions.

I'm comfortable that we can continue to grow at the samerate we have over the last six years or so on an annual average basis in theaftermarket, but it will take more than just applied technology. There will besome years where we do better than that growth rate and others where it may bea little less. I mean, I know it's a steadier business than the new units, butit's still got bumps in it; they are just smaller bumps.

Glenn Primack - Broadview Advisors

Just going back over the past decade where you hovered rightaround anywhere between $450 million and $500 million, and now it seems likeyou've got yourself a potential step-up as you look out a few years, so it is anew level of recurring, higher margin revenue.

Vince Volpe

Yes. In fact, Iwouldn't even say it's a new level. I think it's a new trajectory. That's theway we think about it, Glenn, to be honest with you. It's not a new plateauthat we're going to then oscillate around. We believe that arithmetically goingforward, we ought to be able to continue to grow at the same rate we have beengrowing over the last five or six years, and that's the guidance that weprovided for '08.

Blaise Derrico

We're going to wrap up the call. I want to thank everybodyfor joining us this morning. If you have questions, you can call me. My phonenumber is shown on the news release that we issued last evening. Everybody havea great day. Thank you.

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Source: Dresser-Rand Group Q3 2007 Earnings Call Transcript

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