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LeapFrog Enterprises, Inc. (LF)

Q3 2007 Earnings Call

November 1, 2007 5:00 pm ET

Executives

Eileen VanEss - IR

Jeff Katz – President, CEO

Bill Chiasson - CFO

Analysts

Sarah Gubins - Merrill Lynch

Operator

I would like to welcome everyone to the LeapFrog third quarter earnings conference call. (Operator Instructions) Ms. VanEss, you may begin your conference.

Eileen VanEss

Thanks, Robert. Good afternoon and welcome to LeapFrog Enterprises' conference call to review the results of our third quarter ended September 30, 2007. I'm Eileen VanEss, Vice President of Investor Relations and Treasurer.

Before we begin, we wish to remind you that certain statements made today will include forward-looking statements about management's expectations, including expectations regarding the financial results for 2007 and beyond; forecasted achievement of business metrics; anticipated impact of future initiatives and objectives; planned launches of products, services, and features; and, other similar matters.

In addition, we expect that questions posed in the Q&A portion of this call may prompt answers that contain additional forward-looking statements not contained in our prepared remarks. This cautionary language concerning forward-looking statements applies to both our prepared remarks and our impromptu answers to questions posed during the course of this conference call.

A variety of factors -- many of which are beyond our control -- affect our operations, performance, business strategy and results and could cause actual results to materially differ from those projected in such forward-looking statements. Some of these factors are described in our 2006 annual report on Form 10-K filed with the Securities and Exchange Commission on March 8th of this year, as well as in LeapFrog's other public statements and SEC filings. LeapFrog does not update forward-looking statements and we expressly disclaim any obligation to do so.

With that, I would now like to turn the call over to Jeff Katz, President and CEO of LeapFrog.

Jeff Katz

Thank you very much, Eileen. I'd like to welcome everybody. It's been one year since we presented our strategic plan to return the company to growth and we thought that in today's call it would be appropriate to provide you with a quick update of how we're doing on executing against the plan. I'm going to start the call with a brief overview of our third quarter results and then I'll talk about the plan.

As we previously announced, third quarter revenue fell short of our expectations. Product sales for the first half pretty much tracked to plan, but third quarter sales were weaker than expected, primarily due to legacy products that are being replaced or phased out later next year.

In particular, we saw even weaker performance than we anticipated in our LeapPad family, Little Leaps, Leapster Television or Leapster TV, as we call it and L-Max products. As those of you who follow LeapFrog know, our 2007 new product offering was limited to begin with, and sales from these new products were not enough to offset the decline from legacy products.

Due to the weak sales trends in the third quarter, we recently revised downward our 2007 full-year guidance. The good news is that sales of some new products are very strong, particularly ClickStart, which you may have noticed prominently this morning in the Wall Street Journal; and, our Leapster handheld business continues to do quite well. Total Leapster handheld sales increased and our sellthrough tie ratio increased from 5.3 to 5.6 from last year, through the third quarter of this year.

It's too early to comment on 2007 FLY Fusion sales. Our goal for FLY Fusion seems achievable based on early data, but we plan most of our sales to occur in the fourth quarter, and we know that FLY Fusion is heavily driven by advertising which began in October. The early response to advertising has been good, however.

While recent sales trends overall have been what I can only call awful, other fundamentals are working better than last year. For example, our overall retailer scorecard is better. Our software tie ratios are improved. We continue to make improvements in gross margin.

With respect to our retailer scorecard, it shows major improvements over 2006. Net margin is up a full point at our top account; inventory has been reduced versus last year and remains at what we see as low levels; inventory turns are up quite a bit and markdowns are down 40%. We've seen strong sales per square foot indications, obviously adjusted for shelf space reductions, and we're in good shape in terms of retail productivity and profitability indices as we look to reload the shelves with our new product line in 2008.

Work continues on the launch of our entire 2008 product line. A large crew of about 40 from LeapFrog attended the Dallas Toy Fair in October and as you would know, it was an important show for us. We had an opportunity to visit with all of our big U.S. retailers and some from Australia and Canada as well. I was pleased with the tangible progress we demonstrated to customers, and my sense is that they were pleased -- even impressed -- with what is coming to market and the large scope of new product in a fairly short development cycle that has occurred.

As I am sure you have all heard, retailers have not been very enthused about holiday trends so far this year. We observe retailers to be taking what I would characterize as a smart -- perhaps cautious -- approach to the holiday season with a purchasing strategy that is aggressively managing for SKU productivity, reduced inventory levels, and also planning most of their purchases, or a lot of their purchases, as close to the peak part of the holiday season orders as is possible in anticipation of a late season start.

We're seeing a fair amount of discounting and promotions on the part of retailers that has begun as part of a quite well-publicized effort to drive traffic. We hope this helps get the season fired up. But, where we're participating in it is part of our plan and won't have any impact on our margins for the year. We will still see margin improvement over last year that's pretty significant.

In contrast to the brick-and-mortar retailers, the online retailers are pretty optimistic about the outlook for holiday spending and continued growth of the online retail sector. In a recent earnings call, for example, Amazon's Chief Financial Officer, and I'm quoting from publications: "We expect to see a great record holiday season helped by toy sales." At LeapFrog, we continue to see very sharp increases in sales from LeapFrog.com as well as from online retailers. So this trend bodes well for us.

In mid-October, we launched an improved version of LeapFrog.com that's working particularly well at driving average order size up. It's a notable improvement for us in that it makes the site easier to shop, easier to search, easier to understand what software goes with what hardware and in general allows us to more flexibly change our marketing emphasis than we were able to do before this launch. It also reflects, and this is not yet visible to shoppers, some of the new technology that's fundamental to our web-connected product strategy that we've been discussing. So overall, I'm real positive about web trends at LeapFrog and the progress we've made in a short time. Check out the site if you've not done so recently and look for continuing improvements there and on those sites that sell LeapFrog products.

I'm sure you've all read -- almost ad nauseam -- about the quality control issues some of our competitors have been dealing with. I'm glad to say that we have not had any of these issues and beyond the incredible outflow of bad PR that impacted the category overall, this was not a principal driver of our soft sales during the quarter.

Did it have an impact? Undoubtedly yes. But we know that our product lineup was our principal driver, we knew this would be the case, we just didn't think it would be as soft as we experienced it.

Back to the numbers. Gross margin came in at 42.2%, which is much better than last year and earlier quarters, reflecting the impact of new products which had to meet tougher profitability hurdles, our continued work on reducing product costs, the benefits of tuning our SKU mix, and the absence, of course, of the huge inventory writedowns we took last year.

I want to call out particular kudos to our supply chain and information technology teams who have really operated superbly and we should wait until you see what they are accomplishing with respect to our new products as well.

Operating expenses were $63.8 million in the third quarter; about flat with last year, primarily due to a decline in advertising expenses. Our operating loss for the quarter was $2.8 million, still lousy; it's supposed to be a profitable quarter, after all. While much better than last year, it's lower than we expected due to weaker sales. Cash at quarter end was about $100 million, and inventory remains in quite good shape.

Now, I'd like to turn to an update on the strategic plan. As you may recall, the plan we laid out last year has three distinct phases :

(1) Fixing the basics to set the platform to build LeapFrog upon;

(2) Reload our product portfolio to leverage for the future;

(3) Growth from a largely new product line, from strength in our brand and with strong fundamentals in retail gross margins and reasonable cost structure.

We concluded the fix phase of the plan at the end of 2006. During the fix phase, we significantly reduced inventory and we built cash. This enabled us to enter the reload phase with a healthy balance sheet and significantly improve distribution pipelines for new products.

The reload phase, which has been our focus this year, is all about developing new products, the sales and marketing strategies needed to support them in the grow phase, and improving our product blended gross margins.

The reload phase will continue into next year and we expect to enter the growth phase by mid-2008, concurrent with the launch of our new products.

When we introduced the plan, we outlined a handful of imperatives and since we're going to be covering a lot of this in quite some detail at our upcoming analyst day, I'm going to provide only a brief update on them now.

Retake the reading market; that was priority or imperative #1. We're on track here and we recently introduced our next-generation reading products to retailers at Dallas Toy Fair. I think they were impressed and we hope you will be able to join us November 8 to see these products for yourselves.

Another imperative, building the business around platform architecture. We are making very good progress on this. We have still more work to do. Our goal is to reduce the number of chipsets and software development environments or tools upon which most of our products are built, from four down to two. This will enable us to develop products more quickly and cost effectively than in the past.

Strengthening the portfolio; very, very important. There is no doubt that our product portfolio next year will be stronger than it has ever been. Our 2008 product launches will be our largest and most global launches ever.

First and foremost is our reading line which we will launch big and in more countries than we've ever launched a product. Next, we'll launch new gaming platforms and new software libraries with better licenses, and there will be new grade school products that put us back into a large segment we did well in back in the year 2002, but that we had nearly abandoned by the time we got to 2006.

We will also launch new products in our learning toy line, expanding existing ranges that work well such as our Fridge Phonics Series, but also wholly new products.

Refresh the brand is also an important imperative. In 2008 at retail, you'll notice a new LeapFrog that we think gets us out of the clutter in the everybody does learning aisles of retail and a new, stronger marketing plan that ties the strength of all of our new product together with the brand we know works very well for moms and kids. A brand that research shows far outscores all others when it comes to education that's also fun for kids. We're excited about that.

Web-connect all of our products, also very important. By the end of 2008, all of our key products will be web-connected. This will improve the play experience and make it easier to access and purchase LeapFrog software anywhere. We've also developed a new web-based CRM technology that will help us help kids learn that will drive software sales, that will build the LeapFrog brand and build a longer LeapFrog consumer relationship than we've seen in the past. More on this very important initiative at investor and analyst day.

Driving more content is also important due to the high margins in our content. I referred to this before but looking ahead, you'll see an excellent portfolio of content; better software libraries and absolutely better quality of license titles, including some name brand content that is exclusive to LeapFrog. As I also just mentioned, a LeapFrog management system designed to market content, not just hardware.

Finally, we've spoken about creating a metrics-driven culture. Very important, because I think this is part of how we got to where we got to. I think we're making very good progress here and it will play into our results. Our team has a solid understanding of what we are trying to do. Their role in making it happen and how we and they are doing is also highly tied to metrics. Employee and management incentives are clearly aligned with the trends and the metrics that will drive our performance.

Before I turn the call over to Bill Chiasson for a review of the numbers in detail, I'd like to say that international and SchoolHouse are two areas where we have more work to do. We're still working through how to best deliver growth and importantly profitability, abroad. SchoolHouse is performing a bit better than our plans, and unlike 2006, is contributing positively to earnings. We'll have more to say about our specific plans for both international and SchoolHouse in the coming months.

Overall, I feel we are doing a good job executing on our plan and managing the business fundamentals that matter most in this reload phase: gross margins, inventory and cash. Looking ahead, we'll be focused on making sure the improvements we've made translate into profitable growth from our new products.

We'll be doing that by getting our new products to market; we expect that next year 60% of our sales will come from products launched either late in 2007 or 2008. Further, reducing overhead costs, further improving gross margins, increasing software sales and meeting all of our milestones on time and on our budget.

With that, I'd like to turn the call over to Bill Chiasson for a deeper look into the financials.

Bill Chiasson

Thanks, Jeff. I'd like to give a few highlights before plunging into the details. While sales for the quarter were down 22% from last year, the decline is traced to products that are being phased out over the next year or so, and excluding the impact of the retiring products, sales were essentially equal to last year.

Results were also impacted by the focused, more profitable positioning of the SchoolHouse segment.

Gross margins have improved significantly, the direct result of the actions we've taken to achieve supply chain efficiencies

. Operating expenses were essentially equal to 2006 levels, as the timing of advertising spending offsets higher SG&A.

Driven by the strong improvement in gross profit, the operating loss was improved by over $11 million in the quarter from last year, despite the sales decline. And also, our balance sheet remains very strong, with inventories down 29% from the end of the third quarter last year. We have almost $100 million of cash and investments and of course, we remain debt free.

Now, I'd like to go through the details of our results, starting with net sales. Our consolidated net sales for the third quarter was $144 million, a decrease of $40.7 million, or 22%, compared to the same period in 2006 and that's on both a reported and constant currency basis with sales declines in all segments.

In terms of results by segment, the U.S. consumer business decreased 21% to $109.5 million for the third quarter of 2007, compared to $138.3 million in the same quarter last year. Net sales declines in the U.S. consumer segment were due primarily to the lower sales of products that are being phased out or replaced, particularly the LeapPad family, Leapster TV, Little Leaps and L-Max. Increased sales of Leapster hardware and software products and new products, such as ClickStart, partially offset these declines.

The mix of net sales of platform, software and standalone products as a percent of the U.S. consumer segment net sales were as follows:

  • Platforms were about 35% of net sales in the third quarter this year, compared to 37% in the third quarter last year.
  • Software was about 30% of net sales in the third quarter this year, compared to 24% last year.
  • That leaves net sales of our standalone products at 35% of net sales in the third quarter this year, down 4 points from the 39% of net sales recorded last year.

The shift to a greater percentage of sales from software reflects the higher Leapster software sales, demonstrating the progress we've made against our strategy to increase constant sales and tie ratios.

Net sales in our international segment declined to $30.2 million in the third quarter 2007 from $39.6 million last year, a decrease of 24% on a reported basis. Foreign currency exchange rates favorably impacted our international segment's results for the quarter, and excluding the impact of foreign currency, our international net sales would have declined by 27% for the quarter.

Our international segment net sales decline was primarily due to sales declines in our distributor markets as our distributors worked through excess inventories from prior years. As with the U.S. consumer business, our international business is also impacted by weak performance of products which are being phased out in the near future.

Our SchoolHouse segment's net sales decreased to $4.3 million in the third quarter of 2007 from $6.8 million last year, or a 37% decline. As we've noted before, we've made the decision to focus our sales efforts on profitable products and districts, sacrificing the top line in favor of profitability.

Onto gross profit and gross margin. Despite the lower sales, our gross profit improved to $60.8 million for the third quarter of 2007 compared to $49.2 million for the same quarter in 2006. Our gross margin improved by 15.6 percentage points to 42.2% in 2007, compared to 26.6% in 2006.

The largest portion of the improvement was driven by supply chain improvements, specifically maintaining leaner inventory levels and as a result, we've incurred lower charges for excess and obsolete inventory and fewer purchase order cancellations.

Margins were also aided by product mix. For example during the quarter, software sales represented a greater portion of our U.S. consumer sales mix than last year.

Also, we executed a reduction of about 18% of our low margin SKU's this year which also contributed to the margin improvement.

By segment, gross margin was as follows:

For the U.S. consumer segment, gross margin for the third quarter of 2007 was 46%, compared to 26.4% for the third quarter last year. Again, the leaner inventories especially contributed to the U.S. consumer segment margins, as the majority of the improvement came from reduced charges for inventory writedowns and reductions in purchase order cancellations. We also saw improved margins from a higher portion of higher margin software sales.

In the international segment, gross margins for the third quarter of 2007 fell to 26.8% from 28.3%, reflecting the impact of closeout sales in the United Kingdom of products to be discontinued. For the first nine months, gross margins are up over 5 percentage points to 31.7% in the international segment.

In the SchoolHouse segment, gross margins improved to 53.5% in the third quarter 2007 from 22% in the third quarter 2006. As you may recall, the third quarter 2006 gross margins were depressed by higher than average inventory writedowns.

On to operating expenses. Our selling, general and administrative expense for the three months ended September 30, 2007 was $34.4 million, an increase of $4.2 million for the same period in 2006. The increase in our selling, general and administrative expense was driven by increased patent defense costs and higher stock-based compensation expense. These increases were partially offset by lower costs in our SchoolHouse segment as a result of our workforce reduction in that segment.

Our research and development expense for the third quarter 2007 was $14.2 million, a decrease of $300,000 from last year and is due entirely to the timing of expenses.

Our advertising expense for the quarter was $12.8 million, down from $17 million in the third quarter 2006. We are focusing our advertising activity towards the last quarter of the year in support of the higher seasonal sales. However, for all of 2006, we expect advertising expense to decline from the 2006 levels.

The loss from operations improved to a loss of $3.1 million for the third quarter of 2007, compared to a loss from operations of $14.7 million for the third quarter last year. Higher gross profit and relatively stable operating expenses accounted for the improvement in the third quarter of 2007.

Income or loss from operations was the following for each segment: the U.S. consumer segment had an operating loss of $3.1 million for the third quarter of 2007, compared to a loss of $12.1 million for the same quarter last year. The international segment recorded operating income for the third quarter 2007 of $500,000 compared to income of $2.2 million for the third quarter of 2006. The SchoolHouse segment had a $500,000 loss in operations for the third quarter of 2007, compared to a loss of $4.8 million in the third quarter of last year.

Our income tax expense for the three months ended September 30, 2007 was $637,000 compared to a provision of $37.5 million for the same period last year. The third quarter 2006 expense reflects the cumulative impact of valuation allowances against our domestic deferred tax assets. The valuation allowance was first recorded in the third quarter of 2006 and continues currently, preventing us from recording any current year tax benefit for current U.S. losses, while still incurring tax expense for our non-U.S. operations. The full year effective income tax expense rate for 2007 is expected to be a negative 6.2% compared to a negative 22.5% in 2006.

Our net loss for the third quarter of 2007 was $2.8 million, compared with our net loss of $49.7 million last year. The higher gross profit and lower tax expense contributed to the improved comparison to last year.

On to the balance sheet. Accounts receivable was $127 million at the end of the third quarter 2007, compared to approximately $153 million at the same time last year and $142 million at year end. Our day sales outstanding at September 30, 2007 was 79 days compared to 75 days at September 30, 2006 and 71 days at December 31, 2006. The slight increase in day sales outstanding in the quarter reflects a shift of sales to the latter part of the quarter, consistent with our retailers pushing out their orders to later in the quarter.

Net inventories remain in good shape, despite the lower than expected sales. Net inventory was $110 million at September 30, 2007 down $45 million from the end of September of last year, a reflection of the improved supply chain performance. As compared to the end of 2006, inventories are up $37 million due to the normal seasonal increases.

Before turning it back to Jeff to wrap up, I'd like to recap our results for the quarter. The sales decline is a direct result of the weakness of our legacy products which are obviously impacting our year-over-year comparisons.

Importantly though, we're encouraged by the strength of the core Leapster business, both hardware and software. Also importantly, we're seeing improvements in many of the fundamentals of the business. Product mix is improving with software sales making up a greater portion of our revenues. The SKU reduction is starting to reflect in our performance. Tighter inventory management has been a key driver of improved margins with fewer inventory writedowns and other supply chain benefits. Gross margins for the first nine months are up nicely from last year. The cash position is excellent at $97 million and of course, we have no debt.

Now I'd like to turn things over to Jeff to wrap up.

Jeff Katz

Thank you, Bill. Now for the outlook. It's tough to say at the moment what holiday consumer spending will look like this year. However, fourth quarter is typically our seasonally strongest quarter, and we expect to see shipments improve from third quarter levels.

For the full year 2007, we're expecting a revenue decrease of approximately 10% to 15% compared with 2006; an improvement in gross margin compared to 2006; a reduction in overall operating expenses from the $271.7 million level in 2006; and improvement in the net loss over '06; and cash and investments of approximately $100 million at year end 2007.

I'd like to note that what's ahead is a lot more important than our third quarter results or our fourth quarter outlook. What matters most right now is how we're positioned for next year and we feel very good about that.

In closing, I'd like to say that we're confident that the investments we've made in our people and our products and the steps we've taken to turn the company around are the right ones to build great value over the longer term. We're excited to begin seeing the payback. At least here internally, we're already seeing it from the work we have done in the fix and reload phases, and we appreciate your continued support and interest in LeapFrog along the way.

We are hosting our first ever investor and analyst day here in Emeryville next week. We're planning on a fun and interactive session where you'll have a chance to meet our team and see our products firsthand. If you'd like to come and you haven't yet sent a RSVP, please do give Eileen VanEss a call.

With that, I'll turn it over to Eileen for Q&A.

Eileen VanEss

Robert, could you run the Q&A please?

Question-and-Answer Session

Operator

Your first question comes from Sarah Gubins – Merrill Lynch.

Sarah Gubins - Merrill Lynch

Could you talk a bit about what you're expecting for the new products for 2007? One way to look at it would be within the 10% to 15% decline in sales that you have for '07, what are you generally assuming for the new products?

Bill Chiasson

Sarah, this is Bill. The biggest new products we have for 2007 are ClickStart and the FLY Fusion. We also have new titles for Leapster software and some new infant/toddler/preschool products. Those are nowhere near as big of a contribution to our business as we expect the new products in 2008 will have. We've seen this as a rebuilding year, and we don't see those dramatically changing the needle for this year.

At this stage, I think as Jeff said in his comments, we feel okay about the performance of the new products; but again, they're not really the driving force of our performance for this year.

Sarah Gubins - Merrill Lynch

I'm just trying to get some sort of a baseline for products like ClickStart which are one of your larger launches for the year in terms of what a new product can do -- or at least what you'd expect it to be able to do -- since ClickStart hasn't really been impacted by the problems of the legacy products, just any range of what you're expecting for sales there would be particularly helpful.

Jeff Katz

Okay. I'm looking at the numbers here, Sarah. If we may, let us think about the right way to give you some feedback on that. It is an important launch from a dollar volume and quantity perspective, but I want to give some thought to how to put it in the right context.

Sarah Gubins - Merrill Lynch

Switching to costs, you mentioned ad spend, which was down in the quarter, was more of a timing issue than anything else. Can you give us a sense of what you're thinking of in terms of your ad spend for the fourth quarter?

Bill Chiasson

We're expecting ad spend for the year to be down overall.

Jeff Katz

In the quarter, I think we're up versus the third quarter and down year over year in the quarter, I want to say about 20%.

Bill Chiasson

Yes.

Sarah Gubins - Merrill Lynch

In the fourth quarter?

Jeff Katz

Yes.

Sarah Gubins - Merrill Lynch

From the about $44 million you spent last year?

Jeff Katz

Yes.

Sarah Gubins - Merrill Lynch

In terms of the rest of the operating costs, and particularly in SG&A, when you think out to '08, are there areas where you would expect to be able to get some cost savings or even are there any costs that can be cut there?

Jeff Katz

We'll get into a bit of this at our investor day, but we've already begun the process. In particular, there's two areas, both R&D and SG&A will be impacted. But in particular, we would expect to see reductions in SG&A that are pretty tangible next year. Part of that will come from just pure efficiency of the way we manage the company and to some degree, manage our marketing and product marketing processes here.

Sarah Gubins - Merrill Lynch

As you think about what you're expecting from the new products in '08 and your cost structure, is there a chance that you could have positive operating income in 2008, or are you expecting it?

Jeff Katz

Let me say this. We're looking at that in a lot of detail now. We're structuring our costs so that subject to sales volumes, we'll have that opportunity next year and I think one of the things we're discussing as a management team in effect is do you position the company to take a risk so that in effect, you drive harder towards earnings momentum in '08, '09, 2010?

So in other words, we've got a lot of products to launch. If you launch them really hard in '08, chances are you'll get very good earnings momentum into '09 and even 2010. If you're overly conservative, you might get better '08 earnings, but you might not be as happy with your earnings momentum in '09, for example.

Bill Chiasson

Sarah, just to add to that. Remember that most of our launches will be happening in the back half of the year, so we're not going to have a full-year reflection of those and as we launch a product, typically the hardware precedes the software sales, and so it takes a while for that momentum to build up in the products. So exiting the year with a strong momentum is an important priority for us.

Sarah Gubins - Merrill Lynch

Actually, along those lines then is there a chance we could see gross margins down in '08 because it would be more heavily weighted towards hardware which tends to have lower gross margins than software?

Bill Chiasson

At this time, we feel very good about the actions we've taken this year to improve gross margins and our hope is that we'll at least be building a stronger momentum of stronger margins next year as well.

Jeff Katz

We don't think so, in other words.

Sarah Gubins - Merrill Lynch

It may be too early to know about this, but I'm wondering about how consumers are using the web in terms of FLY Fusion? Are you finding that they're actually downloading content from the web?

Jeff Katz

We are. The Download Store, as it's called, is actually working better than I thought it would; but in terms of pure volume, it's early. This is a product that we expected to ramp up almost exponentially in terms of sales into the fourth quarter. That's what we saw with the launch of original FLY, heavily stimulated by TV in particular. We're seeing a similar trend right now. So it's a bit early to call it, but we've seen the Download Store so far pretty heavily utilized.

Eileen VanEss

Robert, do we have anyone else?

Operator

There are no further questions at this time.

Jeff Katz

Very good. let me just wrap up, if I may, by saying I want to thank everybody for listening in to our call. Again, I hope that those who are on the call have an opportunity to join us on investor and analyst day. I think you'll find it very valuable and we look forward to seeing you then. If you have any further questions later on, please feel free to contact Eileen VanEss, and we look forward to those future opportunities. Thank you.

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