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Eastern Insurance Holdings, Inc. (NASDAQ:EIHI)

Q4 2007 Earnings Call

February 15, 2008 10:00 am

Executives

Mr. Bruce M. Eckert - Chief Executive, Officer, Director

Mr. Michael l. Boguski – Pres and Chief Operating Officer

Mr. Kevin Shook – Chief Financial Officer

Analysts

Randy Binner – Friedman, Billings, Ramsey Group Inc.

Bob Farnum – KBW

Sam Kingtson - North & Webster (ph)

Bob Schwerin – Schwerin Boyle Capital Mgmt

Operator

Welcome to the Eastern Insurance Holdings, Inc. Fourth Quarter 2007 Earnings Conference Call.

(Operator Instructions)

It is now my pleasure to introduce Mr. Kevin Shook, Treasurer and Chief Financial Officer for Eastern Insurance Holdings.

Kevin Shook

Welcome to EIHI’s Fourth Quarter of 2007 Conference Call. Representing the company today are Bruce Eckert, Chief Executive Officer, Michael Boguski President and Chief Operating Officer, and myself, Kevin Shook, Treasurer and Chief Financial Officer.

Before I turn the call over to Bruce for opening remarks, I would like to remind you that the statements made during the conference call are not based on historical facts or forward-looking statements. These statements are made in reliance on the Safe Harbor Provision of the Private Securities Litigation Reform Act of 1995, and are subject to uncertainties and risks.

EIHI’s future results may differ materially from those anticipated and discussed in forward-looking statements. Some of the factors that could cause or contribute to such differences have been described in the press release issued yesterday and in EIHI’s filings with the SEC. We refer you to be sources for additional information.

I would also like to point out that remarks made during the conference call are based on information and understanding that are believed to be accurate as of today’s date, February 15, 2008. With those announcements complete, I give you Bruce Eckert.

Bruce Eckert

The fourth quarter was an exceptionally strong finish to 2007 for EIHI. Our consolidated combined ratio was 75.5% including combined ratios of 51.3% and 86.8% in our two largest segments, worker’s compensation insurance and group benefits insurance respectively.

Our worker’s compensation insurance segment continues to produce truly exceptional results driven by strong individual account underwriting and favorable claim closure patterns which have resulted in exceptional accident year loss ratios and significant favorable loss reserve development on prior accident years.

I am particularly pleased with our underwriting discipline as we have had strong premium renewal retention rates and last year’s renewal rate deceases were only 3.5% on our profitable book of worker’s compensation insurance business.

We are very pleased to report that our Charlotte and North Carolina office opened in January 2008, slightly behind our original schedule of last fall, but I am happy with the interest that we are receiving from our new agency based in North Carolina, Virginia, Georgia, and South Carolina. As of this date, we have appointed 11 agents in this territory. We will continue our rural individual count underwriting strategy in those states, focused on bottom line profitability before topline growth.

This is especially important as a strategy, given our newness in the region and current market conditions. It also mirrors our entry into Pennsylvania in 1998 during similar market conditions. I was extremely pleased with our fourth quarter combined ratio of 86.8% in our group benefits insurance segment. You may recall that previous to the public offering transaction in 2006.

The group benefits book of business consistently recorded combined ratios of 108% and higher. We believe that our restructuring of the distribution network, implementation of prudent expense, management strategies, and reengineering of the underwriting function are responsible for the turnaround in the financial and operational results of this segment.

The group benefits insurance segment of Fourth Quarter in 2007 loss ratio was 59.9%, and the expense ratio was 26.9%.

As of December 31, 2007, our segregated portfolio salary insurance business currently has 13 total programs, while 2 are currently in runoff aspreviously recorded. We are pleased to announce that we have added a new program effective January 1, which brings a total number of active programs of 12.

After a very disappointing Third Quarter of 2007 in our specialty reinsurance segment, I am happy to record this segment produced a profit for the three months ended December 31. Also, you may recall that business in the specialty reinsurance segment is the same through participation in our reinsurance treaty with a nonaffiliated ceding company related to an underground storage tank insurance program referred to as “EnviroGuard” and a non-hazardous waste transportation product referred to as "EIA Liability." Effective January 1, 2008, EIHI's participation percentage in this reinsurance treaty was decreased from 25% to 15%.

Lastly, we remained active in pursuing opportunities to allocate our excess capital through either strategic acquisitions, organic geographic expansion, or product cross-selling initiatives.

2008 will likely present significant challenges for our underwritings operating segments as competition for business intensifies in our underwriting territories. We will continue, however, to focus on individual account underwriting and adhering to our underwriting principles as a means of profitably growing our books of business in 2008.

I would now like to introduce Michael l. Boguski, our President and Chief Operating Officer to review our worker’s compensation insurance and group benefits insurance operating results.

Michael Boguski

After providing a brief overview of our operating results, I will turn the call back to Kevin for our review of our financial results for the three months ended December 31, 2007 and 2006. Finally, we will open the call to your questions.

The focus in the worker’s compensation insurance segment continues to be an individual account underwriting and adhering the disciplined underwriting principles in a competitive marketplace.

Net income was $5.9 million in the worker’s compensation insurance segment for the three months ended December 31, 2007, compared to a $4.1 million for the same period in 2006. The company’s direct written premium increased from $11.8 million for the three months ended December 31, 2006 to $13.1 million for the same period in 2007, an increase of 11%.

Production highlights for 2007 include renewal rate decreases of only 3% on our profitable book of business with a premium renewal retention rate of 88.2%, an excellent result in an environment where a competition for business continues to intensify.

Our underwriters continue to manage our policy holder dividend liability exposure with 90% of our 2007 book of business written on a guaranteed cost basis, which is largely responsible for our policy holder dividend ratio of only 1% with the three months ended December 31, 2007.

The Fourth Quarter of 2007 includes new business writings of $4.2 million. In the group benefits insurance segment, we continue to emphasize profitable new sales opportunities, premium, retention initiatives, and expense-saving strategies. The combination if these efforts produced excellent results for 2007 and in particular, the Fourth Quarter of 2007 was net income of $1.6 million compared to $1.5 million in 2006.

I am very pleased to report that our annual premium volume increased from $35.7 million in 2006 to $40 million in 2007, an increase of 12% driven primarily by new sales of $9.1 million in 2007, compared to $3.6 million in 2006, and a 22% increase in submission activity year-over-year. Premium persistency rates improved seven points over 2006 to 81% for 2007.

I am now going to turn it over to Kevin Shook for review of our fourth quarter financial results.

Kevin Shook

EIHI reported net income of $7.7 million or $0.76 per diluted share for the three months ended December 31, 2007, compared to net income of $4.5 million or $0.41 per diluted share for the three months ended December 31, 2006. Our consolidated combined ratio was 75.5% for the three months ended December 31, 2007, including a consolidate loss ratio of 45.6% and expense ratio of 29.3, and a policy holder dividend ratio of 0.6%.

The increase in net income in 2007 compared to 2006 is due primarily to an increase in net premiums earned from $29.1 million in 2006 to $34.3 million in 2007, after tax favorable loss reserve development on prior accident years, and our worker’s compensation insurance segment of $2.5 million in 2007, compared to $943,000.00 in 2006. A nonrecurring tax-related purchase accounting adjustment in 2007 of an $836,000.00, compared to no such adjustment in 2006, and negligible after-tax purchase accounting charges in 2007, compared to after-tax purchase accounting charges in 2006 of $810,000.00.

The favorable loss reserve development and our worker’s compensation insurance segment was driven by solid acclaimed closure patterns during the Fourth Quarter of 2007, during which the Claims Department closed 70 or 14.1% of the 495 open “lost-time” claims as of December 31, 2006. These claims were settled for amount at, or less than previously established loss reserves.

The 70 closed claims during the Fourth Quarter of 2007 was 42.9% higher than the 49 claims closed during the Fourth Quarter of 2006.

Also of note, in our worker’s compensation insurance segment is the fact that management has estimated that there will not be a Pennsylvania worker’s compensation security fund assessment in 2008 which is based on 2007 direct written premiums which increased diluted earnings per share by $0.6 for the three months ended December 31, 2007 which is consistent with management’s estimate for the Fourth Quarter of 2006.

Consolidated revenue for the Fourth Quarter of 2007 was $38.1 million, compared to $34.1 million for the same period of 2006, an increase of 12.3%. The increasing consolidated revenue is being driven by the aforementioned increase and net premiums earned. The increase in earned premium was primarily driven by the increases in the worker’s compensation insurance and group benefit insurance segments during the Fourth Quarter of 2007, and a decrease in the impact of purchase accounting adjustments for the three months ended December 31, 2007, compared to the same period in 2006. Our book value per share was $16.81 and our diluted book value per share was $16.27 as of December 31, 2007.

Lastly, with respect to capital management, since the implementation of our stock buyback program in the First Quarter of 2007 to December 31, 2007, we have purchased 1,016,865 shares of EIHI stock for $15.6 million.

This concludes our formal remarks.

Question-and-Answer Session

Operator

Before I open the call for your questions, I would like to tell you that the company will not be providing forward-looking earnings guidance, and thus will be unable to answer questions pertaining to that subject.

(Operator Instructions)

Our first question comes from Randy Binner at Friedman, Billings, and Ramsey.

Randy Binner – Friedman, Billings, Ramsey Group Inc.

Just picking up on the buyback comments that Kevin made there at the end. I guess you purchased a little over a million, any further plans for buybacks? Is there any color on the outlook for that? And also, maybe in conjunction with that, what the access capital position is at the end of the quarter.

Kevin Shook

The buyback process will continue on. We think that the stock is very fairly valued. So, from an economic perspective, we are going to continue with the program. I think if you were to take the December 31, 2007 total amount and back up at 930, you would notice that it slowed down over the last couple of months.

In the Fourth Quarter of 2007, we repurchased about 148,000 and we continue through January 2008 with similar, smaller amounts but it is the capital management initiative of the company and we plan on continuing with that program.

With respect to capital management, our view of this is to look at net worth and premiums surplus targets. The net premium is written in worker’s comp for ’07 was about $58.5 million, group benefit was $35.9, and in specialty reinsurance, it was about $14.1 million.

As we said on previous calls, we use a 1:1 in comp and specialty reinsurance in 2:1 in group benefits. So, once you do the math and you look at total shareholder’s equity of about $178 million, we have unallocated capital of somewhere between $73 million and $75 million, which is somewhat consistent with where we had been in the past. The significant net income in the fourth quarter increased at numbers slightly from where it was in prior quarters and that, in the fact that we have not bought as much stock back or what really are contributing to that number.

Randy Binner – Friedman, Billings, Ramsey Group Inc.

So, we are still about 75. I guess you did not asked about that question either way. It seems like there is not that much left authorized, unless I am getting it wrong, I only have about around 160,000 shares left. Are you open, is the board open to more authorizations? Maybe that is more for Bruce.

Bruce Eckert

If you recall, we were required to ask of the insurance department or any capital allocations to this kind of program. We initially asked for 10%, as you might observe, we are almost through that. I think we were some 30,000 shares to get to that 10% number. I think it was earlier in the fourth quarter, we went back to the department and asked for another 10% authorization and received that approval. So, we actually have already have approval for another 10%.

Randy Binner – Friedman, Billings, Ramsey Group Inc.

Perfect, that is very helpful. I know that the M&A environment is maybe possibly still rich for what you are looking for but I know that you are always looking, but any color to add on that would be appreciated.

Bruce Eckert

No particular color, we continued to be active. We were satisfied with the “deal flow” if you will, that we are seeing from any number of banking sources. We have not put our suitcases away even though, as you observed, the valuations did seem to be a little bit rich, but we are still actively engaged in this regard.

Randy Binner – Friedman, Billings, Ramsey Group Inc.

On something more specific, the claims that closed at a higher in the fourth quarter, do you have any feeling on it? Because this is actually something that I have seen, or we have seen here for some other worker’s comp companies, do you have a feeling for why this happened? Is it a seasonal thing, is it a certain type of claim, meaning, are these kind of lower severity claims/higher severity claims? Is there any trend or rationale behind that?

Bruce Eckert

Randy, there is really no specific trend or no class of business that you can identify that would have caused the increase. Throughout the year, it is a big initiative hours would return to work. We continue to push. We had exceptionally good results in the fourth quarter in closing those claims at the 70 versus the 49 in the same quarter in the prior period. From a seasonality perspective, we do tend to close a little bit more claims in the fourth quarter and we do that through compromise and release process.

Randy Binner – Friedman, Billings, Ramsey Group Inc.

Can you run through that state fund assessment issue from Pennsylvania, can you just run through that again? Did you say that there was an impact in the Fourth Quarter of 2007 results from that specifically?

Bruce Eckert

Yes, there was an impact. I would say, we have the same impact in the Fourth Quarter of ’06 as we did in the Fourth Quarter of ’05 and ’04. So, it is kind of four years now running that we do not get the assessment.

Our policy is to accrue for the assessment throughout the year until we get enough information that would lead us to believe that we are not going to get it, and that information is always received in the fourth quarter.

The way the fund works in Pennsylvania, Pennsylvania has a separate worker’s comp guaranteed fund than they do from their other lines of business. The fund is required to maintain a fund balance of $500 million or greater, to the extent that the balance goes below $500 million. They have the opportunity to make an assessment. So, we go through an analysis of looking at any new insolvencies, looking at their investment results, and quite frankly, just having specific conversations with the funds at to where they are going. They do not even get the reports until January of ’08 for the ’07 year. So, it is always in the fourth quarter that this happened, and it ahs been four years in a row that we have not gotten it. It was $0.06 of positive EPS for the quarter.

Operator

Our next question comes from Bob Farnum at KBW.

Bob Farnum – KBW

Where does your reserved equity fit these days in terms of actuarial ranges?

Bruce Eckert

For our worker’s comp, for group benefits, in group benefits, specifically, down on short-term disability. Also, in our specialty reinsurance segment, they are all at the high-end of the company’s actuarial range, at the very high-end.

Bob Farnum – KBW

Another question that I have is that with the reduction of the participation in the expense ratio, it looked like the combined ratio there 106, and that was higher last year. Is it because of maybe not being as profitable as expected, or what was driving the reduction and the participation?

Bruce Eckert

As you know, Bob, we would have some volatility on that line. It historically, has been particularly the EnviroGuard program, has been historically very profitable. The EIA Liability has been somewhat less though. But, volatility on both of those programs has increased. We just strategically decided to try to meliorate some of that volatility by reducing the quota share. I should add that the same, sort of strategic review of our product lines will cause us to exit our very, very small umbrella book of business effective July 1.

That is only 10% participation. It is only about $0.5 million of premium and again, as management and as the board, we just looked at that kind of premium volume and realized that there is not a lot of upside, and there is every reason to protect the downside. So, we will be exiting that.

I should say that umbrella, as a product line, we entered that when our rating was not an A-rating. Some years ago, it is important to try to protect, if you will, or maintain our book of business by putting that product out there and it had that effect with our rating going up to A-minus, it became less meaningful, if you will.

Bob Farnum – KBW

This week, it looks like Governor Randell announced that loss costs were down 10% in Pennsylvania. How would this be impacting your pricing, going forward?

Michael Boguski

We are going to continue to be an individual account underwriting company, and look for adequate per exposure on our book of business. It will certainly provide us with some challenges but we certainly will take it account by account.

Bob Farnum – KBW

Okay, I assume that goes the same for the other states since you are getting into down south.

Michael Boguski

Absolutely.

Bob Farnum – KBW

The last question that I have is investments. I know you have some covered color on this, some prime issues they all have, how about municipal bonds as well. Can you just going to go through credit quality in your investments?

Michael Boguski

Absolutely. From a municipal bond exposure perspective, I think probably the most important point is that the investments have always been underwritten with respect to credit quality first, and not with respect to any kind of insurance wrap. We have pre-refunded of about $17.1 million, pre-refunded or fully collateralized by US Treasury Obligation. The not pre-refunded is about $36.9 million. The underlying credit quality there is AA, with the insurance wrap that is AA+. So, basically, the insurance wrap is not doing anything for us from a rating perspective.

About half of those are in General Obligation Bonds where the state has unlimited taxing authority to make sure that the debt service and the other portion of those are in revenue bonds where there are specific tax buddies. For example, a water and sewer taxing authority where they raise a fee, so we feel very, very comfortable with the credit quality of our Municipal bond portfolio.

Operator

The next question comes from Sam Kingston at North & Webster

Sam Kingston – North & Webster

Could we just go through really quickly, the diluted share count period end, not the average? Can we just walk me through that number?

Michael Boguski

Do you mean the book value number, Sam?

Sam Kingston – North & Webster

No, if we could just get the basic number of shares outstanding at period end, and understand the warrants, restricted stock, and all that stuff.

Michael Boguski

Sure, the basic shares that are outstanding are the ones that are lifted on page 2 of the press release. Originally, as part of the IPO, there was this $6,727,500.00 that was issued and then there were the shares issued as part of the merger with EHC which is at $3,876,048.00. And then there stock warrants of $306,099.00 that were also issued. Those were legacy EHC warrants that were out there and the $300,000.00 was the conversion of those into EIHI stock.

When you are looking at EPS, the weighted average ESOP shares of the accretion of the ESOP shares over the last quarter, the restricted shares gets a little trickier under the accounting rules, you utilize a treasury methodology for coming up with the restricted share dilution piece, and it takes into account the expense that you recognize during the period on those shares and any additional dilution above and beyond, the expense gets recognized in this restricted share account. It is a very complicated transaction. I am happy to walk you through it offline, but that is a 38,000 shares. The weighted average treasury shares are simply the weighted average shares that have been purchased over the period.

Sam Kingston – North & Webster

At the end of the period, how many treasury shares have been purchased?

Michael Boguski

In total, it is $1,016,685.00.

Sam Kingston – North & Webster

And then, the restricted stock shares that are actually outstanding, if we did not use a treasury method, what is the total number?

Michael l. Boguski

$246,675.00 is totally outstanding.

Sam Kingston – North & Webster

When were all those issued?

Michael Boguski

Those were all issued on January 3, 2007 when the stock was at $14.35.

Sam Kingston – North & Webster

Well, that does not matter for restricted stock?

Michael Boguski

Yes, their strike price is zero.

Sam Kingston – North & Webster

Go ahead.

Michael Boguski

No, just to finish it off because I think the options would be the next point, $634,188.00, and those have an effective strike price of $14.37.

Sam Kingston – North & Webster

Could you guys elaborate on the policy holder dividend policy and just sort contrast that with some of your competitors, or just elaborate on that a little bit for me.

Michael Boguski

It is not something that benchmarked against competitors in any kind of public data for the most part. In a “nutshell” when markets get extremely soft, the book of business tends to go to these policy holder dividend plans. If I can just give you a hint in a historical perspective from Eastern and back in 2000 in the height of the soft cycle or book of business, was 50% dividend plans and 50% guaranteed cost. As we speak today, we have managed that to 90% guaranteed cost and 10% dividend. It has the effect of reducing our dividend liability exposure in our financials.

Sam Kingston – North & Webster

Could you just comment quickly on why the worker’s comp expense ratio increased in the quarter?

Michael Bogusk

Sure, there are really two components. Number one, as a public company, there is the incurrence of Sarbanes-Oxley fees over the course of time. Some of those do get allocated down.

I think the second component, Sam, is from an alternative markets perspective, the fees that we receive from the alternative markets business for financial statement purposes is shown as a negative expense. That business period-over-period is down a little bit. So, the fee-based negative expense component is not as strong as this quarter as it has been in other quarters.

Operator

The next question comes from Bob Schwerin at Schwerin Boyle Capital Mgmt.

Bob Schwerin – Schwerin Boyle Capital Mgmt

I have a couple of questions for Kevin. I want to follow up on the asset quality besides immunities. You would have $4.9 million in sub-prime. I wonder if there are any changes there. Also, it seems like every month, there are some new securities at a bad auction rate preferred. Do you have anything like that? Is there anything else besides the immunities that you can talk about?

Michael Bogusk

Let me answer the second part first. There is really nothing that we were concern about. We continue to very, very closely monitor their portfolio. We do not have any CDOs. Let me just further break down sub-prime. You have the numbers right. There are two components to it. There is the actual sub-prime, and then there is the sub-prime exposure as $1 million. We have five investments, three are rated-AAA, tow are AA, the vintage is on the two AA on ’02 and ’03, so there is a lot of equity, and the subordination rates are greater than ALTE exposure is about $4 million. Those are six investments and are already AAA still, and we continue to proactively re-underwrite our MBS and CMBS portfolios to make sure we do not have any problems recognizing that the rating agencies are a little bit slower to react right now because of the backlogs, because of the these issues and some of the bond insurance issues. So we are very comfortable of the portfolio.

Bob Schwerin – Schwerin Boyle Capital Mgmt

Great, and how was goodwill jumped from $5.1 million to $8 million, why was that?

Kevin Shook

That was the purchase accounting adjustment with respect to the tax item that we had noted. There was the one-year true up adjustments as a result of the transaction and we do not expect goodwill of change at all on moving forward.

Bob Schwerin – Schwerin Boyle Capital Mgmt

I guess this is related, you have this positive purchase accounting adjustment of $810,000.00 and that is related to this same tax issue?

Kevin Shook

It is, and it is nonrecurring.

Operator

(Operator Instructions)

Our next question comes from Randy Binner of Friedman, Billings, Ramsey & Co.

Randy Binner - Friedman, Billings, Ramsey & Co.

Just a couple of Quick follow-ups. Bruce, I just want to be sure I am actually clear, so is 30,000 shares left on the first 10% repurchase authorization and then there is another 10% authorized after that?

Bruce Eckert

That is correct. It is a little over a million shares.

Randy Binner - Friedman, Billings, Ramsey & Co.

Great, that is helpful. Kevin, on the investment yield, I guess, thinking about how the investment are generating, that is when the income is going forward. There was a lower yield in the quarter and I think part of that was maybe due to some lumpy results from some of the more variable parts of the investment base. How do we want to think about those funds and how they return steady investment over time? I guess, put in other ways, how much of lumpiness would we expect from those areas versus, like the municipal bond or treasury?

Bruce Eckert

I think you are referring to the LPs where we got about $10 million. They can be lumpy from time to time and they get up and impact in the investment income in the fourth quarter but this is the first quarter where it has been noticeable, so when we forecast our own investment income, we usually kind of keep them at a breakeven level from an investment income perspective because sometimes they can go down a little bit. Sometimes they can go up a little bit. This quarter was probably the exception to the rule, so I would focus more in on the fixed income portfolio and looking at the interest rate environment and what the returns might be on that.

Randy Binner - Friedman, Billings, Ramsey & Co.

And I guess, they are not credit event potentials. To me I have realized that it is a small part of the investment asset, it this kinds of times obviously that can have an impact. So, it is more just kind of a variable slow of the yield that spends out of them.

Bruce Eckert

It is the cyclical nature of the underlying investments and not a systemic problem.

Randy Binner - Friedman, Billings, Ramsey & Co.

When you say cyclical, is it seasonal?

Bruce Eckert

Well it depends on the investment, there is a couple of commodity funds, which, you know, we have had some very good quarters during 2007 and some other quarters that are not as competitive and that is just one example of the cyclical nature of the underlying risk.

Operator

The next question comes from Sam Kingson at North & Webster

Sam Kingtson - North & Webster

Just a couple of final follow-ups here, in terms of the slowdown in the buyback, why are you guys slowing the buyback at this point?

Kevin Shook

We are just not seeing as many opportunities out there to purchase the stock as we have in the past and that is the bottom line. I mean, we think that the stock is very fairly valued and we are very interested in repurchasing everything we can at these prices.

Sam Kingtson - North & Webster

So it is more of a supply issue than your appetite for the stock?

Kevin Shook

Yes, that is correct.

Sam Kingtson - North & Webster

I just want to elaborate on one other thing, in terms of looking at restricted stock trends and options that have been issued since you guys became public first with the number of shares that are repurchased, I mean, I am only getting sort of a net shrinkage and a fully diluted shares of 150,000. Obviously, as a shareholder, knowing that we have spent $15 million, we only got in 150,000 share reduction. That is a little bit troubling to me. I am just wondering if you guys could talk about, what you think that spread is going to look like going forward and I would just leave it there.

Kevin Shook

I think from an auction grant and restricted stock perspective, you know, it is a five-year plan and just about everything is out there. So, any stock repurchases that we make over the next couple of years are only going to shrink that margin further and eventually offset it on the other side of it.

Sam Kingtson - North & Webster

Okay, I mean, these were sort of, I would not say one-time plans but these are long-term plans.

Kevin Shook

No, it was a one-time plan. There are small amounts that have not been granted but you are seeing the vast majority of the grant, so that will be pretty much fixed for the next five years and obviously, our desire to continue with the stock repurchase will eventually overtake that.

Operator

At this time I see no further questions.

Bruce Eckert

Well, thank you everyone for being with us today and we look forward to our next call. Thank you.

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