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Five Star Quality Care Inc. (NYSE:FVE)

Q2 2012 Results Earnings Call

August 1, 2012 10:00 AM ET

Executives

Tim Bonang – Vice President, Investor Relations

Bruce Mackey – President and CEO

Paul Hoagland – Chief Financial Officer

Analysts

Art Henderson – Jefferies

Rob Mains – Stifel Nicolaus

Mike Petusky – Noble Financial

James Gibson – Punch & Associates

Operator

Ladies and gentlemen, good day. And welcome to the Five Star Quality Care Second Quarter 2012 Financial Results Conference Call. This call is being recorded.

At this time for opening remarks and introductions, I would like to turn the call over to the Vice President of Investor Relations, Mr. [Tom] Bonang. Please go ahead.

Tim Bonang

Hello. This is Tim Bonang. Thank you and good morning, everyone. Joining me on today’s call are Bruce Mackey, Five Star’s President and CEO; and Paul Hoagland, Five Star’s CFO.

The agenda for today’s call includes a presentation by management, followed by a question-and-answer session. I would also note that the recording and retransmission of today’s conference call is strictly prohibited without prior written consent of Five Star.

Before we begin, I would like to state that today’s conference call contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, and other securities laws. These forward-looking statements are based on Five Star’s present beliefs and expectations as of today, August 1, 2012.

The company undertakes no obligation to revise or publicly release the results of any revision to the forward-looking statements made in today’s conference call other than through filings with the Securities and Exchange Commission regarding this reporting period.

Actual results may differ materially from those projected in any forward-looking statements. Additional information concerning factors that could cause those differences is contained in our filings with the SEC. Investors are cautioned not to place undue reliance upon any forward-looking statements.

And now, I would like to turn the call over to Bruce Mackey.

Bruce Mackey

Great. Thank you, Tim. And thank you all for joining us today on our second quarter earnings call. Since we last spoke with you in late April, we’ve been very busy working to continuing strengthen Five Star’s position as a premium provider of private pay senior living services.

In particular, there were three events that I believe were significant to our long-term private pay focus. The first event occurred in late May when we announced the settlement in our long running litigation with Sunrise Senior Living.

This litigation related to excess insurance charges by Sunrise on 31 communities that will managed by Sunrise on behalf of Five Star prior to 2007. As part of this settlement Sunrise agreed to pay us $4 million.

The second event also occurred in late May when we reached an agreement with Sunrise, whereby they will terminate their leases for 10 senior living communities’ leased to them by Senior Housing Properties Trust or SNH, and we will be in a managed these communities for SNH’s account. The communities include 2,472 living units and are located across six states. They generate gross revenues of approximately $115 million in 2011.

The management contract has similar terms, to the ones, under which we currently managed to SNH, including a minimum annual management fee equal to 3% of gross revenues plus an incentive fee equal to 35% of annual net operating income after SNH receives return equal towards 2011 rents from Sunrise. These communities will initially add approximately $3 million of annual management fee revenues to Five Star.

In addition, all 10 communities fall within our current footprint where we offer rehabilitation and wellness services which should drive additional revenues to Five Star. We expect to begin managing these 10 communities before the end of 2012 after all appropriate regulatory approvals are obtained.

The third event took place in July when we announced that we had reached the deal, which is agreement rather to sell our pharmacy business to Omnicare, the net proceeds of $39.9 million. It was a fully marketed transaction by an investment bank Jefferies & Company.

We expect this transaction to close in the second half of 2012 after the completion of customary closing conditions, including licensing approvals. As some of you may know, we entered the pharmacy business in 2003 under a very different environment, where we contemplated achieving margins in the 10% range.

Changes in Medicare billing put great pressure on our margins, as the switch to using generic scripts. And as a result, despite growing to be one of the 10 largest institutional pharmacies in the United States, our pharmacy has only been marginally profitable over the past few years.

However, we expect to generate a gain of approximately $24 million with the sale, which will double our return on investment for our shareholders. We think this is an excellent return on investment for Five Star’s shareholders and set an example of the overall value we believe can be found in Five Star. The sale also simplifies the Five Star story for investors and allows us to increase our focus on our core private pay business.

For the second quarter we generated income from continuing operations of $0.06 per share, after excluding a $0.04 per share gain from the Sunrise litigation settlement, which is $0.04 per share better than income from continuing operations last quarter. Second quarter 2012 also marked Five Star’s 14th consecutive quarter of profitability.

EBITDA adjusted for non-recurring items also improved over the first quarter of 2012 by over 50%, the $13.4 million. EBITDA is also up 6% from last year.

We have talked over the last couple of quarters about the different ways industry plans to make-up for the loss EBITDA resulting from the recent Medicare cuts in October of last year, and I think the results over the last two quarters have proved our ability to do so.

From a capitalization perspective, the company’s total debt as a percent of total book capital is only 28%. At quarter end we had $24 million of cash and cash equivalents, owned 12 unencumbered senior living communities with 840 living units and had $146 million of availability under our two revolving credit facilities.

Also, during the quarter, we repaid and terminated our bridge loan from SNH and repurchased $12.4 million of our senior convertible notes at a modest discount to par value.

Now I’ll review some highlights from the quarter. Total senior living occupancy was 85.6%, which was up compared to last year, but down slightly compared to last quarter. Overall same store occupancy was flat year-over-year at 85.2% and also down slightly from last quarter. As of last Friday, senior living occupancy was back up to 86%.

If you look specifically at our core senior -- our core private pay independent and assisted living business. Occupancy is up marginally year-over-year and flat sequentially, while skilled nursing trended down. Our occupancy trends are relatively in line with the NIC MAP industry data.

Increasing our skilled nursing occupancy has been a challenge, we really seeing a shift in the skilled nursing sector. There are more high-acuity short-length stay patients which has caused patient turnover to increase.

In addition, we have seen skilled nursing patients asking to different care and also choosing other home and community-based services which is impacted occupancy as well. We are making efforts to improve occupancy in this portfolio by continue to evaluate the operations and by putting capital in the certain properties to keep them competitive.

Beside from the macro headwinds we believe these actions should help raise occupancy in the long run. And on a positive note, last week CMS announced a net 1.8% increase in Medicaid reimbursement for skilled nursing operators starting on October 1, 2012.

Taking look at our same store sales metrics, we had almost 5,000 admissions during the quarter, which was down 3% from last year. The decline was driven by lower skilled nursing admissions. Our independent and assisted living admissions were actually up year-over-year.

Same store average daily rate for the quarter increased modestly compared to last year, but was up approximately 1% compared to last quarter, which indicates that our private pay rate growth offset the Medicare rate cut in our skilled nursing business.

Our senior living business continues to perform well. In the second quarter, we produced $76.5 million of EBITDA. This was up 8% from the second quarter of last year and 6% from last quarter.

Taking into account, the Medicaid rate reductions in October 2011, our significant margin growth in our senior living business both year-over-year and sequentially is impressive, and underscores our strategy of focusing on high-quality private pay independent and assisted living communities where the majority of revenues come from residents private resources.

Moving on to our rehabilitation hospitals, which accounted for 8% of total revenues and generated $2.5 million of EBITDA during the quarter, which is down from last year and last quarter.

Occupancy was down from last year to 60% from 62%. Our Woburn location had positive results, primarily driven by our new low inpatient satellite units that opened up few months ago. The new low unit is on track to meet up our budgeted expectation.

However, these positive results were offset by lower than expected performance at our Braintree location, which suffered from a less than favorable patient case impairment during the quarter.

We are currently working to renovate our Braintree hospitals for traumatic brain injury unit, which we feel will help make them more competitive. We expect the renovations to be completed in the next several quarters. In addition, full positive, we will get a net 2.1% Medicare rate increase effective October 1, 2012.

Our second quarter results proved our ability to grow earnings following a year of significant growth through acquisitions and the Medicare rate cuts that negatively impacted our bottom line.

We have additional opportunities to grow cash flows, when we take on the management of the 10 Sunrise properties later this year.

Our balance sheet is in great shape and with the proceeds we plan to receive from the sale of our pharmacy business we will pay down existing debt.

Our focus has been and will continue to be on growing our private pay senior living business. Our total unit count is getting closer to 30,000 units, which makes us one of the top players in the senior living marketplace.

We are focused on keeping our proprieties well run and recognized in the local communities. And most importantly, we are focused on increasing our occupancy, which is the main driver of our bottom line growth.

At this point, I will turn the call to Paul Hoagland, our Chief Financial Officer.

Paul Hoagland

Thank you, Bruce. Good morning, everyone. Thank you for joining us today. I will now review our year-over-year quarterly financial results for the second quarter of 2012. Senior living revenues were $278 million, up 4.8%. This increase was due primarily to the revenues from the 13 communities we acquired or leased since last year, which contributed $10.3 million of revenue.

Management fee revenues, which are revenues from the 25 senior living communities we manage, were $1.3 million for the quarter and in line with our expectations. We expect to earn $8.8 million in management fees annually from the properties that we currently operate or scheduled to close on during this year.

Senior living wages and benefits were $137 million, a 2.7% increase from last year. $3.3 million of this increase was from the 13 communities we acquired on leasing last year. Total senior living wages and benefits were 49.1% of senior living revenues, a decrease of 100 basis points from last year.

30 basis points of this decrease was due to decreased labor costs, 10 basis points was due to a decrease in state and federal unemployment insurance taxes and 40 basis points were due to a decrease in both health benefit expense and workers compensation expense. However, on a sequential basis, employee health benefit expense was up 20 basis points.

Other senior living operating expenses were $66 million, up 7.8% and represented 23.8% of senior living revenue, a 60 basis point increase from last year. The main drivers of this increase were as follows, $1.4 million from the new communities we acquired or leased since last year, $1.1 billion from property taxes, partially due to credits that we received of approximately $580,000 in Q2 of 2011. $1.1 million of increased bed provider fees, which were partially reimburse from Medicaid and $300,000 in additional marketing and new turnover-related costs.

Lastly, utility expense was up 10 basis points from last year. However, sequentially it was down 60 basis points due to a milder spring felt throughout the U.S. Our rehabilitation hospitals generated $2.5 million of EBITDARM, a 13% decrease from last year.

Total revenues were $26 million, flat when compared to last year, but due to both the combination of higher quality patient case mix and an offset from decrease in occupancy and an increase in Medicaid case mix, margins were impacted. Occupancy for the quarter was 59.8%, a 200 basis point decline from last year and a 60 basis point decline from last quarter.

Moving on to other income statement items, general and administrative expenses during the quarter were $15.4 million, up 9% from last year and were 4.4% of total GAAP revenue. There was approximately $550,000 of one-time non-recurring legal expenses in the current quarter when compared to the previous year.

Adjusted for actual revenues from our managed communities, G&A was 4.2% of revenues. Rent expense was $50.3 million, up 5.1% mainly due to $1.6 million of additional rent from the six communities we began to lease during the year.

Provision for income taxes was $3.8 million, which is a significant increase over last years and it’s primarily as a result of the elimination of our tax evaluation allowance in the fourth quarter of 2011. And in part, due to the taxes on the gain some of that we recorded in the current quarter, which resulted in a tax expense of $1.5 million for the gain.

Our cash tax rate remains at approximately 11%. Interest expense was $1.6 million, and depreciation and amortization was $6.7 million. All of these items were in line with our expectations as result of our recent growth.

I’d like to now review our liquidity, cash flow and selected balance sheet items. Operating cash flows were $23.4 million. We invested $15.5 million of capital into our existing communities and sold $7.8 million of long-term capital improvements. At June 30, 2012, we had cash and cash equivalents of $23.6 million.

Consolidated EBITDA excluding certain items was $13.4 million, compared to $12.7 million last year. We lost approximately $2 million of EBITDA from the skilled nursing Medicare cuts during the quarter. So we have been able to make up for some of the loss with additional revenues and favorable case mix.

In addition, we did take other cost cutting measures early in Q2 that favorably impacted on our performance. We still have 13 managed communities left to close on in 2012 and taking those into account along 25 communities we currently manage equates to $8.8 million of annual management fee revenues.

Moving on to the balance sheet, our accounts receivable management remains strong and as of June 30th, 2012. The number of day sales outstanding for our consolidated operations was 18.5 days. At quarter end, we had approximately $338 million of net property and equipment, which includes the 31 properties directly owned by Five Star, 12 of which are unencumbered by debt.

We had $24.9 million of convertible senior notes, $46.9 million of mortgage notes payable, which includes $7.6 million related to discontinued operations, and with those $37.5 million outstanding on our $150 million revolving credit facility. We had nothing outstanding on our $35 million working capital facility.

At the end of the quarter, our leverage is 28% of book value and 19% of assets. We believe we are in compliance with all material terms of our credit, note and mortgage agreements.

Over the past year, Five Star has made major changes to strengthen its long-term shareholder value and viability. We have increased our core private pay revenues to 74% and now operate and manage over 27,000 units, a 14% increase. 80% of our units are independent living, assisted living and memory care, virtually all private pay.

Having experienced significantly negative impact from the 11% skilled nursing Medicare rate reduction, we have made up for all, if not most of the estimated increase or loss of $16 million to $17 million of lost EBITDA to our growth and margin management.

We announced the sale of our pharmacy business and we primarily use the proceeds to repay the outstanding balance on our $150 million revolving credit facility. Our focus will remain on building occupancy, increasing rates and aggressively managing margins to continue to be profitable and to grow our private pay business.

With that, we’d like to open it up for questions. Thank you. Operator, are you there?

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from the line of Art Henderson with Jefferies. Please go ahead.

Art Henderson – Jefferies

Hi. Thanks for taking my question. Bruce, I’m sorry. I jumped on a little later than you were into European remarks, could you talk a little bit about your views on occupancy kind of where it is in the assisted living side and kind of what you are seeing out there, and where you’re expected to go?

Bruce Mackey

Sure. Just looking at here at IL, AL, it’s been trending nicely over the last several months. It was flat quarter-over-quarter. We think it trend up over the last month or two. I say it’s fairly inline with the NIC Map data. Our AL, I think is pretty strong, maybe, 10, 20 basis points up, little bit lower in the IL that’s one of the tough one we’ve taking on recently and we’re working on moving that out.

Lot of the indications from the housing sector are seeing positive. I’m moving by that and I’m hopeful that that will help us so. And we are also still continuing to put a lot of efforts into our sales and marketing efforts here at Five Star. We completed our full conversion to our sales force marketing system, our CRM system in the second quarter. So, really, our third quarter will have a full core of that data from one system.

And again having that data, if you got the data to measure it, you can help improve it overtime. So we are really hopeful to that will have the big part of it. And then continuing to improve our sales trend focus across the company is a big part of that as well, and making sure that we’ve got the right people and the right job across the companies. I’m pretty hopeful what we should be able to do in terms of driving that occupancy of inevitable course.

Art Henderson – Jefferies

And I know you’d obviously don’t give up guidance. But just in terms of just how we should be thinking, should we sort of expect just like an incremental sort of rise in the occupancy or should we, kind of, with the -- I see the housing data as well, but just a broader economy in the weakness that we are seeing there, is it kind of, you’d be happy with a stabilized number? And or do you kind of feel like we should feel comfortable kind of tweaking at little higher so we can move forward?

Bruce Mackey

Yeah. I’m expecting tweak a little higher to move forward. And I don’t expect LIBOR just as you said. I think you are right on macro economic. Headwinds are there, they continue to probably be a little stronger now than they were two quarters ago. That will work a little bit against us but for the most part, we expected there was a little growth a little bit with everything that we’ve been doing.

Art Henderson – Jefferies

Okay. Great. And then on your labor, you’ve done a hack of a good job there, hammered away on it, anything specific that you’re doing in those with respect to those labor costs and the benefits that look like -- that look pretty strong there?

Bruce Mackey

Yeah. And I think that the main thing is that, again, we have a good cost containment culture. We continue to focus on the outlier buildings of a standpoint of productivity labor management, which has helped us garner the 30% basis point improvement in productivity.

I think the other big piece too is that our workers compensation programs in Five Star in just about $15 million a year of workers compensations expense. We revamped the administration and management of those programs in early 2011. And we are starting to see the benefits.

Art Henderson – Jefferies

Okay. Great. And then sort of jumping back over, towards your comments on the sale of the pharmacy business certainly what you plan on the use of proceeds. Can you just kind of talk about just sort of views on M&A and what the outlook there is, and any detail you can give around that?

Bruce Mackey

Yeah. Sure. I’m not able to replicate what we did in 2011 It will be pretty difficult given that we’re half way through the year. We sold a couple of properties that we got under agreement right now, management opportunities that we expect to close over the next several months. Our take on the Sunrise was not truly an M&A deal for us, will be a big deal bringing on those 10 communities, 2,500 units that will keep us busy, and should be a nice driver for EBITDA going forward.

We continue to still source a lot of deals. We probably signed CA every week at a minimum most of them don’t pan out but we’ve got that several things that we’re looking at right now. And hopefully, it could pan out in the fourth quarter early next year.

Art Henderson – Jefferies

Okay. Great. Thanks. I appreciate very much.

Bruce Mackey

I’ve been talkative.

Art Henderson – Jefferies

Thank you.

Operator

(Operator Instructions) Our next question comes from the line of Rob Mains, Stifel Nicolaus. Please go ahead.

Rob Mains – Stifel Nicolaus

Thanks, good morning.

Bruce Mackey

Good morning, Rob.

Rob Mains – Stifel Nicolaus

Could you go back, did I get this right there, same-store occupancy and senior housing you said 85.2%, was that the flat figure versus Q1?

Bruce Mackey

Yeah. I think it was down little bit from Q1 less from last year.

Rob Mains – Stifel Nicolaus

Same-store was down little bit as well?

Bruce Mackey

Yeah. Correct. And mostly driven -- if we look at our AL, IL, I know we don’t breakdown that in the press release, but just, it seems that was flat quarter-over-quarter and up marginally from last year at above 50 bps.

Rob Mains – Stifel Nicolaus

Okay. And then did you say about 86% as we speak now?

Bruce Mackey

Correct. Yes, overall.

Rob Mains – Stifel Nicolaus

Okay. So, I guess to some miles from that is -- I mean, you said you had a couple of strong months probably kind of low watermark in the middle of the second quarter has been grown since from then?

Bruce Mackey

That’s there. Yes.

Rob Mains – Stifel Nicolaus

Okay. And then under the two rehab hospital that labor 8% of revenues, but the decline of margins we should attribute that to Braintree?

Bruce Mackey

Yeah. This quarter we saw a little bit of pullback in margin from our first quarter primarily from our Braintree location, New England was up, driven primarily by our new low inpatients, that was a nice driver of growth. But in Braintree, we saw a little bit of -- a little lower Medicare mix in terms of the patients and in terms of the [DARGs], the actual case mix was little lower than what we’ve seen in the past as well.

Rob Mains – Stifel Nicolaus

(Inaudible) mixed issue?

Bruce Mackey

I can say, I think we are unable to take into consideration with rehab hospitals last year 2011. We have hospitals have had EBITDA on growth of about 25% for the year and Q2 for Braintree in particular last year was a really strong quarter.

So again we are not pleased with performance Q2 of ‘12 but Q2 of ‘11 was the strongest performance of the year. We did have a little bit of noise in there with change in increasing Medicaid business with a little bit of length of stay decreases in Medicare.

Rob Mains – Stifel Nicolaus

Okay. And then when you look out at 2013, obviously 2% isn’t a bigger number as 11.1% but in terms of handling the sequestration reduction, is there something which is going to necessitate specific strategies like skilled nursing cuts or is that something that you think you can handle kind of normal course of business?

Bruce Mackey

I think we handle a normal course. I think we’re sure, always can handle with 11.1% breakout into our maths very well. So that’s the question cuts of the 2%. And again essentially that mean a flat rate increase because they are going to give us the 1.8% and then turnaround and potentially take it away from 11.

So I’m not too concerned about it but we’ll push our private pay rates and that will cover it. We expect to grow our occupancy that will cover it. And we expect it to continue to manage our expenses in a manner that will help drive our bottom line growth.

Rob Mains – Stifel Nicolaus

Okay. And then last question the pharmacy sales obviously positive and our last question about M&A, looking kind of the other side of M&A, are there any assets just generally speaking that you would look to lighten?

Bruce Mackey

Rob, potentially, we’ve got two skilled nursing offices right now and this continued. It wouldn’t surprise me if another one joins that mix in the short-term. But we are always looking if a property, we feel is off to lead the market or if a market is turning, we don’t expect to come back. We take a good look, hard look and over the course of time, we’ve probably moved out 20 properties, most of them in the skilled nursing side, few ALs, ILs as well that’s pretty rare, but we do look at it and manage it pretty well.

Rob Mains – Stifel Nicolaus

Right. That’s all I had. Thank you.

Bruce Mackey

Great. Thank you, Rob.

Operator

Thank you. And next from Noble Financial, we’ll go to the line of Mike Petusky. Please go ahead.

Mike Petusky – Noble Financial

Thanks. Good morning. Few questions, could you hear any GAAP chances if this pharmacy transaction closes in Q3 versus Q4, is it more likely Q3 closing?

Bruce Mackey

I would say yes.

Mike Petusky – Noble Financial

Okay. And in terms of I think if you mentioned on this call, forgive me, for asking it again but I think you’d mentioned on last call, you are hopeful for 3% to 4% rate increases in ‘12. I mean is that a reasonable expectation still at this point or is it maybe a little bit lower?

Bruce Mackey

Pure product pay on existing revenues, it’s going to be in that range.

Mike Petusky – Noble Financial

Okay. And then I guess just one more question. To me my read between alliance and that may not be accurate but my read between the lines seems like you guys the language you are using in terms of M&A opportunities on this call is a little bit more bullish than on the last call. Are you -- have you seen a pickup in terms of things that you guys are potentially getting serious about or am I reading too much into what I think I’m hearing?

Bruce Mackey

I think you’re reading a little too much. We source a lot of deals, fairly something similar at last quarter. The deal flow expense is lower this year than last year, I will say that overall. But it still we’re looking at the one-off transactions, a lot of smaller regional type three to four assets here and there. Most haven’t panned out, I’ll be honest with you. A lot of stuff that we’re looking at really hasn’t moved up to what we compare the quality assets consistent what we manage right now on our portfolio. So….

Mike Petusky – Noble Financial

Really -- not any material change since early in the year.

Bruce Mackey

That’s fair.

Mike Petusky – Noble Financial

All right. Very good guys. Thank you.

Bruce Mackey

All right. Thank you, Mike.

Operator

Thank you. And next we’ll go to line of James Gibson from Punch & Associates. Please go ahead.

James Gibson – Punch & Associates

Hi, guys. I was hoping you could comment on what you are seeing in terms of pricing of some other deals. Yeah, you’re seeing cap rates continue to move lower. And is that trickling down into some of the one-off transactions that you guys have been considering?

Bruce Mackey

Yeah. Cap rates still are -- they are low. They are probably at four, five years low point right now. Hence we’ve been able to close a lot of deals. So, really the choice for us to say that they have turned significantly lower than last year. Obviously, the one-offs, you do get a little bit of break on that, paying for portfolio pricing premium but now they are low.

James Gibson – Punch & Associates

About newly constructed properties if you’ve been seeing, more of those being completed or is that still relatively stagnant?

Bruce Mackey

Still relatively stagnant. There are some markets we do hear about construction taking place. I think it’s probably a little bit more this year than last year not significantly. So I would say tough a little bit. But still even when you look at that potential demand in industries, it’s a fraction of where possibly could be. You still there, James.

James Gibson – Punch & Associates

That answers all my questions. Thank you.

Bruce Mackey

Okay. Great. Thank you.

Operator

Thank you. Then next we’ll go back to Rob Mains from Stifel Nicolaus. Please go ahead.

Rob Mains – Stifel Nicolaus

Yeah. I’m sorry. I missed the comment that you had on utilities costs?

Bruce Mackey

Yeah. Our utilities were sequentially favorable to Q1 which we normally enjoy. They were 10 basis points higher than they were last year and quite honestly, there was really nothing unusual in that. As you recall, last year 2011 we put a big focus on reducing expenses then we continue to enjoy lower expenses as a percentage of revenue than we have in years.

Rob Mains – Stifel Nicolaus

So the heat waves that struck various parts of the country has another meaningful impact on them?

Bruce Mackey

We’ve not seen anything yet.

Rob Mains – Stifel Nicolaus

Great. Thank you.

Operator

Thanks. With that, there are no further questioners in the queue. I’ll pass it back to Bruce Mackey.

Bruce Mackey

Great. Well, thank you all for joining today. We will be presenting at the Stifel Healthcare Conference in Boston in early September and hope to see many of you there. Thank you.

Operator

Thank you. That does conclude our conference for today. Thank you for your participation and for using the AT&T Executive Teleconference. You may now disconnect.

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