Kevin Grant- Founder, President, Chairman and CEO
Frances Spark - CFO and Treasurer
Rick Cleary - COO
CYS Investments (CYS) Presentation at Barclays Capital Global Financial Services Conference September 11, 2012 4:15 PM ET
Good afternoon. I have the pleasure of introducing our next speakers from CYS Investments. On the stage we’ve got Kevin Grant, CEO, and Frances Spark, the CFO. And then Rick Cleary, the COO, is sitting in the front row.
CYS is one of these companies - agency-only mortgage REITs - that’s built a great track record, and I think one of the most notable things about them that really differentiates them is the fact that they’ve done something extremely shareholder friendly by internalizing the structure and generating more operating leverage now than I think you’ll see in the average mortgage REIT. That, in addition to great security selection.
So with that, I’ll hand it over to Kevin for his comments.
Thank you very much. Good afternoon everybody. Thanks for coming to the presentation and listening in. If you’re following the webcast, this presentation we’ve got here in New York is available in an 8-K which was just filed. So please pull it up and follow along.
Also, thanks to Barclays. Barclays took us public in 2009 and we think we’ve delivered a good result for our shareholders and a good result for everybody involved. So thanks to Barclays for hosting and continuing to be a supporter of the company.
So yes, CYS is an agency-only mortgage REIT, and I’ll bring your attention to our forward looking statement cautionary paragraph. I’ll let you read this at your leisure. But suffice it to say, I’ll make some forward looking statements and we could change our mind in five minutes. Just be aware the markets change very quickly, and we react.
So the company is an agency-only mortgage REIT. We actually started privately in 2006, and at the time it was a hybrid strategy. And that was something that at the time we felt a lot of value could come from. But very early on in our life, we realized that the credit markets were changing drastically. We changed our investment guidelines in 2007 to be agency-only, and that was very prescient. We got that right. And even today the residential mortgage market really is an agency-only world.
I’m the founder of the company. Started the company in 2006. The team that started the company, really including Frances, has been in place right since the beginning. As Mark mentioned, we are self-managed. Our view on this is that when the company was small it was valuable to have an external manager, really for resources, because you could lean on the external manager. It’s very expensive to start one of these companies.
But as you scale, it really makes sense to become self-managed, and we brought management inside just about a year ago, a little over a year ago, and essentially that transaction was for free. The company had to pay for computers and office buildout and so forth, but essentially it was pretty close to a for-free transaction. We think this is the right structure for us, our particular circumstances, and it really does deliver economies of scale as the business grows.
We’ve got a lot of financing in place, with a lot of different counterparties. We’ve got over 34 counterparties in place now. Believe it or not, we’ve got more counterparties in the works for financing and interest rate swaps. It’s very important to manage these counterparties. The capacity moves around.
The capacity is very good right now in the repo markets, but it does move around. And all of our counterparties have all their own issues, and we like to diversify our sources of financing and types of financing. And, of course, we’re a REIT, so whatever we earn we’ve got to pay out, and it goes out to you all in the form of dividends to our shareholders.
We’re now three years plus as a public company, and we’re very proud of the track record thus far. And we hope to continue to deliver these results. Essentially, since our IPO we’ve just about doubled our initial public investors’ investments, since that June 2009 IPO.
On the expense ratio side, I actually said in the IPO roadshow that our goal was to become the most efficient provider of access to these markets, to our investors. And by these markets I mean the agency mortgage market, the repo market, which is very difficult for you to access yourself, and the interest rate derivatives, basically the hedging markets, the swaps markets.
So if we’re the most efficient provider of access to these markets than anyone else, then we will always be able to generate a better return. And when returns were in the 15%, 16%, 17% neighborhood, the investor base really didn’t focus on expense ratio.
But now we’re in a low teens investment environment, and I think the market is beginning to realize that this expense ratio load and efficiency and quality of management really is a pretty significant differentiator, and we think this really matters to our shareholders and ultimately, obviously, the multiple on the stock.
So let’s move to the mortgage investing environment. Rates are low. The Fed is our biggest competitor for assets, in a very significant way. And the Fed’s activities in the markets and the expectations of more activity in the market is driving the absolute level of rates. A 7/1 hybrid ARM, par priced - this is very theoretical - would yield about 1.4% right now. There really is no such thing. The entire market is a premium market.
So it’s really all about getting the prepayment risk and prepayment story right. We would not be a buyer of a 7/1 hybrid in any great quantity in this market. Prices are just too high for the prepayment exposures that they’ve got. In addition there’s very limited supply. There’s some supply, but relatively limited.
So to the extent that we can find prepayment stories that we like, we’re happy to buy them, assuming the prices are reasonable, but it’s not a fertile field for us right now. The 30-year fixed rate market, which is what the Fed would be targeting, the current yield there is about 2.60%.
Once again, it’s a premium market. The production coupon is 30-year 3s. That’s not normally a sweet spot for us. We do have some 3.5s, and we happen to like 30-year 3.5s more as a tactical opportunity more than anything, not really a core holding. So we do have some of those.
Our biggest holdings are in the 15-year market. This has been the case for a number of years now. We like the 15-year security. It’s roughly a 4-year average life security. It really fits the profile of this business very nicely. The yields are lower. Yields in the 15-year market are 2.10%, 2.20%. Basically low twos right now. The nice thing about the 15-year cash flows is they’re very easy, relatively easy, to hedge with just a simple 4-year vanilla interest rate swap.
You combine all these things, and on a hedge basis what we see right now in the markets is you can get to a net interest spread on new investments of around 160 basis points, plus or minus. We said this on the earnings call in July, and we said that this was our expectation, and this is really what’s been borne out.
The curve has flattened quite a lot. This is by design, by the Fed, as I think we all know. Two effects of this. One is that it pushes down our reinvestment yield, obviously, as we’ve discussed. But it also really drastically reduces the cost of hedging. And if you think about it, do you really need a hedge for the next two years? Probably not. Do you want a hedge as a [tail] risk that goes out five, seven, ten years? You probably do want to hedge the tail risk that goes out much longer term. So that’s really the way we’ve been focusing on the hedge.
Let’s drill down a little bit and look at the 15-year market. So this is a graph of the 15-year yields, with a hedge - that’s the light blue line - and this is on page five for those following the webcast. That’s on a hedge basis. Typical of what we’ll do. And, in fact, this is the trade that I just described. And then the black line is the unhedged strategy where you invest long and borrow short.
And you can see, number one, that spreads have come in a fair amount. They’re really as tight as they’ve been since this graph, 2005. The blue line is hovering around that 1.60% spread level that I just described. But I think the big takeaway is that this really depicts how cheap hedging is, because the cost of hedging is the difference between these two lines. And these two lines are really gravitating to being pretty close to on top of each other. So hedging is very inexpensive in this market, not surprising. So if insurance is cheap, even though you think you might not need it, you probably still ought to buy it.
So no discussion of a mortgage REIT, particularly an agency mortgage REIT, would be complete without a discussion of the Fed. And this Fed - presumably there’s going to be a major announcement, or some big announcement, tomorrow, relating to QE3 or some other program - is extremely important to watch. They’ve faced quite a number of challenges that are really unprecedented for central banks.
They have been very accommodating. There is growing research being done in academia and presumably also within the various central banks - regional offices, rather, of the Fed - relating to different tools. And all this really relates to Fed balance sheet as opposed to Fed funds, as being the tool.
Because if you were to apply some kind of Taylor rule right now, you’d really get to a Fed funds rate that has to be negative. And, of course, we can’t have negative Fed funds. So the next step is to move to the balance sheet. And I think internally to the Fed, the realization that the Fed can be more aggressive using the balance sheet has really surfaced as important within the Fed.
Chairman Bernanke, at the Jackson Hole meeting, said something I think very telling. He said that a labor market stagnation was of grave concern. And I think this is a very important sentence that the press seemingly is just not picking up on. But I don’t think I’ve ever heard a central banker say something that strong. I think the chairman really would like to see unemployment get down to whatever the number is, 6% - whatever number in his mind feels like they’re making progress.
So my sense is that the chairman really is of the mind of doing something much more aggressive in the form of QE3, but he needs to get consensus within the voting members of the Fed. And you can’t do something aggressive with multiple dissenters.
So my take on this, for whatever it’s worth, is that that’s really what’s going on right now, and I think their announcement tomorrow is really a tough call. I think it’s more about consensus building and less about what the chairman thinks. But we will learn soon enough, tomorrow. Obviously the Fed is very accommodating and you can tell from my thoughts that I think they want to be more accommodating.
Chairman Bernanke, his term is up for renewal in 2014. The thesis that we are working on - of course there’s no certainty in this - is that he wants to retire. So I think after the election the market will begin to kind of handicap different potential next Fed chairmen and really start to handicap what that chairman’s view is of the economy and Fed action might look like.
The Fed has multiple tools. The tools that they’ve got in place and are executing right now are Operation Twist 2. So the Twist extension. And this is the program that will go through the end of the year. A couple of economists have given us forecasts on what that looks like. We happen to get these from Larry Meyer, who we like. Their projection - and this, you know, kind of really makes some assumptions about Treasury issuance, which… They’re going to be big issuances, that’s for sure.
But at the end of the year, the Fed will own north of 40% of longer-dated Treasuries. And that’s really a big number. I don’t know the number of Treasuries that U.S. pension plans own, but U.S. pension plans that need to manage their asset liability mix, they own a lot of long-dated Treasuries. So if you add those two owners up, an awful lot of long-dated Treasuries are really put away right now. So this is creating a little bit of a collateral shortage in the Treasury market - actually more than a little bit.
If you look to Japan, if you take the Japanese Central Bank, plus the postal service - so the pension plan in Japan - those entities combined own something like 96% of JGBs. So this is one of the reasons that JGB yields are just so low. The graph on the right shows you really the acceleration of long-dated Treasuries that the Fed owns. This is a reality. This is really just the environment that we’re operating in right now.
One thing I just want to put on your radar screens - I think it’s way too early to be worried about this - but if people at Fed start to believe that there is an inflation threat, despite really high levels of unemployment, they will probably start pointing to this concept of hysteresis. It’s also kind of this long term structural unemployment rate. So a natural rate of unemployment that’s higher going forward than we might like it to be or think it to be.
And there’s a whole lot of components to hysteresis, and if this starts to be a real concern, or something the Fed really wants people to focus on, I wouldn’t be surprised to see some sort of academic paper come out of one of the regional Fed office academic journals over the next year or two or three. So it’s just something to put on your radar screens. I don’t think this is an issue at all right now.
It’s also important to look at central banks around the world. This picture page on page nine, I almost want to take one of these arrows and slide everybody over to the right, because central banks around the world are becoming more accommodating in a significant way. So the global slowdown is real, and central banks around the world are reacting. It’s almost tough to put anybody in a neutral camp at this point.
So global accommodation seems to be growing. This is very important because it’s a global market. Global liquidity is very important. A lot of the banks that we deal with - actually all the banks that we deal with - are global banks in nature. So they look at their balance sheet on a global basis, and deal with global issues, and global liquidity, and global interest rates.
The fiscal cliff. So this is the Congressional Budget Office’s most recent page, and we’re kind of in the same camp as everybody else. Nothing’s going to happen until the election. When get to the election, Congress and the president have an issue that they need to resolve ASAP.
Under the extended alternative fiscal scenario - so that’s continuing some of the Bush era tax cuts and so forth for another period of time, you can see what happens the deficit longer term. Note that right now, on a debt to GDP basis, the U.S. is around 70%. It’s not off the charts. It’s really not out of balance for the major European countries.
And what the rating agencies are concerned about, what we should all be concerned about, really is where it’s going. So the gap between the green line and the brown line, that is the path that needs to be maneuvered and defined over the next 10 years.
The U.S. rating agencies, S&P and Moody’s, obviously they look through policy to figure out what this looks like longer term. And I think the election, this go around, is really of extreme consequence, to see how this all gets solved and resolved.
A couple of economic slides. We’re focused on the unemployment rate, just like everybody else, because it really drives Fed policy, interest rates and so forth. The housing market does seem to have found bottom, and it seems like the bottom in home prices is behind us. This is a good thing. And hopefully we’ll get some job creation here going forward. Although, at a pace of 96,000 jobs a month, it’s very slow paced to keep the unemployment rate moving lower materially. So we think this is very important to watch, because it really drives Fed thinking and Fed policy.
Gas prices, we do watch. Like everybody else, we see high gas prices, high energy prices, as a essentially a tax, a tax on GDP. So we monitor it as yet another economic indicator.
Turning to the mortgage market, more apropos for this business, the mortgage market is shrinking. We’ve talked about this in the past, and I’ll just highlight it here. If you think about it, home prices have dropped from the peak by, call it 30%, plus or minus. So if the value of the asset that’s being levered has dropped 30%, well, the leverage that can be applied to that market, and the need for debt, has dropped by at least 30%.
Combined with higher underwriting standards, and a real sentiment on the part of consumers, homeowners, that they really want to have less leverage. They want to own their home. This is one of the reasons that there’s plenty of supply in the 15-year market. People are refinancing out of longer-dated mortgages into 15-year mortgages, keeping the same payment, cutting their term in half, and really building equity in their homes.
So this is a very powerful trend, and this is, effectively, shrinking the mortgage market. If you combine this reality with Fed purchases of agency mortgage-backed securities, you can see why spreads have come in so much.
Net supply in mortgages is the middle graph. It has been negative for quite a while. And underwriting standards, as we all know, have gotten much tighter. And just the hurdles to closing a mortgage application, whether it’s a refi or a purchase, have become very extreme. So there are a lot of frictions in the system.
We see it in prepayment speeds, and we’ve had a lot of questions about prepayment speeds. Back in the day you would expect the mortgage market to be paying down its 60 CPR. It’s actually paying down, now - and this is probably the peak month - probably around in the low 30s CPR. The market is probably priced for 40-45 CPR. So what that tells you is there is still good yield, because the market prices aren’t really priced for a 30 CPR. But it’s nothing like what speeds would have been years ago.
So mortgage prices are high. My guess is with everything that’s going on, and the frictions in the refi system that mortgage prices in the agency market are going to stay high for quite a while.
Let’s just touch on the elections really quick. I don’t want to spend a whole lot of time on politics, but it’s important to look at this, because this election is so important. The Iowa Electronic Futures Market has Obama in quite a lead, but they also have the Republicans taking both the House and the Senate. And that’s the right graph here. That’s the Iowa Futures Market.
Lots of people look at Intrade. Intrade supports that. It has the House of Representatives staying Republican, and the Senate - by a relatively small margin, 53.7% - going Republican. And it also has President Obama being reelected. So that’s what Intrade says now. I think the debates are going to be extremely important.
A good website, by the way, just to keep up on the debates, is debate.org. The first debate is October 2. And who knows what the outcome of the debates are going to be. But I think it’s probably going to get pretty good ratings on television. They start at 9 o’clock, which is kind of late for the east coast.
Of course, the presidential election is not a populist election. It’s an electoral election, so this map tells you where most of the dollars are going to be spent. And it’s really those toss up states. Florida’s a big one. Ohio is a big one. Colorado is actually a pretty big one. Michigan’s a pretty big one as well. So it’s not surprising, if you visit friends, or you’re on business in these states, if you turn on a television and it’s just wall to wall political ads, this is why. And we’ll just see how it goes over the next several weeks.
All right, turning to something a little more mundane, on page 16, this is a print of a - it’s a couple of days old - market screen, and it shows you the 15-year market. And we have circled 15 year 3.5s just so we have something to talk about. If you were to buy a 15-year 3.5 today, and settle that trade in September - so basically short dated settle, assuming you could find a bond - you’d pay 106 and 13. These are all time high record prices.
If you agreed to settle in November, which is typically what we do, there’s a little bit of a discount. And the reason there’s a discount in this forward rate, of this forward market, is that your cash is sitting in cash earning zero along the way as opposed to a 3.5% coupon. So arbitrage free, you’ve got to get to a lower dollar price in that forward market.
So we like to use this forward market. Dollar prices are lower so the bonds go on our balance sheet at a lower price. That’s valuable. But the big thing is our counterparty has a chance to essentially custom manufacture a bond for us. So if there are certain features we’d like in that bond, if we want a certain geography, if we want certain loan balances, whatever it is, whatever we think has value, we can talk to that counterparty and we can ask them to essentially custom manufacture a bond for us.
Now, that counterparty may or may not charge for those features, and we have to make a judgment on whether it’s worth paying up for some of those features. A very popular feature over the past two or three years has been low loan balance. And I’ve got to say, everybody now talks about low loan balance and the pay ups for low loan balance are extraordinary. And it’s great. In some cases, it might still be worth it. In a lot of cases, it’s pretty full, and that story, I think, is pretty well fully priced at this point.
There are other stories. We consider these things proprietary, and usually by the time we or some other company talks about it publicly, they’ve really already got the trades on. So if you wouldn’t mind, I’ll keep some of those things quiet for now.
So here’s the portfolio composition. The pie chart is on the left. So you can see that we are heavily invested in the 15-year market, for the reasons I mentioned earlier. Very good structural fit for this business. We do have a small amount of 20-year mortgages. Very similar kind of refi product as the 15-year market. So we kind of look at them as fungible. The 20-year market is relatively small.
We do have some hybrid ARMs. Most of these are older. And we like what we’ve got. They are paying slower than we would have expected, but they are more seasoned and kind of rolling off the portfolio. Very little production of hybrid ARMs these days. There’s some, but not like a few years ago. And then we do have a small amount of 30-year fixed rate bonds.
But this portfolio has been very stable. We did do a capital raise in July, and this pie chart is indicative of where the portfolio sits today. The mix hasn’t changed a whole lot since then. But the portfolio’s been very stable. It’s really driven pretty good stability in the dividend.
We just declared, half an hour ago, and put out in a press release, our Q3 dividend of $0.45. We telegraphed this to the market in July. And if you do the math real quick, what you’ll see is a 160 basis point net interest spread, times the leverage. Add back the yield on the piece that’s not levered, and then take out expenses. You get to around a 13% ROE, 13% dividend, and that’s $0.45.
So what we see right now is that this is pretty stable. But as I said earlier markets are markets, and the spread market could change tomorrow. But for right now we see this spread environment as pretty stable.
Page 18 just gives you a snapshot of the portfolio in tabular form. It also gives you the prepayment rates on the far right column of the different buckets of what we’ve owned. So this just gives you the tabular form.
And then last but not least, I’d just like to highlight that CYS uses financial reporting for investment companies. So what this means is that when you look at our financials, our Qs and Ks and press releases, what you see is the entire portfolio, line by line, with really a lot of detail. We give you every single hedge, every single asset. We actually give you all our financing counterparties. We give you our exposures to all those counterparties. It’s very, very transparent financial reporting.
We like it. It really takes a long list of questions off the table, and we can focus on more important matters when we meet with investors. So we like this method of financial reporting a lot.
I think the big difference is that there’s no OCI account. So everything is mark-to-market and goes through the income statement. So you see it right there. So we happen to like that financial reporting a lot.
And then last but not least, on page 20 - you can’t see it here in the room, just because of the small print, but - we broke out some of the financial highlights for the quarter on this particular slide. And once again it’s in the 8-K and of course in the earnings release from July.
Just to wrap it up, and we’ve got a few minutes for questions, the curve still has some steepness to it. It’s not dead on flat. There’s still some spread. There has to be some spread for mortgages, otherwise mortgage prices would just readjust. The tailwinds that we’re getting on our financing, we think those tailwinds are in place, and they’re going to be in place for a long, long time.
We think the Fed’s transparency is actually very helpful to this business. We think the forward rate guidance is very helpful. And if you think about it, if the Fed says something to change the forward rate guidance, basically to be more bearish on the bond market, the curve’s going to steepen. The curve’s going to steepen, and that’s going to improve our reinvestment opportunity.
We would love that to happen, because the curve will steepen first, improve our reinvestment opportunity, and then the tightening comes later. So in other words we can invest ahead of the actual tightening, and we think that’s an environment where the spreads get better. But unfortunately, that’s not today’s environment.
So that covers it. We’ve got a couple of minutes for questions. And if there’s anything you’d like addressed, happy to do it.
Unidentified Audience Member
I think you indicated you think spreads and returns are stable at this level. Does that contemplate the QE3 and what that might do to mortgage spreads?
It does contemplate a QE3, basically of what’s already impounded in the market. There is probably a $600 billion to $700 billion program already built into expectations with probably an 80% probability. So that’s really already built in there.
Unidentified Audience Member
Assuming 80%, not fully priced in, would you still expect the Fed buying to be concentrated in the 30-year part of the curve? And then have less of an impact on your 15-year mortgages?
Well, if the Fed buys a couple hundred billion of anything, it’s going to affect everything. Their target is the rate that the homeowner sees. So their target bond would be 30-year 3s, and possibly 30-year 2.5s, which aren’t really yet being made. But they would be made in that kind of environment. That’s not a place that we would normally spend a lot of time, but it would take prices up in the whole market, for sure.
Unidentified Audience Member
You made a separate comment around hedging, where it makes a lot of sense that when insurance is really cheap, even if you’re not sure you need it, you buy it. How do you think about QE, though, within that context, in the sense of not wanting to add too much negative duration right before a potential big, Fed-induced rate rally? Do you just focus on hedging and shorter tenure so that if you’re putting on negative duration it’s in parts of the curve that are much less likely to be impacted by Fed action?
The interesting thing really is the basis risk. So if there’s a big QE program coming… You know, we’re not hedging the asset. We’re not hedging the mortgage. We’re hedging the financing of the asset. So we’re really trying to hedge LIBOR. And LIBOR, on the further end of the yield curve, is really swaps. So that basis risk gives me some comfort that I’m not really foreclosing asset appreciation, I’m really trying to lock down the cost of financing those assets by focusing on LIBOR. Because the Fed’s not buying swaps. They’re buying mortgages, possibly Treasuries. So things that were long naturally.
Unidentified Audience Member
Can you just discuss what kind of repo rates you’re seeing in the 15-year production environment versus where it’s been over the past several months?
The repo market at this point is in the low 40s - you know, 41, 42 basis points, something like that. Everybody’s focused right now on managing and getting over year end, because of Basel III and all these other issues. We’re focused on that just like everybody.
The repo market probably in the past six months has widened a little bit. And this all related to the Street getting downgraded back in June, and really the bid offer in repo has widened out. So that’s what’s going on there.
15-year market supply is running about what it’s been running. So I think back in the spring it was 40% of production. I haven’t seen the most recent numbers, but I’ve got to believe it’s same kind of zip code. So for us, for our $2.4 billion company, there’s enough product out there for us to be comfortable.
Unidentified Audience Member
As your legacy portfolio ages - I’m sure it’s all pristine underwriting, so it’s people who could refinance if they had a rate term opportunity to refinance - is there a point in rate, whether it’s 50 or 75 down from here, where at that point you begin to see either a pickup in prepayments or at least things don’t begin to slow down. For the 30 year. In other words, if they actually got down to a 3% flat 30-year, just by example. Is there just kind of a red line where you’re beginning to worry that it goes up five, ten points on your CPR?
The refi environment is really kind of strange, because obviously the Fed is targeting a rate, and the Fed sees the mechanism of their policy as essentially the homeowner, home prices, and home construction. That’s how the Fed sees the job situation. But counter to all this are the G-fees and mortgage insurance. So the Fed could do a QE3, push down the 10-year Treasury 25 or 30 basis points, which actually in this environment would be a lot. But G-fees went up last week another ten basis points. So the homeowner is not necessarily seeing all of this.
When I talk to originators, their complaint to regulators is that in this environment they cannot get to the collateral. So if they make a loan that just doesn’t work out for whatever reason, it’s very difficult to foreclose, get the property, and actually get it sold in any reasonable period of time.
So what does that mean? Originators are really only making, basically, perfect loans, because they need to minimize the probability of something going down that path. That’s a structural, regulatory issue. That has not been solved. I think, best case, that’s a 2013 kind of issue. But if you think about 50 states, 50 attorney generals, all the different regulatory bodies, the social issues of foreclosing and evicting, which nobody wants to do, it’s a pretty significant issue.
Well, all right. Thank you very much, and have a good rest of day.
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