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MB Financial, Inc. (NASDAQ:MBFI)

Q2 2008 Earnings Call

July 25, 2008 11:00 am ET

Executives

Mitchell S. Feiger – President & Chief Executive Officer

Jill E. York –Vice President & Chief Financial Officer

Thomas D. Panos – President & Chief Commercial Banking Officer

Thomas Prothero – Senior Credit Officer

Analysts

John Pancari – J.P. Morgan

Brad Milsaps – Sandler O’Neill & Partners, LLC

[Unidentified Private Shareholder]

Kenneth James – Robert W. Baird & Co.

Daniel Cardenas – Howe Barnes Hoefer & Arnett, Inc.

Operator

Welcome to the second quarter 2008 MB Financial earnings conference call. (Operator Instructions)

With us today are Mitchell Feiger, President and Chief Executive Officer, Jill York, Chief Financial Officer of MB Financial, and Tom Panos, President of MB Financial Bank and head of commercial banking; also Tom Prothero, Senior Credit Officer.

Before we begin, I need to remind you that during the course of this call, the company may make forward-looking statements about future events and future financial performance. You should not place undue reliance on any forward-looking statements which speak only as of the date made. These statements are subject to numerous factors and could cause actual results to differ materially from those anticipated or projected. For a list of some of these factors, please see MB Financial’s forward-looking statements disclosure and their 2008 second quarter earnings release.

Mitchell S. Feiger

We very much appreciate your interest in our company and the time you’re taking this morning to listen to our comments. Earlier today, we issued our regular quarterly earnings press release. We’re trying to make our press releases as useful to you as possible. We try to anticipate your questions and if you listen carefully, your comments about our prior release so this quarter we’ve included some new disclosures and comments that I’m hoping you’ll find useful. We remain interested in hearing from you about the things you’d like to hear from us so let us know.

This quarter’s report is a relatively clean one. The only significant non-core item is a large net income benefit caused by adjustment of a tax valuation reserve and Jill will give you more detail on that in a minute. I think the 30,000 foot view of operating performance in the second quarter is that loan growth was good, our net interest margin expanded, fee income was good and expense control was good. Of particular note is that we saw strong net interest income growth in the quarter as a result of a good, healthy increase in average earning assets up 18% annualized in the quarter and a 3 basis point increase in our net interest margin. It’s gratifying; we’ve been waiting for the time when our net interest margin would stabilize, allowing our earning asset growth to fall to the bottom line and fortunately that’s what happened in the second quarter. Now that’s a very high-level view of operating performance and Jill will give you more information on that.

Let’s turn to credit quality. Just to refresh your memory, for many quarters now we have been reporting information about both non-performing and potential problem loans, and potential problem loans are those loans that we’re concerned about but aren’t yet bad enough to call non-performing and we do this to give you better clarity on credit quality and the flow of loans from performing status to potential problem loan status to non-performing status; and I think we’re among a small number of companies that provide this level of credit detail each quarter. With that said, I have conflicting, I think, things to tell you about credit quality for the second quarter. Basically, problem loans previously identified got worse but we added new ones at a much slower rate. We continue to wrestle with those same five to seven construction credits that we talked about for several quarters now; three of them moved from potential problem loan status at the end of the first quarter to non-performing status in the second quarter. I don’t have to tell you but I’ll say it, I mean, the for sale residential market remains very weak and these credits deteriorated in the quarter. In numbers, non-performing loans increased by around $43 million while potential problem loans decreased by about $48 million. Total non-performing assets now stand at $95 million and total potential problem loans are $75 million; both we feel are very manageable amounts.

Now, of the $75 million of potential problem loans at the end of the second quarter, four credits are over $5 million and those account for $52 million of the $75 million. Three of the four are the group of three loans that we mentioned last quarter that were discovered during a detailed review of a commercial banking division that wasn’t following our prescribed procedures; those are three of the four over $5 million. The fourth one is a loan to a home builder in the Chicago market and now we’re in settlement discussions at this moment with one of the group of three that may result in some amount of charge-off in the third quarter and we believe we have that loan fully reserved. Now, speaking of the group of three, just to be clear, we completed our review of the entire situation in the second quarter, corrected procedures that needed to be corrected, implemented procedures that needed to implemented and reviewed the other divisions for similar instances and found none. We consider the matter closed except for, of course, collecting on these three loans.

Alright, let me turn it over to Jill now for a bit more detail.

Jill E. York

From an overall standpoint, earnings were quite strong for the quarter. Net income was $22 million or $0.63 per share for the quarter. As Mitch noted, including in these numbers was a favorable tax benefit totally $7.3 million or $0.21 per share. This tax benefit related to the removal of valuation reserves on our state tax net operating loss carryforwards and the adjustment of our tax contingency reserves on one of our state tax divisions. Excluding this item, we place our core earnings at $14.7 million or $0.42 per share.

As Mitch noted, from an operating perspective, there were many positives in the quarter. We can continue to enjoy strong balance sheet growth, both on the loan and deposit side of the balance sheet. Commercial related credits grew 18% compared to a year ago while DDA balances grew 15% on an annualized link quarter basis. Our loan growth was driven by strong CNI and commercial real estate growth and we have good momentum here. We have continued to add commercial and private bankers; at this point have added 32 people on the sales side since the third quarter of last year. We have also added a number of supporting credit folks to directly support the sale side.

Our securities portfolio continues to perform very well with unrealized gains over $5 million. As a result of the strong balance growth and an expansion of our margin to 3 basis points compared to the first quarter, we enjoyed robust net interest income growth. Net interest income increased approximately 22% on an annualized link quarter basis. We continue to see significantly better credit spreads on our new and renewed credits and on new investment securities purchased. Unfortunately, competition for deposits continues to be fierce, which is impacting both customer and wholesale deposit pricing. This seems to be constraining more significant net interest margin improvement.

Our provision for loan losses was $12.2 million while charge-offs for the quarter were $8.4 million. If you were to break down the provision, about 85% of our charge-offs this quarter were reserved for in the first quarter. Thus, about $1.4 million of the provision related to charge-offs this quarter. $8.4 million of the provision related to the downgrade of credits from potential problem to non-performing status as these credits worsened during the quarter. As Mitch noted earlier, our non-performing loans increased by $43 million while our potential problem loans decreased by $48 million. The remainder of the provision, which amounts to about $2.4 million related to normal migration of risk ratings and loan growth within the portfolio.

Now let’s talk about fee income and operating expenses. Similar to the last couple of quarters, we have included schedules which divide up fee income and operating expenses between core and non-core sources for the past five quarters. Core fee income continues to be quite strong and grew by 12% compared to the second quarter of 2007. Our Cedar Hill acquisition early in the second quarter positively impacted our asset management fees while loan service fees and deposit fees have increased substantially compared to a year ago. This is primarily due to the low interest rate environment, which has positively impacted treasury management deposit fees and prepayment fees on loans. Core expenses have been manageable. If you exclude our investment in net new bankers hired over the past three quarters, the impact of which on the second quarter was $1.6 million and the impact of our Cedar Hill acquisition on expenses which totaled around $1.1 million, our expenses increased about 2% compared to a year ago.

As noted earlier, during the quarter we benefited from the removal of valuation reserves on our state net operating loss carryforwards and adjustment of state tax contingency reserves. Excluding these items, our year-to-date effective tax rate was 17.6%. We believe our effective tax rate will be in the neighborhood of 15% to 20% for the balance of 2008 depending on a pre-tax income and the effective rate will most likely increase in 2009 due to state taxes and also will depend on our level of pre-tax income.

Regarding capital, we continue to maintain the strong capital position and I’m pleased to report that our board approved our normal quarterly dividend of $0.18 per share this week. While we have about 700,000 shares left in our buy-back program, we will most likely not purchase more shares in the open market at this time as we believe that we have outstanding opportunities to use our capital within our market.

Now at this point I’d like to turn the call over to Mitch for final remarks.

Mitchell S. Feiger

I have one more comment and then we’ll take your questions. Last night, we announced that Ron Santo, a member of our executive management team, will be retiring in September and I have mixed feelings about this. While I’m happy for Ron certainly, we are going to miss him. Ron has had a remarkable 40-year career in banking, beginning at the First National Bank of Chicago. He was a senior executive of Mid City National Bank of Chicago. When MB and Mid City merged to create the foundation of our company, Ron was absolutely instrumental in making that merger successful and has been a tremendous leader at our company since that time. Fortunately for us though, Ron has agreed to continue serving as Chairman of MB Financial Bank, a position he holds now and as a member of our Board of Directors MB Financial, Inc., a position of which he holds now.

Let’s open it up to questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from John Pancari - J.P. Morgan.

John Pancari - J.P. Morgan

Can you give us a little bit more detail on how you arrived again at your provision this quarter and explain just a little bit more on your view on the adequacy of your reserve where it stands? Obviously, given the sharp increase in your non-performers I know given your comments, Jill, that some of these were already reserved for but just given the sharp increase in the non-performers, more than double there, would expect that you may need a higher reserve level just given the progression that we’re seeing across the banks this quarter particularly in terms of the potential loss content here so I want to get an idea of what your thought process is around where your reserve needs to be.

Mitchell S. Feiger

Let me start by making comment that anybody who’s in the room here can join in. John, we tried to do is stay ahead of the provisioning and anticipate perhaps where credits are going and the reserves there needed. It’s not uncommon for a reserve to go from potential problem loan to non-performing loan and be fully reserved already as a potential problem loan and that may account for some of the discrepancy that you’re talking about. I don’t know if anybody in the room here has anything to add to that. We do go through our non-performing loans and do a detailed and impairment analysis on each one. I believe, correct me in the room if this is incorrect, with regard to all of our real estate non-performing loans we have updated appraisals. We are very aggressive on the quality of those appraisals and we also talk with others in the market. We try and get loan value sales, we try and get properties’ value amounts and we call them as we see them. I’m don’t know how to explain it any other way.

[Thomas D. Panos]

That is correct.

John Pancari - J.P. Morgan

I was just going to ask, in terms of those updated appraisals, Mitch, what has been the depreciation, the collateral value that you’ve seen?

Mitchell S. Feiger

Your question is what is depreciation from prior appraisals we may have seen?

John Pancari - J.P. Morgan

Yes.

Mitchell S. Feiger

Already know such a thing?

[Thomas D. Panos]

It varies from project to project but if I had to put an average I would say somewhere in 15% to 20%.

Jill E. York

And in our determinant analysis we would discount those appraisals as well.

[Thomas D. Panos]

Absolutely. We’d take a further discount of the bulk value.

[Thomas Prothero]

Yes. And they are done at a bulk value basis so they’re already present value so they’re not done at a retail basis.

Mitchell S. Feiger

So we’re using, if you will, wholesale sell-out amounts, for ‘for sale’ residential we’re talking about, so we’re not doing evaluations based on individual sell-outs of each home or whatever condo that needs to be developed. We’re getting an appraisal if the whole thing were sold at once to a buyer and then we’re discounting from there and taking reserves to that point.

Jill E. York

And of course we also factor in any cost to complete and also selling costs.

Mitchell S. Feiger

And that’s how we’re doing it. I don’t know how else to do it.

John Pancari - J.P. Morgan

Okay and then the 15% to 20%, it sounds a bit low in terms of, we had talked to some other banks in the Chicago markets there and it seemed like more on the outskirt markets, but still that we had seen or heard about higher priced declines on some of the resi construction properties on the re-appraisals and then possibly in the ballpark of 25% to 35% versus the 15% to 20%. Can you shed some light on that? Is it a function of your credits being closer to the downtown market?

[Thomas D. Panos]

That’s absolutely the reason. On some of our more suburban projects, we have seen value declinations 30% to 40% but most of our Chicago projects, the decline in value has been in the 5% to 10%, 15% and if I were to average it it’s where I’m coming up with 15% to 20%.

John Pancari - J.P. Morgan

Okay. And then my last question is actually away from credit but on the loan growth side. Can you just give us an idea of some estimate of what percentage of that growth you saw came from recent banker hires?

Mitchell S. Feiger

Have any sense of that yet?

[Thomas Prothero]

We’ve always had a good group of bankers in the bank that have been working here for years and years so our progress there continues with that group of bankers and the bankers we hired, I think the 30 or so are just now beginning to contribute.

Mitchell S. Feiger

Yes, I don’t think, my sense is the majority, maybe a large majority of the growth came from bankers who had been here prior to October 1, 2007 and that’s the 32 that we hired, referenced in the release doc post-October of 2007, so most of the ones we hired, John, arrived sometime in the late first quarter. It takes a while for them to get going.

Operator

Your next question comes from Brad Milsaps - Sandler O’Neill & Partners, LLC.

Brad Milsaps – Sandler O’Neill & Partners, LLC

Jill, just wanted to see if you could talk a little bit more about the margin, kind of what you’re thinking over the next couple of quarters in terms of potential additional expansion and also it looks like you relied a little more heavily on the brokered CDs this quarter to fund the majority of your growth. Just curious, using a brokerage versus Federal Home Loan Bank advances, etc.

Jill E. York

Okay. With respect to the margin I was pleased to see the margin stabilize this quarter and actually improve by 3 basis points. We are seeing, as I mentioned in my prepared comments, much better spreads on the loans which is great to see. The question, I guess, that’s in my mind is will we get better pricing on deposits and right now it seems like deposit pricing, whether it’s wholesale or retail, is still pretty expensive in our market. Competition is tough and I don’t know that we’ll get a lot more margin improvement until we can get better pricing on deposits and then, with respect to the brokered growth, you are correct. I think what we tried to do on both our retail and brokered deposits this quarter is extend out a bit so, in other words, we went out with brokered deposits ranging from one to five years and on the retail side, we’ve been securing deposits in the one-year, eighteen month, and two-year range to boost our liquidity so that’s kind of been our approach. From an advances standpoint, certainly advances are cheaper but I guess I like the liquidity of either using longer retail deposits or longer broker deposits; really better than advances plus you don’t have to collateralize those types of deposits.

Brad Milsaps – Sandler O’Neill & Partners, LLC

Okay and I just wondered if you could talk a little bit about commercial real estate. I know everyone’s focused on construction and that’s where the bulk of the increase in MPAs came from this quarter but looked like there was almost about a $10 million increase in commercial real estate, maybe a lot of smaller loans, maybe one larger one. Just kind of curious of what you’re seeing there; that’s also where the bulk of your loan growth came from. Just can you talk a little bit about that segment as well?

Mitchell S. Feiger

Let Tom Panos and Tom Prothero cover that, Brad.

[Thomas Prothero]

There was growth in our commercial real estate loans. Some of that, certainly, is from our commercial industrial customers that borrow for their real estate needs. We have some industrial customers as well; customers that are involved in the self-storage business, apartment building owners. Apartments are doing well in the city so it’s really a combination of loans to all those segments.

Brad Milsaps – Sandler O’Neill & Partners, LLC

See anything specifically in that non-performing category on the CRE side?

[Thomas Prothero]

Actually, the one large customer there is a apartment building owner; that particular loan.

Mitchell S. Feiger

It’s just one?

Jill E. York

Yes, it’s just one.

Brad Milsaps – Sandler O’Neill & Partners, LLC

Okay and then final question: Jill, just curious how you get to the, just what will you guys might be doing to get to the 15% to 20% kind of tax rate for the second half of the year?

Jill E. York

I guess I just factored in where I think we’re going to be at from the state’s standpoint and I guess that’s my best estimate at this point in time. We in placed a particular tax strategy that goes away in 2009 so that’s why I believe that in 2009 you’ll see an increase in the effective rate.

Brad Milsaps – Sandler O’Neill & Partners, LLC

Because that’s about half of what you were sort of running at the first part of 07?

Jill E. York

No, I don’t think that’s the case but a lot of it too depends on the level of pre-tax income and our non-taxable sources like munies and [inaudible] so you’ve got to factor those in as well but I think we benefited much more from our state strategy in 08 than 07 and that’s probably most of the difference.

Operator

Your next question comes from the line of [Unidentified Private Shareholder].

[Unidentified Private Shareholder]

Are you a live talk? You should be four. My wife owns a whole bunch of stock in your company. She is a real estate executive in New York and still scared to death about collapse of some of the MPAs in your portfolio that could wipe out the reserves and more. I have been listening to the first answer but it was not very complete. How much reserves do we have and how do you see that this year will develop because I look at the market and based on your robust earnings you would expect the stock to go up but that’s not doing it. You are moving a little bit with the market then maybe a little bit against the market. Second question is do you have any exposure to CDO or CDF assets? Do you hold any and if so what do we do about it?

Mitchell S. Feiger

Alright, let me take him in reverse order. We don’t have any CDOs or subprime loans or investments with subprime or anything like that so you don’t have to worry about that. With regard to our stock price, I presume you’re speaking about as we’re speaking? Is that your question? Why isn’t our stock price moving up as we’re talking right now?

[Unidentified Private Shareholder]

No, I don’t mean that momentarily. I’ve been following all the banks talks over the last three, four weeks how badly they’re moving and you look so good but the stock is not moving.

Mitchell S. Feiger

Oh, we released earnings this morning so I think it’s going to take time for people to digest what we’ve reported. I can’t count really on a stock price; it goes where it goes. I think our investors are very intelligent people. The analysts that follow us are very smart and our stock price goes where it should go; I can’t really comment on that. With regard to reserves, we put our reserve levels at the amount we feel, after an exhaustive analysis, I might add. There are hundreds and hundreds of hours of work that go in every quarter looking at our reserve levels, looking at our non-performing loans, loan by loan. We talked a little about the process on construction loans and real estate loans, how we think about it. This isn’t the process that’s done by one person; it’s done by a group of people with multiple lines. Our people are very, very experienced at this kind of thing and it’s our responsibility and we think we have the reserve at the appropriate level. I don’t know if I can answer it any other way. I’m happy to answer, if you have any specific questions on reserving methodology or something like that, we could talk to you offline. I don’t know what other…

[Unidentified Private Shareholder]

I look at roughly your 2% of your portfolio that is in MPA. If you say 95 is in MPA and your portfolio is what, about $9 billion of loans. It’s 2% in MPA. Now, that’s a huge amount. What happens if something bad happens in that grouping? Do we have a good reserves to catch it? That’s really what my wife is asking me everyday when I talk with her about your stock.

Mitchell S. Feiger

First, I don’t know what the 2% number includes, potential problem loans? Is that?

Jill E. York

Yes, it must. They found a reported data, non-performing assets, full assets is 1.13 or non-performing loans to total loans is 1.5.

Mitchell S. Feiger

So I don’t know what the 2% number is and the answer is, look, if you want to plan for a catastrophe that’s one thing but our responsibility is to plan in a realistic way, according to GAAP accounting rules and our best judgment and that’s what we’ve done. I suppose if you think disaster’s going to happen you shouldn’t own bank stocks.

Operator

Your next question comes from [John Halpel] - Financial Insurance Interests.

[John Halpel] – Financial Insurance Interests

I just wanted to bring an update to the situation with regard to fraudulent loans. It was mentioned at the last quarter. Can you comment generally on that?

Mitchell S. Feiger

Okay, yes. What you’re speaking about, I think generally, are three loans we identified as a result of an investigation.

[Thomas Prothero]

For fraudulent loans.

[John Halpel] – Financial Insurance Interests

And you indicated that you had placed the insurance carrier on notice. Is there any possibility of recovery under those circumstances?

Jill E. York

Yes, we put the insurance carrier on notice. At this point there, first of all, we have not taken on those loans any charge-off, those three loans. With respect to write offs we took in the first quarter, there was no evidence that the lender involved profited from the situation so -

Mitchell S. Feiger

At least none that we could find.

Jill E. York

So at this point when we put them on notice, there has been no recovery.

[John Halpel] – Financial Insurance Interests

And there doesn’t appear to be a tremendous prospect of any claim being substantiated? Is that a fair assumption?

Mitchell S. Feiger

Not at this point. I think you’re correct.

Operator

Your next question is from Kenneth James – Robert W. Baird & Co.

Kenneth James – Robert W. Baird & Co.

I want to ask a question about the CNI loan growth line, in particular. The past four quarters have been growing those loans at a 20% to 30% annualized plus pace. This quarter kind of dropped off. Wondering if that’s either A) an anomaly kind of just the point in time or if that’s a reflection of kind of the economic environment, if you’ve seen a slowdown in those particular type of credits or line utilizations and particularly given since you talked about how strong your growth prospects were and such. Just wanted to see if we’d see a pick up back there again.

[Thomas Prothero]

Our line utilizations are steady, actually, quarter over quarter. We had a couple larger payoffs in the second quarter and we’re generally being as careful as we possibly can with regard to putting new credit on the books and we’re trying to get paid for the risk we take.

Mitchell S. Feiger

So, I mean, in the quarter, just as happenstance, it’s not. It wasn’t by design to reduce CNI growth or anything like that. I think quarter-to-quarter loan flow can be, it can be uneven. I don’t know; does that answer your question? I’m not sure.

Kenneth James – Robert W. Baird & Co.

So it hasn’t fallen off a cliff and we’re not looking at low single-digit pace, we know probably in that category going forward, obviously.

Mitchell S. Feiger

I don’t think so. I think if you go back like 5 years, 10 years, 15 years, loan growth in the commercial category has been quite steady. There’s a little bit quarter-to-quarter but year-over-year and I just don’t see how that changes.

Kenneth James – Robert W. Baird & Co.

And then in the construction portfolio, for the last few quarters there’s been some pretty market declines on an annualized basis. We expect that to continue at this pace? I mean, if you de-emphasize it to the point where payoffs and working out some of these loans you’ve got on, problems are going to; second, are you worried about that being a drag on overall growth at all or do you still see some opportunities to do some good projects in that area?

Mitchell S. Feiger

I don’t think we’re seeing too many good residential projects.

Kenneth James – Robert W. Baird & Co.

Or even in the commercials. Just the overall construction portfolio.

Mitchell S. Feiger

Yes, we’re seeing a few commercial projects so I, my guess is, and it’s a guess, I think that category is going to continue to decline slowly over time.

Kenneth James – Robert W. Baird & Co.

Jill, you talked about obviously a lot of favorable margin in this quarter but then think you get a whole lot of expansion until the deposit environment improves. Do you feel comfortable calling them a bottom in the margin here the last couple quarters at least within a basis point or two?

Jill E. York

It’s tough to predict but like I said, I was glad to see it stabilize this quarter and actually go up a bit. I think, in our favor, we, like I said earlier, we continue to see much better spread on the loan side. I’m encouraged that, based on that but the competition is just tough on the deposit side.

Kenneth James – Robert W. Baird & Co.

Okay and you’ve been getting a lot of benefit from that loan service line that’s running probably twice as much as it was this time last year. Any reason that drops off precipitously any time in the near term?

Jill E. York

That’s really a function of this low interest environment where we’re getting more pre-payment fees. We also are doing more in capital markets with respect to swaps for our customers. We have increased fee income there but it’s really a function of the low interest rate environment.

Kenneth James – Robert W. Baird & Co.

Then with respect to the acquisition of the asset management firm. The number you put up there this quarter in terms of revenues; you review that as sustainable going forward, or something in that ballpark?

Jill E. York

Oh yes. They’re doing great so yes, I think that’s sustainable.

Kenneth James – Robert W. Baird & Co.

Then in terms of an effective tax rate for next year, do you just see it going back to where it was maybe in 07, around up high 20s, 30% level? I know there’s been some changes in the Illinois tax law, I mean, could it go meaningfully higher than that or should we just be modeling something high 20s, 30%?

Jill E. York

That’s a tough one to predict because again, there are a number of sources of income we have that are not taxable like munies and there are some things we have that aren’t taxable for state purposes either so, to tell you the truth, I have not recently modeled out what it’ll be for next year so it’s also highly dependent on pre-tax income. Not going to make enough doing it on that.

Operator

The next question is from Daniel Cardenas – Howe Barnes Hoefer & Arnett, Inc.

Daniel Cardenas – Howe Barnes Hoefer & Arnett, Inc.

Quick question on the talent additions. What are your thoughts for the second half of 08. Are you pretty much done right now and then going to be focusing on digesting the people that you’ve acquired or can we expect some more hiring on your part?

Mitchell S. Feiger

No, I think we’ll return to now, to a more normal hiring level so no, there won’t be anything noticeable.

Daniel Cardenas – Howe Barnes Hoefer & Arnett, Inc.

And then just looking at your securities portfolio, can you comment on whether or not you have any exposure on Freddie or Fannie?

Mitchell S. Feiger

We do, well as far as stock, preferred or common, we do not. Of course, we own agency guaranteed mortgage securities so I suppose; did you follow me on that?

Operator

And there are no other questions in queue at this time. I would like to turn the call back over to Mr. Mitchell Feiger for closing remarks.

Mitchell S. Feiger

Thank you everyone for listening to us this morning and we’ll talk with you again next quarter. Goodbye.

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