Nelnet, Inc. Q2 2008 Earnings Call Transcript

Aug.12.08 | About: Nelnet, Inc. (NNI)

Nelnet, Inc. (NYSE:NNI)

Q2 2008 Earnings Call

August 12, 2008 3:00 pm ET

Executives

Phil Morgan - Investor Relations

Michael S. Dunlap - Chairman of the Board, Chief Executive Officer

Jeffrey R. Noordhoek - President

Terry J. Heimes - Executive Director and Chief Financial Officer

Analysts

Analyst for Matt Snowling - Friedman, Billings, Ramsey Capital Markets

Mike Taiano - Sandler O’Neill Partners

Moshe Orenbuch - Credit Suisse First Boston

Sameer Gokhale - Keefe, Bruyette & Woods

[Shane Wilson - QBT Financial]

Brian Roman - Robeco Investment Management

Operator

Good day everyone and welcome to Nelnet’s second quarter 2008 conference call. Today’s call is being recorded and broadcast over the Internet. Now at this time for our opening remarks and introductions I’d like to turn the conference over to Mr. Phil Morgan with Investor Relations.

Phil Morgan

Good afternoon and thank you everyone for joining us today. Note that the second quarter earnings release and financial supplement have been posted to the Investor Relations website at www.nelnetinvestors.com. On today’s call Jeff Noordhoek, President, and Terry Heimes, Chief Financial Officer, will be making formal remarks and Mike Dunlap, Chief Executive Officer, will be joining us for the question and answer session.

Before we begin the formal remarks, I would like to read the Safe Harbor statement. We would like to remind you that there will be forward-looking statements made during today’s call. The forward-looking statements may differ materially from actual results and are subject to certain risks and uncertainties that are detailed in the company’s Form 10K and other filings with the SEC. The company does not intend to update any forward-looking statements made during the call.

During the course of this call we will refer to a non-GAAP financial measure which the company defines as based net income. Please refer to our second quarter 2008 supplemental earnings disclosure which is posted on our website for the reconciliation of GAAP net income to base net income.

After Jeff and Terry have concluded their formal remarks we will open up the call for questions. I would like to now turn the call over to Jeff.

Jeffrey R. Noordhoek

Good afternoon everyone. Obviously we are quite pleased with our results for the second quarter. The three significant items impacting the company this quarter were liquidity, reduced operating expenses, and improved core student loan spread.

First I will discuss liquidity. Our funding sources for new FFELP loan originations have always been corporate cash, unsecured lines of credit, participation agreements, and our ABCP warehouse line of credit. When the credit crisis started hitting in August of last year and the term ABS market became disrupted, we used our financial strength to quickly supplemental our capacity to fund new loan originations by increasing the size of our warehouse facility to $8.9 billion. As the ABS market continued its free fall it became apparent that renewing the liquidity backstop for our existing warehouse facility would be very expensive. Fortunately we had two things working in our favor. First, in early 2007 when the credit markets were strong we negotiated a multi-year component to our warehouse facility instead of the traditional 364-day structure with terms significantly better than those offered in the current market. Even though the banks and the ABCP warehouse facility worked extremely hard to come up with acceptable terms for all parties, in the end we agreed to disagree and we decided not to renew the facility. That said, we maintain an ongoing positive and mutually beneficial working relationship with these institutions and the facility will remain outstanding through May of 2010.

Second, Congress passed the Ensuring Continued Access to Student Loans Act. As a result of this legislation the Department of Education developed a plan to purchase loans and offer short-term liquidity to lenders. In the spirit of the legislation we will utilize the government provided liquidity facility for its intended purpose of making sure that every eligible student has access to FFELP loans for the upcoming academic year. The Department of Education has been working long hours to implement the new legislation and we applaud their efforts to get the facility up and running. The funding facility is far from perfect but we believe it will serve its intended purpose. We have filed our documents with the Department and we anticipate we will begin funding loans in the facility as early as next week.

Hopefully this provides some background on why we chose to take a palatable step-up in cost of funds by terminating the warehouse facility versus the very expensive and restrictive option of renewing it. Given the ongoing global credit crisis, we believe it’s the right long-term decision for the company.

The second significant item for the quarter was reduced operating expenses. We continue to aggressively manage our operating costs and have decreased them by more than $20 million or 18% compared to the second quarter of last year and $40 million year to date. While we have achieved most of the run rate reductions that we set out to accomplish, we will continue to evaluate different areas of the company where we can operate more efficiently. As a company we are laser focused on staying ahead of our competitors in a rapidly-changing world.

The third significant item was improved spread which was a welcome develop in what continues to be an extremely difficult capital market environment. Terry will cover the spread in greater detail.

But before I turn the call over to him I want to discuss our continued diversification. As you know we have never operated our company based on quarterly performance but instead we remain focused on long-term cash flow and value creation for our customers and our shareholders. That said, typically the second quarter each year is seasonally the slowest revenue quarter in some of our fee-generating businesses. Despite this seasonality we continue to experience planned net income contribution from our fee business, specifically in our tuition payment plan and enrollment services businesses.

In our tuition payment and campus commerce segment we are adding a record number of new schools, we are growing our revenue at existing schools, and we are deploying new products. We also continue to see new wins in the enrollment services business. A perfect recent example of this is the $3.8 million contract we entered into with the Department of Defense to provide college service and selection, test preparation, job readiness, and military success programs to personnel in all branches of the military.

Now I’ll turn the call over to Terry to dive deeper into the financial analysis of the quarter.

Terry J. Heimes

As Jeff indicated we’re very pleased with the results this quarter. Besides the improvement in our net interest margin and the continued reduction of our operating costs, we also benefit from continued performance of our fee-based businesses and some non-recurring items have added to our bottom line. Let me start with some of the high level numbers.

Our GAAP net income for the quarter was $0.89 per share. Our base net income from continuing operations excluding any restructuring charges was $0.54 per share for the second quarter compared to $0.31 per share for the first quarter and $0.44 per share last year. The $0.54 per share does include $0.06 related to a change in estimate and approximately $0.14 from improvements in our student loan spread which may not benefit future periods. Excluding these non-recurring items our base net income per share was approximately $0.34 per share for the quarter.

Expanding on the student loan spread or core spread was 107 basis points for the second quarter compared to 73 basis points in the first quarter. The first quarter was substantially impacted by the credit market crisis and accordingly was abnormally low. While there is still substantial volatility in the credit markets we did begin to see some stabilization in the relationship between certain rate indices.

We saw a narrowing of the CP LIBOR spread which benefited our entire portfolio. We also saw improvement in our funding costs, our short-term warehouse, as well as anomalies in the periodic reset of our auction rate debt. While we have employed various discreet versus average derivative products to protect our spread in the time of falling interest rates, we do not maintain 100% hedged portfolio and we’ve benefited from the timing of the resets and the leveling off of interest rates. We estimate that approximately 15 basis points of our spread improvement was due to the anomalies in our auction rate securities and other rate reset relationships which most likely will not continue going forward. Nevertheless we did see significant improvement in our core spread which we believe will carry forward into future periods.

Moving to our fee-based businesses, our loan and guarantee servicing segment is our largest and most stable fee-based business in terms of operations and scale. As anticipated, revenue for the second quarter and year to date had declined driven by the legislative changes related to guarantor VFA agreements. Fortunately we have also started to achieve some efficiencies in terms of operating expense reductions this quarter, and more importantly we are beginning to see opportunities for new revenue generation and expansion of revenue with existing clients.

Nelnet business solutions continues to achieve very impressive results though some of them will not show in our operating numbers until the last half of 2008 and into 2009. Operating margins have compressed slightly during the second quarter compared to last year as we’ve made investments in new products and technology. It’s important to note that we are the market leader in this area. We are the largest provider of tuition payment plans in the nation. In the current academic year or school year Nelnet business solutions achieved a greater than 15% growth in revenues, and based on projections of new schools and transaction volume we will exceed that for the next academic year beginning this fall.

We see significant opportunities in the lead generation and planning areas. Revenues related to these areas of enrollment services are up more than 30% year-over-year for both the quarter and the six months ended June 30. The operating results of our enrollment services segment as a whole however are masked by the anticipated challenges we have experienced in our risk management business. We continue to focus on increasing margins and operating leverage and we see opportunity to generate new revenue.

With that, let’s open it up for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Analyst for Matt Snowling - Friedman, Billings, Ramsey Capital Markets.

Analyst for Matt Snowling - Friedman, Billings, Ramsey Capital Markets

I had a quick question based upon the operating expenses and the run rate going forward. I know a lot of the restructuring was focused in 1Q and a little bit forwarded into 2Q, but could you just give us a sense as to whether or not this is a good run rate or what the sustainability of the operating expense base is from 2Q?

Terry J. Heimes

We’ve achieved most of the targeted reductions that we had planned. I would use Q2 as a good run rate in terms of going forward. Obviously we’re going to continue to look for ways that we can identify efficiencies but the second quarter would be a good run rate.

Operator

Our next question comes from Mike Taiano - Sandler O’Neill Partners.

Mike Taiano - Sandler O’Neill Partners

On the variable rate flooring column, is that something that will go away in the third quarter after the July 1 resets or do you expect some residual impact from that?

Terry J. Heimes

The variable rate floor will go away with the reset on July 1.

Mike Taiano - Sandler O’Neill Partners

On the tax rate, I think it was down 31% and I think you said in the Q that it would probably stay around there for the remainder of the year. Should we use that as the run rate going forward into 2009 as well?

Terry J. Heimes

No, that’s primarily for the rest of this year. Because of the operating loss that we sustained in the first quarter, that’s going to have the impact on the tax rate for the remainder of the year. As we move into 2009 it will probably go back to the 36% to 37% to 38% range.

Mike Taiano - Sandler O’Neill Partners

On the spread in the quarter, the improvement, could you give us some sense of guidance because I know there are a lot of moving parts and it’s highly dependent on where the credit markets end up, but should we expect further or compression going later into 08 and into early 09 despite the government facility that’s in place?

Terry J. Heimes

As you said there are a lot of moving parts with the spread and the various components. We anticipate that as much as 15 basis points of the spread improvement that we achieved this quarter may be non-recurring on a go-forward basis. However we did achieve some stability in the various rate indices so that’s very positive. I think also in terms of the new facility that will be at CP plus 50 so that will provide a stable base. Anything that we issue in terms of new securitizations will be dependent upon the issuance level compared to the loans that we’re refinancing out of our warehouse. So all of those factors could impact that going forward. I think if you start with a base of 90 to 95 basis points given that 15 basis point non-recurring level would be a good starting point.

Mike Taiano - Sandler O’Neill Partners

On the $3.8 million Department of Defense contract that you have, over what period is that?

Jeffrey R. Noordhoek

That contract started in July and it’s over a 14-month period.

Operator

Our next question comes from Moshe Orenbuch - Credit Suisse First Boston.

Moshe Orenbuch - Credit Suisse First Boston

How do your lenders decide whether the spread on your warehouse line is going to be the higher number or the lower number? In other words, is there a contingency there they can’t use their commercial paper facilities to spread wide significantly?

Jeffrey R. Noordhoek

The way that works is if they fund the assets in their commercial paper conduits as they have done always in the past, then it stays at the current rate plus a stepped up amount of 10 basis points. If they choose to take the assets out of their conduit and fund them on their balance sheets, which means they have to hold capital against those assets, then they would go up to the higher return of 128.5 basis points. So it’ll be an individual decision by each institution if they want to fund it off their balance sheet at the lower spread or on their balance sheet while holding capital at the higher spread.

Moshe Orenbuch - Credit Suisse First Boston

I guess I’m a little confused. You have no insight as to what they’re going to do. Are they able to issue the commercial paper?

Jeffrey R. Noordhoek

Our insight would be that the vast majority of the banks anticipate funding them in their conduits off their balance sheet and that’s why we’ve come up with the average number that we did contend 30 basis points in our announcement. Maybe one or two banks might choose to put it on their balance sheet but we think it will be a limited amount.

Moshe Orenbuch - Credit Suisse First Boston

Separately, in terms of the interplay if you will, if that’s even relevant, between the income which has been declining in absolute terms and expenses which have been declining, is there kind of a way that we could think about the two of those together? Is there going to be a positive relationship from an earnings perspective between the two of them at some point? And when would you think those lines would cross?

Terry J. Heimes

While there is some interplay there, they really are focused on two different aspects. Many of the expense reductions that we targeted and have achieved have been in the asset generation area and/or in terms of infrastructure were our corporate activities area. On the fee generation businesses we have the opportunity to generate significant operating leverage. We have chosen to make investments specifically in for example our Nelnet business solutions where we made investments and you saw a decline in the operating margin this quarter from investments in technology and new products, we expect to gain significant operating leverage going forward. And we’ve experienced very positive growth results there and we would expect to capitalize really on the growth in revenue without adding significant expense as we go forward. The same would be true in terms of our enrollment services area. That probably has a slightly higher relationship to the growth in revenue as there is some cost of goods sold type relationship there, but we would expect as we move forward into the last half of 2008 and 2009 to get pickup from those two areas in terms of the revenue growth without adding significant expense.

The other decline that you saw in terms of our fee-based revenues really was in the loan and guarantee servicing area and that was driven by legislative changes related to how guarantors earn revenue and how we earn revenue related to that contract. So while we were able to achieve some expense reduction to offset some of that loss in revenue, as we go forward we are well positioned to focus on growing that revenue from a base here without adding significant expense to that because we will have the ability to again capitalize on operating leverage. So the decline in revenues has been offset by the decline in expenses but they were done really for different reasons and different purposes and we expect to capitalize on the operating leverage going forward.

Moshe Orenbuch - Credit Suisse First Boston

Right. And the second part of the question was when do you think those lines will actually cross when the operating leverage will actually -

Terry J. Heimes

I think towards the last half of this year into the fourth quarter and the beginning of 09.

Operator

Our next question comes from Sameer Gokhale - Keefe, Bruyette & Woods.

Sameer Gokhale - Keefe, Bruyette & Woods

I had a question on growth expectations for Stafford and PLUS loans. If you look at the year-over-year growth there, they’re actually I think a modest decline year-over-year and I think recently you reiterated your commitment to making loans to all students at all schools who needed the government guaranteed student loans. So at this point given that you probably have a very good sense for what the origination volume is going to be, could you give us a hint or some data point which suggests how high your origination volume is expected to be in Q3?

Jeffrey R. Noordhoek

Our new retention loan volume is down as we expected. Now there are a whole bunch of factors affecting new volume and let me just list some of the things that are going on that affect the volume. If you go back obviously we proactively modified our borrowed benefits and our marketing costs in order to retain value on all new loan originations. We proactively reduced our capital market exposure in response to liquidity crisis by reducing loan origination volume. Subsequently we successfully eliminated our liquidity risk on all loans and obviously then with our announcement in the spirit of the new legislation we’ve announced that we’ll make a loan to any student in the United States.

Let me give you some more data points to think about. We have seen 124 lenders exit the loan generation market in the last six months. We have seen virtually all remaining lenders follow us on the elimination of borrowed benefits. And we’ve offset [inaudible] just in the last couple of months seeing a significant amount of new lender list wins. Take all that and the ultimate impact to our volume from the combination of these decisions is very difficult to predict at this time and really is part of the reason we eliminated earnings guidance this year. We believe that by the third quarter we should expect to have a better line of sight on what the volume is going to be. It’s very difficult at this point in time in this part of the process.

Sameer Gokhale - Keefe, Bruyette & Woods

When do you expect to actually get some sort of information from the schools and the financial offices that say, “Okay, this is the amount of loans that the students are taking out. This is what you need to disperse.” When do you find that out?

Jeffrey R. Noordhoek

Our largest single month for dispersement is August and September. Those two months that we believe that’s why by the next call we’ll have a real clear sight of what our volume is going to be for the year.

Sameer Gokhale - Keefe, Bruyette & Woods

You curtailed originations of private student loans but do you have a sense when there’s been a lot of talk recently about the lack of availability of private student loans and how it may be hurting students. In your view are you seeing any signs that the application volume has been hurt because of the lack of availability of private student loans? What kind of color can you share there?

Jeffrey R. Noordhoek

Well, as relates to our FFELP loan originations we don’t believe that private loan originations are since we’ve renewed this process affecting the volume on FFELP loan originations. We think those are decoupled in the market pretty much today so we don’t see a real impact there. That said, we do believe there is a large disruption going on in the private loan market that has not fully come to the forefront of the press. I know there is an article this week in the Wall Street Journal about that. We believe that there is a vacuum of private loans that are not there and that students are going to be struggling to try to replace them coming up in the months of August and September as they realize that they can’t get private loan financing due to the credit crisis.

Sameer Gokhale - Keefe, Bruyette & Woods

So it doesn’t really sound overall from a FFELP perspective that volumes have been hurt just because some students are saying we can’t get private loans so we’re not going to go to school at all. That doesn’t seem to be happening based on what you’re saying.

Jeffrey R. Noordhoek

We don’t believe that’s happening and from our perspective also we have partnered with other entities to upstream private loan applications to [inaudible] if you are making private loans.

Sameer Gokhale - Keefe, Bruyette & Woods

Can you give us some sort of breakdown on spreads on consolidation loans versus your Stafford loans or versus PLUS loans? Clearly your consolidation loan portfolio is running off but it would help from a modeling standpoint if you could give those pieces.

Terry J. Heimes

Sameer we can try to take some of this offline but basically the primary difference in spread on consolidation loans will be drive by the top line. Consolidation loans 159 basis points over the commercial paper. The Stafford and PLUS loans are going to be between 234 and 264 basis points over the commercial paper. For the most part if they’re in a securitization transaction they’re going to be on a blended cost response. If you look on a new loan or Post 10 One, the new Stafford loans and PLUS loans that we originate for the most part are going to be in-school loans. They’re going to be at 119 basis points over commercial paper. If we fund those in the government warehouse facility, that is at CP plus 50 so that will generate a spread of roughly 69 basis points. We are not generating any new consolidation loans so that’s relatively a moot point, but those would be kind of the spread components that are driving each one of the asset pieces.

Sameer Gokhale - Keefe, Bruyette & Woods

That’s helpful. Those are the general terms in which we were thinking about it but I was just hoping we could get maybe a little bit more specific there. But maybe we can follow up offline.

Operator

Our next question comes from [Shane Wilson - QBT Financial].

[Shane Wilson - QBT Financial]

I was just wondering if you could give some general commentary on how you see the securitization market, both sort of how it evolved during the quarter and how it is now. It seemed like at some point it was getting better and now it’s getting worse. Can you give some thoughts on that?

Jeffrey R. Noordhoek

Sure. It’s been pretty volatile. You’re right, it did start to improve in May and June as we saw significant improvements in the market then, and in July and August which are typically slow months anyway it really reversed back in direction fairly significantly. Right now this being the slowest month and typically the worst month in the market, we do see it widening and we hope that as the fall comes it would start to tighten back up again. But the bottom line is right now it’s very volatile. That’s why as we access the market we think we’re in a great position to fund loans whenever we’re ready. So we can go out with a transaction at any point in time, we’re keyed up and ready to go, and we’re going to time the market if we think it’s a good time to go in and fund more loans in the securitization market as it improves.

Operator

Our next question comes from Brian Roman - Robeco Investment Management.

Brian Roman - Robeco Investment Management

Everybody else seems to know this company better than me, but I’ll give it a try. Sameer’s question about loan growth sort of begs a question that Sallie Mae touched upon in their conference call and I think you guys have gone there as well. My sense is that the student lending season has been delayed. How delayed is it?

Jeffrey R. Noordhoek

Interesting question. I think that you’re right in the sense that with all of the new legislation came out and changes, there was a lot of repackaging of students throughout the end of the summer.

Brian Roman - Robeco Investment Management

What do you mean by repackaging?

Jeffrey R. Noordhoek

When you’re a student and you go to college you get a financial aid package that states what you’re grants are and what your -

Brian Roman - Robeco Investment Management

A package sent as opposed to my son.

Jeffrey R. Noordhoek

Right. And then with the increase in loan limits and the last-minute legislation that was changing and all these lenders that were signed up that are now exiting, there’s been a big shuffling of the deck. So that’s what I mean by repackaging. I think there’s been a lot of last-minute shuffling of the deck as it relates to where loans are going to go and who’s going to fund them.

Brian Roman - Robeco Investment Management

So schools are actually probably experiencing some delay in their cash flow as well I would think.

Jeffrey R. Noordhoek

That’s what we expect.

Brian Roman - Robeco Investment Management

To use a baseball analogy, the lending season you’re still going to get a nine inning game in but there’s been a rain delay?

Jeffrey R. Noordhoek

I guess you could use that analogy. We’ll see if that’s true or not in the coming weeks and months.

Brian Roman - Robeco Investment Management

You provisioned the first six months this year at almost twice the rate of last year. Could you just talk about what’s going on there?

Terry J. Heimes

The biggest reason for that change is you may or not be aware that last year in accordance with legislation prior to October 1 there was a provision that allowed for exceptional performer designation which limited our exposure on risk sharing to 1%. And that went away with the new legislation October 1 so therefore we have to provide for the full amount of the risk share because we don’t qualify for exceptional performer. And that risk sharing is really between 2% and 3% without the exceptional performer designation. So that’s why we had to increase our allowances because of the elimination of the exceptional performer designation that was in the prior legislation.

Brian Roman - Robeco Investment Management

How do you feel about your provisioning right now? Do you think that year to date $11 million or $12 million is adequate? Obviously this is new ground for you guys, so is your experience coming in higher or lower than expected?

Terry J. Heimes

It’s not necessarily new ground for us because we’ve been in the business for a long period of time and we happen to qualify as an exceptional performer because of the quality of our servicing. Obviously we analyze our exposure every period and we feel very good about the quality of our loan portfolio. If you look at our loan portfolio, 99% is government guaranteed. There is a risk share component to that. Less than 1% is in our private loans. We’ve experienced an improving delinquency rate in our private loans. We’ve experienced a very low loss rate in our private loans. So we’re very pleased with the quality of our portfolio and believe we are adequately provisioned.

Brian Roman - Robeco Investment Management

A gentleman earlier asked about the ABS markets and obviously you’ve got the government funding program in place right now. Looking over the second quarter, how much was ABS spreads have to come down to be competitive with the current government program, the one passed in early May?

Jeffrey R. Noordhoek

The current government program funds loans that were generated after May 1 of this year and the cost of funds to that is the CP rate plus 50 basis points.

Brian Roman - Robeco Investment Management

Right. Because that CP and ABS is priced off other stuff but varies in time. How much do you think ABS would have to come down?

Jeffrey R. Noordhoek

The ABS market is priced off of LIBOR and as we talked about earlier it’s fairly volatile at this point in time. So any day it could be different.

Brian Roman - Robeco Investment Management

Toughest question for last and try and avoid answering it by saying “I don’t know” or “I don’t want to go there.” Eventually when we get to September of 09, we’re either looking at a cliff where the business just falls off and you put the business back to the government because they haven’t come up with a new program or as investors we’re watching over the next 12 to 14 months as they renegotiate some sort of loan package and program with private lenders that has some sort of longer shelf life to it than 15 months. What do you think happens when we get to September of 09?

Jeffrey R. Noordhoek

Sure. That’s a really good question. We have liquidity to make loans as we talked about for the upcoming 08/09 lending season. Remember there are over 7.5 million students and growing which require about $80 billion of new loan financing each year. So yes it is possible that the ABS market takes a prolonged period to recover. If this occurs and the temporary government fix that is in place is not extended to the next year for those 7.5 million students, then we’ll need to re-evaluate our position at that time. And I’ll remind you that we are in the business to make a proper return based on the risk profile of our investments. So every decision we make at that point in time will be based upon that criteria.

Terry J. Heimes

I think the other piece to add to that is we do have an existing portfolio of $26 billion. It’s generating significant cash flow well into the future and we’ve diversified so that over half of our revenues actually come from our fee-based businesses and we’ve been able to cut our expenses and maintain our service quality so when we get to September of 09 we will be looking at questions involving one portion of our business rather than our business as a whole.

Operator

There appears to be no further questions at this time. I’d like to turn things back over to Jeff for any additional or closing comments.

Jeffrey R. Noordhoek

We are encouraged by our second quarter results and our outlook for the future. Consider the following: Despite the turbulent capital markets we maintained our ability to access the securitization market. Approximately 90% of our portfolio is financed to term for the life of the loan at rates which will create significant and a viable cash flow stream in excess of $1.4 billion. We have capital and liquidity for new loan originations through the government participation and put programs and see opportunities for growth in our loan generation area. We have maintained the value of our service and delivery platforms while reducing our operating costs in excess of $40 million for the first six months of the year. We have developed a broad diversified offering of fee-based businesses with significant growth opportunities and operating margins, and we have a strong capital base with which to create long-term value for our shareholders.

Thank you for taking the time to participate in our call and have a great day.

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