Knoll's (KNL) CEO Andrew Cogan on Q1 2016 Results - Earnings Call Transcript

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Knoll, Inc. (NYSE:KNL) Q1 2016 Earnings Conference Call April 22, 2016 10:00 AM ET

Executives

Andrew B. Cogan - CEO

Craig B. Spray - SVP and CFO

Analysts

Matthew S. McCall - BB&T Capital Markets

Budd Bugatch - Raymond James

Kathryn Thompson - Thompson Research Group

Operator

Good morning everyone and welcome to the Knoll, Inc. First Quarter 2016 Conference Call. This call is being recorded. This call is also being Webcast. Presentation slides accompany the Webcast.

In addition, this call may offer statements that are forward-looking. These forward-looking statements are based largely on the Company's expectations and are subject to a number of risks and uncertainties, certain of which are beyond the Company's control.

Actual results may differ materially from the forward-looking statements as a result of many factors, including the factors and risks identified and described in Knoll's annual report on Form 10-K and its other filings with the Securities and Exchange Commission.

The call today will also include references to non-GAAP financial measures. Reconciliations of these measures to the most comparable GAAP financial measures are included in the presentation slides that will accompany the Webcast.

Now let me turn the call over to Andrew Cogan, the CEO of Knoll. Thank you.

Andrew B. Cogan

Good morning, everyone. We are pleased to be reporting a strong start to 2016 today. Before we get into the results in detail, I thought reiterating the broader context of our strategy would be helpful. Our pursuit of building a constellation of high-design high-margin businesses that leverage our historic relationships with architects, designers and decorators has resulted in the creation of a singular and distinct entity.

Clients around the world use our designs to create inspired workplaces, education, hospitality and residential settings versus those to whom some will want to lump us, North America Office furniture represents a smaller part of our total sales, our European business is highly profitable and split evenly between office and residential customers and distributors, our residential strategy doesn't involve building out a separate direct-to-consumer retail business and we don't have any exposure to mass supply driven channels.

Simply put, we are playing a different game than others and are executing that game plan well. We believe over the long run, our diversification efforts and strategy will continue to result in a more profitable and less cyclical enterprise. And importantly, our brand DNA and ownership of the authentic design position in the markets we compete gives us an emotional resonance with buyers and specifiers, which few others in any industry enjoy.

We committed three years ago to put in place a strategy to improve our profitability and diversify our business. Our first quarter 2016 results continue to demonstrate the benefits of this strategy. In the context of a slowing market, we delivered 6.8% top line growth, well in excess of the 1% growth reported by BIFMA.

Gross margins expanded by over 200 basis points from 35.8% to 37.9%. Operating profits increased from $22.3 million to $31.8 million and operating margins expanded by 280 basis points from 8.4% to a best-in-class 11.2%, the strongest first quarter operating margin we've reported in more than seven years.

The bulk of our first quarter improvement this year came from our North America Office business. In our Office segment, growth of just over 10% combined with significant productivity performance in our plants plus the leverage of greater volume and favorable commodity costs resulted in an incremental contribution margin north of 50%. This helped push operating margins up over 100% from 4.3% to 9%, close to our goal of double-digit margins for this key segment.

Studio segment sales grew more modest 1.9% as solid growth at HOLLY HUNT was offset by project declines and difficult comps in Europe. Orders were up nicely across all our Studio segment businesses, from KnollStudio to Knoll Europe to HOLLY HUNT, as we benefitted from increased marketing efforts and new product introductions, and as a result we are well-positioned heading into Q2. Studio segment gross margins expanded and 12% plus operating margins remained strong for our first quarter.

In Coverings, weaker industry conditions weighed particularly on our KnollTextiles business. We have new leadership in place in our Textiles business and I am confident the new leadership team here will start to move things in a positive direction.

The good news is that our Edelman Leather business has stabilized and margins continue to climb year-over-year as we focus on profitable engagements. Spinneybeck and Filzfelt continue to grow and innovate and we'll add a new natural material into their architectural portfolio this NeoCon.

With 22.4% operating margins, Coverings continues to generate meaningful profits for our overall enterprise. In the quarter, over 35% of our sales and approximately 50% of our profits came from outside our North America Office segment. No contract furniture company could make that statement.

In February, we discussed the trends we were seeing in the modern workplace, whereas the traditional boundaries between residential and contract were blurring and the importance of a total environment was beginning to trump any one particular element as clients were allocating more of their furniture budgets to ancillary spaces and architectural elements.

This is one of the reasons you've seen some of the smaller players in the industry gaining share from our larger competitors. For Knoll, given the breadth of our offer into singular constellation of businesses from our innovative mix of office furnishings, KnollStudio design classics and lounge designs, Spinneybeck and Filzfelt architectural materials and our broad range of KnollTextiles Coverings materials, we are well-positioned to capitalize on this trend to both capture more of our clients' total spend and elevate the profitability of these engagements in a way that it doesn't for others.

To this end, Knoll has identified immersive planning as a new approach that blurs the lines between traditional, assigned and unassigned space, enhancing interaction and a sense of hospitality at every exchange. In short, immersive planning targets group-based workspace where the actions of the people themselves define the space. To target this opportunity, this coming June at our NeoCon trade show, we will be previewing a dramatic and extensive collection called Rockwell Unscripted by the world-renowned designer David Rockwell.

Rockwell Unscripted encompasses over seven categories of products with over 25 different individual offerings, leveraging David Rockwell's innovative approach to hospitality environment and public space and inspired by the award-winning designs for theater entertainment. It's a collection meant to adapt to the spontaneous choreography of the workday. It is an all-encompassing vision that leverages our design heritage and existing capabilities to go after a significant greater share of both our clients and dealer spend. We hope you will join us in June for this significant unveiling.

We also talked about the time we are seeing client incrementally investing in giving the individual more adjustable and high-performance options. This can increase the average selling price of an individual space. Coupled with an increased focus on wellness, this also creates opportunities to innovate with new types of products which give our clients compelling reasons to incrementally invest in the individual workspace. Here too at NeoCon we will be launching one of the most innovative new seating products calling [Hi-Lo] [ph] designed by the young West Coast design firm Box Clever that we shared with you on our February earnings video. Based on early client reaction to both this and Rockwell Unscripted, we are quite excited about some of the newest, most innovative design work we think we have ever done.

We are demonstrating that this is a time of great opportunity across all of our design driven businesses and we look forward to taking profitable advantage of this environment to continue to build one of the greatest all-time design brands ever created, Knoll.

Now let me turn the call over to Craig to walk you through our results in more detail. Craig?

Craig B. Spray

Thank you, Andrew. Knoll, Inc. first quarter net sales increased $18.1 million or 6.8% from a year ago. Our Office segment was up $17.6 million or 10.5%. Growth in Office was broad-based across our product portfolio. While this growth was driven by recently introduced complementary products like adjustable tables and storage products, we also experienced solid growth in our core Office systems.

Our Studio segment sales were up $1.3 million or 1.9%, primarily driven by strong growth at HOLLY HUNT. This increase was partially offset by lower sales in Europe as we faced tough year-over-year comps due to the timing of several projects. The Coverings segment was down $0.8 million or 2.8% as continued year-over-year growth in Spinneybeck and Filzfelt offset weakness at KnollTextiles.

Gross margin improved 210 basis points from 35.8% a year ago to 37.9%. While gross margin improved across all segments, the Office segment was the primary driver as operating efficiencies and improved fixed cost leverage on the incremental volume offset some mix driven net pricing pressure. Sequentially, gross margin improved 50 basis points.

Total operating expenses in the first quarter were $75.9 million compared to $73 million in 2015. The increase is due to investment in marketing and sales training as well as higher incentive accruals from increased profitability. We continue to believe that operating expenses for the year will average around 27% of sales.

Operating profit was up 42.8% from $22.3 million in the first quarter of 2015 to $31.8 million in Q1 2016. Operating profit margin improved 280 basis points from 8.4% to 11.2%. This improvement was primarily the result of a 470 basis point improvement in the Office segment from 4.3% to 9%.

Interest expense was down $0.3 million from a year ago as we continued to reduce the balance on our term and revolving loan credit facility. For the quarter, other expense was $2.6 million compared to other income of $7.2 million a year ago. Other income and expenses are primarily related to foreign exchange gains and losses.

The Q1 2015 gain was due to the settlement of an outstanding receivable with our Canadian subsidiary. Other expense in Q1 2016 was primarily related to foreign exchange losses that resulted from the revaluation of inter-company balances between Knoll's Canadian and U.S. entities.

As a result, foreign exchange increased earnings $0.09 per share in Q1 2015 and reduced earnings by $0.03 per share in the first quarter of 2016. We continue to put measures in place to further reduce the impact of foreign exchange related volatility.

Our tax rate for the quarter was 37.6%, up from 36.8% in Q1 2015. The change in our tax rate was due to the mix of sales and the varying rates in the countries and states in which we operate. Net earnings for the first quarter of 2016 were $17.3 million, down from $17.4 million for the same period of 2015. Diluted earnings per share were $0.36 for Q1 2016 and 2015.

Regarding our balance sheet and cash flow, cash and cash equivalents were up $1.2 million for the quarter at approximately $5.3 million. Operating activities provided $21.1 million of cash in the quarter. We used the excess cash generated from operating activities to reduce our debt outstanding, invest in the business and pay dividends.

Investing activities included capital expenditures for the quarter of $7 million, compared to $4.9 million in Q1 2015. These expenditures are reflective of our continued commitment to invest in our manufacturing and information technology infrastructure.

Total cash used by financing activities was $13.6 million. The primary use of cash in financing activities was the repayment of debt. Other financing outflows during the first quarter of 2016 include the payment of dividends of $7.2 million.

Our balance sheet remained strong. In the quarter, the continued combination of increased EBITDA and further reductions in our outstanding debt drove the leverage from 1.67 at the year-end to 1.53. We remain comfortably within all debt covenants.

We will now take any questions.

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from the line of Matt McCall. Please proceed.

Matthew S. McCall

Let me start with the Office segment. You had tough comps, didn't really matter, I mean the growth was really impressive there. The comps get a lot easier as we move through the next couple of quarters. Is there anything, I didn't hear you call anything out, you just said new products and core system sales were good, is there anything that was abnormal about the Office growth in the quarter?

Andrew B. Cogan

It's Andrew. No, I don't think so. One of the things we're seeing is some of the investments we've made particularly in the complementary product category and we've talked about wellness and adjustability and we are seeing some really nice success there. So I think that's been one of the key drivers. But also we saw good day to day activity from our dealers, and in fact we did have some challenges internationally that we were able to overcome as kind of our Middle East business looks to be more kind of later in the year loaded and last year it was more front-end loaded. So I think our team did a good, did a very good job on the front-end.

Matthew S. McCall

So if you look at the 10.5 points of growth, so there was some drag internationally, how much of that growth came from complementary, how much of it came from new products versus kind of existing or core products?

Andrew B. Cogan

I think the complementary category is full of new products. So it's really been in new investments we've been making in kind of the high performance adjustable space and some of the wellness initiatives. Those were really the biggest driver, followed then by our existing systems portfolio, and then – those were probably the two biggest drivers.

Matthew S. McCall

Okay. The margin performance was much better than we expected, and when I looked at the normal seasonal pattern, looks like Q1 is typically the lowest margin quarter of the year. Is there anything that's changed that would cause that to not be the case? I mean I'm thinking of maybe some FX adjustments as we move forward, anything that we should think about as we are baking out or modeling out the seasonality?

Andrew B. Cogan

Sure. I guess I would just say this. Our operation teams are doing terrific jobs and we were significantly more efficient in the first quarter of this year than we were the first quarter a year ago, a higher level of productivity, less overtime, higher levels of service, just a variety of improvements that we really focused on. So I think we're just starting to realize the potential of what we can do here.

I will say, as we kind of look at the rhythm through the year, my only caution would be around some of the FX help and some of the commodity help. We're in good shape on commodities and we have some longer-term agreements there, but definitely there will be some FX impact becomes less favorable as we move through the year as well as potentially some incremental fuel and transportation cost that we didn't have in the first quarter.

Craig B. Spray

And recall Matt top line we get hurt a little bit from FX. We would have done a little better top line without the foreign exchange. We also get a little benefit on the COGS side and we continue to receive that in Q1 and then we of course took a little bit of expense on the other income. So it moves around in our P&L.

Matthew S. McCall

And you made reference in the release that you are making some moves to reduce the FX exposure. How should that play out? Are we going to see reduced, is it going to be the gross margin line, is it going to be more on the other income line where we see that...?

Craig B. Spray

So the comments are more around the other income line and we'll reduce that volatility. Now FX can get more volatile and it can be counter to that, but in general we are going to work to and we have worked and we'll continue to work to reduce that volatility through other income.

Matthew S. McCall

Okay, all right. So, last question, the Studio margins, I guess there's a little bit more volatility there than I am used to, and Andrew, I think you said at the start of the year it was actually not that bad, but is there a change in the fixed/variable components with the addition of HOLLY HUNT, I'm just thinking about the impact of the studios and the fixed nature there, or is this going to be a mid-teens type margin and pretty consistent over time, much like we see in Coverings?

Andrew B. Cogan

I think the latter, Matt. There is more fixed cost with the HOLLY HUNT showrooms. The biggest difference really in the first quarter this year for Studio versus last year was some incremental operating expense spending. So we've kind of ramped up some of our advertising, we've ramped up some of our marketing, and we did a pretty extensive across-Knoll training program in the first quarter really focusing on this whole constellation of brands idea and training both our Office people as well as some of our Studio segment sellers to go and promote the entire Knoll portfolio, and that was a major investment in the first quarter.

So if we had kind of normalized operating expenses, you would have actually seen a higher Studio operating margin because gross margin in this segment were up year-over-year. So I think it's really front-loading some of the marketing, training and promotion investments and it's more timing than anything else.

Matthew S. McCall

So is it a couple of hundred…

Andrew B. Cogan

Yes, it was a couple of hundred basis points of incremental spending. And so I still believe that the Studio segment margins are going to be between 12% and 14%, the Coverings margins are going to be 22% to 23%, and our goal is to get the Office business up to double-digit operating margins and we made a substantial step in that direction this past quarter.

Matthew S. McCall

Okay. I'm sorry I'm going to sneak one more in. The gross margin, Craig, you gave the outlook for SG&A. The outlook for gross margin, I'm just trying to make sure I'm understanding what you were saying from an FX perspective, what's the expected kind of full-year outlook for gross margin and how does FX impact it?

Craig B. Spray

FX does roll through our gross margin. So it's primarily driven by the Canadian-U.S. relationship. So depending on where that ends up, that could help us, hurt us or be flat. And so we don't expect a lot of incremental help throughout the rest of the year from where we're at, but FX can move around.

Matthew S. McCall

I guess relative to 2015, the gross margin, given – let's just assume that the Canadian dollar is unchanged from current level, what would that look like from a gross margin perspective?

Andrew B. Cogan

Matt, I'd put it this way. I think gross margins in the first quarter were up over 200 basis points. There was some extraordinary help from the Canadian dollar in that quarter, but over the course of the full-year, I'd go back to the guidance we gave at the end of last year, 100 basis points of growth and operating margin improvement for the full year and to the extent we get off to a better start we should be able to bank some of that and do even better for the full year.

Matthew S. McCall

All right. Thank you, guys.

Operator

Your next question comes from Budd Bugatch, Raymond James. Please proceed.

Budd Bugatch

Congratulations on nice performance. Couple of questions, if I could. First question is, I guess, what surprised you in the quarter mostly in Office? We had expected an improvement over a terrific performance last year but clearly not as much. So were you as surprised as we were or what was surprising about that, if anything?

Andrew B. Cogan

Two things. One, we did go into the quarter with a strong backlog. We had a very strong orders performance in the fourth quarter of last year. So I think the plants were well loaded and pretty evenly loaded. Normally we have a more significant falloff in the first quarter, but from a timing and project standpoint we didn't have that falloff. So the plants were able to keep running on a very even keel. So that definitely helped in terms of what was going on.

Budd Bugatch

And were they project related, Andrew, or with the adjustable height being a bigger factor in that improvement, is it more day to day type business that you were seeing come in more rapidly?

Andrew B. Cogan

I think it was both, Budd.

Budd Bugatch

Okay. And how did those orders look going into – you characterized the strong orders in the first quarter, what's the backlog look like going into the second quarters, are the plants as well loaded for the second quarter and maybe the third quarter, because I think you have a harder comparison in the second quarter than you did in even the first, but you had some large projects that I thought were due to start shipping in the second quarter?

Andrew B. Cogan

I think we're in good shape for the second quarter. We grew orders nicely better than the market in the first quarter and we're I think well-positioned for the second quarter. So I think we're in pretty good shape.

Budd Bugatch

And on the currency, you talked about 200 basis points of improvement in gross margin in Office, did I get that right, to make sure I have that right, in the quarter?

Andrew B. Cogan

No, I think I was talking across Knoll in the first quarter.

Budd Bugatch

And then how did Office [indiscernible] on that gross margin issue, that 470 basis points or so operating margin benefit in the quarter year-over-year?

Andrew B. Cogan

Gross margin was a big chunk of that, but there was also some operating expense leverage from the higher volume.

Budd Bugatch

And so of that gross margin, did you say that the currency was – you said it was a significant portion of that, can we get [indiscernible]?

Andrew B. Cogan

It could have easily been 100 basis points of currency help that may not repeat through the year. But let me say this. There are a lot of other initiatives going on in the sites to more than continue to drive year-over-year gross margin performance in the plants. So I feel like we're on a very good trajectory. The leadership is doing a terrific job. I just think it's going around to virtually all our plants in the last couple of weeks and the depths of the initiatives, the work they are doing on efficiency, productivity, lean, the process improvements we are making, it's at a different level than I've ever seen us operate before. So I feel very good. Yes, 100 basis points here or there I think is going to move around with FX and some of the things Craig talked about, but we are making substantive improvement in how we do things more efficiently and more productively.

Craig B. Spray

I would tell you, Budd, our continuous improvement initiatives and our leverage were by far the biggest two drivers of the improvement.

Budd Bugatch

That's really exciting. It really is. So would you bet that the operating margin gets to your bogie by the end of the year either at a quarter rate or a run rate?

Andrew B. Cogan

I'm not good enough to make, I'm not smart enough to make that projection, Budd, but I think clearly we are getting closer than farther.

Budd Bugatch

Now I do disagree with you. You are good enough but [I'm not going to bet you] [ph] on that. My last question is the David Rockwell Unscripted, sounds pretty exciting. Are there any teasers, can we see any preview of that before NeoCon?

Andrew B. Cogan

There are no teasers but you will see I believe about 35% to 40% of the showrooms will be dedicated to Rockwell. I think it's one of the most significant introductions we've done. I look back on the history of [indiscernible] generation when we launched Currents and Dividends, I think this has the potential to be another game changer for us because it really extends us into areas that we don't play a lot in today. It's very complementary to our existing offering, so you can backwards integrate it. We've always talked about this commitment to non-obsolescence. So if you bought Knoll before, you can add Rockwell Unscripted.

But it really moves us forward. It's unscripted, it's un-corporate, it's un-systems. We think it's very much what the market is looking for and we will be putting a significant effort after it. We'll be previewing it at NeoCon and we should start shipping the product in the first quarter of 2017. It's an exciting story, something we've had research, design, development teams working on now for almost 2.5 to 3 years.

Budd Bugatch

Okay. He said, I think in some of his interviews he said New York is his favorite city, if I remember right. Is it very urbane or is it able to go across the country and not just metropolitan based?

Andrew B. Cogan

It is something that is good for, I mean people and companies who are trying to create looser, more adaptive, less formal environments, and I think we're seeing that across geographies, across vertical segments, there is a spontaneous-ness to it and it really I think facilitates the ways we see clients wanting to work today. So we're excited about it. It's not a New York only product but.

Budd Bugatch

Okay. That's good to hear. Thank you very much and congratulations again and look forward to seeing you at NeoCon.

Operator

Your next question comes from Kathryn Thompson from Thompson Research Group. Please proceed.

Kathryn Thompson

First just to focus on Office and the top line, can you discuss first what sized customers showed the greatest strength in the quarter in terms of orders and any dynamics you're seeing by customer size in the market and how that is helping to drive demand for Office?

Andrew B. Cogan

Firstly, what we are seeing is we did have more million-dollar-plus orders in the quarter which helped us, but we're seeing while there were more million-dollar-plus orders, there were fewer larger million-dollar-plus orders. So kind of the $5 million plus, there wasn't much activity there. It was more in the $1 million range. And I think that's kind of typical of what we're seeing now going forward. There are less big wells out there. So we got to make it up in a lot more smaller pieces. We also saw good growth in our day to day essentials dealer business. So that was encouraging as well.

Kathryn Thompson

It's interesting you're seeing good growth in your day to day business and it just seems that only let's just say three or four months ago all the headlines were impending doom and heading into a recession, but the day to day business improvement would indicate that things are okay. How do you put those two contrasting, A, the reality, what you're seeing in the market against the headlines that things or the sky is falling?

Andrew B. Cogan

I don't think anyone is saying the sky is falling. I mean the BIFMA data…

Kathryn Thompson

[Indiscernible]

Andrew B. Cogan

I mean the BIFMA data has been kind of flat. I do think we have some good share growth opportunities and as we focus on kind of clients that value their workplace, and even when we're talking about our day to day business, it's not through superstores or – I mean it's clients valuing highly performing well-designed workplaces are the clients buying our day to day products. So it's not someone for a one-person shop or something like that.

So I think people are valuing their workplace and I think if we continue to come to market with differentiated solutions that address trends in the workplace and do it in a meaningfully different way, then we can keep growing. There is plenty of opportunity out there.

Now I will say there are geographic pockets of weakness and verticals. So I mean Houston and energy are weak. Even some of the kind of I'd say North Eastern financial service businesses have been weak. But we're offsetting that with growth in areas more technology West Coast driven areas. So we are pretty diversified and we're able to kind of move where the growth is, and I think that helps us as well.

Kathryn Thompson

All right. And one lapping, just [indiscernible] one question on margins that you've had throughout the call, I think you said that leverage and continuous improvement initiatives were the largest drivers for gross margin, but how much, and this is particularly the process improvement has been a big focus for that segment, how much did volume and pricing contribute to the overall improvement and has there been any change in those two categories in terms of relative contribution to your margin expansion?

Craig B. Spray

So for Q1, pricing for us is often a function of timing, what projects are coming through and hitting the P&L at any given point in time. So for Q1, pricing, net pricing was actually slightly negative. So it had really no bearing on our improvements.

Kathryn Thompson

And on volume?

Craig B. Spray

You mean through the volume movement, it's just leveraging our fixed costs. So it was – the largest would have been CI, the second-largest would've been, but almost equally so, leverage and again the third was the FX.

Kathryn Thompson

Okay, perfect. And then finally, how should we think about Studio? We're spending a lot of time on Office, but when we look at Studios in terms of margin progression and overall growth in that segment, can you just maybe help us how we should frame the year or even the next 18 months?

Andrew B. Cogan

On the Studio segment, I'll just point out two things. One is the reported growth is understated by about 50% based on FX. So we still had – and we decided not to break out our results with FX adjustments, just trying to keep it really simple, but the one segment that was impacted by FX was Studio. So Studio's growth would have been about double what you see if we had done it on a constant currency basis.

On an orders basis, Studio had very strong double-digit orders growth. So I feel like demand is robust. And what we're trying to do is find areas to incrementally invest to drive more activity here. So there was definitely a step-up in marketing, training and other investments in some feet on the street and some initiatives in the Studio category.

We just came back from, last week we were all in Milan for Salone which is a big fair there. We had the most amazing display. [Indiscernible] booth with some wonderful new product introductions. We wrote twice as much business at the show as we have ever written before. And so I see good momentum in the Studio business in Europe. Studio in kind of KnollStudio, our classic Studio business, is growing both on the residential consumer end as well as on the contract end and we have some particular areas that we have invested in training tables and other meeting spaces that are meeting very, very broad acceptance.

And then HOLLY continues to be a home run. We are expanding the showroom footprint this year a little more modestly than in the past, but again across all the categories, lighting, textiles, rugs and furniture, we are seeing broad-based growth there. So I think there is opportunity to drive every single one of those businesses and I believe as we move through the year you'll see better growth than we reported in the first quarter.

Kathryn Thompson

All right. Thanks very much. Good luck.

Operator

I would now like to hand it back to Andrew Cogan for closing remarks.

Andrew B. Cogan

Thank you everyone for your continued interest in Knoll. We hope you all visit with us at NeoCon. It will be a really exciting show and we'd love the opportunity to share with you what we're investing in and where we think the market and the workplace is going. So we'll see you all in June, everyone. Take care.

Operator

Ladies and gentlemen, that concludes today's conference. Thank you for your participation. You may now disconnect. Have a wonderful day.

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