Telephone & Data Systems, Inc. Q2 2008 Earnings Call Transcript

| About: Telephone and (TDS)

Telephone & Data Systems, Inc. (NYSE:TDS)

Q2 FY08 Earnings Call

August 7, 2008, 11:00 AM ET

Executives

Mark A. Steinkrauss - VP - Corporate Relations

Kenneth R. Meyers - EVP and CFO

Steven T. Campbell - EVP, Finance, CFO and Treasurer-U.S. Cellular

Bill Megan - EVP Finance and CFO

Jay M. Ellison - EVP and COO

Analysts

Simon Flannery - Morgan Stanley

William V. Power - Baird

Greg Lundberg - Communications Equity Research

Kevin Roe - Roe Equity Research

Operator

Good day and welcome to the TDS & U.S. Cellular Second Quarter Conference Call. Today's conference is being recorded.

At this time I'd like to turn the conference over to Mark Steinkrauss. Mr. Steinkrauss, please go ahead, sir.

Mark A. Steinkrauss - Vice President - Corporate Relations

Thank you, Sara. Good morning, everyone. With me today are Ken Meyers, Executive VP and CFO of TDS; Steve Campbell, Executive VP Finance, CFO and Treasurer at U.S. Cellular; Bill Megan, Executive VP Finance and CFO at TDS Telecom. And also joining me are Jack Rooney, CEO and Jay Ellison, Executive VP and COO at U.S. Cellular.

A replay of this teleconference will be available today at 01:00 PM Chicago Time and run through midnight Friday, August, 8th the replay number is 800-723-6498, conference ID 9648709. For international callers the number is 785-830-7989, same passcode. This call is being simultaneously webcast on the Investor Relations sections of both TDS and U.S. Cellular's websites. The webcast will be available for the next two weeks after which it will be available on the conference call archives. Please recall that archives calls are not updated.

Some information during the call and subsequent Q&A period contains statements about expected future events and financial results that are forward-looking and subject to risk and uncertainties. Please review the Safe Harbor paragraph and the releases in the more extended versions on our website as well as in our filings with the SEC. Shortly after we released our earnings results earlier this morning and before this call TDS and U.S. Cellular filed 8-Ks, the 8-Ks include the press releases we issued this morning and some additional information.

Both companies plan to file their SEC Form 10-Q later today. Both press releases have been posted to the TDS Internet home page and U.S. Cellular has posted their release to their website as well. You will also find posted on the website additional information and reconciliation of non-GAAP financial measures that maybe used management when discussing the operating data during today's teleconference, as well as the company's guidance for 2008, two of the reconciliations of the net income and diluted earnings per share.

All of the information is included on a separate page entitled Guidance and Reconciliation to make it easier to find. The information can also be accessed on the Conference Call page of the Investor Relations sections of both our websites. Please note that the comparisons made by the speaker today in their prepared comments are second quarter year-to-year compares unless otherwise noted. We have added a consolidated statement of cash flow to the press release to allow to you to access some key information more quickly and we'll continue to do this going forward.

We will be presenting at a couple of investment conferences in the next month or two on September 4th, we're going to be appearing at the 14th Annual Kopman [ph] Brothers Investor Conference in New York City. And Ted Carlson and I will be meeting with investors in Europe from September 22nd through October 2nd. And on October 3rd, we have a meeting with investors in Boston. If you'd like to meet with us at any of these events please let me know and we will try to accommodate you if at all possible.

With that I'll turn the call over the Ken Meyers.

Kenneth R. Meyers - Executive Vice President and Chief Financial Officer

Thank you, Mark. Good morning, thanks for joining us today. I've just a few comments to make before turning the call over to Steve and Bill who will cover the operating results. And then we'll take questions at the end of the prepared comments. Operating revenues for TDS were up 7% to nearly $1.3 billion with most of the increase coming out of U.S. Cellular. Operating income declined slightly principally due to U.S. Cellular's investment in its new branding and advertising campaign and increasing handset subsidies.

Quickly, let me cover some of the year-over-year, non-operating comparisons on the income statement. One, under the TDS current stock repurchase authorization the company has bought back 4.1 million common shares or about $211 million to-date of about $38.7 million remaining under that authorization. We've been buying the stock as aggressively as the Exchange regulations allow. U.S. Cellular continues to purchase shares under it's the limits [ph] program purchasing 150,000 shares in the second quarter.

In the second quarter the company settled the last of the Deutsche Telekom variable prepaid foreign contracts, resold remaining DT shares. This removes a lot of complexity from the balance sheet. So we have no longer of any prepaid forward contracts or derivative liabilities. Of note the Rural Cellular Shares are still listed as marketable securities on the balance sheet since the acquisition by Verizon had not closed as of the end of the quarter.

Also going forward interest expense will be reduced so we will no longer make quarterly interest payments on the prepaid forward contracts, the interest... the income line felling sharply year-over-year. In the second quarter of 2007 the Deutsche Telekom we've been was $118 million and that was the only $11 million in second quarter of this year, reflecting the change in the company's holding as it is unwound of various prepaid forward contracts.

For the quarter the effective tax rate was 33.4% which was reduced due to state tax benefits related to the settlement of the DT prepaid forward contracts. For the year, we still expect the effective rate for both companies too be approximately 40% to 41%. The end of the quarter with a great balance sheet $1.1 billion in cash all of which is still invested in treasuries and virtually unused credit facilities we have a lot of financial flexibility.

Finally, you'll note that we've updated the guidance of U.S. Cellular as disclosed in today's press releases. While affirming the guidance of TDS Telecom, the change to U.S. Cellular's net add in operating include targets, reflect our current best estimate in a rapidly changing marketplace, while handset pricing has increasingly been one of the key areas of competition in the marketplace. The dynamics keep changing especially around smartphones. Everyone has reported that smartphone usage at ARPU than regular phones. Thereby justifying the bigger discount to get these phones to users hands quickly. I believe that was the thinking had AT&T's pricing on the iPhone and now Verizon's recent book.

These moves carry both a risk and a secondary effect, the risk is that the new smartphone customers of tomorrow don't generate the same higher incremental revenue. Thereby failing to justify this higher level of investment, this is something we continue to watch. The secondary effect is of this new pricing on smartphones create a pricing ceiling for all phones and in fact there is a value hierarchy with smartphones [indiscernible] so not only does this affect smartphone pricing it probably affects and lowers the pricing and all terms.

How these two recent changes play out over the next couple quarters could significantly affect our result and could cause such results to vary from even our current guidance. We will continue to monitor and react to these competitive actions.

With that let me turn the call over Steve Campbell with U.S. Cellular.

Steven T. Campbell - Executive Vice President, Finance, Chief Financial Officer and Treasurer-U.S. Cellular

Thanks, Ken and good morning everyone. I am going to begin with a few general comments about the business and then I will highlight some of the key results for the quarter. Overall, we found the second quarter to be challenging as we face difficult economic conditions, strong industry competition and weather related flooding in some of our key markets.

Despite these challenges U.S. Cellular again delivered solid results for the second quarter of 2008. First, we continue to grow our subscriber base. We added 34,000 net retail customers and we ended the quarter with 6.2 million total customers up 3% from the prior year. We're also reporting year-over-year growth in both service revenues at 9% and ARPU at 6%. Both of these trends reflect outstanding growth in our data revenues. This is the 11th consecutive quarter in which we're reporting year-over-year growth in ARPU.

At the same time, we're experiencing increased costs in a number of areas of our business. As a result we're reporting operating cash flow that is essentially flat year-over-year. In this tough competitive and uncertain economic environment we believe that it's important to continue to invest in our business and customers for the long term. One of the significant steps that we're taking further differentiate our customer satisfaction based business model is our new, Believe in Something Better, branding campaigning that was launched in June. With this campaign we're showing that we recognize that wireless plays an important part in our customers' lives that goes well beyond just completing calls. Along with the campaign we're investing in training and other programs so that our associates can deliver the ideal customer experience.

The initial response for the campaign from our customers has been positive, as they recognize our efforts to bring humanity to an industry that has often been devoid of it.

To capitalize on the growth and demand for data products and services; we continue to expand our smartphone and related offerings.

We recently introduced the Black Berry 8330 Curve, Motorola Q9C and HTC 6800 devices. In addition we launched several product enhancements including an updated picture messaging online album and new Black Berry plans designed to penetrate deeper into the consumer segment of the marketplace. To help ensure that our data customers receive a high quality service experience we're expanding EVDO coverage in select service areas.

By the end of 2008, our EVDO coverage will reach 30% of our covered population we plan to continue the targeted expansion in 2009. We also continue to strengthen our overall network with new cell sites and towers in selected areas. There's a foundation for future growth, we participated through our interest in King Street Wireless in the recent FCC auction of 700 megahertz spectrum. King Street Wireless was the provisional winner bidder for 152 licenses covering 42 million props in areas that primarily overlapped or approximate of contiguous two areas covered by licenses that we currently own.

These additional licenses will increase the dept of our footprint to meet future capacity and new technology requirements. We didn't launch any new markets during the second quarter, don't have any plans of along those lines at present. For the next few quarters we intend to focus on adding customers and growing revenues and profitability within our existing markets and of course we're maintaining our relentless focus on customer satisfaction including the commitment to ensuring that our customers have access to a high quality network.

On July, 1st the FCC published this order adopting an interim cap under Federal Universal Service Fund high cost program. As a result of the cap which will be of a definite duration wireless, eligible tower [ph] communications carriers such as U.S. Cellular likely will receive less support in a given state than they otherwise would have been eligible to receive because overall support will not increase as a carrier adds customers whereas additional carriers are granted ETC status in the state. The FCC also is considering other changes in the Universal Service Fund under the heading of long-term reform which could reduce the amount of support that wireless carriers such U.S. Cellular would be eligible to receive.

During the second quarter we received ETC funding of $31 million, a level of ETC funding that we'll receive in the future is somewhat uncertain but we don't expect much of a change over the next couple of quarters.

Now I'll cover some of the details of our second quarter results. As I mentioned earlier retail net adds for the quarter were 34,000, in the postpaid segment which is our primary area of focus it represents approximately 95% of our total retail customer base, we added 33,000 in that new customers.

Retail postpaid churn remains low at 1.4% about the same level as in the prior year quarter. Service revenues of $987 million increased 9% year-over-year driven primarily by customer growth and demand for our data products and services. ARPU of $53.27 was up 6% year-over-year.

We continue to see substantial growth in data revenues, which were up 45% to $124 million, data now represents about 13% of our total service revenues up from 9% a year ago and with plenty of rooms still to grow.

Operating income for the quarter was $118 million compared, to $123 million in the prior year and operating cash flow was $269 million essentially flat relative to last year's $272 million. As I mentioned earlier higher costs in a number of areas put pressure on margin. The net loss on equipment for the quarter was $99 million up 20% factors include a higher net subsidy per unit reflecting handsets with expanded capabilities including smartphones and aggressive promotions across the industry.

Like others we've experienced solid growth in service revenues and data revenues in particular and the equipment subsidy is a cost of these additional revenues. We expect that the expanded capabilities for the handsets that we're currently selling will continue to drive growth in data revenues in the future.

System operations expenses for the quarter were $197 million up 11.5%, the increase reflected an increase in number of cell sites and service, higher total custom minutes of use and higher expenses incurred when our customers use other carrier's networks when roaming.

Selling, general, and administrative expenses were $422 million up 12.7%, advertising expenses increased almost $11 million or 20% primarily due to media purchases and TV production expenses and the launch of our new Believe in Something Better branding campaign.

Investments and other income totaled $4.1 million down from $18.2 million. In 2007 the company recorded a pre-tax gain of $132 million on settlement of variable prepaid forward contracts related to Vodafone ADRs and sale of the remaining Vodafone ADRs and also a pre-tax loss of $18 million on fair value adjustments the variable prepaid forward contacts prior to settlement.

Net income for the quarter was approximately $73 million or $0.83 per diluted share. As I mentioned earlier the company generated operating cash flow of $269 million during the quarter. We also borrowed $50 million net under our revolving credit facility. We used some of this cash to fund capital expenditures of $138 million including expenditures related to the EVDO deployment. And we contributed $203 million to King Street Wireless which in turn used these funds to pay the FCC, for its remaining obligation incurred in the 700 megahertz spectrum launch.

In addition, we purchased 150,000 of our common shares at a cost of about $8 million. At June 30th, our balance sheet remains very sound. The cash balance was $51 million net of outstanding borrowings under the revolving credit facility. We have additional borrowing capacity of about $650 million under that facility.

Our updated guidance, for expected full year 2008 results is contained in today's press release. We're confirming our guidance for service revenues but given our year-to-date results on the uncertain economic, and competitive outlooks we're lowering our guidance for retail net adds in operating income.

Also we're reducing our estimate for capital expenditures. In his comments Ken provided some important context with his guidance. I won't repeat those comments but I will say that the revised guidance reflects a balanced approach to dealing with the challenges in the current environment. We are taking the actions that we can to sensibly control cost and to reduce capital expenditures in order to produce strong free cash flow while continuing to invest in our business and customers for the long term.

Our goal is to continue to drive for growth in customers, revenues, operating income, and cash flows but while not compromising our customer satisfaction strategy and relative competitive position in the market.

Now I will turn the call over to Bill Megan for a discussion of TDS Telecom's results. Bill?

Bill Megan - Executive Vice President Finance and Chief Financial Officer

Thank you, Steve, good morning everyone. The headline for the quarter at TDS Telecom is that not withstanding a weak economy, ESL subscribers increased by 29% and our access line rates held steady. Also the company continues to actively manage and change its cost structure to offset revenue decline thereby holding cash flow steady. For the quarter combined ILEC and CLEC revenues declined by 4% with the segments declining at approximately the same the rate.

The principle drivers on the ILEC side were physical access line losses which were 5% year-on-year excluding acquisitions and lower access revenue. It's intrastate minutes of use declined s21%. Revenues were also affected by a election to exit certain revenue pools in mid 2007. As we have mentioned in the past the decision to withdraw from the pools for our DSL service was an economic one in exiting the pool revenues were reduced by $2.1 million but the corresponding expense contributing to the pools was reduced by twice that amount.

Clearly, a positive element of the quarter was the increase in ILEC data revenues which grew 24%. We had good success with our promotional campaign selling DSL adding about 8,000 net subscribers sequentially and 36,000 year-on-year. Our gross adds remains strong at 17,000. These numbers exclude the effect of acquisitions. Residential DSL ARPU increased 8% to just shy of $35. We also had success in selling our triple play adding nearly 6,600 net subscribers in the quarter and we now have nearly 49,000 in total.

We have a very strong partner in dish network for the video component and are experience has been the triple play customers have significantly lower churn. Over the past year we have introduced a series of promotions in key markets including pre-service for alimony period, a gift card to be used as the customer wishes, a guarantee of lower price for more extended period and so forth. These present different value propositions and if kept the program fresh and customers have responded favorably.

Also, contributing to the increase in data revenues was the expansion of high capacity Ethernet services for commercial customers. As we mentioned on our last call we have rolled out a service that uses specialized equipment to bond together copper facilities to expand bandwidth. And the bandwidth is symmetric often an important feature for commercial customers.

In our CLEC segment, the revenue decline was driven by our decision to improve profitability by focusing our marketing and sales efforts in smaller medium businesses and limiting our investment in acquiring residential customers.

Another positive element in the quarter was expense control, we reduced cash expenses for our combined operations by $11.9 million and thus we're able to improve cash flow by 4% over last year. Importantly, we have been able to combine support functions and make our other process improvements permitting us to lower average headcount by 5% while still maintaining high levels of customer satisfaction.

We continue to invest in out network; capital expenditures were 28 million for the quarter on a consolidated basis and we will continue to evolve our network and put the necessary infrastructure in place to offer broadband feeds that are very competitive. 89% of our ILEC clients who've quit [ph] for DSL service with 84% of our customers taking speeds of 1.5 megabytes or greater and 46% at speeds from 3 to 6 megabytes.

In key markets we are launching 10 megabyte service over copper facilities in 15 to 25 megabyte service where we have fiber facilities. At the end of May, TDS telecom acquired Mosinee Telephone Company which serves about 4,900 access lines in Central Wisconsin. This acquisition is a good strategic fit for us. Contiguous with our current operations has a good residential and commercial customer mix and network capable of higher data speeds and present a good opportunity per synergies in our operation. And finally, our guidance for the year is unchanged.

And now I'll turn the call back over to Mark Steinkrauss.

Mark A. Steinkrauss - Vice President - Corporate Relations

Thank you, Bill. Sara before we go to the Q&A period I'd like to give you some updated replay numbers we had a change. So if you would cross out the old ones I gave you at the beginning and note the following. The replay number 888-203-1112 that's domestic. For international 719-457-0820 and the conference ID number is 6948709. Thank you. And Sara, now I'll turn the call back to you for questions and answers.

Question And Answer

Operator

[Operator Instructions]. Our first question comes from the side of SimonFlannery. Your line is open please go ahead.

Simon Flannery - Morgan Stanley

Okay. Thanks very much. Good morning everybody, wanted to come back to the wireless gross adds if I could for a second, you referred in the release to consumer anxiety I think in the past you've talked about people trying to get their monthly recurring charge down as well but not seen it so much in the number of actual gross adds. So can you give us a sense of how much of this is the economy versus increased completion, bigger handset subsidies versus just over a market maturity as wireless penetration starts to climb, what's your sense of that and have you've seen any change during the quarter are things are going progressively worse or fairly stable through the quarter? Thanks.

Jay M. Ellison - Executive Vice President and Chief Operating Officer

Yes, this is Jay Ellison. A lot of questions in there I think I'll try to summarize what I think I heard. First of all... in the first part I think you were talking I think we had in previous calls we've talked about customers, consumers trying to adjust their wireless spending without disconnecting I think I our churn numbers continue reflect very strong results that we are keeping our customers.

But as customers do call into our call centers or going to our stores we have seen them trying to work with their plans to get either better value overall and in some cases it actually may increase their level of spend a little bit but it is delivering more value over time or make some adjustments relative to the actual products or services cost consolidation of those rate plans into more family plans versus single lines plans and things along those lines.

Some of our market that like in the Northeast, Northwest obviously, may see a little more significant impact in rural areas relative to some of the economic environment but that's also where we've seen some this activity of giving value out of the rate plans themselves [ph] and I would argue that we've pretty much have seen kind of... that environment that Ken and Steve both described this competitiveness, on handset subsidies really a crop all of the footprint and obviously we are going to compete to provide our customers with the greatest value that we can, it's pretty much been across the enterprise throughout... really the first half of the year.

Simon Flannery - Morgan Stanley

Okay, thank you.

Jay M. Ellison - Executive Vice President and Chief Operating Officer

Yes.

Operator

And our next question comes from the side of Will Power. Your line is open please go ahead.

William V. Power - Baird

Great. Thanks, just a couple of questions. I guess first is there is a follow-up on the previous question just thinking about wireless competition generally I know you've talked about the handset price it's been an ongoing phenomenon. I guess occasionally [ph] are you actually seeing more advertising and marketing dollars spent by your competitors in your markets is it that also one of the contributing factors, and I guess I'll also be curious if you have any comments on early impact from the iPhone in Q3 is that helping raise awareness and what's happening on the reporting front there? Thanks.

Steven T. Campbell - Executive Vice President, Finance, Chief Financial Officer and Treasurer-U.S. Cellular

Yes, Will this is Steve. I'll start and Jay will build on it. But to your first question about advertising I think it's a unquestionable and unambiguous yes, I mean like one of the real competitive factors that we're dealing with now are substantial increases in advertising from all the competition and we ourselves are investing in that area I talked little earlier about the increase that we saw in the quarter.

Jay M. Ellison - Executive Vice President and Chief Operating Officer

Yes, I am agree with Steve, honestly as we launched our the recent Something Better campaign that was an incremental media around that to start that and year-over-year we continue to see those... all the wireless space being a very well advertised area in media relative to the iPhone and it's launch clearly there is a lot of... another area of course we see that increase spent in advertising.

But we did see some of our metro our urban market that we saw a little bit and very similar to the visional introduction we see a little bit of spike and then it stabilizes relative to the activity around AT&T, but I think also what is does is create additional awareness around those types of devices and we continue to add to our portfolio smartphone devices in all of our retail stores and so we can kind of see off that frame view as well.

Steven T. Campbell - Executive Vice President, Finance, Chief Financial Officer and Treasurer-U.S. Cellular

Yes, the other competitive point there and it really relates to pricing and obviously margin realization but Ken talked earlier about the secondary affect of what we have seen in smartphone pricing. So it's important to understand that when the pricing on the iPhone gets set at the $199 that has a repel effects all the way down through the handset hierarchy. And so we expect to see a significant competition on pricing up and down the handset line not only for smartphones but on smartphones but much more broadly than that.

William V. Power - Baird

Okay, thank you.

Operator

Thank you. And our next question comes from the side of Greg Lundberg. Your line is open. Please go ahead.

Greg Lundberg - Communications Equity Research

Hi, gentlemen, there was a footnote in your release that said you reviewed your customer reporting procedures. And that appears to have brought down historical subs have change the gross adds and I was wondering if you could walk through. What exactly that was and also why in the second quarter if we do take the ending subscriber cancel report comes after your change of 19,000 net adds not 16,000 if you could describe that adjustment. Thanks.

Steven T. Campbell - Executive Vice President, Finance, Chief Financial Officer and Treasurer-U.S. Cellular

This is Steve. I'll take both parts of that. The adjustment that's referred to in that footnote is that we have a catch up of some of the reporting from our reseller vendor. They were some disconnects that the reseller vendor had delayed in their reporting, the effects were not significant I think overall we're talking round numbers about 25,000 spread over several quarters.

So we thought it was important to footnote it the impacts are not significant, the other point that or question that you raised has to do with the reporting of the acquisitions, the net debt activity does not include subscribers acquired through acquisitions. So that accounts for the difference. During the second quarter we purchased the remaining 50% interest in the North Carolina One partnership. You'll find some expanded disclosure about that acquisition in the 10-Q report.

Greg Lundberg - Communications Equity Research

Perfect, thank you.

Operator

Thank you. [Operator Instructions]. Our next question comes from the side of Chris Mancenne [ph]. Your line is open, please go ahead. Mr. Mancenne please check the mute function on your telephone or access your handset.

Unidentified Analyst

Hello.

Mark A. Steinkrauss - Vice President - Corporate Relations

Okay, we can hear you Chris.

Unidentified Analyst

Hi, yes sorry about that, could you comment on whether TDS did in fact received an offer from a strategic buyer in late 2007, and if it did could you comment on why this wasn't disclosed to shareholders in a public way?

Kenneth R. Meyers - Executive Vice President and Chief Financial Officer

Hi, Chris, this is Ken Meyers. We have had questions like that at the Annual Meeting in other forums where we have reiterated the company's policy is not to comment any rumors like that.

Unidentified Analyst

Okay, so I guess the thing is the letter that came out from the other shareholder you would qualify that as a rumor?

Kenneth R. Meyers - Executive Vice President and Chief Financial Officer

Company has no comment on that matter at all Chris.

Unidentified Analyst

Okay, okay thanks.

Operator

Thank you. And our next question come from the side of Kevin Roe. Your line is open, please go ahead.

Kevin Roe - Roe Equity Research

Thank you, good morning the Verizon acquisition of Alltel as you know requires a pretty material divestiture, can you talk a little bit about your appetite to enhance your footprint in any material way and whether that may or may not to be of interest in what kind of balance sheet ability you have to significantly grow your footprint and on a smaller case you've got Rural Cellular having to the best in small properties. I don't if that to be of interest there any comments would be helpful.

Kenneth R. Meyers - Executive Vice President and Chief Financial Officer

Kevin, this is Ken. It's hard to comment on a unknown set of facts right now and the unknown set being what does Verizon actually wind up divesting in the Alltel transaction, the company has a history of looking at both wireline and wireless acquisitions as they come across, we will look at these, the company does, have a very strong balance sheet with a lot of financial flexibility, but the company also has a rather diligent M&A process where we spent a lot of time making sure that any opportunities that we due pursue are such that they fit with our strategy, around our foot print and fit our operating mile. So I can't comment on any specifics at this time. We don't even know what that looks like.

Mark A. Steinkrauss - Vice President - Corporate Relations

Kevin, any follow on to that?

Kevin Roe - Roe Equity Research

No, thank you.

Mark A. Steinkrauss - Vice President - Corporate Relations

Okay, thank you. Sara we'll take the next question.

Operator

[Operator Instructions]. And it does appear that we have no further questions in the queue at this time.

Mark A. Steinkrauss - Vice President - Corporate Relations

Okay, so thank you everybody for joining us on the call. I am available the rest of the day, if you have any follow on questions just give me a buzz. Thank you, thank you, Sara.

Operator

Thank you. This does conclude today's teleconference. Thank you for your participation. You may disconnect at any time and have a wonderful day.

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