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Old National Bancorp (NASDAQ:ONB)
Q2 2018 Earnings Conference Call
July 23, 2018, 8:00 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Welcome to the Old National Bancorp Second Quarter 2018 Earnings Conference Call. This call is being recorded and has been made accessible to the public in accordance with the SEC's Regulation FD. Corresponding presentation slides can be found on the Investor Relations page at oldnational.com and will be archived there for 12 months.

Before turning the call over, management would like to remind everyone that as noted on Slide 3, certain statements on today's call may be forward-looking in nature and are subject to certain risks, uncertainties, and other factors that could cause actual results to differ from those discussed. The company's risk factors are fully disclosed and discussed within its SEC filings. In addition, certain slides contain non-GAAP measures, which management believes provides more appropriate comparisons. These non-GAAP measures are intended to assist investors' understanding of performance trends. Reconciliations for these numbers are contained within the appendix of the presentation. I'd now like to turn the call over to Bob Jones for opening remarks. Mr. Jones?

Robert G. Jones -- Chairman and Chief Executive Officer

Great. Thank you, Dorothy. Obviously, last quarter, I didn't do as good a job with those statements as you did, and John Moran passed the buck to you, so I appreciate that. Good morning, everybody, and thank you for joining us. Slide 4 provides an overview of our second quarter, which by all accounts was very good and consistent with our guidance in prior quarters. We did see very strong C&I growth of more than 21% driven by a record quarter of production of almost $600 million.

Our reported total loan growth was slightly muted by the sale of almost $65 million in student loans that we had acquired via our Wisconsin partnership, and we also did see the continuation of our balance sheet remix strategy with the decline in indirect loans. Our commercial real estate outstandings were flat for the quarter, driven in large part by paydowns of over $100 million in loans that went to the secondary market, which is an abnormally high quarter of activity for us. As you know, the secondary market has become very aggressive for quality commercial real estate.

I might add a bit of a cautionary statement here. Commercial real estate remains a very good asset class for us, and we comfortable with the quality of the portfolio we have built over the last few years. While we still have capacity to increase our outstandings and remain committed to lending within our risk tolerance, we are beginning to see aggressive competition in the commercial real estate market, both in terms of structure and in pricing, and that may impact our growth in commercial real estate going forward.

We did experience our normal seasonal decline in our end-of-period deposits. Deposit pricing is becoming much more aggressive, particularly from those banks who do not have strong deposit bases. We continue to benefit from our diverse franchise and pricing discipline, and we're pleased with our lower-than-peer deposit beta of slightly over 10% through the cycle. Just to remind you, today, we have a top ten deposit share in all but four of our top 20 MSAs and 20-plus market share in over a third of our markets. In many cases, we are the gorilla in setting the market price. This should continue to allow us to be a market laggard in terms of deposit pricing during this rate cycle.

Our focus on operating leverage and expense control was evident in the quarter as we improved our operating leverage by over 220 basis points year over year. On an adjusted basis, our efficiency ratio was just over 61%. We continue to report strong credit results with net recoveries in the quarter. We did see an increase in our provision for the quarter, driven in large part by the strong loan growth that we had experienced. In addition, there was also the migration of one large credit to non-accrual in Michigan and some movement in other categories. While that's not concerning at this time, as we all know, we are in an extended recovery, and at some point -- probably in the not-too-distant future -- we will begin to see credit move back into the headlines for the industry. At this stage, while we see some pockets of slight concern in our portfolio, we remain very confident in the quality of our portfolio, as well as our reserve coverage.

As it does relate to the economy, John Moran pointed out to us that post our Minnesota entry, our five-state footprint is larger in terms of GDP than Canada. We also enjoy strong economic indicators within the region with historically low unemployment and GDP growth higher than most regions. While we continue to benefit from this strong economic activity, as evidenced by our near-record loan pipeline, we do not know the impact that the implemented and proposed tariffs will have on our markets.

Sectors that have or could be impacted are agriculture, non-domestic auto industries, and manufacturing. Currently, the largest impact is on the agricultural sector. This is a sector that has been under pressure for some time, and this is yet again one more challenge for our farmers. As a reminder, we have slightly less than $300 million in outstandings, and in most cases have been able to secure additional collateral and feel the loss content is manageable.

During the quarter, we were quite busy in the Minnesota market. We executed our conversion on what was Anchor Bank successfully and announced our new partnership with KleinBank. Our performance for the quarter in Minnesota was extremely strong as they led our commercial loan growth with over $58 million. We are very excited about the opportunity as we bring these two teams together to better serve the Twin Cities, Mankato, and the west market.

A brief comment on M&A: While we continue to see several opportunities, we remain a very selective partner and are focused on execution in our markets. With those comments, I'll turn the call over to Jim Ryan for greater detail.

James C. Ryan -- Chief Financial Officer and Senior Vice President

Thank you, Bob. Starting on Slide 5, I will reiterate a few items that we think are important to our strong second-quarter results. Adjusted earnings per share was $0.29. The most significant distinction between the second quarter and the first quarter was the $11.9 million in tax credit amortization. Adjusted earnings per share for the second quarter excludes $2.5 million of merger chargers, $2.2 million of student loan sale gains, $1.6 million of branch closure charges, and $1.5 million of securities gains. Overall, we are very pleased with the results this quarter as we continue to execute our strategic initiatives.

Moving to Slide 6, adjusted pre-tax pre-provision net revenue was almost 20% higher year over year. This result was driven by increased scale from our recent partnerships, maintaining our strong low-cost deposit base, and a continued focus on expense management. Next, on Slide 7, as Bob highlighted, we had record commercial production during the quarter of almost $600 million. This translated into more than 8% commercial growth despite a large number of commercial real estate deals being refinanced in the secondary market. Despite the strong pull-through we experienced in the quarter, our commercial pipeline still stands at $1.7 billion. Our loan yields increased 15 basis points, primarily aided by the increase in short-term rates during the quarter and in improved mix. You should also note that our indirect portfolio was down 7% and we sold our entire student loan portfolio during the quarter. We inherited this book from a Wisconsin acquisition and opportunistically exited this portfolio.

Slide 8 demonstrates our year-over-year change in earning assets. Again, this is very consistent with our stated strategy and ongoing remix objectives. As a percentage of total earning assets, commercial loans are up almost 8%. Less productive earning assets, including indirect lending and securities, are down 5% year over year. Moving to Slide 9, you can see our deposit balances increased on average. However, they did experience their typical end-of-period seasonal decline. We continue to believe that stable, low-cost core funding creates a sustainable competitive advantage. Our deposit beta is now just 10.3% current cycle to date.

Next, on Slide 10, our net interest margin exceeded our expectations and the outlook we provided you last quarter. Our net interest margin excluding accretion income was 3.25% and benefited from short-term rate increases, an improved mix, and day count. Accretable yield was up slightly from the first quarter. We have provided the normal schedule for accretion in the appendix. Slide 11 shows trends in adjusted non-interest income. Mortgage revenue and wealth management were seasonally higher. We have included the purchase versus refi percentage. As you would expect, refis were only 17% of our volume. Other fee areas were fairly stable.

Next, Slide 12 shows the trend in adjusted non-interest expenses. We guided toward $115 million in the seconds quarter with annual merit increases effective April 1, and we made the decision to increase our 401(k) match. This increase in the match will cost $3 million to $4 million annually. We decided the best long-term use of some of the federal tax savings was to invest in the financial health of our associates versus one-time bonuses and other short-term benefits. Our adjusted efficiency ratio for the second quarter was 61.7%, a 134-basis-point improvement over the second quarter of 2017. Expense control remains a key focus in 2018, and we're committed to continuing to generate positive operating leverage.

Slide 13 has our credit metrics. We reported net recoveries during the second quarter, while at the same time recording a $2.4 million provision expense, primarily reflecting our strong commercial loan growth and some commercial loan grade changes. With 64 basis points against organic loans and 373 basis points on loan mark against the acquired loans, we continue to have very adequate reserve coverage.

Next, Slide 14 provides an update on our tax rate expectations. Our statutory rate is expected to be 24.5% for the year. This is the rate you should use to adjust for non-core and non-reoccurring items. For the full year, we continue to expect a net after-tax benefit of our tax credit business of approximately $3 million, or about $0.02 per share. The full-year GAAP tax rate should be approximately 10% or approximately 14% on an FTE basis. These tax rates are slightly higher than previously projected, but we now expect lower tax credit amortization. Those numbers are expected to be $9 million to $11 million for the third quarter and $22 million to $24 million for the full year.

As we have discussed, the exact timing of this project can be difficult to project since many of these are construction projects on historical buildings. We expect the tax credit amortization to be $1 million to $2 million in the fourth quarter. Historical tax credit deals going forward will be contributed to a fund structure. This should smooth quarterly volatility. As we start contributing assets to the fund, we will provide projections for 2019.

Slide 15 provides some key takeaways from the quarter. The first half of 2018 is off to a strong start with good execution against our strategic objectives. We continued to show strong commercial growth funded by low-cost deposits, remixed our balance sheet into more productive earning assets, drove positive operating leverage, maintained strong credit metrics and sound risk management, grew tangible value per share by 7% annualized, and continued our expansion strategy to higher-growth markets with our client/bank partnership.

Slide 16 provides details around our updated outlook. Our expectations remain consistent with our outlook we framed last quarter and our view on loan growth is unchanged. Assuming no rate changes, we expect a stable to moderately increasing net interest margin excluding accretion income. We remain positioned to benefit from future rate increases. Fees should follow normal historical and seasonal patterns for the second quarter, generally being our best quarter. As already highlighted, we expect run rate non-interest expenses to decrease in the back half of the year with savings from our Minnesota partnership fully realized. We expect to close on our Wisconsin branch, so we'll have ten branches in the fourth quarter. We've already covered tax matters in detail on Slide 14.

Finally, with respect to Anchor performance, we continue to see great results. From day one to the end of the second quarter, loans are up 13% on an annualized basis. This is the second partnership in a row that has seen robust loan growth right out of the gates. We expect the addition of Klein, another great platform in the Minneapolis market, to bolster an already strong presence. With that, we're happy to answer any questions that you might have, and to remind you, we do have the rest of the team with us, including Jim Sandgren and Daryl Moore. Thank you, Dorothy.

Questions and Answers:

Operator

At this time, I would like to remind everyone in order to ask a question, please press *1 on your telephone keypad. We will pause for just a moment to compile the Q&A roster. Your first question comes from the line of Scott Siefers with Sandler O'Neill.

Robert G. Jones -- Chairman and Chief Executive Officer

Scott, do you get up at 3:00 in the morning just to get on the line so you can be No. 1?

R Scott Siefers -- Sandler O'Neill & Partners -- Principal

Well, I am fortunate to have people who do that for me, actually.

Robert G. Jones -- Chairman and Chief Executive Officer

Oh, you've got people. I need people.

R Scott Siefers -- Sandler O'Neill & Partners -- Principal

Well, I don't always have people. I got lucky today, so, thanks. Good morning, guys. Two rate-based questions: So, Jim, maybe if you can just discuss the margin in a little more detail. the core exclusive of the PAAs came better than I would have anticipated, so as you look forward, if you could discuss the biggest puts and takes as you see them. I might have guessed it would have been the yield curve as the biggest pressure, but it looks like it might be deposit betas lagging as the biggest benefit, perhaps. And then, as a segue, if you might just spend a little more time discussing deposit pricing by market. Bob, as you noted, you've got some places where it's you guys and almost nobody else, but then, some newer places, so if you could bifurcate those, that'd be great, please.

James C. Ryan -- Chief Financial Officer and Senior Vice President

So, Scott, we are pleased with the performance of our margin, and a lot of it, in my opinion, was driven by the fact that we were able to lag some of the deposit repricing. The guidance we give to a stable to slightly increasing kind of includes trend line increases we're seeing, and as Jim will talk about, we are being defensive and being selective in where we're raising rates, but that will continue to either drive or not drive positive changes in the margin. Certainly, the flat yield curve does not help our ability. We have a lot of medium- to longer-term assets in our investment portfolio, so, to the extent that that 10-year stays stubbornly below 3%, that will be a challenge to the margin growth growing forward. With respect to deposit pricing, Jim can answer a little better.

James A. Sandgren -- President and Chief Operating Officer

Yeah, Scott. Obviously, as Bob mentioned, in the markets where we have over 20% market share, we're really driving the deposit pricing. We really haven't had to move off our current chart rates. I think where you're seeing more movement is certainly the newer markets where we have less than 5% market share. So, being a little bit defensive, as Jim pointed out, but it's nice to have that mix, and to have that legacy deposit franchise has been very helpful through the cycle.

R Scott Siefers -- Sandler O'Neill & Partners -- Principal

Okay, that's perfect. Thank you guys very much.

Robert G. Jones -- Chairman and Chief Executive Officer

Thanks, Scott.

Operator

Your next question comes from the line of Jon Arfstrom from RBC Capital Markets.

Robert G. Jones -- Chairman and Chief Executive Officer

Arf, you need to get people.

Jon Arfstrom -- RBC Capital Markets -- Managing Director

I need to what?

Robert G. Jones -- Chairman and Chief Executive Officer

You need to get people so you can get on the call before Siefers.

Jon Arfstrom -- RBC Capital Markets -- Managing Director

My people are on, so I hope they're taking notes on that, Bob. A little bit on your loan growth targets -- on one hand, I think you're saying commercial is strong, but commercial real estate is a little bit tougher. Just talk a little bit about what you're seeing in commercial, and then give us an idea of where and what is better and what's tougher in commercial real estate.

Robert G. Jones -- Chairman and Chief Executive Officer

I think we continue to benefit from a strong economy in the five-state market. We're seeing a lot of expansion and manufacturing inventory expansion, a lot of opportunities for folks as they think about what they're doing with their tax benefits. The other side -- as I've mentioned briefly -- we still don't quite know the impact that tariffs will have. Right now, I think it's more of a conversation with folks other than just in the ag sector, Jon.

Commercial real estate -- I don't want to -- while we're starting to see structure and pricing challenges, I think the pipeline still remains strong. The quality of the projects we're seeing, other than a few sectors, remains good. We're very cautious toward retail, obviously. Multi-family is an area where we have a little bit of angst and senior housing is another one we're seeing a lot of issues around, but the traditional warehouse/office development continues to remain strong. We continue to have really strong growth in the Wisconsin market. We're starting to get good growth out of Minnesota, and even some of our legacy markets.

Jon Arfstrom -- RBC Capital Markets -- Managing Director

Okay. And, where would you like to see that loan mix go? You've referenced the loan and deposit mix a couple of times, but you're approaching 50% on commercial and commercial real estate. Is that enough, or do you want to go higher?

James C. Ryan -- Chief Financial Officer and Senior Vice President

I think we've got room to go a little bit higher. Obviously, the trick and the key for us all is to fund that with low-cost deposits. To the extent we can continue to do that, I think we can allow that to drift a little bit higher.

Robert G. Jones -- Chairman and Chief Executive Officer

It's a better-yielding asset on the C&I side as we continue to wind down the indirect book, and really, the indirect book that we've talked about before is less of an issue of quality of credit. It's really an issue of yield, as that's such a hypercompetitive market. With the market's we've entered and with the quality of the program that Jim Sandgren's built, we just feel C&I -- and, to a degree, CRE -- gives us a good replacement asset.

Jon Arfstrom -- RBC Capital Markets -- Managing Director

Okay, good. And then, just one follow-up on Scott's question on deposits. The 6-basis-point increase was better than we've seen from most of your peers. Is there more to come there? Some other competitors have had more of a step up that quarter. Would you just say that that's due to your deposit mix, and you don't see any unusual pressures there, other than just tracking up from here?

Robert G. Jones -- Chairman and Chief Executive Officer

Yeah, I think Jim said it well. A lot of that depends on the shape of the yield curve, but at this stage, we're not feeling a significant amount of pressure. Again, that just reinforces the beauty of the franchise that we've built, that we can fund it with low-cost deposits and what was our legacy markets, and then be selective in any rate increases. But, deposits -- Chris Wolking can go back ten years ago. We kept talking about the quality of a deposit franchise, and it's finally becoming true, and folks that have the ability to raise and retain deposits at low costs are going to be the winners in this cycle, and we think we're clearly there.

Jon Arfstrom -- RBC Capital Markets -- Managing Director

Okay, thank you.

Operator

Your next question comes from the line of Terry McEvoy with Stephens.

Robert G. Jones -- Chairman and Chief Executive Officer

Good morning, Terry.

Terry McEvoy -- Stephens Incorporated -- Managing Director

Good morning. Maybe the first question -- for the last couple years, you've talked a lot about the deposit base in those more community markets and the low betas. What's going on on the loan demand side? Is there any economic activity that's spurring growth, or is that maybe more in a run-off phase?

Robert G. Jones -- Chairman and Chief Executive Officer

Actually, Terry, one of our better growth markets this last quarter was southern Indiana, which, again, is not exactly the hypercompetitive economic market, but again, what Jim has built with that gorilla theory -- we're getting every at-bat we can in those markets. We're seeing good growth out of Jasper, Indiana, for instance, which is a market that, as you well know, we've got a very strong competitor in. So, we continue to get at-bats, and again, the benefit of the strong economy in the states we serve -- even in what would not be considered growth markets -- is still very good.

Terry McEvoy -- Stephens Incorporated -- Managing Director

Thanks, Bob. And then, just a follow-up -- Page 16, the outlook, where you talk about commercial and CRE growth of approximately 10%. It sounds like in the back half of this year, it's going to be heavily weighted toward the C&I side, and based on CRE slowing down, do you see that growth rate of loans in the back half of the year slowing down given the CRE commentary, where it's just not going to be as high as what we've seen, at least through the first two quarters of this year?

Robert G. Jones -- Chairman and Chief Executive Officer

I think we're very comfortable with the guidance, which would be consistent with the first two quarters. CRE -- it all depends on the size of the secondary market. We had over $100 million, which is an abnormally high market, but we've got a record pipeline, there's a good balance between C&I and CRE, and it's the CRE in those types that we're comfortable with. Plus, we've got some undrawn commitments yet in the CRE side, and strong credits as well, so we're comfortable with the guidance, the mix... The second half shouldn't be all that different than the first half.

Terry McEvoy -- Stephens Incorporated -- Managing Director

All right. Lastly, you doubled your presence in the Twin Cities. Obviously, you felt the scale was going to be necessary and the opportunities were there. As you look across your franchise, are there any other markets that really stand out where you see opportunities and would like a larger scale to make sure you can capitalize on those growth opportunities?

Robert G. Jones -- Chairman and Chief Executive Officer

Sure. Michigan. You think about how strong Grand Rapids is -- it's a terrific market. Ann Arbor is a great market. Even Kalamazoo has a lot of good activity going on. So, that triangle that we've established there -- clearly, we'd like bigger scale. Louisville continues to be a market where we have just had great success on the C&I side. It would be nice to build out a franchise there. We continue to look at northern Indiana. As everybody's aware, in the second quarter, there was a transaction in northern Indiana that just, for us, didn't make financial sense, but we'll continue to look at the right opportunity at the right price.

Terry McEvoy -- Stephens Incorporated -- Managing Director

Great, thank you.

Operator

Your next question comes from the line of Chris McGratty from KBW.

Robert G. Jones -- Chairman and Chief Executive Officer

Good morning, Chris.

Christopher McGratty -- Keefe, Bruyette & Woods -- Managing Director

Hey, Bob. Good morning, everybody. Maybe just a question on the balance sheet. Obviously, the quarter was impacted by some seasonal deposit flows, but can you remind us the target on the loan-to-deposit? You still have some flexibility to peers, but we're right around 90%.

Robert G. Jones -- Chairman and Chief Executive Officer

We've never really come out with a target. I think any time we get above 100%, we have to take a bit of a look at it, but with Klein coming on, they've got such a low loan-to-deposit ratio, we're comfortable that even with the growth we're seeing, we're going to be well under that as we go forward.

Christopher McGratty -- Keefe, Bruyette & Woods -- Managing Director

Okay, great. So, a little bit more of a remix to the balance sheet, Bob -- you have a securities portfolio trending flat, down...

Robert G. Jones -- Chairman and Chief Executive Officer

Yeah, flat to slightly down. Again, I hate to keep up bringing up Chris Wolking as the historian, but for years, Chris talked about getting our investments down to 25% in the infamous barbell, and we're finally at 25%. Obviously, the yield on that -- particularly as you look at reinvesting in the long term -- is not really what we want to focus on, and it still generates a lot of good cash flow.

Christopher McGratty -- Keefe, Bruyette & Woods -- Managing Director

Great. And, if I could get just one clarification on the fee income guidance, is that guidance relative to the reported 49, or the adjusted ex the gains and the securities in the branch?

James C. Ryan -- Chief Financial Officer and Senior Vice President

The adjusted numbers, yeah.

Christopher McGratty -- Keefe, Bruyette & Woods -- Managing Director

So, 45-46 is the starting point for next quarter?

James C. Ryan -- Chief Financial Officer and Senior Vice President

Yeah.

Christopher McGratty -- Keefe, Bruyette & Woods -- Managing Director

Great, thank you.

Operator

As a reminder, if you would like to ask a question, press *1 on your telephone keypad. Your next question comes from the line of Nathan Race with Piper Jaffray.

Nathan Race -- Piper Jaffray -- Vice President

Hey, guys. Good morning.

Robert G. Jones -- Chairman and Chief Executive Officer

Good morning. How are you?

Nathan Race -- Piper Jaffray -- Vice President

Doing well, thanks. Jim, a question on interest rate sensitivity -- could you just remind us the percentage of the dollar amount of loans that are tied to either prime or LIBOR on the short end there?

James C. Ryan -- Chief Financial Officer and Senior Vice President

It's very consistent with what we've done in the past. The commercial side -- slightly over 50% is really variable-rate in total, and then, the total loan portfolio -- I think it's probably closer to 43% when you throw in all the mortgages and some of the other indirect auto, so on the commercial side, slightly over 50%, and slightly over 40% when you look at the total loan portfolio.

Nathan Race -- Piper Jaffray -- Vice President

Got it. I imagine that'll stay relatively flat with Klein coming on later this year.

James C. Ryan -- Chief Financial Officer and Senior Vice President

It will, but the nice benefit of doing more C&I lending and having that growth is it tends to be a little shorter and have a little more variable, so, generally speaking, we'd really like to see that. Klein's asset sensitivity is pretty similar to ours -- slightly asset-sensitive -- so we'll maintain our current asset sensitivity position.

Nathan Race -- Piper Jaffray -- Vice President

Got it. And, changing gears a little bit, I'm thinking about credit quality. The reserve build that we saw this quarter has been a little larger than we've seen in the past, so I'm just curious if this type of run rate is a good number to use going forward. Obviously, charge-offs were fairly benign this quarter, and it's a little more scientific in that, but any thoughts on the reserve build from here, assuming loan growth continues at the pace we saw here in 2Q?

Robert G. Jones -- Chairman and Chief Executive Officer

I think for modeling purposes, I'd look at the year-to-date number as a way to think about the back half of the year because you get movement -- both positive and negative -- in the loan grades. Obviously, a large portion of the larger provision was because of the growth we had in C&I, but as I mentioned, we did have a large credit that moved. But, I think for the back half of the year, I'd use the first half of the year as a good forecast.

Nathan Race -- Piper Jaffray -- Vice President

Understood. I appreciate all the color, guys. Thanks.

Robert G. Jones -- Chairman and Chief Executive Officer

Thank you.

Operator

There are no further questions at this time.

Robert G. Jones -- Chairman and Chief Executive Officer

Great. Thank you so much. Obviously, Lynell and John are available for any follow-on questions, and we appreciate your support.

Operator

This concludes Old National's call. Once again, a replay, along with the presentation slides, will be available for 12 months on the Investor Relations page of Old National's website, oldnational.com. A replay of the call will also be available by dialing 1 (855) 859-2056, conference ID code 6293046. This replay will be available through August 7th. If anyone has additional questions, please contact Lynell Walton at (812) 462-1366. Thank you for your participation in today's conference call.

Duration: 28 minutes

Call participants:

Robert G. Jones -- Chairman and Chief Executive Officer

James C. Ryan -- Chief Financial Officer and Senior Vice President

James A. Sandgren -- President and Chief Operating Officer

Daryl D. Moore -- Chief Credit Executive and Executive Vice President

R Scott Siefers -- Sandler O'Neill & Partners -- Principal

Jon Arfstrom -- RBC Capital Markets -- Managing Director

Terry McEvoy -- Stephens Incorporated -- Managing Director

Christopher McGratty -- Keefe, Bruyette & Woods -- Managing Director

Nathan Race -- Piper Jaffray -- Vice President

More ONB analysis

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