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Armstrong Flooring Inc (NYSE:AFI)
Q2 2019 Earnings Call
Aug 6, 2019, 10:00 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Greetings and welcome to Armstrong Flooring Second Quarter 2019 Earnings Call. [Operator Instructions] A question-and-answer session will follow the presentation. [Operator Instructions].

I'd now like to turn the conference over to Doug Bing, Chief Financial Officer. Thank you. Please go ahead.

Douglas B. Bingham -- Senior Vice President, Chief Financial Officer and Treasurer

Thank you for joining us today for Armstrong Flooring second quarter 2019 earnings conference call. I am joined by our Chairman and Interim CEO Larry McWilliams; our Chief Product Officer and SVP of Global Operations, Dominic Rice; and our SVP of North American sales Brent Flaharty.

We trust you have seen our press release this morning. Additionally, a copy of the slide presentation to accompany this call is available on the investor section of our website at www.armstrongflooring.com.

I refer you to Slide 2 of that presentation and advise you that during this call, we will be making forward-looking statements that involve risks and uncertainties. Actual outcomes may differ materially from those expected or implied. For a more detailed discussion of the risks and uncertainties that may affect Armstrong Flooring, please review our SEC filings. Forward-looking statements speak only as of the date they are made, and we undertake no obligation to update any forward-looking statements beyond what is required by applicable securities laws.

In addition, our discussion of operating performance will include non-GAAP financial measures within the meaning of SEC Regulation G. A reconciliation of these measures to the most directly comparable GAAP measures is included in the press release and in the appendix of this presentation.

With that, I will now turn the call over to Larry.

Larry S. McWilliams -- Chairman and Interim Chief Executive Officer

Thank you, Doug. Good morning everyone, and thank you for participating on our second quarter 2019 earnings call. On the call today, I will be discussing our operating highlights and business activity. Doug will then cover additional details regarding our financial results before I offer some closing remarks and open the call for questions.

During the past several months, I along with Armstrong team have been working hard to address the continuing trend of challenging industry dynamics in soft market conditions. We have a number of initiatives under way to improve our execution and financial performance. We are focused on innovation and serving our valued customers to drive profitable growth in every facet of our operations. During the second quarter, our customers continue to reduce inventory from elevated levels in previous quarters. This destocking activity represented the tail-end of demand pull forward into 2018 ahead of the initial wave of tariffs on Chinese imports implemented late last year.

We believe, we ended the quarter with channel inventory at more sustainable levels. That said the destocking activity, combined with softer end market demand adversely impacted second quarter sales, particularly in our residential categories. In this environment, the team did a good job of delivering stronger adjusted EBITDA margin and free cash flow in the second quarter. However, our year-to-date performance does not mirror all the internal efforts that are being made to grow our business and get the portfolio in the right place as we look forward. We are driving innovation to bring new products to market. We are working closely with customers to implement price actions in response to input cost pressures. And we are achieving productivity gains in our facilities and realizing cost savings in overhead to right size our operations. These actions together with our strategic priorities support our confidence in the potential of our business to generate more favorable results.

In LVT, we continue to rapidly shift our portfolio emphasis to Rigid Core products, such as our essentials product line, as we stay at the forefront of the innovation curve. Our award winning Diamond 10 Technology continues to appeal to a wide range of customers and we are working rapidly to apply it -- on to even more product lines within our portfolio. In VCT, we've recently added Diamond 10 Technology to our non-PVC product, providing enhanced durability and ease of installation, in addition to its strong sustainability attributes. As we continue to introduce a steady stream of products, we are tightly coordinating our marketing efforts with distributors to more effectively grow our market presence, especially in commercial. We are committed to improving our performance in all product categories, through innovation and cost efficiencies. We have a strong balance sheet to invest in our business as we take advantage of some -- significant opportunities ahead. We look forward to our internal efforts becoming more evident in our results, as we continue to execute on our objectives.

Before I pass the call to Doug, I would like to mention that I'm working with the Board to fill the permanent CEO role. We are making good progress and we will keep you updated as appropriate. In the Interim, I'm committed to working with the talented teams across our business, along with our customers and suppliers to facilitate a seamless transition.

I'll now turn the call over to Doug to walk through the details of our current financial performance.

Douglas B. Bingham -- Senior Vice President, Chief Financial Officer and Treasurer

Thank you, Larry. I'll begin with a review of our second quarter results on Slide 5. For the second quarter 2019, net sales were down 11.7% to $178 million as compared to $201 million in the prior year quarter, including an unfavorable impact of 110 basis points from changes in currency exchange rates. The decrease in net sales was largely due to lower volumes and unfavorable mix in almost all product categories. Volumes were affected by distributor destocking and soft end market conditions, similar to last quarter.

The factors were more pronounced on the residential side of our business, including residential LVT. The effect on commercial sales was less severe, partly attributable to the emphasis of our strategy on that end market. Selling prices were up modestly year-over-year in response to inflationary pressures from tariffs. Our second quarter 2019 adjusted EBITDA was $20 million as compared to $20.7 million in the second quarter of 2018. This decline in adjusted EBITDA was primarily due to lower net sales. This was partially offset by lower SG&A spending and improved productivity. The lower reported SG&A spend included a $2.5 million benefit related to an early sublease termination fee by the owners of our former wood business.

As a percent of sales, adjusted EBITDA was 100 basis points higher year-over-year. In the distributor channel we believe customers have largely worked down unusually high levels of inventory, purchased ahead of tariffs on Chinese imports last year. That said, the general uncertainty around the ultimate outcome of U.S.-China trade negotiations has continued to influence normal seasonal buying patterns. Our several rounds of price increases since October 2018 have allowed us to partly blunt the impact of inflation due to tariffs. In May, we announced additional price actions on select products in response to the U.S. decision to raise tariffs on Chinese flooring imports from 10% to 25%. We have worked closely with our customers to minimize the impact of their supply chains from recent price increases, while providing us an opportunity to help offset these costs to increase. During the second quarter, we generated operating cash flow of approximately $29 million. Consistent with our expectation, the main driver of our operating cash flow in the second quarter was a reduction in working capital, as we drove down a significant working capital build in the first quarter, or the quarter we invested $7 million in capex, which remain below our run rate depreciation.

During the quarter, we were pleased to return excess capital to our shareholders through the repurchase of 4.5 million shares, for a net purchase price of approximately $50 million. This repurchase activity fully utilize the remaining unused portion of our share repurchase authorization. We ended the quarter with a strong balance sheet, providing us the flexibility to invest in initiatives and growth avenues that makes sense for our business. Our capital allocation objectives remain unchanged, with our focus on maintaining the business, funding internal growth initiatives and pursuing M&A opportunities that support our growth strategy.

Moving to our full year outlook, we have moderated our adjusted EBITDA expectations for the full year, which we now expect to be in the range of $46 million to $54 million. While we believe elevated inventory levels in the channel have been largely worked down, unfavorable market conditions are likely to pressure results into year-end. As a reminder for quarterly balancing into year-end, our prior year comparison is relatively tougher in the third quarter, given the significant prebuy activity in September 2018. While our full year outlook has been tempered, we anticipate that pricing actions, productivity gains and other cost savings will allow us to achieve our full year objectives.

We remain committed to growing our adjusted EBITDA margin to 10%. However, based on our revised 2019 expectations in the light of persistent market challenges. At this time, we believe it will take longer to achieve than initially expected. As such, a 10% margin level is a more attainable target, as we look beyond 2020. On the P&L, our effective tax rate could change significantly quarter-to-quarter, so we continue to expect our tax rate to be approximately 25% in 2019. In regard to cash flow, we continue to expect capital expenditures of approximately $30 million for the year. Maintenance CapEx should continue to approximate 2% to 3% of sales, with the balance of the spending budgeted for high-return investments. We expect to build cash as we progress through the balance of the year.

With that, I will now hand the call back to Larry for closing comments.

Larry S. McWilliams -- Chairman and Interim Chief Executive Officer

Thanks, Doug. As we have discussed today, our team has been focused on executing our key initiatives. We are working to improve our growth trajectory and augment our margin profile. We have a strong portfolio of award-winning products, and our team is committed to expanding its leadership positions in the resilient flooring industry. We are working closely with our customers to maintain strong relationships, and exceptional levels of service. We aim to accelerate positive momentum in our business over the long-term, as we build upon our strong brand and market leadership to drive returns for our shareholders. Operator, we are now ready to take questions.

Questions and Answers:

Operator

Thank you. [Operator Instructions] Our first question is coming from the line of Alvaro Lacayo with G. Research.

Alvaro Lacayo -- G. Research -- Analyst

Good morning.

Douglas B. Bingham -- Senior Vice President, Chief Financial Officer and Treasurer

Hey, Alvaro.

Alvaro Lacayo -- G. Research -- Analyst

I wanted to start with just the revenue outlook, and if you could talk about the first half, what you think growth rates, how much they were impacted by this inventory build, that seems to be reducing. And what are your expectations for the second half? And if you could just provide color by sub-segment LVT, VCT and resilient sheet?

Douglas B. Bingham -- Senior Vice President, Chief Financial Officer and Treasurer

Sure. Yeah. So as I, comment as earlier, we did see continued inventory destocking. For the first half it was roughly, half of the sales change was due to the destocking activity, fairly similar in Q1 and in Q2. Within the categories, it was more pronounced in the residential categories as opposed to the commercial categories, both the destocking, as well as the software end market drawdown that we saw.

Alvaro Lacayo -- G. Research -- Analyst

What are the expectations for the second half, baked into your guide?

Douglas B. Bingham -- Senior Vice President, Chief Financial Officer and Treasurer

Sure. Yeah. So we did indicate that it will be a relatively tougher comparison in Q3, just given that there was a large inventory build last year around the tariffs, that we don't expect to repeat this year. And then Q4, we had a little bit of inventory drawdown kind of coming-off the Q3 peak, but not too heavy.

Alvaro Lacayo -- G. Research -- Analyst

With regards to your fixed cost footprint today, how would you categorize it? Is it fully rationalized or do you see opportunities there? And are there any updated updated commentary around reconfiguring existing capacity?

Douglas B. Bingham -- Senior Vice President, Chief Financial Officer and Treasurer

Yeah. So, we are constantly evaluating our footprint for opportunities as volumes continue to decline. We will certainly take action when it's appropriate. We basically look at it on a cash basis. So at the point where the plant is going to stop generating positive cash flow, that's the time that we would take action on it. Based on our -- what we see out in the marketplace, more broadly, with the sourcing opportunities that are available in China, we think there is -- there are good opportunities to source LVT products and rigid products from suppliers overseas. And so that will be our focus more on the sourcing element rather than the domestic manufacturing of LVT, just given that evolving R&D curve and the expansion of the supply chain, that's moving beyond China at this point.

Alvaro Lacayo -- G. Research -- Analyst

Got it. And the $4.7 million in strategic projects that's part of the adjusted EBITDA, can you maybe talk about what you're doing, what the payback period is? And then from a price cost perspective, have you been able to offset the first 10% around already today. Are you still lagging a little bit that original 10% of tariffs?

Douglas B. Bingham -- Senior Vice President, Chief Financial Officer and Treasurer

Yeah. So we took some actions, as you know, back in last year, we were able to get a partial offset on those. We were also able to get some supplier concessions, which help to offset as well. The second round, that's gone into place we've announced price increases, it's been kind of a mixed bag, what the competitive response has been on that. And so we continue to work to price our products appropriately and work with our suppliers to offset the cost impact. Your question on the strategic projects and cost reduction initiatives, a fairly large piece of that, $4.7 million is the severance related to the separation of our former CEO

Alvaro Lacayo -- G. Research -- Analyst

All right. Thank you.

Operator

Our next question is from the line of Michael with Nomura.

Michael Wood -- Nomura Instinet -- Analyst

Hi, good morning.

Douglas B. Bingham -- Senior Vice President, Chief Financial Officer and Treasurer

Hey, Mike.

Michael Wood -- Nomura Instinet -- Analyst

I first wanted to ask about the 10% margin goal that you said was pushed out beyond 2020. So curious to hear, line of sight in terms of getting there, it does still seem like a stretch. And are there any mean flooring product categories that you might need to exit in order to reach that 10% goal?

Douglas B. Bingham -- Senior Vice President, Chief Financial Officer and Treasurer

Yeah, that's a good question, Mike. I think as we look at that, we still feel that that's an appropriate target for us to get to the timing of it, is a little more uncertain at this point. Looking at our product portfolio, there are certainly some products that are above that, that we feel comfortable with and we'll continue to expand other product categories, are a little more challenged. It's possible that we may over time exit some of those or reduce their relative waiting in the portfolio. But I don't think it's a pre-condition that we jettisoned any of the existing products to get to that 10%

Michael Wood -- Nomura Instinet -- Analyst

Okay. Can you, also give us an update on the lockout at the Lancaster facility, what product line that is? And is it interrupting production or having a profit impact at all for you?

Dominic Rice -- Chief Product Officer and SVP Global Operations

Hey, Mike. Dominic Rice, here. Thanks for the question. So, at our Lancaster floor plant, we produce both LVT and residential sheet vinyl. We continue to operate the plant with both salaried staff and temporary labor. And so we have not seen and don't anticipate any interruption to our -- to the service to our customers with those products.

Okay, great. And just finally can I ask in terms of post the Dutch tender offer, how are you feeling in terms of comfort with your leverage? And are there any large capital opportunities that may be in front of you now, in terms of either larger productivity or restructuring initiatives or any other growth investments? Thank you.

Douglas B. Bingham -- Senior Vice President, Chief Financial Officer and Treasurer

Yeah, I think we're still comfortable with the leverage that we've got, where we're at now. We've got about $28 million of net debt, so we're still pretty comfortable on the leverage ratio. If there are projects that come up that are -- that are meaningful, we'll certainly discuss those. We do feel like we've got adequate dry powder -- excuse me, adequate dry powder to address any opportunities to invest that come up.

Michael Wood -- Nomura Instinet -- Analyst

Thanks.

Operator

Our next question is from the line of Justin Speer with Zelman.

Justin Speer -- Zelman & Associates -- Analyst

Hello, good morning guys. Thank you. I appreciate the color on the revenue growth, but in terms of the EBITDA margin, it's implied in the back half. I guess maybe you can help us unpack that a little bit, the EBITDA or maybe look at it differently, the SG&A level at $27 million on an adjusted basis, how should we think about that on a quarterly run rate basis into the back half?

Douglas B. Bingham -- Senior Vice President, Chief Financial Officer and Treasurer

Yeah, so our SG&A in this quarter was a little, a little lower than normal because of that $2.5 million lease breakage fee. But other than that, it was, it's a relatively good baseline. We still got some income related to the TSA [Phonetic] of the wood business in there. But we've also got some expense running through as well.

Justin Speer -- Zelman & Associates -- Analyst

So I don't. For the full year, I guess what kind of SG&A margin you're looking at for the full year, as you think about your guidance?

Douglas B. Bingham -- Senior Vice President, Chief Financial Officer and Treasurer

Yeah. So we've taken our SG&A expectations into that guidance, based on the Q1 and the Q2 that you've seen kind of adjusting for some of those one-timers or unusual items would be fairly typical for what we had expect in the back half.

Justin Speer -- Zelman & Associates -- Analyst

Okay. And then the other -- the other element of this is on the gross margin side of things. As you think about your raw materials, I know there is a lot of like moving parts with tariffs and underlying demand trends. But as you think about your mapping, how should we think about raw materials being a tailwind in the back half? Do you think you can hold on to those and how much tailwind do you expect in the back half from raw materials?

Douglas B. Bingham -- Senior Vice President, Chief Financial Officer and Treasurer

Yeah. So I'll kind of set aside the tariff piece, because that's kind of its own animal. Raw materials have been fairly flattish for us. They're down from the peaks that they had in 2018, so we should get some tailwinds from those transportation, likewise, we had some improvement in Q2. So we're not facing the same pressures that we were previously.

Justin Speer -- Zelman & Associates -- Analyst

Okay. So some tailwinds there potentially. And then the other element that I would like -- I'd be curious to get your thoughts with the tariffs now, particularly on the largely imported LVT product. How do you think about the momentum of demand now that you may have some of the economics of LVT, maybe modest friendly, relative to where they were before the tariffs stepping up. How do you think about your overall portfolio, as you think about LVT portion of your business and a non-LVT portion of your business into the back half and into next year?

Douglas B. Bingham -- Senior Vice President, Chief Financial Officer and Treasurer

Yeah, we still really like the portfolio that we've got in LVT, and we're constantly looking at new ways that we can expand the portfolio, and Larry mentioned in his remarks, the introduction of elements, which will be I think a great -- excuse me, essentials, which will be a great product in the marketplace. You know the dynamics is out in the industry right now on LVT, there is a lot of noise because of the tariffs. But we think the fundamentals are still there, it's a great product and we expect that people continue to adopt that. With the cost impacts from the tariffs -- if that is something that ends up slowing down the growth rates of LVT, given that we do have a large domestic portfolio of other products. That's not necessarily a bad thing for us.

Justin Speer -- Zelman & Associates -- Analyst

And I guess from your perspective, are you injecting any of that kind of dynamism in your guidance or is it -- in terms of the revenue growth implied in your guidance? I guess, think stripping out the inventory element, what do you think the underlying demand looks like for your flooring products into the back half?

Douglas B. Bingham -- Senior Vice President, Chief Financial Officer and Treasurer

Yeah. We've kept a fairly consistent view from kind of looking at what last year was, just on a little lower base, it's how we view it.

Justin Speer -- Zelman & Associates -- Analyst

Got it. And last question for me is just in terms of -- or I'll ask two questions. I have two more questions. On cash conversion side, do you think you can generate positive free cash flow for the full year 2019, based on the way things are following or or do you think it might be a tough part from here?

Douglas B. Bingham -- Senior Vice President, Chief Financial Officer and Treasurer

Yeah. So what we've said is that we feel, we feel strongly that we'll continue to generate cash in the remaining quarters of the year. But as you know we had a kind of a large headwind in Q1.

Justin Speer -- Zelman & Associates -- Analyst

Okay. And then, last question for me in terms of filling the permanent CEO role. In terms of those discussions, do you have any good candidates and are those candidates from within the industry?

Larry S. McWilliams -- Chairman and Interim Chief Executive Officer

Yeah, this is Larry. We are very active in the process, we're well -- through the process now. We're seeing some very, very good candidates, I won't comment on their backgrounds, but I'm very pleased with where we are in getting a new CEO in place.

Justin Speer -- Zelman & Associates -- Analyst

Excellent. Thank you very much for your time gentlemen.

Operator

Our next question comes from the line of John Baugh with Stifel.

John Baugh -- Stifel, Nicolaus & Company -- Analyst

Good morning, and thanks for taking my questions. I was wondering on flexible LVT which you're making in their Lancaster plant. Is demand for that still growing and what's the status of the sort of line utilization on flexible LVT?

Dominic Rice -- Chief Product Officer and SVP Global Operations

Yeah, John, thanks for the question, it's Dominic here. Certainly and primarily on the residential side, Rigid is more of a growth catered grade and flex. But flexible LVT remains particularly in some segments, the preferred product of choice. Then notably in commercial -- in commercial it remains primarily a flexible LVT, and a significant part of our Lancaster plant is devoted to servicing the commercial segment with our flexible LVT.

John Baugh -- Stifel, Nicolaus & Company -- Analyst

So it was flexible caught up in all this destocking and whatnot because more of that's made, I believe in the U.S. than certainly Rigid.

Dominic Rice -- Chief Product Officer and SVP Global Operations

Yes, there was the both the stocking up and the destocking activity with across the broad LVT portfolio, both Rigid and flexible.

John Baugh -- Stifel, Nicolaus & Company -- Analyst

Okay. And any comment, Doug, you used to kind of call it legacy products, but obviously non-LVT Resilient tile, sheet final and VCT. Any comment there, because I wouldn't think those products would be is greatly impacted by the Rigid Core Chinese imports, but I may be wrong on that.

Douglas B. Bingham -- Senior Vice President, Chief Financial Officer and Treasurer

Yeah. So we haven't really seen a market change in kind of the market dynamics for those legacy products. I think they all continue to be impacted by by LVT in one form or another. The Rigid impact as Dominic mentioned, is probably more pronounced from the residential products, like residential sheet. But certainly LVT, the flexible form impacts VCT as well.

John Baugh -- Stifel, Nicolaus & Company -- Analyst

And do I construe your comments around sourcing more or not producing much as your efforts to try to convert, I think, the old engineered wood plants to make Rigid Core LVT, that that's essentially what, abandon process? Or you're not going to, I assume, try to make SPC here in the U.S.?

Douglas B. Bingham -- Senior Vice President, Chief Financial Officer and Treasurer

Yeah. As it stands now, as we've looked at it, the -- we'll continue to look for opportunities to use our existing assets, but the development in the overseas markets around SPC continues to evolve and produce some pretty phenomenal products. And as far as the tariff concern has evolved, what we're seeing is a lot of Chinese manufacturers are starting production in countries like Vietnam and other areas that would not be impacted by the tariffs.

John Baugh -- Stifel, Nicolaus & Company -- Analyst

Okay. And currently on that topic, what amount, if any, are you sourcing LVT from outside of China currently? Or is this all kind of in development and discussion more than our actual at this point?

Douglas B. Bingham -- Senior Vice President, Chief Financial Officer and Treasurer

Yeah, I'd say it's more in development discussion. There is some minimal amounts, but it's primarily in China at this point.

John Baugh -- Stifel, Nicolaus & Company -- Analyst

Okay. And finally, we've heard that, the price increase announced but the big players yourselves included in Shaw and Mohawk on LVT is, as I think, the words you used is sort of uncertain? Or we're going to have to see how it all shakes out, primarily because there were still inventory brought in, particularly from many smaller players that was perhaps delaying the implementation of that price increase? Is that -- to have that kind of ride in, where do you think we are time-wise in the running through that lower-cost of pre-tariff inventory in the United States?

Douglas B. Bingham -- Senior Vice President, Chief Financial Officer and Treasurer

Yeah, I think you've got the right perspective there. The channels from us and from others, everybody was buying a lot of material ahead of the tariffs. I think at this point, we indicated that from what we see in our own space, the inventory is getting to better levels, there may be still a few pockets that are a little bit high. But given that the tariffs just increased in about two months ago, there's probably still a little bit of time before all that pre-tariff inventory is out of the system.

John Baugh -- Stifel, Nicolaus & Company -- Analyst

Great. Thanks for answering my questions and good luck.

Douglas B. Bingham -- Senior Vice President, Chief Financial Officer and Treasurer

Thank you.

Operator

We have a follow-up question from the line of Alvaro Lacayo with G. Research.

Alvaro Lacayo -- G. Research -- Analyst

Thanks for taking my follow-up. I just had a question on VCT. In the past, you've talked about kind of a low single-digit volume decline, offset by solid pricing, wanted to get your thoughts on whether anything has changed from that kind of level of demand. And then secondly, the $2.5 million that you received relative to the Wood divestiture, is that part of adjusted EBITDA? I just wanted to be clear on that.

Douglas B. Bingham -- Senior Vice President, Chief Financial Officer and Treasurer

Yeah. So the $2.5 million that is part of our adjusted EBITDA. Your other question, sorry, Alvaro, I forgot your other question.

Alvaro Lacayo -- G. Research -- Analyst

Just VCT, in the past, we've discussed it as being -- given that you are by far the largest player, you had -- it was a category with low single-digit volume declines, but a lot of it offset by good pricing, and I wanted to get an update on the dynamics, if that still holds or if there is been a change.

Dominic Rice -- Chief Product Officer and SVP Global Operations

Hey, Alvaro, it's Dominic. Thanks for the question. No, we continue to see that to be a fairly consistent dynamic with VCT.

Alvaro Lacayo -- G. Research -- Analyst

Thank you.

Operator

Okay. Thank you. We have now reached the end of our question-and-answer session. I would like to turn the floor back to Larry McWilliams for closing comments.

Larry S. McWilliams -- Chairman and Interim Chief Executive Officer

Thanks everyone, for joining us today. We appreciate your interest in Armstrong Flooring, and we look forward to updating you in future calls.

Operator

[Operator Closing Remarks]

Duration: 30 minutes

Call participants:

Douglas B. Bingham -- Senior Vice President, Chief Financial Officer and Treasurer

Larry S. McWilliams -- Chairman and Interim Chief Executive Officer

Dominic Rice -- Chief Product Officer and SVP Global Operations

Alvaro Lacayo -- G. Research -- Analyst

Michael Wood -- Nomura Instinet -- Analyst

Justin Speer -- Zelman & Associates -- Analyst

John Baugh -- Stifel, Nicolaus & Company -- Analyst

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