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Quanex Building Products (NYSE:NX)
Q3 2020 Earnings Call
Sep 04, 2020, 11:00 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:


Operator

Ladies and gentlemen, thank you for standing by, and welcome to the Q3 2020 Quanex Building Products Corporation earnings conference call. [Operator instructions] Please be advised that today's conference is being recorded. [Operator instructions] I would now like to hand the conference over to your speaker today to Mr. Scott Zuehlke, senior vice president, CFO, and treasurer.

Thank you. Please go ahead, sir.

Scott Zuehlke -- Senior Vice President, Chief Financial Officer, and Treasurer

Thanks for joining the call this morning. On the call with me today is George Wilson, our president and CEO. This conference call will contain forward-looking statements and some discussion of non-GAAP measures. Forward-looking statements and guidance discussed on this call and in our earnings release are based on current expectations.

Actual results or events may differ materially from such statements and guidance, and Quanex undertakes no obligation to update or revise any forward-looking statement to reflect new information or events. For a more detailed description of our forward-looking statement disclaimer and a reconciliation of non-GAAP measures to the most directly comparable GAAP measures, please see our earnings release issued yesterday and posted to our website. I'll now discuss the financial results. We reported revenue of $212.1 million during the third quarter of 2020, compared to $238.5 million during the third quarter of 2019.

The decrease was primarily attributable to lower volume related to the COVID-19 pandemic. More specifically, our two manufacturing facilities in the U.K. were shut down in compliance with government orders on March 25, 2020, and manufacturing operation at those manufacturing plants did not restart until mid to late May. However, volume across all segments increased significantly in June, and net sales in July exceeded prior year on a consolidated basis.

We reported net income of $10.8 million or $0.33 per diluted share for the three months ended July 31, 2020, compared to $11.8 million or $0.36 per diluted share during the three months ended July 31, 2019. On an adjusted basis, net income was $11.1 million or $0.34 per diluted share during the third quarter of 2020, compared to $13.7 million or $0.41 per diluted share during the third quarter of 2019. The adjustments being made to EPS are for restructuring charges, impairment charges, certain executive severance charges, accelerated D&A, foreign currency transaction impacts and transaction and advisory fees. On an adjusted basis, EBITDA for the quarter was $27.7 million, compared to $32.8 million during the same period of last year.

Moving on to cash flow and the balance sheet. Cash provided by operating activities was $45.1 million for the three months ended July 31, 2020, which represents an increase of 50.8% compared to the three months ended July 31, 2019. Cash provided by operating activities was $47.6 million for the nine months ended July 31, 2020, which represents an increase of 58.7% compared to the nine months ended July 31, 2019. Free cash flow improved significantly during the third quarter to $40.7 million, which represents an increase of 57.1% compared to the third quarter of 2019.

Year-to-date 2020, free cash flow more than doubled to $26.9 million compared to the same period of 2019. Our focus on managing working capital continues to provide benefit, but we realize most of the heavy lifting on this front has been accomplished. Our balance sheet is healthy, our liquidity position is strong and getting stronger, and our leverage ratio of net debt to last 12 months adjusted EBITDA improved to 1.1 times as of July 31, 2020, which is lower than where we exited fiscal 2019. We will continue to focus on generating cash and paying down debt in the fourth quarter, which should allow us to exit fiscal 2020 with a leverage ratio of net debt to last 12 months adjusted EBITDA at or below one time.

We will continue to be opportunistic with respect to repurchasing our stock. As previously disclosed, due to the uncertainty related to the ongoing pandemic, we withdrew full-year guidance and reduced our capex budget for fiscal 2020. Having said that, the recovery has been more robust than expected on all fronts, and we are now comfortable providing the following full-year 2020 guidance: net sales of $832 million to $837 million, adjusted EBITDA of $97 million to $102 million, capex of approximately $25 million and free cash flow of approximately $50 million. It is important to note that although free cash flow increased significantly in the third-quarter and year-to-date 2020 compared to 2019, much of that improvement came from systemic improvements to our management of working capital.

Looking ahead, it will be more challenging to continue this rate of improvement in working capital. In addition, we expect that a higher pension contribution and an increase in cash tax payments will make fourth-quarter comps more challenging. I'll now turn the call over to George for his prepared remarks.

George Wilson -- President and Chief Executive Officer

Thanks, Scott. Overall, we are very pleased with the results we delivered in a quarter that again presented many unprecedented challenges. As we began our third quarter, there were still many unknowns related to COVID-19 and its impact on our company and the worldwide economy. As Scott mentioned, our facilities in the U.K.

were closed by government mandate through mid to late May. In North America, we still have many employees on furloughed status for the first few weeks of the quarter. Fortunately, those headwinds changed directions very quickly and demand rebounded swiftly as we entered June. All facilities are now operating at pre-pandemic run rates and consolidated revenue in July actually exceeded prior year.

As discussed on prior earnings calls, our cost structure is highly variable and allowed us to anticipate this change and effectively meet a rapid run-up in demand. I'd like to take a moment to thank my Quanex teammates for their continued hard work and dedication to meeting our customers' needs during this changing and uncertain time. I'll now spend a moment discussing results from each of our segments, beginning with the North American fenestration. Revenue in this segment was $122.4 million, down 10.2% from prior-year third quarter.

This shortfall was primarily driven by the pandemic's negative impact on demand, especially during the month of May. Adjusted EBITDA of $17.8 million was $4.8 million less than prior-year third quarter. Volume-related impacts and higher overtime costs in June and July, combined with pandemic-related delays to the upgrade project in our vinyl extrusion business in North America, all negatively impacted the results. We generated revenue of $38.3 million in our European fenestration segment, which was 13.7% less than prior year or down 12.9% after excluding the foreign exchange impact.

As mentioned earlier, our U.K. plants were shut down through mid to late May and effectively had very little revenue during that month. However, volumes rebounded quickly and revenue in June and July was actually stronger than prior-year levels. In Continental Europe, spacer volumes remained steady, with strong demand continuing in Germany, Austria, Switzerland and Scandinavia.

Despite low volume in May, this segment was able to realize adjusted EBITDA of $7.7 million in the quarter, which represents margin improvement of approximately 290 basis points over prior year. This margin expansion was driven by favorable material costs, efficient ramp-up and productivity gains. Our North American cabinet components segment reported revenue of $51.9 million, which was 11.5% less than prior year. However, revenue was only down 7.5% if you adjust for the customer that exited the cabinet manufacturing business in late 2019.

We saw a significant increase in demand in June and July driven by opportunities created by supply chain disruptions in the cabinet component import markets. Adjusted EBITDA for the segment was $3.1 million, down $1.7 million from prior-year third quarter. It is important to note, though, that EBITDA was negatively impacted by a $1.7 million accrual for writing off the final amount of customer-specific inventory associated with a customer that exited the cabinet business. Absent this write-off, we would have realized margin expansion of approximately 90 basis points in this segment as well.

Finally, unallocated corporate and SG&A costs were $1.4 million better than prior-year third quarter. The primary drivers of this improvement were lower executive compensation costs and a favorable medical cost true-up for the quarter. As Scott also mentioned in his commentary, we are focused on generating cash flow, and those efforts have allowed us to continue deleveraging our already strong balance sheet. While the potential to benefit from a further improvement in working capital will be limited on a go-forward basis, the increased demand we are seeing provides us with confidence in our ability to maintain a healthy balance sheet, generate cash and opportunistically repurchase stock.

Market fundamentals and demand for our products, combined with our ongoing focus on operational efficiency gains, give us further confidence in our ability to meet the full-year 2020 guidance. All that said, there's still much uncertainty for the mid to long term. COVID-19 continues to be a problem around the world and the timing and successful distribution of a potential vaccine is questionable. In addition, the U.S.

presidential election is right around the corner, and the result could have long-lasting economic and societal impacts regardless of who the winner is. With these things in mind, we feel our current strategy of focusing on operational excellence, maintaining a healthy balance sheet, generating cash and opportunistically repurchasing shares remains our best near-term strategy. We have demonstrated our ability to execute on this strategy, and we feel that our efforts have positioned us well to capitalize on opportunities when and if they arise. And with that, operator, we are now ready to take questions.

Questions & Answers:


Operator

Thank you, sir. [Operator instructions] Our first question comes from the line of Daniel Moore from CJS Securities. Please go ahead.

Daniel Moore -- CJS Securities -- Analyst

George, Scott, good morning, and congrats on the nice results. I'll start with EU fenestration, recovering much quicker than certainly we had expected or maybe feared. How much of that increase do you think in July and August was catch-up from being shut down earlier in the year? And what order patterns look like as we enter September?

George Wilson -- President and Chief Executive Officer

So great question, and I wish we had complete visibility into that answer, Dan. We think it's a balance of both. There is a piece of that that we do believe is catch-up. However, with that being said, September -- August and September orders look relatively strong.

So we're confident. The big question mark with the EU is how does that play into the next year. So we're pretty confident we'll see a strong remainder of our fiscal year, but how that plays into 2021 is still a little unknown.

Daniel Moore -- CJS Securities -- Analyst

Understood. That's helpful. In North American cabinets, are you seeing any pressure from rising input commodity costs? And can you give us kind of an updated view of where EBITDA margins in that segment can get to over the next, say, maybe two to three years?

George Wilson -- President and Chief Executive Officer

Yeah, sure. So there's been a lot of discussion on the talk around wood pricing. We primarily deal in the hardwood markets. And for us, we have not seen a significant amount of inflationary pressure.

What you're hearing in the news is a lot on the softwood and the softer species, which we don't have a lot of exposure to. So we're not seeing a significant amount of pressure on our input costs at this point. Looking ahead, on your question as it relates to the EBITDA expectations, we are very confident through what we're doing on the sales side, as well as our operational projects that we've had in place now for two to three years that we're starting to see the results of that we can get to low double-digit EBITDA margins over the next couple of years, and we're very confident on our ability to do that.

Daniel Moore -- CJS Securities -- Analyst

Perfect. I'll sneak one more. Just in terms of working capital, you guys have, obviously, been working really hard on that front. Going forward, is it just going to be more of a headwind going forward or just less of a tailwind? Essentially, are the gains -- I know it's going to be hard to continue to generate more, but are the gains that you've achieved sustainable?

Scott Zuehlke -- Senior Vice President, Chief Financial Officer, and Treasurer

Yeah, Dan, this is Scott. I'll take this one. I think going forward, the focus will continue to be on working capital management. I think our message here is that any gains or benefit on that front going forward are going to be challenging to get to.

I think I don't -- we don't think it's going to be a headwind by any means, but it's going to be hard to improve going forward.

George Wilson -- President and Chief Executive Officer

I think, to add to that, Dan, what we mentioned in our script and what we've done over the last couple of years, and we are seeing, they've been systematic changes. So these -- we've effectively changed the way we've done business and very much put the whole working capital project as any other manufacturing. It's a process, and we've optimized that, and we've done a very good job of that. So that's what you're seeing right now.

Daniel Moore -- CJS Securities -- Analyst

OK. And as I hand it over, it sounds like buybacks are now potentially back on the table opportunistically, if I heard you. Is that correct?

Scott Zuehlke -- Senior Vice President, Chief Financial Officer, and Treasurer

Yes. Opportunistically, you are correct.

Daniel Moore -- CJS Securities -- Analyst

OK, perfect. Thank you.

Operator

Thank you. Our next question comes from Reuben Garner from Benchmark. Please go ahead.

Reuben Garner -- The Benchmark Company -- Analyst

Thank you. Good morning, everybody, and congrats on the quarter.

Scott Zuehlke -- Senior Vice President, Chief Financial Officer, and Treasurer

Good morning, Reuben.

Reuben Garner -- The Benchmark Company -- Analyst

Maybe I had some connection issues at the beginning, so if you already answered this, I apologize. I think I heard you say that your sales were up -- back to up year over year in July. I guess, first, did I hear that correctly? And then, can you tell us how August trended, I guess, maybe across the three businesses?

Scott Zuehlke -- Senior Vice President, Chief Financial Officer, and Treasurer

So you did hear that correctly. On a consolidated basis, July was up year over year. Keep in mind that Europe exceeded expectations across all fronts. So that really helped July.

We're still closing August books, but August was another strong month and that gave us confidence in putting out the guidance that we included in the release.

Reuben Garner -- The Benchmark Company -- Analyst

OK. And then, on the -- your implied margins, I think, for the fourth quarter are kind of even year over year, roughly, I think, at the EBITDA level. Can you just talk about how that looks between gross margin and SG&A? I know you made some cuts on the SG&A front earlier in the year. Should we expect that that's coming back and you maybe get some -- you're starting to get some improvement in the gross margins that's offsetting that?

George Wilson -- President and Chief Executive Officer

Yes. I think the way you're looking at that is correct. In terms of our operational improvements at that gross margin level, there are some projects that we're working on. We've talked about our North American vinyl process improvement and the technology upgrade.

We're starting to see benefits from that project, which we would have expected. And so your view on that is accurate.

Reuben Garner -- The Benchmark Company -- Analyst

OK. And then, last one for me is I heard you mention increased over time in the quarter, I think, in June and July. I'd imagine that running full out is more difficult today than it was last year just given the environment we live in. Is there any opportunity for you guys to the demand environment's, obviously, increasingly or improving.

Is there any opportunity just given some of the costs that you might have to undertake to keep up with demand? Is there an opportunity to push price in any of your businesses, maybe even more so than you would have in other times just because you're facing elevated labor costs and other things associated with COVID?

George Wilson -- President and Chief Executive Officer

Very good question, Reuben. First, in terms of the overtime, I'll comment on that first and then on the pricing second. There was -- the ramp-up was fast. We saw it coming.

However, the reason for the overtime utilization was, first, because of the rate at which it came back. And then, second, because of the difficulties that are in the marketplace, and I'm sure we are not the only person -- we're effectively hiring in almost every plant that we have. And the CARES Act -- and it's hard to get someone to leave unemployment right now to come to work and fill open positions. So recruiting across the board for every position has become at least a short-term challenge, and we know that that's the case for most companies.

So that's why we had to utilize the overtime as much as we did. However, again, our structure allowed for that. And I think we did a fantastic job of fulfilling demand and making sure we were able to capitalize on the orders as they come. In terms of pricing, it's a little -- that becomes more complicated, Reuben.

I mean, we'll, obviously, go after price where we think it's different by each product line and different challenges in each of the regions. So I can tell you, where we are able to go after price, we will do that and have done that.

Reuben Garner -- The Benchmark Company -- Analyst

Great. Congrats, again, and good luck navigating through the rest of the year.

George Wilson -- President and Chief Executive Officer

Thank you.

Operator

Thank you. Our next question comes from Julio Romero from Sidoti & Company. Please go ahead.

Julio Romero -- Sidoti and Company -- Analyst

Hey, good morning. I hope you all are well.

George Wilson -- President and Chief Executive Officer

Thanks.

Julio Romero -- Sidoti and Company -- Analyst

I wanted to start with North American fenestration. If you could talk about what particular product lines have the strongest demand out of -- coming out of July. I think you've talked in the past about the screens leading your growth there and less so from Micron and Spacer. Can you maybe just talk about what you're seeing today in regards to which product lines are driving demand?

George Wilson -- President and Chief Executive Officer

In the quarter, there was strong demand across all the product lines. But that trend of, if I were to rank the opportunities and the ability to grow revenue faster, the market continues to be present more so in the screens area than the other product lines. But we saw consistent strong demand across all three product lines.

Julio Romero -- Sidoti and Company -- Analyst

OK. And on the cabinet side, I guess, your cabinet sales adjusting for that one customer who exited outperformed the KCMA data for the last three months. And I think I saw for the July data for KCMA, semi-custom actually outperformed stock, which was surprising. Can you maybe just talk to what you're seeing there in regards to semi-custom and value and what you're hearing from the customers?

George Wilson -- President and Chief Executive Officer

No, you're exactly right. We saw the spike in demand. And what we're doing is capitalizing on some spot business along with some new sales opportunities that have arisen for us. So the fact that our demand, we have been very busy in all of our cabinet plants.

So I guess, we were pleasantly surprised when we saw the KCMA data. And based on the order pattern that we see, that data is real. It is the first time in a long time that we've seen semi-custom outperform stock. And I think as you continue to have impact from the anti-dumping and the tariffs and combined with the stabilization of the hardwood pricing, that market is kind of catching up with itself and it will balance out.

So we're seeing the same thing, and we are seeing it in terms of our order patterns as well.

Julio Romero -- Sidoti and Company -- Analyst

Got it. And then, just last one for me is, and you touched on it earlier, your balance sheet is in a much better position than it has been in the past and you paid down some debt in the quarter. As we approach 2021, can you maybe talk about what capital projects are maybe top of mind for you?

George Wilson -- President and Chief Executive Officer

In terms of capex operational projects, I could see us -- there's a mix in project that we would like to initiate over in our U.K. vinyl business, as well as probably a Wave 2 of our second vinyl extrusion. The results that we're beginning to see in the initial project are very encouraging. And that could potentially lead to Phase 2 and continue to develop there, as well as the remaining capex will go to support growth.

We mentioned that we have opened up a new screen plant in the Northeast, and we're evaluating other areas of this country that we could expand out as well. So I think that that would be the priority that we'll be looking at going into 2021 for operational projects.

Scott Zuehlke -- Senior Vice President, Chief Financial Officer, and Treasurer

I think for modeling purposes for next year, you should assume a capital budget that's higher than this year. So this year, we just guided to about $25 million. Something higher than that. I don't think that you're going to see us go much more than $30 million to $35 million, but we're going through our budgeting process now, and we'll come out with official 2020 guidance in December.

Julio Romero -- Sidoti and Company -- Analyst

Got it. Yeah, that makes sense. That's it for me. Thanks very much guys.

George Wilson -- President and Chief Executive Officer

Thank you.

Operator

Thank you. Our next question comes from the line of Steven Ramsey from Thompson Research. Please go ahead.

Brian Biros -- Thompson Research -- Analyst

Hi, good morning. This is actually Brian Biros on for Steven. I guess, on the guidance range you guys provided, what would you call out as the biggest drivers to reaching the high or low end of that range?

George Wilson -- President and Chief Executive Officer

So for the higher end of the range, I think what we would consider to see is maybe there's still some pull-through volume and that the seasonality would be favorable to us in that extended build season. Wet weather, obviously, can have an impact either way. So if we get an early hard fall that may drive us toward the low end of the range. But outside of that, it's specifically just timing of customer orders, and I think we're pretty comfortable that we'll be right in there.

Scott Zuehlke -- Senior Vice President, Chief Financial Officer, and Treasurer

I think, Europe continuing to perform as it has over the last couple of months will play a role in ultimately where we fall within that guidance. But as we sit here today, we are comfortable.

George Wilson -- President and Chief Executive Officer

And obviously, I have to put out the disclaimer, anything that happens unknowingly as COVID and some sort of secondary shutdown, but that goes for everyone, I suppose.

Brian Biros -- Thompson Research -- Analyst

Yes, understood. And then, on the -- I guess, just following up on some of the capex commentary you guys gave. On the kind of German spacers unit, I guess, what level of investment are you guys thinking behind that in Q4 and then into '21?

George Wilson -- President and Chief Executive Officer

I think for our European spacer business, I mean, the investment will continue to be very similar to where we're at. So we don't break out our capex to that level of detail between the two product lines in Europe. But we continue to be very happy with what we're seeing in terms of our spacer growth in European and international markets. So we'll continue to invest in that growth and some capacity expansion.

Brian Biros -- Thompson Research -- Analyst

Got it. Thanks so much.

George Wilson -- President and Chief Executive Officer

Thanks.

Operator

Thank you. I show our next question comes from the line of Ken Zener from KeyBanc. Please go ahead.

Ken Zener -- KeyBanc Capital Markets -- Analyst

Good morning, George and Scott.

George Wilson -- President and Chief Executive Officer

Good morning, Ken. How are you?

Ken Zener -- KeyBanc Capital Markets -- Analyst

I'm doing well. Very nice quarter in terms of your operational stability and the cash flow. So windows, screen is doing better as they outsource spacers and extrusion in the other side. Can you talk about what you're seeing or hearing from customers or really the end user preference for having someone come into their house? Because I think one of the big issues or trends we saw in 2Q was smaller ticket items.

I'm just going to Home Depot, let's say, picking up a gallon a paint. Windows are very different because it involves a contractor. And what I'm trying to understand is how much demand might be building up for this product once people get comfortable allowing contractors to come into the house because that could be a real tailwind for, I think, higher-priced items that involve contractors next year. Could you expand on that to the degree you feel comfortable?

George Wilson -- President and Chief Executive Officer

Sure. And we've spent a lot of time talking to our customers about this. I think what we've seen that's evolved, when you replace a window, there's -- although there's contractors in the home, there's able to be separation. It's not like redoing and painting the entire inside of your home.

So there is an ability to separate yourself a little bit. What has changed and I think where our customers have evolved is actually the selling process. So they've -- a lot of our customers have done a phenomenal job of creating online sales tools, virtual selling tools that have replaced that experience where a guy goes in and measures all your windows and does this and that. And so there's new tools that have come out to help facilitate that.

And what we're hearing is that demand for the windows -- and we had the same concern initially, Ken, about what that means. And they have not skipped a beat, and demand has remained very strong. And our customers continue to be optimistic even going into next year. So we've been thrilled at what that has done.

But really the most significant change is in their selling process.

Ken Zener -- KeyBanc Capital Markets -- Analyst

Interesting. Staying on that segment or that business line, the extrusion. Could you just expand upon the -- you talked about delay for the domestic extrusion improvements. Could you clarify that? I'm just a little foggy on that, as well as your comments about Phase 2, if that applies to the U.S.

as well. And just restate the context that has made that business worthy of incremental investments. Why the supply or competitions improve for you on that extrusion? Thank you very much.

George Wilson -- President and Chief Executive Officer

Well, in terms of the delay of the project, the main reason why is the supplier of the equipment is from Austria. So obviously, there's travel restrictions and the ability to send a lot of their technical teams over to launch has forced us to be able to do things different. So installation via Zoom. And the process was a little clunky and slow at first.

But now, what it has done is our team has learned an enormous amount and the technology that we are using to be able to launch with our own asset resources has really picked up speed. So it delayed it initially, but we have recovered and happy with the progress. In terms of the vinyl market itself, there's just -- as we continue to learn what we're good at, what we're learning in the process, we know from that experience and what we've done operationally that we can be competitive. We can win in this market.

So it's more learning about ourselves internally over the course of the last four years of our process and then with new technology and what that's been able to generate for us in terms of benefits. The other thing that we're doing in terms of a vinyl extrusion is we're beginning to extrude in some off markets. So filling up capacity in areas that may not be traditionally just window profiles, but utilizing our extrusion assets as a contract manufacturer has helped our profitability. So that's why you see a little bit of a change in direction, and it's more because of our operational improvements.

Ken Zener -- KeyBanc Capital Markets -- Analyst

Great. And then, Scott, you said $1.7 million in cabinets was the charge in this quarter. Is that correct?

Scott Zuehlke -- Senior Vice President, Chief Financial Officer, and Treasurer

Correct. And there was actually a similar charge in 2Q. So almost $3.4 million and nothing's left there. So if you adjust cabinet results for that inventory writedown, you can really see that the cabinet business is doing very well, much better than it has for us in a long time.

Ken Zener -- KeyBanc Capital Markets -- Analyst

And it's fair to assume prospectively, meaning 2Q and 3Q next year, we should assume the margin base will be adjusted for those charges, correct, as a reasonable comp?

Scott Zuehlke -- Senior Vice President, Chief Financial Officer, and Treasurer

Easier comps next year, correct, for 2Q and 3Q.

Ken Zener -- KeyBanc Capital Markets -- Analyst

Thank you very much, gentlemen. Bye-bye.

George Wilson -- President and Chief Executive Officer

Thank you.

Scott Zuehlke -- Senior Vice President, Chief Financial Officer, and Treasurer

Thanks.

Operator

Thank you. I show no further questions in the queue. At this time, I'd like to turn the call over to Mr. George Wilson, CEO, for closing comments.

George Wilson -- President and Chief Executive Officer

Great. Thanks. We'd like to thank everyone for joining, and we look forward to providing you all an update on our next earnings call, which will be in December. Thank you.

Operator

[Operator signoff]

Duration: 35 minutes

Call participants:

Scott Zuehlke -- Senior Vice President, Chief Financial Officer, and Treasurer

George Wilson -- President and Chief Executive Officer

Daniel Moore -- CJS Securities -- Analyst

Reuben Garner -- The Benchmark Company -- Analyst

Julio Romero -- Sidoti and Company -- Analyst

Brian Biros -- Thompson Research -- Analyst

Ken Zener -- KeyBanc Capital Markets -- Analyst

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