P.F. Chang's PFCB
December 11, 2006 - 1:51am EST by
2006 2007
Price: 36.22 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 962 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV (in $M): 0 TEV/EBIT

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P.F. Chang’s is one of the cheapest of the major restaurant equities on a P/OCF basis at 8.8x.  Though the stock may still look expensive on a P/E basis (31x est. ’06 EPS of $1.17), it’s actually getting very cheap on its cash flow, especially considering that profitability is currently being constrained due to investment in not one but two development-stage franchises, Pei Wei and Taneko, which have excellent growth potential. 
Several of the more mature restaurant companies – e.g., Applebee’s, Brinker, Darden – also trade at similar if not higher multiples to OCF, but with much less growth potential.  P.F. Chang’s will end 2006 with 261 total locations across three distinct concepts, representing a fraction of the unit count at Applebee’s (1,804 units; 10.0 x OCF), Brinker (1,622 units; 7.7x OCF), or Darden (1,427 units; 9.4x OCF).  The closest comparable to P.F. Chang’s in terms of size and concept distinctiveness is probably Cheesecake Factory (also beaten down) which has a $2.1 billion market cap, 103 locations, and trades for 12.7x OCF.  If you put that same 12.7x OCF multiple on P.F. Chang’s, you’d get a $52 share price.
Business Overview
My wife, who is of Chinese descent, likes to joke that the sign of a truly authentic Chinese restaurant is a mop and bucket in the bathroom right next to a bag of rice.  Even though it’s a joke, it drives home the point that many Chinese restaurants tend to be dives – dives with good food at a reasonable price, but dives nonetheless.  It’s no wonder that Chinese food in America has traditionally been very popular for carry out or delivery, but not usually the spot for a romantic evening or to impress a first date.  At least that was the case until P.F. Chang’s arrived on the scene with their combination of delicious traditional Asian cuisine, sophisticated décor, and American hospitality. 
Founded in 1996, P.F. Chang’s has already developed two successful restaurant concepts, with a third in early development, all centered around the chic Asian theme.  The original concept was the company’s name-sake P.F. Chang’s Chinese Bistro which offers innovative Chinese cuisine using Mandarin style wok cooking in an upscale environment, at a moderate price (average check per person of ~$20).  The second concept, introduced in 2000, was Pei Wei Asian Diner which serves classic Asian favorites in a fast-casual format at a reasonable price (average check per person of ~$10) and tailored to quick dine-in meals or take-out flexibility.  The third concept, having just opened its first prototype location in October, is Taneko Japanese Tavern, a higher-end eatery (average check per person of ~$35) modeled after izakayas, Japan’s own local taverns and pubs, with a culinary focus on grilled and braised dishes roasted in a wood-burning oven, as well as traditional Japanese favorites such as tempura and sushi. 
Unlike some growing restaurant companies that venture into all manners of cuisine, P.F. Chang’s is keeping its focus squarely on the Asian segment, while at the same time aiming to meet a wide variety of consumer preferences, both in terms of culinary tastes and price points.  It’s a winning strategy that is still in the very early innings of growth with presently only 153 Bistros, 107 Pei Weis, and 1 Taneko.
P.F. Chang’s success these past ten years has attracted many would-be competitors, but none of which have succeeded.  In fact, the only other major branded Asian concept of any size is Panda Express.  This subject was discussed at the company’s recent investor day on November 9, with the following comments from CEO Rick Federico:
“… we have had a lot of what I think are very, very good companies, particularly very good branded companies, that have attempted to get into the Asian space.  And for one reason or another, they have not been able to gain the traction that you might expect, given the quality of the operators that are trying to find a way to enter into the Asian food business.  Our friends at Outback and our founder tried to develop the Paul Lee business. Our friends at Darden very early on were involved with China Coast.  Our friends at Brinker tried to partner with Rich Melman in the development of Big Bowl.  Our Yum! brand competitors have worked on the development of a Pei Wei-like business, which was [Yan Tan].  And nothing has seemed to take hold in the marketplace.  And I wish I could tell you why, other than in order to execute a concept like a P.F. Chang's or a Pei Wei, and now like a Taneko, is not an easy proposition.  It is a very complex and very challenging culinary experience and requires incredible amounts of training and focus and attention in order to execute at the highest level 100% of the time.”
If anything, P.F. Chang’s is positioned to be a share taker, especially at the low-end through its Pei Wei concept.  There are now close to 36,000 Chinese restaurants in the United States, according to trade publication Chinese Restaurant News (as cited by The New York Times in a Sep 2004 article), which is more than the combined number of U.S.-based McDonald's, Wendy's and Burger King franchises.  Most of those 36,000 Chinese restaurants are small, family-run establishments with little differentiation, providing easy prey for Pei Wei which offers similar if not better food at a similarly low price point and with much more appealing atmosphere. 
Below is a snapshot of P.F. Chang’s historical financial performance, both for the company as a whole, as well as the individual concepts through 2005:
$ millions
OCF Margin
Net Cash
Diluted S/O
·          OCF excludes tax benefits from stock options and minority interest-related cash flows.
·          Capex includes purchases of PP&E and capitalized interest expense.
·          ROIC is calculated as net operating profits after tax (at a constant tax rate of 32.5%, which is PFCB’s rough average over the past six years) divided by end-of-year invested capital (shareholder’s equity + net debt).
P.F. Chang’s Chinese Bistro
Pei Wei Asian Diner
$ millions
# Units
Op Inc.
# Units
Op Inc.
·          Segment operating income is pre-tax income before corporate overhead.
·          ROIC is calculated as restaurant-level pre-tax income (i.e., before either segment or corporate overhead) divided by restaurant-level invested capital including the present value of remaining lease obligations.
Market Misunderstandings
Retail and restaurant businesses are some of the simplest and most easily understood of all equities, and yet for several reasons unique to P.F. Chang’s growth strategy, this is actually an underappreciated business suffering from a number of investor misperceptions. 
First, a bit of history.  P.F. Chang’s early growth propelled it to become a stock market darling, rising from its December 1998 IPO price of $7.75 (split-adjusted) to an all-time high of $65 in July 2005, marking a compound annual growth rate of nearly 39%.  At its $65 peak, P.F. Chang’s was valued at an EV of $1.7 billion, giving it a P/E of 45.5x and EV/OCF of 18.0x.  Since then, however, PFCB has fallen 44% from its highs as growth investors gave it the boot due to slowing EPS growth and weak comp store sales.
P.F. Chang’s came under particularly severe selling pressure in the first half of 2006 after management twice reduced its earnings forecast due to weaker-than-expected comp store sales.  Coming into 2006, management had expected comp gains of 1.9% for the Bistro and 2.1% for Pei Wei.  Now, as of the latest revision following Q3 earnings on October 25, management is expecting 2006 comps to be down 0.3% for the Bistro and down 2.2% for Pei Wei.  This caused a reduction of forecasted 2006 EPS from an original estimate of $1.39 to the latest revision of $1.26 (both of which exclude stock-based compensation of an expected $0.28 per share).  As a result, PFCB this year is facing its first YOY earnings decline, with reported EPS expected to be down by 10% ($1.40 to $1.26). 
Declining EPS and weak comps have many investors wondering whether P.F. Chang’s is losing its edge, and some are even questioning the popularity and sustainability of its concepts.  Let me address several areas of investor concern and attempt to explain why those concerns are misplaced.
1) Overemphasized comp store sales.

Retail investors have a nasty habit of fixating on comp store sales and using that single metric to judge a retail operation’s health and direction.  In the case of P.F. Chang’s, comps at the Bistro have been trending down for the past several years, and more recently Pei Wei’s comps have turned negative.  This has led investors to the simple conclusion that both of these concepts are growing stale with consumers. 

Comp Store Sales
FY 2003
FY 2004
FY 2005
Q1 - 3/06
Q2 - 6/06
Q3 - 9/06
    Pei Wei

Softer consumer demand may be partly to blame, but the much larger issue is the company’s expansion strategy which places new units in close proximity to existing units, causing deliberate cannibalization.  This cannibalization is mostly in the form of Pei Wei vs. Pei Wei, but it also occasionally is in the form of Bistro vs. Bistro or even Pei Wei vs. Bistro.  Management’s strategy is to in-fill markets where existing units have the strongest traffic and highest ROIC, because that’s where new units are most likely to offer the highest returns.  Geographical concentration also creates greater brand awareness, and offers the potential for advertising efficiencies. 

If you listen to P.F. Chang’s conference calls, you discover that management is willing to sacrifice some temporary cannibalization in order to more deeply penetrate existing markets.  This strategy hurts comps at the existing units in the short run, but it leads to maximization of returns on invested capital in the long run. 
2) Underappreciated potential for Pei Wei.

Pei Wei presently accounts for 18.6% of overall revenue, and yet contributes exactly zilch to the company’s pre-tax income.  Because of the lack of profit contribution, I believe the market is overlooking Pei Wei as a value driver.  This is a classic Wall Street mistake – to ignore an unprofitable division that’s quietly building value. 
Below is a view of Pei Wei’s historical profit contribution:

Pei Wei Contribution
FY 2000
FY 2001
FY 2002
FY 2003
FY 2004
FY 2005
Pei Wei Revenue ($M)
Pei Wei Pre-tax Profit ($M)
Overall Pre-tax Profit ($M)
% Pei Wei Contribution

Pei Wei has grown its unit locations by 106% in 2003, 61% in 2004, 45% in 2005, and is on its way to 39% unit growth in 2006.  During this hyper-growth phase, management’s strategic aim has been to invest in a base of locations, along with infrastructure and management, which can generate strong future returns on capital. 

At some point over the next several years, Pei Wei’s value will become evident as the segment shifts to sustained profitability.  When this shift happens, the company will experience a nice bump in overall earnings and cash flow.  At that point, I expect the market to wake up and begin assigning Pei Wei the value it deserves.  This probably represents one of the most significant fundamental catalyst for the stock over the next several years.

3) Underrated profit margins due to introduction of stock comp expensing.

Through the first nine months of 2006, P.F. Chang’s net margin is 3.6%, which is down from 4.8% in the first nine months of 2005.  It’s natural to suspect this reduced profitability must be due to rising utilities costs, wage inflation, lower comps – or some combination of all the nasty pressures currently facing retailers and restaurateurs.  But in fact, of the 120bp decline in net margin, fully 108bp was actually due to the 2006 introduction of required stock-based compensation expense.  In other words, had it not been for the advent of stock comp expensing, this year’s net margin would’ve been virtually identical to last year’s. 

A more accurate way to judge P.F. Chang’s year-over-year margin situation is to look at OCF, which adds back the impact of stock-based compensation to give us a true apples-to-apples comparison.  (Note regarding PFCB’s OCF:  Minority interest expense, though non-cash, should be treated as a true economic expense.)  On this basis, P.F. Chang’s through nine months of 2006 has seen its OCF grow by 22.9% YOY to $67.7 million, up from $55.1 million in the same period of 2005.  The margin comparison between these two periods is a 9.9% OCF margin in 2006 versus 9.3% in 2005.  Surprise, surprise – P.F. Chang’s margins aren’t declining, they’re rising!  My suspicion is that the market is totally missing this.
4) Overblown P/E ratio.

Based on P.F. Chang’s trailing reported earnings of $1.25, the P/E ratio is a not-so-cheap-looking 29x.  And on a forward basis, with 2006 EPS estimated at $1.17, that’s an even loftier P/E of 31x.  How can we reconcile such a high P/E with any pretensions of value?  The answer is that P.F. Chang’s has several categories of expenses that are either overstated or utterly non-economic in nature:

First, there’s D&A which is very high because of the significant upfront cost of building new restaurants ($2.7 million for a Bistro; $0.8 million for a Pei Wei).  D&A over the past year was $43.5 million, or 4.8% of revenue.  I estimate that those D&A charges are about four times higher than the maintenance capex necessary to support the existing business.  P.F. Chang’s 10-K breaks out the amount spent on new construction, from which it can be deduced how much is being spent on maintenance-related capex.  Based on this disclosure, it appears that true annual maintenance capex is roughly $50,000 per Bistro, $15,000 per Pei Wei, plus an additional $3 million for general corporate purposes (e.g., IT infrastructure). 
Second, there’s pre-opening expense which is analogous to growth capex – it’s a cost of growth, but a cost that goes away upon maturity.  TTM pre-opening expense was $11 million, or 1.2% of revenue.
Third, there’s something called “partner investment expense,” which is a non-cash, non-economic expense that’s essentially just a form of amortization.  This expense arises due to P.F. Chang’s store-level partnership structure which allows store managers to invest capital and earn a portion of that store’s cash flow (more on this later).  When P.F. Chang’s receives this partnership capital, they have to amortize whatever portion is above the so-called “fair value.”  The details of this expense are unimportant – what matters is that it’s an expense with no economic impact whatsoever.  This “partner investment expense” was $4.1 million over the TTM, or 0.5% of revenue.  (FYI, the cash flows that go to these partners are accounted for as “minority interest expense” which, though non-cash, I treat as a real expense and exclude it from OCF.) 

Add up those above three expenses, and that comes to $58.6 million in what I’d broadly categorize as “overstated” expenses.  That’s a big number compared to P.F. Chang’s reported profits of only $33.8 million.  This is why P.F. Chang’s has chronically understated earnings, and therefore a chronically overstated P/E.  Thus, to the casual observer, P.F. Chang’s appears richly valued, even though it’s not.

My solution is to ignore earnings and instead focus on OCF (less minority interest expense) minus maintenance capex, which sums to maintenance FCF, or MFCF.  For the TTM thru Sep ’06, OCF of $109.7 million less maintenance capex of roughly $12.3 million (assuming 153 Bistros, 107 Pei Weis, and $3 million of general corporate capex), which gets us to MFCF of $97.4 million ($3.67/sh).  That’s 2.9 times higher than reported net income.  So while the market sees a P/E of 29x, I see a P/MFCF of only 9.9x.

Management and Operator Incentives
P.F. Chang’s top three execs all came with significant prior experience at Brinker International (NYSE: EAT), the $3.0 billion industry giant that owns Chili’s, Macaroni Grill, Maggiano’s, Corner Bakery, and On the Border.  Here’s a summary profile of the top three execs:
·         Chairman & CEO Richard Federico (age 51) joined P.F. Chang’s as President in 1996, after having served as President of Brinker’s Italian Concepts division which he grew from one unit in 1989 to more than 70 units by 1996. 

·         Robert Vivian (age 47) joined P.F. Chang’s in 1996 and served as the company’s CFO until December 2000, after which he took his current role as President of the P.F. Chang’s China Bistro concept.  From January 1991 to April 1996, Mr. Vivian served in a variety of positions at Brinker International, Inc., the most recent of which was Vice President of Investor Relations.

·         Russell Owens (age 47) joined the Company as President of Pei Wei Asian Diner, Inc. in May of 2001.  Prior to joining the organization, Mr. Owens served as Executive Vice President and Chief Financial and Strategic Officer of Brinker International, Inc. During his 18-year tenure at Brinker, Mr. Owens served in a variety of positions, including Senior Vice President of Operations Analysis and Senior Vice President of Strategic Development for Italian Concepts. Prior to joining Brinker, Mr. Owens worked for the public accounting firm, Deloitte & Touche, LLP.
So we see several common threads here:  significant overlapping experience at Brinker (and presumably shared values based on that experience), financial expertise (for Vivian and Owens), and all of prime executive age with plenty of good years ahead.  This seems like the makings for a very successful team.
Turning to some of my personal observations, based on everything I’ve read and seen of this management team, I’m struck by their financial transparency, their straight-shooting communication, their ROIC discipline, and their long-term perspective. 
First, regarding financial transparency, P.F. Chang’s management at the beginning of each year publishes a comprehensive financial forecast for the year ahead, including comp store sales, revenue, expenses by line item, all the way down to EPS.  Commenting on this practice, President Robert Vivian said the following on the Q2 ’06 call:  “With our detailed forecast we obviously set ourselves up for lots of opportunities to be wrong, but that’s okay.  I think the intent is to make sure that everyone has a good understanding of what our business looks like and our current thoughts on the business.” The only other company I’ve ever known to be so transparent is Kinder Morgan, who did virtually the same thing. 
Second, regarding their straight-shooting communication, listen to any of P.F. Chang’s quarterly earnings calls and you’ll see these guys never try any promotional spin.  Here are a couple of quick examples from the Q3 ’05 call which was a tough quarter due to Hurricanes Katrina and Rita:  “In summary, it was not a high quality quarter by any stretch of the imagination. [Robert Vivian]” “Frankly, I’m embarrassed by how we performed this year in development and it’s been that way since the beginning of the year. [Russell Owens]”  Another example came on the Q4 ’05 call when an analyst asked whether it’d be reasonable to expect less cannibalization impact in ’06 versus ’05.  Robert Vivian’s answer:  “Well, boy, I’ll tell you I wouldn’t be so bold as to say that.”  Perhaps my favorite example came on the Q1 ’06 call, in response to an analyst question about the Easter impact of whether sales were diverted from March to April:  “The Easter bunny comes every year, and what I told our folks was, ‘Look, I don’t care it if is in March or April, just so long as people come.’  So we didn’t spend a whole lot of time worrying about whether we lost a body in March and we picked it up in April or vice versa, so I really can’t answer that question specifically. [Robert Vivian]”
Third, regarding ROIC discipline, P.F. Chang’s website contains a year-by-year ROIC analysis of each concept going all the way back to the company’s founding in 1996.  ROIC also plays a major role in executive compensation, in which bonuses are 50% weighted according to management’s performance versus its planned ROIC (with the other 50% weighted by EPS).  Finally, the earnings conference calls are peppered with comments that reveal management’s ROIC mindset.  The earlier excerpts in the section on overemphasized comp store sales show that this management team cares far more about maximizing ROIC than its quarterly sales comps.
Fourth, regarding long-term perspective, here are a couple of longer excerpts that I think show the long-term mindset that’s guiding this company’s decision making:
[Analyst question:  It seems like you've got two competing issues, higher labor costs and then the sensitivity around the consumer, and therefore pricing, so which do you think you would do? Which are you more sensitive to? Do you want to protect margins throughout the year with pricing or would you rather drive the traffic in the sacrifice margins in the near term?]  RESPONSE:  The truth of the matter is and the guests really don't care if our costs are up. They just care about great food and great service. That's really what our focus is on. We believe if we do the right things the right way, that we will continue to have a long-term business here, and that's really what we focus on. We know that there is going to be ups and downs in the economic cycle. We know that the consumer is going to run hot and cold. We can't do a whole lot about that. We focus on the things that we have some control over. That's taking care of our employees and taking care of our guests. [Robert Vivian; Q1 ’06 call]
[Analyst question:  Rick, one for you. You began the conference call by talking about having lived through periods like this more than 15 years ago. Just kind of curious to get your perspective on how you're thinking about this environment, what period specifically in the past you're comparing it to and what you think similarities and differences might be.]  RESPONSE:  Joe, the most relevant period, probably the most challenging period that both Russell and I and Bert went through was probably around '91. A lot of people were sitting around watching the war. We were in the beginnings in growing recession and there was a very definitive consumer shift in terms of where they were spending money and what their trading patterns were. My confidence in being proactive through periods like this comes from having watched guys like Norman Brinker initiate things in their businesses that were very proactive and very focused on product quality and very focused on the employee and the guest and as that cycle worked its way through, you can go back and see some of the dynamic changes and shifts in their business as you got into like '93 and '94 and beyond. So I guess I rely on people that are a little smarter than I am and history to say that this is an opportunity for us to be aggressive in terms of enhancing the experience for the guest and that will benefit it from -- on the back side.  [Rick Federico, Q2 ’06 call]
P.F. Chang’s doesn’t have high inside ownership (only 5.9%), but it does have good incentive systems in place for both the senior officers and key restaurant-level operators.  I mentioned earlier that the senior execs have their bonuses tied significantly (50%) to ROIC.  In addition, P.F. Chang’s management philosophy allows regional managers, general managers and executive chefs to become partners at the inception of each restaurant’s business and participate in the cash flows of the restaurants for which they have responsibility. 
Concept Growth Potential
When asked the inevitable question about the  potential universe for either the Bistro or Pei Wei, management has used it as an opportunity to re-affirm their ROIC discipline – which is to keeping expanding as long as incremental returns on capital justify the new investment.  I find it refreshing to see a management team devoted to a rational course of action, rather than some preconceived unit count goal.  Nevertheless, because the question has been asked so often, management has begun to suggest the potential for at least 250 Bistros, while saying it’s simply too early to judge the potential for Pei Wei.
Using management’s guidance as a starting point, here’s my stab at a conservative growth outlook:  At the rate of current Bistro expansion (18-20 per year), that concept would reach 250 units by 2011.  I think 250 units is a very conservative expectation compared to other mid-priced casual dining concepts such as Red Lobster (648 units), Olive Garden (557 units), and Outback Steakhouse (900 units).  I believe we could reasonably forecast 300 Bistros, but I’ll stick with 250 to be conservative. 
As for Pei Wei, I’m assuming the current trajectory of unit count expansion will continue to expand by an additional 5 units per year (i.e., 36 new units in 2007, 41 in 2008, 46 in 2009, etc.), topping out at 50 per year (due to a constraint of quality locations and quality restaurant operating personnel). That would put Pei Wei on-track to surpass 500 units by 2015.  I consider 500 units for Pei Wei a very achievable goal.   As one point of reference, Chipotle is already closing in on 500 units.
Finally, as for the new Taneko concept, management has indicated that it will operate its prototype location (Scottsdale, AZ) for at least six months before making a decision on any additional locations.  As of now, I’m not modeling any specific contribution from Taneko, so let that be considered a free call option.
At a current price of $36.22, P.F. Chang’s carries a market cap of $962 million.  The balance sheet has a small amount of net cash, so the EV is virtually the same as market cap.  The company has historically plowed all of its OCF back into new unit expansion, leaving no FCF to speak of.  But capex is of course heavily weighted towards growth efforts.  That portion of capex necessary for maintaining the current store base is only about $12 million.  (Management actually estimates their 2006 maintenance capex at $7-8 million, but I’ve tried to be a bit more conservative in my assumptions.)  My specific maintenance capex assumptions, per year, are:  $50K per Bistro, $15K per Pei Wei, and $3 million for general corporate purposes.  Based on these assumptions, P.F. Chang’s maintenance FCF is approximately $97 million.  That puts the current P/MFCF at a very reasonable 9.9x.  In other words, if P.F. Chang’s were to stop its new unit expansion, the existing business would be well positioned to generate a FCF yield of roughly 10% per annum.  That provides a solid margin of safety within the current price.
But of course I expect P.F. Chang’s to grow and for that growth to create considerable value.  Using a DCF model that assumes 250 Bistros by 2011 and 500+ Pei Weis by 2015, I value PFCB today being worth somewhere in the mid-$50 per share range.  At $55, the trailing P/OCF multiple would be 13.3x.  By way of comparison, growth-oriented restaurant chains frequently trade at higher multiples to OCF – e.g.,  Texas Roadhouse (13.9x), IHOP (14.6x), Chipotle (16.7x), and Panera (17.9x).
Stock Repurchase Program
The P.F. Chang’s board also apparently recognizes that their stock is cheap.  In July of this year, concurrent with the Q2 earnings release, the board authorized a $50 million repurchase plan, and then wasted no time executing on it.  In Q3 alone, the company spent $39.5 million to repurchase 1.2 million shares – representing an incredible 4.5% of shares outstanding at an average price of only $32.92.  In early Q4, the company followed up with an additional 0.2 million shares purchased around $35/share.
The restaurant sector is notorious for short-lived concepts that destroy capital, making the sector a happy hunting ground for short sellers.  P.F. Chang’s itself has attracted significant short selling interest, with 26.5% of its shares sold short as of November 8.   But I believe the shorts have severely misjudged this one based on its high notional P/E, weak comp store sales, and perhaps some notion that P.F. Chang’s is a fad.
Clearly I have a variant perception on P.F. Chang’s.  Where the market sees sluggish comps, I see an intelligent growth strategy that’s aiming for deep market penetration and maximization of ROIC.  Where the market sees little value in Pei Wei, I see a concept with real legs and the potential to add meaningfully to overall profits within several years.  Where the market sees contracting net profit margins, I see expanding OCF margins.  And where the market sees a sky-high P/E, I see a rock-bottom P/MFCF. 

If the current growth path succeeds in reaching 250 Bistros and 500 Pei Weis, then the stock has a present value of $50+ per share.  And that’s not even counting the upside if expansion continues to 300 Bistros, 750 Pei Weis, and an untold number of Taneko Japanese Taverns.  Any of those factors could allow the stock to be worth much more.



-Easier comps in 2007
-Pei Wei profitability
-Early success of Taneko
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