Centex Home Services Company, LLC and Subsidiaries
Notes to Consolidated Financial Statements
December 31, 2007
(dollars in thousands)
(A) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Business Description
The consolidated financial statements include the accounts of Centex Home Services Company, LLC and its wholly-owned subsidiaries Hometeam Pest Defense, Inc. and Hometeam Pest Defense, LLC, collectively referred to as the Company. The Company is a wholly-owned subsidiary of Centex Corporation (“Parent”), a publicly traded Nevada corporation which is primarily engaged in residential construction and related activities, including mortgage financing. Parent is one of the largest homebuilders in the country and is a customer of the Company (See Note I). Certain of the Company’s customer base came as a direct result of new housing construction of Parent, and it is reasonable to presume that this relationship had a favorable impact on the historical operating results of the Company. As such, it is not practical for management to estimate what the financial position, results of operations or cash flows would have been if the Company had been an independent, public company for the historical period presented.
The Company provides pest and termite control services to both residential and commercial customers. It has 50 offices in 13 states and the District of Columbia providing services to approximately 418 thousand customers as of December 31, 2007.
The Company has only one reportable segment which includes its pest and termite control business. The Company’s results of operations and its financial condition are not reliant upon any single customer or a few customers.
On March 28, 2007 the Company entered into an asset purchase agreement to sell substantially all of its assets and the assumption of certain liabilities for $137,000 to Rollins, Inc. The purchase price is subject to adjustment based on net assets as defined in the agreement and reflected on the closing balance sheet date. The transaction is expected to close in April, 2008.
Basis of Presentation
The accompanying financial statements include all of the Company’s costs. These costs include direct charges incurred by the Company as well as direct charges incurred by Parent and billed to the Company for the period presented. Parent does not allocate any additional costs outside of direct costs incurred as these costs, if any, would have little impact to the financial performance of the Company. Management believes that intercompany billings are reasonable; however, the consolidated financial statements may not necessarily reflect the financial position, results of operations, and cash flows of the Company in the future, nor is it practical for management to estimate what the financial position, results of operations or cash flows would have been if the Company had been an independent, public company for the period presented.
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Principles of Consolidation
The Company’s policy is to consolidate all subsidiaries, investees or other entities where it has voting control, is subject to a majority of the risk of loss or is entitled to receive a majority of residual returns. The Company does not have any interest in other investees, joint ventures, or other entities that require consolidation. All material intercompany accounts and transactions have been eliminated.
Estimates Used in the Preparation of Consolidated Financial Statements
The preparation of the consolidated financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the accompanying notes and financial statements. Actual results could differ from those estimates.
Trade Receivables and Allowance for Doubtful Accounts
Trade receivables include amounts due within one year. The Company maintains an allowance for doubtful accounts based on the expected collectibility of accounts receivable. The Company evaluates the adequacy of the allowance on a quarterly basis based on historical collection results, accounts receivable aging information, and other factors in order to determine the expected collectibility of trade receivables. The Company does not require collateral nor does it charge interest on past due accounts receivable. Although the Company considers the allowance for doubtful accounts reflected in its Consolidated Balance Sheet to be adequate, there can be no assurance that this allowance will prove to be sufficient over time to cover ultimate losses related to bad debt as of December 31, 2007.
Materials and Supplies
Materials and supplies are stated at the lower of standard cost (which approximates actual cost on a first-in, first-out basis) or market and primarily consist of pest chemicals and installation materials.
Property and Equipment, net
Property and equipment are carried at cost less accumulated depreciation. Depreciation is calculated using the straight-line method over estimated useful lives assigned to each major asset category as shown below:
Asset Category | | | | Estimated Useful Life | |
Computer Equipment | | | | 3 years | |
Software | | | | 3 years | |
Equipment | | | | 3-5 years | |
Office Furniture and Fixtures | | | | 4 years | |
Automobile and Installation Vehicles | | | | 4 years | |
Leasehold improvements are amortized using the straight-line method over the life of the asset, not to exceed the length of the lease. Repairs and maintenance costs are expensed as incurred.
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Goodwill and Other Intangible Assets
The Company accounts for all business combinations under the purchase method of accounting. The Company first allocates the cost of acquired companies to identifiable assets based on their respective fair values. Goodwill represents the excess of purchase price over net assets of businesses acquired. The Company classifies intangible assets as goodwill or intangible assets with definite lives subject to amortization. The Company does not amortize goodwill. Goodwill is tested for impairment at the reporting unit level on an annual basis (at January 1) or when management determines that due to certain circumstances the carrying amount may not be recoverable. Goodwill is tested for impairment using a two-step process with the first step comparing the fair value of the reporting unit (the Company) with its carrying amount, including goodwill. If the carrying amount exceeds the fair value, the second step is performed to measure the amount of impairment loss to be recognized defined as the carrying value of the reporting unit goodwill that exceeds the implied fair value of that goodwill.
Management periodically evaluates whether events and circumstances have occurred that indicate the remaining balance of goodwill may not be recoverable. Fair value is estimated using a discounted cash flow approach. Key assumptions utilized in the discounted cash flow model include estimated service revenue, estimated cost of services and products sold, and estimated customer retention rates. Material variations of these assumptions may have a significant impact to the carrying value of goodwill. There was no goodwill impairment for the period April 1, 2007 to December 31, 2007.
Impairment of Long-Lived Assets
In accordance with Statement of Financial Accounting Standard (“SFAS”) No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets”, the Company’s long-lived assets, such as property and equipment and intangible assets with definite lives are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of these assets may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to estimated undiscounted future cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated undiscounted future cash flows, an impairment charge is recognized in the amount by which the carrying amount of the asset exceeds the fair value of the asset. There was no impairment of long-lived assets for the period April 1, 2007 to December 31, 2007.
Insurance Accruals
The Company has certain self-insured retentions and deductible limits under its workers’ compensation, automobile and general liability insurance policies. The Company establishes reserves for its self-insured retentions and deductible limits based on its historical claims and an estimate of claims incurred but not yet reported. Projection of losses concerning these liabilities is subject to a high degree of variability due to factors such as claim settlement patterns, litigation trends and legal interpretations, among others. On a quarterly basis, the Company assesses the adequacy of its insurance accruals based on an estimate of unpaid claim exposures and estimates for its incurred but not yet reported exposures for its workers’ compensation, automobile, and general liability policies and adjusts the amounts as necessary. Although the Company considers the insurance accruals reflected in its Consolidated Balance Sheet to be
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adequate, there can be no assurance that this accrual will prove to be sufficient over time to cover ultimate losses. Expenses associated with insurance claims up to the Company’s deductible limits were approximately $3,700 for the period April 1, 2007 to December 31, 2007. As of December 31, 2007, accrued insurance included in accrued liabilities in the accompanying Consolidated Balance Sheet was $9.2 million.
Accrual for Termite Contracts
The Company maintains an accrual for termite warranty claims representing the estimated cost of termiticide reapplications, repairs and associated labor and chemicals, settlements, awards and other costs relative to termite control services beyond the contractual service period. The accrual is based on factors that may impact future cost including termiticide life expectancy and government regulation. The Company considers the accrual reflected in its Consolidated Balance Sheet to be adequate; however, there can be no assurance that this accrual will prove to be sufficient over time to cover ultimate losses (see footnote H for additional information).
Contingency Accruals
The Company is a party to legal proceedings with respect to matters in the ordinary course of business. In accordance with Statement SFAS 5, “Accounting for Contingencies,” the Company estimates and accrues for its liability and costs associated with the litigation. Estimates and accruals are determined in consultation with outside counsel. Although the Company considers its estimate for costs associated with litigation to be adequate, there can be no assurance that such estimate will prove to be sufficient over time to cover ultimate losses. However, in the opinion of management, the outcome of the litigation will not have a material adverse impact on the Company’s financial condition or results of operations.
Income Taxes
The operations of the Company are included in the consolidated U.S. federal income tax return of Parent. The Company accounts for income taxes as if it were a separate taxpayer using the deferral method whereby deferred tax assets and liabilities are provided for the tax effect of differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. In accordance with the provisions of SFAS 109, “Accounting for Income Taxes” (“SFAS 109”) the Company assesses, on a quarterly basis, the realizability of its deferred income tax assets. There was no valuation allowance recorded at December 31, 2007.
On April 1, 2007, the Company adopted Financial Accounting Standards Board (“FASB”) Interpretation No. 48, “Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109” (“FIN 48”). In accordance with the provisions of FIN 48, the Company recognizes in its financial statements the impact of tax return positions or future tax positions if it is more likely than not to prevail (defined as a likelihood of more than fifty percent of being sustained upon audit, based on the technical merits of the tax position). Tax positions that meet the more likely than not threshold are measured (using a probability weighted approach) at the largest amount of tax benefit that has a greater than fifty percent likelihood of being realized upon settlement.
The Company recognizes accrued interest and penalties related to unrecognized tax benefits in the financial statements as a component of the income tax provision, which is consistent with the Company’s historical accounting policy. The Company’s liability for unrecognized tax benefits, combined with accrued interest and penalties, is reflected as a component of accrued liabilities.
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The Company’s adoption of FIN 48 did not require a cumulative adjustment to member’s equity to comply with the recognition provisions of FIN 48. As of December 31, 2007, the Company had no estimated liability for unrecognized tax benefits.
Revenue Recognition
The Company’s revenue recognition policies are designed to recognize revenues at the time services are performed. Residential pest control services are primarily recurring in nature on a quarterly basis. In general, pest control customers sign an initial one-year contract, and revenues are recognized at the time services are performed. Termite baiting revenues are recognized based upon installation and monitoring services performed. The Company recognizes revenue for the delivery and installation of the monitoring stations, initial termiticide treatment, and monitoring services. The entire arrangement fee under the termite baiting and monitoring contracts is recognized over the service period which approximates a straight-line basis. Revenue from traditional termite treatments is deferred and recognized over the annual contract period on a straight-line basis that approximates the timing of the contractual service requirements. All revenues are reported net of sales tax, and the cost of reinspections, reapplications and repairs and associated labor and chemicals are expensed as incurred. For outstanding warranty claims, an estimate is made of the costs to be incurred based upon current factors and historical information (see footnote H for additional information). Unearned revenue consists of amounts of amounts that have been billed and collected based on contractual terms in the underlying customer contract in advance of revenue being earned under contract.
Advertising Costs
Advertising costs are expensed as incurred. Advertising costs for the period April 1, 2007 to December 31, 2007 were $865.
Employee Compensation Arrangements
The Company participates in the Parent’s stock-based compensation arrangements. The Company accounts for such arrangements in accordance with the provisions of SFAS 123(R), “Share-Based Payment” (“SFAS 123(R)”), under which the Company recognizes compensation expense of a stock-based award over the vesting period based on the fair value of the award on the grant date, net of forfeitures. Compensation expense related to share-based awards was $974 for the period April 1, 2007 to December 31, 2007. Share-based awards include the issuance of both stock options and stock units. A summary of the activity of the stock option plans for the period April 1, 2007 to December 31, 2007 is presented below (dollars in thousands, except per share data):
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| | Number of Shares | | | | Weighted – Average Exercise Price | |
Options Outstanding at April 1, 2007 | | 177,091 | | $ | | | 42.93 | |
Options Granted at Fair Market Value | | 37,879 | | | | | 45.53 | |
Options Exercised | | (33,330 | ) | | | | 31.84 | |
Options Cancelled | | (67,502 | ) | | | | 50.59 | |
Options Outstanding at December 31, 2007 | | 114,138 | | $ | | | 42.50 | |
Options Exercisable, End of Year | | 81,285 | | $ | | | 39.58 | |
Weighted-Average Remaining Life (Years) | | 3.8 | | | | | | |
In addition to stock options, the Company also issues stock units. At December 31, 2007, there were 69,480 stock units outstanding. The stock units were issued at a weighted-average grant price of $50.26 and vest over a three to four year period.
During the period April 1, 2007 to December 31, 2007 the Company issued long-term performance awards to employees that vest after three years with an initial aggregate value of $225. These awards will be settled in cash and adjusted based on Parent’s performance relative to its peers in earnings per share growth and return on equity, as well as changes in Parent’s stock price between the date of grant and the end of the performance period. In accordance with the provisions of SFAS 123(R), these awards are accounted for as liability awards for which compensation expense will be recognized over the vesting period with a corresponding increase in the note payable – related party. Compensation expense related to the long-term performance awards during the period April 1, 2007 to December 31, 2007 amounted to $29 and is included in general and administrative expenses in the Consolidated Statement of Operations and Member’s Equity.
From time to time the Company issues deferred cash awards to its employees. The awards vest over various periods and are accounted for as liability awards for which compensation expense is recognized over the vesting period with a corresponding increase to accrued liabilities. Compensation expense related to deferred cash awards during the period April 1, 2007 to December 31, 2007 was $356. At December 31, 2007 accrued liabilities associated with the deferred cash awards were $1,289.
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Fair Value of Financial Instruments
The carrying amounts of trade and short-term receivables, accounts payable, and short-term liabilities approximate fair value because of the short maturity of these instruments. The carrying amounts of long-term notes receivables and notes payable approximate fair value as the effective interest rates for these instruments are comparable to market rates at December 31, 2007.
Recently Issued Accounting Pronouncements
In December 2007, the FASB issued SFAS 141, as revised, “Business Combinations” (“SFAS 141(R)”). The objective of this statement is to improve the relevance, representational faithfulness, and comparability of the information that a reporting entity provides in its financial reports about a business combination and its effects. SFAS 141(R) is effective for the Company on April 1, 2009 and is not expected to have a significant impact on the Company’s financial statements.
In September 2006, the FASB issued SFAS 157, “Fair Value Measurements” (“SFAS 157”), that serves to define fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. SFAS 157 will be effective for the Company as of April 1, 2008. The Company is currently evaluating the impact, if any, of adopting SFAS 157 on its financial statements.
In February 2008, The FASB issued FASB Staff Position (“FSP”) 157-2 that delays the effective date of SFAS 157 for all nonfinancial assets and nonfinancial liabilities, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). Examples of items to which the deferral applies include, but are not limited to, reporting units measured at fair value in the first step of a goodwill impairment test and long-lived assets (asset groups) measured at fair value for an impairment assessment (e.g. inventory impairment assessments). For the Company, the FSP defers the application of SFAS 157 to nonfinancial assets and nonfinancial liabilities to April 1, 2009.
(B) PROPERTY AND EQUIPMENT
Property and equipment cost by major category and accumulated depreciation at December 31, 2007 are summarized below:
| | | | Amount | |
Computer Equipment | | $ | | | 2,815 | |
Software | | | | | 2,501 | |
Equipment | | | | | 1,526 | |
Office Furniture and Fixtures | | | | | 893 | |
Leasehold Improvements | | | | | 687 | |
Automobile and Installation Vehicles | | | | | 535 | |
| | | | | 8,957 | |
Accumulated Depreciation | | | | | (7,883 | ) |
| | $ | | | 1,074 | |
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The Company recognized $679 of depreciation and amortization expense on its property and equipment for the period April 1, 2007 to December 31, 2007.
(C) NOTES RECEIVABLE
As of December 31, 2007, the Company had two notes receivable due from third parties. The notes bear interest at an average rate of approximately 6% and are due in varying amounts through March 2012. In addition, the Company had one note receivable due from a current employee in the amount of $199 at December 31, 2007. The note is non-interest bearing and due on demand.
(D) GOODWILL AND OTHER INTANGIBLE ASSETS
Intangible assets consist primarily of goodwill, customer contracts and non-compete agreements, all of which relate to businesses acquired. A summary of the change in goodwill for the period April 1, 2007 to December 31, 2007 is summarized below:
Balance as of April 1, 2007 | | $ | | 88,367 | |
Goodwill Acquired | | | | | 2,598 | |
Goodwill Disposed | | | | | (1,516 | ) |
Balance as of December 31, 2007 | | $ | | | 89,449 | |
| | | | | | | | | | |
The Company also acquired customer contracts and non-compete agreements in the amounts of $1,051 and $145, respectively, during the period April 1, 2007 to December 31, 2007. Customer contracts and non-compete agreements are amortized on a straight-line basis over the period of the agreements or the estimated lives of the contract, which is typically five years depending on the customer type. The carrying amounts and accumulated amortization for customer contracts and non-compete agreements as of December 31, 2007 were as follows:
| | | | Customer Contracts | | | | Non-Compete Agreements | | | | Total | |
Cost | | $ | | | 11,884 | | $ | | | 4,435 | | $ | | | 16,319 | |
Less: Accumulated Amortization | | | | | 6,202 | | | | | 3,148 | | | | | 9,350 | |
Carrying Amount | | $ | | | 5,682 | | $ | | | 1,287 | | $ | | | 6,969 | |
Total amortization expense for the period April 1, 2007 to December 31, 2007 was $1,997. Estimated amortization expense for each of the next five years ending December 31 is as follows:
2008 | | $ | | 2,655 | |
2009 | | | | | 2,009 | |
2010 | | | | | 1,416 | |
2011 | | | | | 781 | |
2012 | | | | | 108 | |
| | $ | | | 6,969 | |
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(E) INCOME TAXES
The Company’s income tax benefit for the period April 1, 2007 to December 31, 2007 consisted of the following:
Current: | | | | | | |
Federal | | $ | | | (2,796) | |
State | | | | | 54 | |
Deferred: | | | | | | |
Federal | | | | | 910 | |
State | | | | | (368) | |
| | $ | | | (2,200) | |
The primary factors contributing to the difference between the income tax benefit and the federal statutory rate for the period April 1, 2007 to December 31, 2007 were as follows:
| | | | | |
Income Tax at Statutory Rate | | $ | | | (2,387 | ) |
State Income Tax Expense, net of Federal Benefit | | | | | (204 | ) |
Other | | | | | 391 | |
| | $ | | | (2,200 | ) |
| | | | | | | |
The income tax benefit resulted in an effective rate of 32.3% on loss before income tax benefit for the period April 1, 2007 to December 31, 2007. The effective rate differs from the annual federal statutory tax rate primarily due to state income taxes and the non-deductibility of goodwill for income tax purposes related to a disposition.
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Deferred income taxes reflect the net tax effects of the temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and income tax purposes. Significant components of the Company’s deferred tax assets and liabilities at December 31, 2007 were as follows:
Deferred Tax Assets (Liabilities) | | | | | | |
Current: | | | | | | |
Accrued Liabilities | | $ | | | 391 | |
Capitalized Expenses | | | | | (307 | ) |
Allowance for Bad Debts | | | | | 248 | |
| | | | | 332 | |
Long-Term: | | | | | | |
Goodwill | | | | | (14,157 | ) |
Intangible Assets with Definite Lives | | | | | 1,736 | |
Property and Equipment | | | | | 347 | |
Other | | | | | 311 | |
| | | | | (11,763 | ) |
Net Deferred Tax Liabilities | | $ | | | (11,431 | ) |
(F) LONG-TERM DEBT
The Company has notes payable as a result of its various acquisitions. Included in long-term debt is $522 of notes payable to previous sellers who are now currently employees of the Company. The outstanding notes bear interest from 5% to 10% and mature over various dates through April 2017. Debt maturity for each of the next five years ending December 31 is summarized below:
2008 | | $ | | | 1,194 | |
2009 | | | | | 310 | |
2010 | | | | | 153 | |
2011 | | | | | 152 | |
2012 | | | | | 152 | |
Thereafter | | | | | 199 | |
| | $ | | | 2,160 | |
(G) EMPLOYEE BENEFIT PLAN
Benefits are provided to eligible salary and hourly employees of the Company under defined contribution plans sponsored by Parent. The aggregate cost of the plans to the Company was $317 during the period April 1, 2007 to December 31, 2007.
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(H) COMMITMENTS AND CONTINGENCIES
Letters of Credit
In the normal course of business, the Company issues letters of credit pursuant to various lease obligations and insurance programs. The letters of credit expire on various dates through January 2012 and totaled $10,439 as of December 31, 2007. The Company does not believe that these letters of credit will be drawn upon.
Warranties and Guarantees
The Company maintains an accrual for termite claims representing the estimated costs of reapplications, repairs and associated labor and chemicals, settlements, awards, and other costs relative to termite control services beyond the contractual service period. Factors that may impact future costs include termiticide life expectancy and government regulation. The amount is included in accrued liabilities in the Consolidated Balance Sheet. Changes in the Company’s accrual for termite claims during the period April 1, 2007 to December 31, 2007 are as follows:
Balance at Beginning of Period | | $ | | | 1,949 | |
Warranty Expense | | | | | 765 | |
Settlements Made | | | | | (585 | ) |
Balance at End of Period | | $ | | | 2,129 | |
Operating Leases
The Company leases certain property and equipment. Rent expense charged to operations during the period April 1, 2007 to December 31, 2007 was $5,716. Future minimum lease payments for each of the next five years ending December 31 are as follows:
2008 | | $ | | | 2,945 | |
2009 | | | | | 1,883 | |
2010 | | | | | 1,355 | |
2011 | | | | | 1,001 | |
2012 | | | | | 205 | |
Thereafter | | | | | 16 | |
| | $ | | | 7,405 | |
The Company guarantees any deficit on disposal related to certain of its vehicle leases which it leases over a one-year period. Historically, the Company has not incurred any significant cost related to this arrangement. Due to the short-term nature of the agreement and the lack of performance under the guarantee, the fair value of the guarantee is considered nominal.
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(I) RELATED PARTY TRANSACTIONS
The Company participates in a cash management system whereby substantially all cash on deposit is swept daily to a consolidated cash account managed by Parent. Direct costs incurred by Parent are charged to the Company and recorded through the intercompany note reflected in the note payable – related party on the balance sheet. Under this arrangement, amounts outstanding are due on demand and bear interest at prime rate (prime rate at December 31, 2007 was 7.25%).
The Company rents certain office space from Parent. Total rent expense during the period April 1, 2007 to December 31, 2007 associated with leases to Parent was $195.
In the ordinary course of business, the Company provides certain pest and termite control services to subsidiaries of Parent. Sales to the Parent’s subsidiaries totaled $3,881 during the period April 1, 2007 to December 31, 2007 or 3.8% of net revenue.
(J) SUBSEQUENT EVENTS
On January 3, 2008, the Company sold substantially all of the assets and certain liabilities related to a branch in Santa Rosa, California for $1,200. The Company recorded a gain of $304 as a result of this transaction.
At December 31, 2007, the Company’s note payable to Parent was $169,891 including accrued interest of $1,097. On February 28, 2008, Parent contributed equity of $172,000 in cash to the Company. The Company subsequently paid $171,082 to Parent to satisfy its intercompany obligation. The effect of the transaction served to increase Member’s Equity by $172,000 with a corresponding decrease to note payable – parent by $171,082.
On March 10, 2008, the Company acquired substantially all of the assets and assumed certain liabilities of Pest Management of Richmond, Inc. for $1,030 in cash and notes payable. As a result of the acquisition, the Company estimates recording $530 in goodwill and $406 in identifiable intangibles, primarily customer contracts.
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