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Edited Transcript of ARR earnings conference call or presentation 15-Feb-19 1:30pm GMT

Q4 2018 ARMOUR Residential REIT Inc Earnings Call

VERO BEACH Feb 18, 2019 (Thomson StreetEvents) -- Edited Transcript of ARMOUR Residential REIT Inc earnings conference call or presentation Friday, February 15, 2019 at 1:30:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* James Robert Mountain

ARMOUR Residential REIT, Inc. - CFO, Treasurer & Secretary

* Jeffrey J. Zimmer

ARMOUR Residential REIT, Inc. - Co-CEO, Co-Vice Chairman & President

* Scott J. Ulm

ARMOUR Residential REIT, Inc. - Co-CEO, Co-Vice Chairman & Chief Risk Officer

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Conference Call Participants

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* Christopher Whitbread Patrick Nolan

Ladenburg Thalmann & Co. Inc., Research Division - EVP of Equity Research

* David Matthew Walrod

JonesTrading Institutional Services, LLC - MD & Head of Financial Services Research for New York Office

* Douglas Michael Harter

Crédit Suisse AG, Research Division - Director

* Trevor John Cranston

JMP Securities LLC, Research Division - Director and Senior Research Analyst

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Presentation

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Operator [1]

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Ladies and gentlemen, thank you for standing by, and welcome to the ARMOUR Residential REIT, Inc., Fourth Quarter 2018 Earnings Conference Call. (Operator Instructions) As a reminder, this conference is being recorded on Friday, February 15, 2019.

I would now like to turn the conference over to the Chief Financial Officer, Mr. Jim Mountain.

Please, go ahead.

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James Robert Mountain, ARMOUR Residential REIT, Inc. - CFO, Treasurer & Secretary [2]

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Thank you, Frank. And thank you all for joining our call today to discuss ARMOUR's fourth quarter 2018 results. This morning, I am joined, as usual, by ARMOUR's co-CEOs, Scott Ulm and Jeff Zimmer; and by my colleague Mark Gruber, our Chief Operating and Chief Investment Officer. By now everyone has access to ARMOUR's earnings release and Form 10-K, which can be found on ARMOUR's website, www.armourreit.com.

This conference call may contain statements that are not mere recitations of historical fact and, therefore, constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. All such forward-looking statements are intended to be subject to the Safe Harbor protections provided by the Reform Act.

Actual outcomes and results could differ materially from the outcomes and results expressed or implied by the forward-looking statements due to the impact of many factors beyond the control of ARMOUR. Certain factors that could cause actual results to differ materially from those contained in the forward-looking statements are included in the Risk Factors section of ARMOUR's periodic reports filed with the Securities and Exchange Commission. Copies are available on the SEC's website at www.sec.gov.

All forward-looking statements included in this conference call are made only as of today's date, and are subject to change without notice. We disclaim any obligation to update our forward-looking statements unless required to do so by law.

Also, our discussion today may include references to certain non-GAAP measures. A reconciliation of these measures to the most comparable GAAP measures is included in our earnings release, which can be found on ARMOUR's website. An online replay of this conference call will be available on ARMOUR's website shortly and will continue for one year.

ARMOUR's Q4 GAAP net loss was $212 million or $5.07 per common share. The net loss was driven by -- driven primarily by mark-to-market movements of our interest rates swaps and sales in our Agency MBS portfolio, which caused largely prior quarter mark-to-market valuation adjustments to move out of comprehensive income and flow through fourth quarter P&L.

Core income, which excludes mark-to-market items and includes TBA Drop Income was $32.2 million or $0.64 per common share.

For the last 10 straight quarters, our core earnings have exceeded dividends. Through December 31 that access totaled $33.5 million, which represents about $0.77 per common share outstanding at year-end.

Based on stockholders' equity at the beginning of Q4, core income represents an annualized return on equity of 10.6%.

ARMOUR's quarter-end portfolio consisted of over $7.1 billion of Agency Securities, another $900 million of Agency TBA positions, and approximately $800 million of credit risk and nonagency positions.

Quarter-end book value was $20.86 per common share. That's a down $2.63 for the quarter, due primarily to continued rate increases and spread widening. Adjusted for dividends that represents a total economic return of minus $2.06. GAAP book value at February 13, 2019, was estimated to be approximately $21.39 per common share outstanding.

Remember that we include recent book-value estimates in our update presentations available on our website or EDGAR. Usually they come out around the middle of the following month.

We paid dividends of $0.19 per common share during each month in the fourth quarter, and for -- that totals $24.5 million or $0.57 per common share. We've announced monthly common dividends for the first quarter of 2019, continuing the steady rate of $0.19 per share per month.

We're also -- we were also active in the equity markets. We raised over $185 million since we last spoke to you.

We issued approximately 9,125,000 common shares through our aftermarket offering program with securities dealers, directly to investors through investor waivers as part of our dividend reinvestment and stock purchase program and in the underwritten block trade in January in 2019.

Now we have 51,486,573 shares of common stock outstanding.

Now let me turn the call over to Co-Chief Executive Officer, Scott Ulm, so that he can discuss ARMOUR's portfolio position and our current strategy. Scott?

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Scott J. Ulm, ARMOUR Residential REIT, Inc. - Co-CEO, Co-Vice Chairman & Chief Risk Officer [3]

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Thanks, Jim. Good morning. The completion of third quarter of 2018 served as a calm before the storm precursor to the fourth quarter's volatility. By early fall, a looming trade war, a gridlocked congress and down trending data out of Europe and China have gathered like dark clouds over economic projections for 2019 and 2020. Suddenly the Fed's vision of a tighter monetary policy on autopilot collided with market's growing concerns over maturing economic cycle. Widening credit spreads and rising funding costs cut quickly into growth expectations resulting in the worst quarterly plunge for the U.S. equity market since 2011. Yields on the 10-year treasury declined by 55 basis points from their highs of 3.24% down to 2.69% on December 31.

The yield on the 2-year note declined in step with longer tenders, ending the year at 2.49% or just 9 basis points above Fed funds, implying almost no chance of further Fed hikes in the near term. Due to their superior liquidity and U.S. government backing, agency MBS served as a haven in the turbulent markets and outperformed credit by a wide margin.

However, negative convexity and exposure to volatility meant that agency mortgage bonds couldn't keep up with the U.S. Treasury and interest rates swap curves, resulting in wider mortgage spreads versus both.

This was particularly pronounced in higher coupon MBS, where high risk of refinancings and shorter duration led to underperformance versus lower coupon cohorts.

The CRT, or Credit Risk Transfer, market traded in sympathy with widening credit. Newer 2017 and 2018 vintages underperformed more seasoned M2 cohorts by as much as 30 basis points, supporting our negative view on weaker credits in newer issues.

As we noted last quarter, we view the new issue CRT market as nearly fully priced, but acknowledge that strong participation and support of housing markets will -- may provide tailwinds to valuations for a while.

Last quarter, we modestly reduced our CRT exposure. In doing so, we were pleased to find the sector exhibited fine liquidity amongst the broker community. Despite their positive convexity in GOC guarantee, spreads on 10 -- 9.5% DUS pools have maintained higher correlation to high-grade credit markets and widened by nearly 20 basis points during the fourth quarter, their cheapest since early 2016. This move presented a rare opportunity to add a positive convexity instrument to the portfolio at historically attractive levels, prompting us to increase the allocation of this asset class to 22% of our entire portfolio.

The bias to higher coupons in our agency MBS portfolio was one of the main drivers for book-value underperformance. Spread widening in CRT, DUS and Ginnie 2 swaps added an additional drag on the performance, albeit to a lesser degree.

You can view our December 31, 2018 portfolio in our 10-K, but after our recent capital raise, ARMOUR's positioning, as of January 31, 2019, is as follows: We've maintained a hedged book of paid fixed, received floating swaps of $8.8 billion no-show. Our agency fixed rate repo position was covered 103.5% by swaps. Our net duration was negative 0.28 basis points, an increase of negative 0.49 at the end of the year. This number does not include any negative duration effects from our repurchased liabilities.

Our spread DV01, at January, 31, was $5.8 million. We anticipate that core earnings will cover our dividends during the first quarter of 2019.

As of January 31, our funded leverage ratio, or debt-to-equity, was approximately 6.1x. Adding in the leverage effect of unfunded TBA dollar-roll positions and forward-settling transactions, results in an implied leverage of 8.2x as of January 31.

While TBA dollar rolls are no longer trading at the levels specialists observed over the past few years, we continue to find pockets of opportunities where dollar-roll financing is more favorable than the general collateral repo market.

The average prepayment rate on our agency assets decreased from 6.1 CPR in the third quarter to 4.7 CPR in the fourth quarter. Our January 2019 CPR was even lower at 3.9 CPR. It is important to note that a good portion of our agency portfolio is composed of assets with prepayment protection through lower loan balances or contractual prepayment lockouts, as in our DUS paper.

Repo financing remains consistent and reasonably priced for our business model. ARMOUR is currently active with 23 repo counter parties, and in addition, has signed MRAs with another 25. Total repo financing was $7.9 billion at the end of January 2019.

Importantly, our affiliate BUCKLER Securities is financing approximately 49% of our entire repo position and 53% of our agency portfolio liabilities. Financing through BUCKLER provides us with greater control over our liabilities.

Our best and in-credit risk transfer securities was valued at $734 million at the end of January of 2019, and represented 89% of our credit risk and non-agency portfolio.

In the CRT transactions, we take the credit risk of Fannie and Freddie underwriting in return for an uncapped floating-rate coupon. The credit quality of our CRT bonds has continued to be reliable due in large part to strong GSE underwriting standards on the 2013 to 2016 vintages that we own.

In addition, these securities benefit from increasing credit enhancement over time that can lead to credit rating upgrades. 59% of our CRT portfolio has been upgraded to investment grade.

Rating upgrades resulted in better financing terms and possible price appreciation.

At the end of January, ARMOUR owned 71.8 million of nonagency legacy RMBS. Currently, we see very few opportunities for investment in this asset class.

However, our existing holdings from that period continue to perform well. Although, the jumbo and non-QM market issuances is, again, projected to double versus 2018, nonagency mortgage issuance remains very low on a historical scale, keeping spreads tight. Given the tight valuations in the nonagency markets, we currently see better opportunities in agency collateral.

As of February 13, our estimated book value on a GAAP basis is up 2.5% since year-end, driven by spread tightening.

2019 presents new uncertainties as robust economic at home and abroad is being questioned. Although valuations are regained some of their losses after a tough fourth quarter, we are encouraged by Fed Chairman Powell's doveish stance to maintain easy financial conditions to keep our economy on track.

The strong response from the Fed also bodes well for bond spreads and broad-market volatility, a tailwind for ARMOUR's portfolio. Our response has been to take advantage of recent wide spreads by deploying the newly issued capital, and increasing our leverage back from historical lows. While we like spread risk, we maintain a neutral to a slightly shorter stance on duration.

Operator, that concludes our prepared remarks, and we will now take any questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question comes from the line of Douglas Harter with Crédit Suisse.

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Douglas Michael Harter, Crédit Suisse AG, Research Division - Director [2]

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Just following up on one of the last comments that you made about leverage, I guess, where do you see kind of leverage going to? And what is, kind of, the right level in this current environment?

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Jeffrey J. Zimmer, ARMOUR Residential REIT, Inc. - Co-CEO, Co-Vice Chairman & President [3]

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This is Jeff. So the apex in spread widening was the day after Christmas. And since then, 30-year force, for example, are in, say, 3 OAS , 15-years in 5 OAS. Since that period of time, DUS bonds, which were trading at 70% to 71% off swaps, are now into the 60- to 61-ers percent, so they've tightened quite a bit. However, at 8.2x leverage, should spreads widen a little bit, we have some dry powder. So I would not expect at this point, our leverage to go down, if we see opportunities it might go out 0.5 turns. And I think that range would be -- kind of quantify us here for the first quarter.

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Douglas Michael Harter, Crédit Suisse AG, Research Division - Director [4]

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Got it. And then, I guess, how -- just how are you thinking about that risk reward of kind of if you see another spread widening is taking up leverage? Obviously, that comes with extra return, but with that potentially comes extra spread risk from being higher leveraged. So how are you thinking about trying to protect yourself versus kind of, another fourth quarter versus, kind of the ability to generate extra returns with that higher leverage?

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Jeffrey J. Zimmer, ARMOUR Residential REIT, Inc. - Co-CEO, Co-Vice Chairman & President [5]

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So in the fourth quarter, we were probably a full turn less leverage. So if we'd been where we are right now, the book-value performance would have been a little bit worse. When spreads widened out to historically wide levels over a multiyear period, it inevitably is a very good time to invest. You cannot pick the wide apex point all the time, and certainly didn't do that this time. But that's a good place to invest if we're looking out for next year. So once again, if we do see spreads widening, and we think they're good investment opportunities, we'll up-leverage a little bit. But all these things change every single week. And if for some reason something happens with economic data that would show that the Fed is now, uh-oh, maybe we're not going to be so doveish, then we have a different perspective and possibly reduce leverage. We -- sometimes we let monthly prepayments just roll up and not reinvest, and that's also a way that you can modestly reduced leverage. So I hope that answers your question.

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Operator [6]

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Our next question comes from the line of Trevor Cranston with JMP Securities.

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Trevor John Cranston, JMP Securities LLC, Research Division - Director and Senior Research Analyst [7]

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Question on one of the last comments about the portfolio being somewhat negative duration at this point, and you guys obviously, being relatively comfortable with spread risk. How are you guys thinking about the risks of the portfolio of spreads and rates being correlated in the sense that if there is a spread-widening event and may be likely that rates drop and that could sort of be a negative duration, along with having spread risk, could amplify the book-value exposure in that scenario? I'm just curious how you guys are sort of thinking about that correlation risk?

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Jeffrey J. Zimmer, ARMOUR Residential REIT, Inc. - Co-CEO, Co-Vice Chairman & President [8]

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That's a good question. So we're modeled out as such. Just looking at the curve, evenly across the curve, the whole curve goes up or down 25 basis points. Our model show our book value is very stable, okay? The risk that we have is the business that we're in and that's owning mortgages. So as I just told Doug, we love the leverage, where we are right now and that's why we're there. We do own mortgages. We are in the mortgage-investment business. If spreads do widen a little bit, we will potentially invest in more mortgages. If we feel that the market's change and we're going to get a bull flattened year, the 10-year and the 5 are going to run a little bit, we'll either take off some hedges or maybe add a little bit more convexity. One of the reasons that we added so many DUS bonds after our capital raise is to address exactly what you're asking about, because they're going to trade like corporate bonds in a rally. So we are better positioned for a move, even though the duration is slightly negative than we have in a number of quarters.

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Trevor John Cranston, JMP Securities LLC, Research Division - Director and Senior Research Analyst [9]

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Got you. Okay. That make sense. And then looking at the latest portfolio update, it looks like you added both some spec pools and some TBAs. How are you guys thinking about the trade-off between spec pools versus TBAs today? I know I've seen some commentary about risk and TBAs, given wider gross WAC spreads versus bond coupons. So just curious how are you thinking about that allocation going forward?

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Jeffrey J. Zimmer, ARMOUR Residential REIT, Inc. - Co-CEO, Co-Vice Chairman & President [10]

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Yes. That research that you're reading is completely correct. Now the Fed March rolls on a lot of the higher coupons Ginnie, Fannie 4.5s, Ginnie 2.5, we're actually really good, low teens 12% , 13%, even one we did some 14% kind of return stuff. The March, April, and the March-May rolls don't look as good. So as we go forward and address those roll opportunities, we'll either take delivery and sell, or most likely swap in to some specified pools, there are very good opportunities still, double-digit opportunities in specified more than some of the other Ginnie 2 products as well. So what happens on a month-to-month as the dollar rolls progress, sometimes they look kind of crummy, 30 days out, and all of a sudden you get 10 days in advance and they pop up, because dealers have to start covering their short positions. So we take that a month at a time, but always looking simultaneously at that investment opportunities in taking collateral in at specified pool basis.

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Operator [11]

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Our next question comes from the line of David Walrod with JonesTrading Canada.

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David Matthew Walrod, JonesTrading Institutional Services, LLC - MD & Head of Financial Services Research for New York Office [12]

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You, obviously, raised capital in January, and you put out your monthly update last night. When we look at the asset allocation, it looks like you put a lot of new capital to work in that Agency space. Is that just temporary thing? And you are going to look to look to allocate more to non-Agencies? Or are you seeing the Agency space as more attractive today?

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Jeffrey J. Zimmer, ARMOUR Residential REIT, Inc. - Co-CEO, Co-Vice Chairman & President [13]

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David, good to hear from you. So as Scott alluded to, and I think somewhat specifically we talked -- let's talk about CRTs first. The seasoned CRTs that we own, the 2014, '16, vintage is really high-quality vintage. The newer CRTs, so the non-Agency space, we don't see the quality as good, and I discussed that in detail in the last quarter's conference call. So we'd have to see a real nice widener in the current production CRTs for us to add, and that's the only non-Agency area where we're spending any time focusing at all, okay?

In terms of the specified, as I just told Trevor, we did a mix of investing in DUS, specified pools and some dollar rolls. And we will take a look and see if vintage paper looks good as we get into the next dollar roll or if we continue the dollar-roll product. DUS right now, however, are a little tight. I will tell you an area we will not invest in and that's the adjustable rate or hybrid securities. We don't like that sector right now. We figured -- we feel that the pricing is opaque and the trading is very limited there.

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David Matthew Walrod, JonesTrading Institutional Services, LLC - MD & Head of Financial Services Research for New York Office [14]

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Okay, that's very helpful. And my other question is, the dividend, you noted in your press release that your core earnings have exceeded dividend for 10 consecutive quarters. How is the Board thinking about the dividend today?

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Jeffrey J. Zimmer, ARMOUR Residential REIT, Inc. - Co-CEO, Co-Vice Chairman & President [15]

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The -- as we said, as Scott said in his comments, we are going to -- core earnings are expected to equal or exceed the dividend for the first quarter. And as we look out to the future, we feel that our investment run rate is very sustainable. And I talked about that in 2 earnings calls about the sustainability of earnings is very important to our investor base. So we're going to try without doing anything, like excessive leverage, to maintain our dividend. And the board is comfortable with the way we're operating in that regard right now.

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Operator [16]

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Our next question comes from the line of Christopher Nolan with Landenburg Thalmann & Company.

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Christopher Whitbread Patrick Nolan, Ladenburg Thalmann & Co. Inc., Research Division - EVP of Equity Research [17]

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Given where your stock price is right now and given your positive comments in terms of the environment, what are your thoughts about additional equity raises?

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Jeffrey J. Zimmer, ARMOUR Residential REIT, Inc. - Co-CEO, Co-Vice Chairman & President [18]

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So equity raises are, as I want to say, it's the pleasure of the Board, and the -- if the investment opportunities and our stock price is in a good spot, we will look to raise capital. That's not something that we're doing this morning.

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Operator [19]

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Mr. Mountain there are no further questions at this time. Please continue with your presentation or closing remarks.

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James Robert Mountain, ARMOUR Residential REIT, Inc. - CFO, Treasurer & Secretary [20]

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Well, Frank, thank you. And thank you all for joining our call this morning. As always, if anybody has other questions, feel free to call us at the office. We try and either pick right up or get back to you as promptly as possible. We look forward to constructive dialogue with everybody in the investor community. And we'll talk again soon.

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Operator [21]

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Ladies and gentlemen, that does conclude the conference call for today. We thank you for your participation, and ask that you please disconnect your line.

Have a great day, everyone.