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Edited Transcript of ARR earnings conference call or presentation 2-May-17 12:00pm GMT

Thomson Reuters StreetEvents

Q1 2017 ARMOUR Residential REIT Inc Earnings Call

VERO BEACH May 4, 2017 (Thomson StreetEvents) -- Edited Transcript of ARMOUR Residential REIT Inc earnings conference call or presentation Tuesday, May 2, 2017 at 12:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* James R. Mountain

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

* Jeffrey J. Zimmer

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

* Mark R. Gruber

ARMOUR Residential REIT, Inc. - COO and Head of Portfolio Management

* Scott J. Ulm

ARMOUR Residential REIT, Inc. - Co-Vice Chairman, Co-CEO, CIO and Head of Risk Management

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Conference Call Participants

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* Douglas Michael Harter

Crédit Suisse AG, Research Division - Director

* Mickey Max Schleien

Ladenburg Thalmann & Co. Inc., Research Division - MD of Equity Research and Supervisory Analyst

* 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. Welcome to the ARMOUR Residential REIT, Inc. First Quarter 2017 Conference Call. (Operator Instructions) As a reminder, this conference is being recorded, Tuesday, May 2, 2017. I would now like to turn the conference over to Chief Financial Officer, Jim Mountain. Please go ahead.

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James R. Mountain, ARMOUR Residential REIT, Inc. - CFO, Treasurer and Secretary [2]

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Thank you, operator, and thank you all for joining ARMOUR's first quarter 2017 earnings call. By now, everyone has access to ARMOUR's earnings release and Form 10-Q, which can be found on ARMOUR's website. This conference call may contain statements that are not recitations of historical facts, 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 protection of 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 discussions 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 1 year.

ARMOUR's Q1 GAAP net income was $52.7 million or $1.33 per common share. Core earnings were $29.1 million or $0.69 per common share, which represents an annualized return on equity of 10.7% based on book value at the beginning of the quarter. Differences between GAAP and core income are mostly due to the treatment of TBA drop income and unrealized gains on our interest rate contracts. ARMOUR does not use hedge accounting for GAAP reporting and fluctuations in the fair value of our open interest rate swaps is a dominant factor in GAAP income while the inversely related mark-to-market on our Agency Securities flows directly in shareholders equity.

We paid dividends of $0.19 per common share during each month of Q1 for a total of $21 million or $0.57 per common share. We also paid common dividends of $0.19 per share for April 2017 and have announced May common dividends of $0.19 per share to shareholders of record on May 15, payable on May 26.

At March 31, 2017, ARMOUR's book value was $25.62 per common share or up 5.04% over the quarter. As a reminder, we include updated estimates of our book value per share in our monthly company updates available on our website at www.armourreit.com.

ARMOUR's quarter-end portfolio consisted of over $6.1 billion of agency securities plus another $1.3 billion of agency TBA positions. Our non-agency positions were $1.1 billion at March 31, the majority of which are credit risk transfer securities and NPL, RPL deals.

Our mortgage-backed securities portfolio was financed with approximately $6.5 billion of borrowings under repo agreements. ARMOUR's interest rate hedge positions were $4.2 billion of notional coverage at the end of March.

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

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Scott J. Ulm, ARMOUR Residential REIT, Inc. - Co-Vice Chairman, Co-CEO, CIO and Head of Risk Management [3]

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Good morning. In addition to the customary SEC filings, we’ve also continue to provide a company update, which is furnished to the SEC and available on EDGAR as well as our website, www.armourreit.com.

The company update contains a considerable amount of information about our portfolio, our hedge book and our repo financing book. These company updates along with the comments we made during our last conference call provide our shareholders and analysts with substantial information on the state of the company. Thus, the quarterly financial reports we filed last night should contain very few surprises for any of our listeners today. ARMOUR realized total shareholder return of 7.5% and total economic return of 7.4% for the first quarter of 2017, or approximately 30% annualized.

Additionally, core income exceeded dividends declared and paid for the third quarter in a row. Our book value increased by 5% during the quarter. As of April 27, our book value was $26.07, up 1.8% in the second quarter versus the end of the first quarter. The prepayment rate on our agency assets declined during the quarter from 11.2 CPR in the fourth quarter to 8 CPR in the first quarter. Our portfolio paid 7.8 CPR in April.

Please note that a majority of our agency portfolio, excluding TBAs, is composed of assets with prepayment protections with lower loan balances or contractual prepayment lockups.

Our notional swap position is unchanged at $4.2 billion at the end of the fourth quarter. Repo financing remains consistent and reasonably priced for our business plan. ARMOUR maintains MRAs with 43 counterparties and is currently active with 27 of those, with total financing of $6.5 billion at the end of the first quarter. We carefully analyze opportunities for longer-term financing and will add to this -- add this to our book when it looks attractive.

The agency portfolio is comprised of 6 major components, not including the TBA dollar loans. At the end of the first quarter, 29.2% of our agency portfolio was comprised of 15-year final maturity pass-throughs with a weighted average seasoning of 56 months. 41.9% of those 15-year pass-throughs have loan balances less than or equal to $175,000. We believe these are great convex assets.

23.8% of our agency portfolio was comprised of Fannie Mae Multifamily bonds or DUS, which stands for Delegated Underwriting and Servicing bonds. The DUS bonds we purchase are generally locked out from prepayments for the first 9.5 years of their 10-year expected maturity. Any prepayment penalties received due to early payoffs can enhance the yield on the bonds.

At the end of the first quarter, our DUS bonds had a weighted average maturity to the end of the lockup period of 6.5 years. The bullet-like maturity of these assets means they roll down the curve over time, much like a corporate bond or treasury note, providing great potential to trade tighter, particularly as they approach benchmark areas like the 5-year and 7-year treasury notes. 39.3% of our agency portfolio was comprised of 30-year maturity fixed rates, currently maturing between 241 months and 360 months, 23.6% of which have a $175,000 loan balance or less.

4% of our agency portfolio was comprised of 20-year fixed-rate assets, maturing between 181 months and 241 months with a weighted average seasoning of 141 months.

The seasoning provides great convexity as well. Our 10-year final maturity or shorter agency assets represent 1.9% of our portfolio. Our $79.2 million ARM position, 1.3% of our agency assets, has a weighted average reset of 12 months. $28.6 million of our agency portfolio are interest-only securities. These act as interest rate hedges and can have positive carry. At the end of the first quarter, we had dollar rolls with a net notional value of $1.3 billion. We continue to see certain TBA dollar rolls at very attractive levels versus owning in financing bonds. We actively monitor the attractiveness of risk and return in dollar rolls and may increase or decrease this position depending on market conditions. We believe our current investments in non-agency assets will provide attractive and stable returns going forward, enable us to operate in a lower leverage multiple and reduce the risks associated with swaps.

Our allocation of repo financing to non-agencies is approximately 45%. We define that equity allocation as a percentage of our equity tied up in haircuts from repo, while gross portfolio allocations will show a much larger quantum of agencies on our balance sheet. We think the purest way to think about capital allocation is equity committed to financing haircuts in each sector. Equity that is not tied up in financing haircuts is our liquidity, and that liquidity is available to support any part of the portfolio. Over a year ago, we began accumulating nonagency assets with a focus on credit risk transfer of securities, a position which was valued at $842 million at quarter end. We were rewarded both by the spread tightening that has occurred in the sector over the last 3 years and by the attractive carry. Our weighted average CRT coupon as of the end of the first quarter was 5.5% with a weighted average margin of 4.5%. The weighted average purchase price of our CRT positions is 98.49.

As of March 31 of this year, the weighted average market price of our CRT position was 180 -- 108.4. In the CRT transactions we take the credit risk of recent Fannie and Freddie underwriting in return for an uncapped floating rate coupon. We continue to believe that housing trends and strong mortgage underwriting will give robust underpinning to the credit quality of the CRT bonds.

As of March 31, ARMOUR owned $113 million of nonagency NPL RPL securities, nonperforming and re-performing securities. We have not added any of this asset class to our portfolio in the last 2 quarters as spreads have tightened in this sector to a level that could not provide the company with the levered yields available in other investment opportunities.

At the end of the first quarter, ARMOUR owned $95.2 million of nonagency legacy MBS. Today, we see very few opportunities for investment in the 2008 and prior nonagency MBS asset class. However, our existing assets from the period continue to perform well as they run off. Like many market participants, we continue to hope for a revival in the jumbo securitization market. While we own more significant amounts in the past, our new issue jumbo MBS exposure is only $19.1 million.

The second quarter has started well for us and as of this date we anticipate strong dividend coverage with core income for the second quarter. The principal issues we face are, as always, rates and prepayments and in addition, we have the continuing discussion on when and how the Fed may change policy on reinvestment or sale of MBS portfolio. We remain constructive on the rate environment seeing the long end as broadly range bound. We expect more Fed hikes this year and have planned for that with our swap positioning and floating-rate assets. Prepayments will likely move up this quarter, but should remain within expectations and constrained by our prepayment-protected assets on the agency side.

While there has been much discussion about the Fed halting reinvestment in MBS portfolio and even potentially beginning to dispose of assets, we see a variety of constraints there that suggest the Fed will take the utmost care to avoid market disruption. While more MBS supply without the Fed suggests higher spreads. We also note that spreads have moved out to pre-QE2 levels in fact -- QE3 levels in fact. More widening in MBS is always possible, but with investment-grade, high yield and CRT spreads still quite tight. Overall, we're very constructive about the environment we're operating in despite the headline risks of rate increases and Fed taper. We see the U.S. economy as continuing to make progress but with headwinds from domestic challenges with productivity and a strong dollar and weak economies abroad. The Trump administration policies hold the potential for both positive and negative effects on our operations. We feel that the pace of change is likely to be moderate. We've positioned the portfolio and our hedging to reflect this assessment of risks while still allowing us to earn our dividend which we feel is sustainable in the current environment.

Operator, that concludes our prepared remarks. We will now take 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 from Crédit Suisse.

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

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I was wondering if you -- how you're thinking about possibly using some of the strength in book value this quarter to take down some of the risk and maybe try to damp down volatility going forward.

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Scott J. Ulm, ARMOUR Residential REIT, Inc. - Co-Vice Chairman, Co-CEO, CIO and Head of Risk Management [3]

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I think what we have been doing with that is I think we are broadly seeing 2 avenues. One is, we've been keeping leverage as moderate as we can consistent with our goals. And, secondly, I think it’s portfolio selection, and we actively look at contributors to risk within the portfolio versus return and likely under priming guides they look like unbalanced choices. So those probably are the 2 major avenues.

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James R. Mountain, ARMOUR Residential REIT, Inc. - CFO, Treasurer and Secretary [4]

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Yes, Doug, the leverage is down 3 full turns from where it was 2 years ago, and the addition of the floating rate assets under CRT has helped to mute some of the volatility that we exhibited in the past partly because we don't have the amount of hedging that we have being the caretakers of in the first quarter of 2016 like so many of our peers. The hedges got you in trouble. Rather than the book value go up they went down. So we feel very balanced right now with our portfolio and our leverage. And I anticipate that what you're looking at today may look very similar another 1, 2 quarters down the line, and you know we were up book value again this quarter of more than 1% so far.

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Operator [5]

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(Operator Instructions) Our next question comes from the line of Mickey Schleien from Ladenburg Thalmann.

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Mickey Max Schleien, Ladenburg Thalmann & Co. Inc., Research Division - MD of Equity Research and Supervisory Analyst [6]

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I wanted to start with the question about leverage. At around 6x, it's relatively conservative, and you also had a net receivable for securities sold, which means you could -- we could see the balance sheet shrink some more this quarter. Does that trend imply a strategy of retaining liquidity ahead of potential market volatility when the Fed unwinds its balance sheet? Or is there some other factor that's on your mind that's keeping leverage down a bit?

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Scott J. Ulm, ARMOUR Residential REIT, Inc. - Co-Vice Chairman, Co-CEO, CIO and Head of Risk Management [7]

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Well I think there are 2 factors involved there. One, with liquidity, we've always maintained at a robust level. But I think the advantage of lower leverage is, it manifests itself in a number of different ways, which are, first, obviously dry powder to the degree there are opportunities and we can certainly take advantage of those, and still have relatively modest leverage. And that's, I think, important in all the markets that we operate in. Secondly, it limits the element of other risks that we have, in particular, spread risk. It's moderated a bit by lower leverage as well. So I think it's largely in response to a time in which there may be opportunities, but there certainly may be risks as well.

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

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Just to remind you, Mickey, for every CRT we bought, we probably sold 4x pass-through. So that in and of itself helped us reduce the leverage. But to Scott's point, we do feel we have dry powder right now if we see some great opportunities. However, we feel we've reduced the risk profile considerably in anticipation of the volatility related around Trump's policies and the volatility later on the Fed's policies.

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Mickey Max Schleien, Ladenburg Thalmann & Co. Inc., Research Division - MD of Equity Research and Supervisory Analyst [9]

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I appreciate that. A few more questions. How will the investment in Buckler potentially help to reduce your repo costs?

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Scott J. Ulm, ARMOUR Residential REIT, Inc. - Co-Vice Chairman, Co-CEO, CIO and Head of Risk Management [10]

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The Buckler, the principal objective of it is to provide more certainty and control over a portion of our repo book. That is really the driving element there. Away from that, we think Buckler could make a little bit of money. And so if it can make some money, that will effectively lower ARMOUR REIT's financing cost.

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Mickey Max Schleien, Ladenburg Thalmann & Co. Inc., Research Division - MD of Equity Research and Supervisory Analyst [11]

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Okay. Just some questions about the actual results for the quarter. I estimate your economic yield was essentially flat, fourth quarter to first quarter. But as you noted CPR declined pretty meaningfully. What caused the yield -- what hampered your yield from 1 quarter to the next from expanding?

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Scott J. Ulm, ARMOUR Residential REIT, Inc. - Co-Vice Chairman, Co-CEO, CIO and Head of Risk Management [12]

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Mark, you want to take that one?

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

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Sure. I would start the number one, we have the reduction in leverage. So for actual cash earnings, if I have the leverage down, you just do the numbers, which are a bit lower. That's your primary driver right there. We did not unwind any swaps during the period. And so that's -- you would have those even quarter-over-quarter. So the size -- basically the leverage number is the main driver. I would anticipate -- we do anticipate maybe a month or 2 down the road here having prepayments go up a little bit and so in the back of our minds we're trying to earn $0.19 to $0.20 a month to pay the dividends we declared for May. We feel very good where we're right now. Mark, do you want to improve on that?

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Mark R. Gruber, ARMOUR Residential REIT, Inc. - COO and Head of Portfolio Management [14]

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I mean those are going to be the main drivers. That and just some portfolio reallocations during the quarter.

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Mickey Max Schleien, Ladenburg Thalmann & Co. Inc., Research Division - MD of Equity Research and Supervisory Analyst [15]

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Okay. And on the flip side, your economic cost of funds actually went down, according to my calculations, about 10 basis points. And that's in a quarter, we had a Fed increase in December and March. Can you just walk us through what factors helped you contain your interest expense?

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Mark R. Gruber, ARMOUR Residential REIT, Inc. - COO and Head of Portfolio Management [16]

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Sure. Repo expenses went down. The rates on repo declined from the end of the year to the midyear, so mid quarter. So that was the biggest benefit for cost of funds.

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Jeffrey J. Zimmer, ARMOUR Residential REIT, Inc. - Co-Vice Chairman, Co-CEO and President [17]

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You may remember Mickey about 2.5 weeks before the Fed increased it in March, people weren't expecting a March increase. So all of a sudden every Fed member got on the tape and said, Mohamed El-Erian, was like the first non-Fed member, he said something and then you kept hearing day after day, you got to be prepared, and then rates went back up. But what we're paying on December 15 was much higher than we were paying on January 15.

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Mickey Max Schleien, Ladenburg Thalmann & Co. Inc., Research Division - MD of Equity Research and Supervisory Analyst [18]

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Okay. That's helpful. My last question is, you had a nice net unrealized gain in the multifamily MBS investments. Can you just give us some background on what generated that gain?

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Scott J. Ulm, ARMOUR Residential REIT, Inc. - Co-Vice Chairman, Co-CEO, CIO and Head of Risk Management [19]

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It's mainly spread tightening. So remember, these are bullet bonds, so they roll down the curve a little bit. They get little tighter. But just in general they tighten just overall spread in the market.

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Operator [20]

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

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Trevor John Cranston, JMP Securities LLC, Research Division - Director and Senior Research Analyst [21]

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Can you talk about on the margin, when you're thinking about redeploying pay downs or allocating capital, what sectors you are finding the most attractive today given the tightening we have seen in most of the credit assets over the last few months?

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Jeffrey J. Zimmer, ARMOUR Residential REIT, Inc. - Co-Vice Chairman, Co-CEO and President [22]

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The drop income in the dollar roll positions have been quite attractive and we haven't released our portfolio. Of course, we do it at the end of January, end of February and we will be releasing it after the end of April. But you will see a little more emphasis on some of the dollar rolls. I'm talking low teens to even a little bit higher dropped income from that. So that's been a very good place for us. CRT is, as Mark and Scott indicated on his comments, have tightened in a lot. We are not investing -- have not put anything in CRTs now for a couple of quarters.

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Operator [23]

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And there are no further questions on the phone line at this time.

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Jeffrey J. Zimmer, ARMOUR Residential REIT, Inc. - Co-Vice Chairman, Co-CEO and President [24]

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Well, Scott and I and Mark and Jim want to thank everybody for dialing in. Once again, you can call the office and ask for any of us and we'll be happy to address your questions and we'll look forward to either seeing you in person or talking to you 1 quarter from now. Thank you very much.

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Operator [25]

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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 lines.