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Edited Transcript of IVR earnings conference call or presentation 22-Feb-17 2:00pm GMT

Thomson Reuters StreetEvents

Q4 2016 Invesco Mortgage Capital Inc Earnings Call

ATLANTA Feb 22, 2017 (Thomson StreetEvents) -- Edited Transcript of Invesco Mortgage Capital Inc earnings conference call or presentation Wednesday, February 22, 2017 at 2:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Tony Semak

Invesco Mortgage Capital Inc. - IR

* Rich King

Invesco Mortgage Capital Inc. - CEO

* John Anzalone

Invesco Mortgage Capital Inc. - CIO & Incoming CEO

* Jason Marshall

Invesco Mortgage Capital Inc. - Head of the Mortgage Backed Security Portfolio Management & Incoming CIO

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Conference Call Participants

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* Trevor Cranston

JMP Securities - Analyst

* Joel Houck

Wells Fargo Securities, LLC - Analyst

* Eric Hagen

Keefe, Bruyette & Woods - Analyst

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Presentation

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Operator [1]

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Good morning, ladies and gentlemen. Welcome to Invesco Mortgage Capital Incorporated fourth-quarter 2016 investor conference call.

(Operator Instructions)

As a reminder, this call is being recorded. Now, I would like to turn the call over to Tony Semak, Investor Relations. Mr. Semak, you may begin the call.

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Tony Semak, Invesco Mortgage Capital Inc. - IR [2]

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Thank you, Frank, and good morning everyone. Again, we want to welcome you to the Invesco Mortgage Capital fourth-quarter 2016 earnings call. I'm Tony Semak with Investor Relations, and our management team and I are very delighted that you've joined us as we look forward to sharing with you our prepared remarks during the next several minutes before we conclude with our usual question-and-answer session.

Before we begin, we'll provide a customary forward-looking statements disclosure, and then we'll proceed to management's remarks. Comments made in the associated conference call may include statements and information that constitute forward-looking statements within the meaning of the US securities laws as defined in Private Securities Litigation Reform Act of 1995, and such statements are intended to be covered by the Safe Harbor provided by the same.

Forward-looking statements include our views on the risk positioning of our portfolio, domestic and global market conditions, including the residential and commercial real estate market, the market for our target assets, mortgage reform programs, our financial performance, including our core earnings, economic return, comprehensive income, and changes in our book value, our ability to continue performance trends, the stability of portfolio yields, interest rates, credit spreads, prepayment trends, financing sources, cost of funds, our leverage and equity allocation.

In addition, words such as believes, expects, anticipates, intends, plans, estimates, projects, forecasts, and future or conditional verbs such as will, may, could, should, and would, as well as any other statement that necessarily depends on future events, are intended to identify forward-looking statements. Forward-looking statements are not guarantees and they involve risks, uncertainties, and assumptions.

There can be no assurance that actual results will not differ materially from our expectations. We caution investors not to rely unduly on any forward-looking statements and urge you to carefully consider the risks identified under the captions risk factors, forward-looking statements, and management's discussion and analysis of financial condition and results of operations in our annual report on Form 10-K, and quarterly reports on Form 10-Q, which are available on the Securities and Exchange Commission's website at www.sec.gov.

All written or oral forward-looking statements that we make or that are attributable to us are expressly qualified by this cautionary notice. We expressly disclaim any obligation to update the information in any public disclosure if any forward-looking statement later turns out to be inaccurate.

To view the slide presentation today, you can access our website at InvescoMortgageCapital.com and click on the fourth-quarter 2016 earnings presentation link you can find under the investor relations tab at the top of our home page. There you could select either the presentation or the webcast option for both the presentation slides and the audio.

Again, we want to welcome you and thank you so much for joining us today. We'll now hear from our Chief Executive Officer, Rich King. Rich?

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Rich King, Invesco Mortgage Capital Inc. - CEO [3]

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Thanks, Tony. We are pleased to have generated attractive economic returns to our shareholders in 2016 as well as over the last three and five year periods in absolute terms and relative to our peers. I'm also excited about the future of IVR due to our very strong team, which will now be led by John Anzalone.

Many of you are aware that several months ago, we announced my retirement and John's elevation from Chief Investment Officer to become the Company's new CEO. John has served as our CIO since the Company's inception and is well equipped as he has keen instincts for value and timing in our markets, and of course, he has a very eminent understanding of IVR in a 25-year carrier in real-estate debt markets.

He is highly familiar to many of you as well as he has been a very visible figure representing IVR at numerous analyst and investor events along with being a consistent contributor to this quarterly call and other public forums. John enjoys a strong endorsement by our Board, from me personally, and I am delighted he is our new CEO.

Our shareholders can look forward to benefiting from John's guidance and his commitment to working in their best interest. Let me say thank you now to the team here for a job well done and to you, our shareholders, for the faith you've placed in us since 2009. And now, I introduce our incoming CEO, John Anzalone.

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John Anzalone, Invesco Mortgage Capital Inc. - CIO & Incoming CEO [4]

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Thanks, Rich. First of all, on behalf of the team, I would like to thank Rich congratulate him on his retirement. We obviously wouldn't be where we are right now without his leadership over the last 7.5 years. While Rich's departure is going to leave a big hole to fill, we have an extremely deep and talented team that will meet the challenge.

I am honored to have the opportunity to continue his legacy of working for our shareholders and delivering on our commitments. I would like to highlight the individuals that have been elevated within the Company and will be taking on expanded roles.

Beginning officially on March 1, Rob Kuster, our Chief Operating Officer, will become President and Chief Operating Officer. Jason Marshall, our Head of the Mortgage Backed Security Portfolio Management at Invesco, will become our Chief Investment Officer. And Dave Lyle and Kevin Collins, our Heads of Residential Mortgage Backed Securities and Commercial Backed Securities Credit at Invesco, will become Executive Vice Presidents in charge of Residential and Commercial Credit, respectively.

This Group has worked closely together since IVR's inception in June of 2009, so we anticipate this transition should be seamless. As for today's call, I'll provide some brief remarks about the quarter, and then I'll give the floor to Jason Marshall who will talk about our portfolio in greater detail before opening the call to Q&A.

IVR's economic performance has been strong during 2016. Despite a slight negative economic return of minus 1.1% during the fourth quarter, IVR's overall economic return for 2016 was a robust 11.3%, which compares very favorably to our peers, and you can see that on slide 5.

Going into the fourth quarter and throughout most of 2016, we sought to actively reduce the risk profile of our portfolio in anticipation that the market might experience heightened volatility caused by the presidential election, the potential for the FOMC to increase the fed funds rate, and the ongoing Brexit negotiations. You'll notice that we've reduced the overall size of the portfolio and have been biased to add shorter duration agencies.

This [prove proved pression] as the markets were quite volatile during the fourth quarter after the largely unexpected result of the US presidential election, followed by the FOMC's decision to increase the fed funds rate by 25 basis points in December. We saw interest rates rise sharply and yield curve steepen meaningfully. As the market priced in a high probability, the new administration will quickly enact fiscal stimulus, tax cuts, and regulatory reform.

Risk markets reacted favorably as equities rally and spreads on credit assets tightened nearly across the board while longer duration ADC spreads had trouble keeping up with the sharp moving rates. During the fourth quarter, our core EPS was $0.36 per share. Our reduced core earnings number was largely a result of our conservative positioning, lower leverage, faster than expected prepayment speeds, and increased funding costs after the FOMC and into year end.

As we head into 2017, all of these headwinds have reversed, and we expect our core run rate to recover to levels more in line with our current dividend. We observed a material slowdown in prepayment speeds recently as the impact of higher rates makes refinancing less attractive.

Repo rates have decreased as the year-end balance sheet pressures on our counterparties have eased. And because we were conservatively positioned, we've plenty of dry powder to redeploy capital into investments in a more favorable environment where rates are higher and yield curve is steeper.

While our more conservative stance led to a temporary reduction in our core run rate, it also helped to protect our book value. For the quarter, our book value was down 3.3% to $17.48, while for the full year, our book value increased by 2%. This is despite the 10-year treasury rate rising by 84 basis points during the quarter and 18 basis points during the year with the trading rates of [124] basis points in peak to trough.

While spreads in our credit assets tightened during Q4, this was not enough to offset the widening of agency spreads that occurred. Since year end, rates have traded in a much narrower range, while credit spreads continued to tighten, and our current book value is up approximately 2% year to date.

Looking forward to 2017, we believe we are very well positioned for the uncertain environment that we now face. While the risk markets have priced in a high probability that fiscal stimulus, tax cuts, and regulatory reform will have a positive impact on the economy, none of these are sure things, and even if they happen, the timing is quite uncertain.

On the flip side, we believe the market may be underestimating the risks of protections, trade policies, and the chaotic news flow out of Washington. As such, we remain cautious on adding additional credit assets at these valuations. Our credit portfolio is highly seasoned and high quality and has benefited from the rallying of risk assets, but we are waiting for a more opportune time to deploy capital out of liquidating [C] securities.

While the opportunities in credit are limited currently, we have taken advantage of the wider spreads on third year ADCs and the greater hedged ROEs they generate and have increased our earning assets during the first quarter. This should also increase our earnings power going forward while preserving our ability to be ready to capitalize on opportunities as they become available.

I'll stop here and let Jason talk about the portfolio in more detail.

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Jason Marshall, Invesco Mortgage Capital Inc. - Head of the Mortgage Backed Security Portfolio Management & Incoming CIO [5]

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Thank you, John, and good morning, everyone. As John mentioned, we were positioned more considerably in the fourth quarter because of our expectations for volatility around the presidential elections and the December FOMC meeting. We primarily accomplished this by foregoing reinvestment of paydowns during the quarter to decrease leverage and spread risk.

We did end up experiencing significant volatility, as John mentioned, with the 10-year note up 84 basis points for the quarter and risk assets rallying rather significantly. Given our desire to reduce risk during the quarter, our activity was limited during the quarter but we did add credit risk transfer bonds in December as we viewed the prospects for housing has improved and the ROE in the sector was attractive.

If you look at page 6 of the earnings deck, you'll see our equity allocation at year end was 41% in agency MBS, 32% in commercial credit, and 27% in residential credit. Our allocation to agency MBS does give us the flexibility to shift into credit assets should spread levels reach levels we view as attractive. I'll speak now more specifically about each of the sectors.

If you turn your attention to slide 7, you'll see that our agency MBS portfolio remains well-diversified with limited exposure to 30-year -- to lower coupon 30-year MBS, which widened as interest rates sold off in the fourth quarter. Our allocation to 15-year and hybrids benefited us during the quarter as the 15-year sector held in relatively well versus 30s, and hybrid arms tightened significantly as rates sold off and prepayment risk diminished.

We continue to favor owning specified pool stories that we view as offering relative value instead of generic collateral or TBA. Moving on to commercial credit, our allocation was little changed during the quarter and continues to be concentrated at higher-quality seasoned collateral. We continue to benefit from property price appreciation in commercial real estate with our effective LTV, including subordination, declining below 35% in the quarter, and that's illustrated on slide 12.

This has resulted in rating agency upgrades on many of our bonds, which improves financing terms and helps improve the NIM as well. I should also note that our loan portfolio benefited from the increase in the federal funds rate in December as those coupons are directly indexed to LIBOR. As I mentioned earlier, on the residential credit side, we did add to our credit risk transfer position in December because of the fact there is limited duration profile and attractive ROEs.

House price trends remain positive and demand has increased while supply remains limited. Relative to other residential credit alternatives, CRT remains the most efficient alternative for gaining exposure with compelling ROEs. I'll now provide an update on our portfolio activities since quarter end. Having been conservatively positioned in the fourth quarter, we had capital and continue to have capital available to the full end of portfolio.

We recently put capital to work in the 30-year MBS sector for the first time in several years because of the steeper yield curve, improved financing terms, slower prepayment speeds, and an improved convexity profile. Also, we have found attractive ROE opportunities farther down the capital structure in seasoned CMBS deals but remain relatively cautious because of the manual spread tightening that has occurred in the last several months.

Lastly, we continue to use CRT as an attractive investment alternative but are remaining patient for a better entry point since our December purchases. That concludes my prepared remarks on the portfolio. I'll now turn it over to -- back to the operator for the Q&A session.

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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 Mr. Trevor Cranston of JMP Securities.

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Trevor Cranston, JMP Securities - Analyst [2]

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Thanks, good morning. A question on near-term asset allocation. Obviously, you guys took up the agency position this quarter. I guess when I think about the trend that had been going on for the last couple years, you'd been making a concerted effort to move more into shorter duration, just low rate type assets.

Are you thinking about the increase in the position in fixed rate agencies as a temporary place holder as you wait for better entry points in credit? Or with the changing convexity profile, are you guys thinking of that as an asset cost that you're more comfortable holding again? Thanks.

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Rich King, Invesco Mortgage Capital Inc. - CEO [3]

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Yes. I will start and Jason can add in. I think that we view it as -- we're always evaluating the different asset classes against each other for risk return. For the first time in a long time, we have seen agency ROEs in the, call it 12% to 13% range hedged and with rates 100 basis points higher essentially, the convexity profile looks better. Right now, that looks like the most attractive place to go.

We still have a lot of assets in shorter duration, agencies also, and hybrid ARMS in 15 years. And also, we have a lot of legacy especially on the residential side, a lot of legacy assets that continue to pay down that we need to redeploy also. I would say going forward, we think right now agencies look best but if we do see credit opportunities, we have plenty of dry powder to make that happen.

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Trevor Cranston, JMP Securities - Analyst [4]

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Got it, okay. On the funding side for agencies, can you comment on where you are seeing repo rates trending in the first quarter versus where they were towards the end of year on sort of an absolute basis or versus LIBOR or anything else you like to talk about?

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Jason Marshall, Invesco Mortgage Capital Inc. - Head of the Mortgage Backed Security Portfolio Management & Incoming CIO [5]

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This is Jason. We see them trend lower. You always have the year-end funding pressures. I think we saw kind of low to mid 90s going into year end. Anything that was capturing the turn. We have seen that come off 10 to 15 basis points, so right now one month repo on agency MBS is in the low 80s.

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Trevor Cranston, JMP Securities - Analyst [6]

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Okay, appreciate the comments. Thank you.

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Operator [7]

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Our next question comes from the line of Mr. Joel Houck from Wells Fargo.

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Joel Houck, Wells Fargo Securities, LLC - Analyst [8]

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Thanks. Given the commentary about where spreads have gone, which is not I guess a huge mystery, I'm wondering what your thoughts are in terms of selling credit assets into strength. I mean, obviously, a lot of these are legacy and their money good, but maybe give us your thoughts if you could kind of parse it out between the various subsectors of residential credit, where you might be looking to sell and where you're comfortable holding through the cycle.

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Rich King, Invesco Mortgage Capital Inc. - CEO [9]

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I think at current spread levels, we are still comfortable holding, and that is primarily based on our fundamental view in both residential housing and commercial credit. Certainly, there is spread levels where you would likely become a seller, but I think if we were to get another -- significantly tighter, we might start to consider potentially selling.

Or if our fundamental view deteriorated at all, we might consider selling. But so long as our fundamental review remains relatively positive, we'll probably continue to hold our current position and look for opportunities to add refi bonds that make sense.

But to summarize, though, clearly there will be a spread level if we continue to tighten where we may start to lighten up and move into agencies or other sectors that might appear attractive or have lagged the tightening.

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Joel Houck, Wells Fargo Securities, LLC - Analyst [10]

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Is there a hard limit in terms of the agency exposure? Obviously, you pointed out it's more attractive for a lot of reasons but is there some type of limit or is this one of those things where as long as agency remains, the convexity profile looks good, that the ROEs are good, you could simply take that up and there aren't any limits?

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Rich King, Invesco Mortgage Capital Inc. - CEO [11]

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There is no hard limit really to tending the sector subject to the REIT rules, but agency MBS are the most friendly relative to the whole pool test. So, no. There is no effective limit for agency exposure.

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Joel Houck, Wells Fargo Securities, LLC - Analyst [12]

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Okay, thanks.

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Operator [13]

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Our next question comes from the line of Mr. Bose George of KBW.

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Eric Hagen, Keefe, Bruyette & Woods - Analyst [14]

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Thanks. Good morning. It's Eric on for Bose. I'm trying to square up the market. You reported on your CMBS segment this past quarter. I think we expected spreads to be tighter there, so if you can just comment on what drove that negative $0.81 in hit to book value?

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Rich King, Invesco Mortgage Capital Inc. - CEO [15]

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I think that reflects just dollar prices on the bond duration -- (multiple speakers). Our average duration on our CMBS book is probably five to six years, so you get 85 basis point move in rates, and that's going to have a pretty significant impact. So we did see spread tightening but not enough to offset just the pure duration move there.

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Jason Marshall, Invesco Mortgage Capital Inc. - Head of the Mortgage Backed Security Portfolio Management & Incoming CIO [16]

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And we do obviously hedge that in our slot portfolio as well.

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Rich King, Invesco Mortgage Capital Inc. - CEO [17]

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When we break that out, the slots are separate so they are not kind of attached to the assets they are hedging in that [stable].

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Eric Hagen, Keefe, Bruyette & Woods - Analyst [18]

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I typically associate the swaps with just the agency book. Should I continue doing the same thing going forward?

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Jason Marshall, Invesco Mortgage Capital Inc. - Head of the Mortgage Backed Security Portfolio Management & Incoming CIO [19]

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Yes, it's really the CMBS and the agency book where all the duration lies. The residential credit book has very little duration, so it's really those two sectors that the swaps are hedging.

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Eric Hagen, Keefe, Bruyette & Woods - Analyst [20]

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Got it. What are your expectations around Fed policy this year? The three core segments of yours, have you changed the way you approach any of those strategies with regard to hedging or asset allocation based on your expectations for the short end of the yield curve?

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Rich King, Invesco Mortgage Capital Inc. - CEO [21]

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We really haven't. I would say our expectations are not very far off of market with potentially two to three moves by the Fed. We do think on the longer end, though, we could establish a higher trading range here.

Certainly, the expectations for fiscal policy have driven this reflation or Trump trade but you kind of see tax reform continues to be pushed off for other more pressing matters. You've got issues in the EU with Greece in the headlines again and the [pen] gaining momentum. And we do see a lot of continued factors that could hold the long end lower and potentially call into question how many times the Fed moves.

Right now if the data continues on its current trajectory barring any [allergic] kind of risk, I think two to three probably is the right answer, but certainly we do see some risk out there that could call that into question.

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Eric Hagen, Keefe, Bruyette & Woods - Analyst [22]

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Thanks, that's a helpful answer. I appreciate it.

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Rich King, Invesco Mortgage Capital Inc. - CEO [23]

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You're welcome.

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Operator [24]

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At this time, there are no further questions.

(Operator Instructions)

That concludes today's conference. Thank you all for participating. You may now disconnect.