First Republic Bank at Morgan Stanley Financials Conference

Jun 10, 2014 AM EDT
FRC - First Republic Bank
First Republic Bank at Morgan Stanley Financials Conference
Jun 10, 2014 / 07:00PM GMT 

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Corporate Participants
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   *  Jim Herbert
      First Republic - President and CEO
   *  Martin Gibson
      First Republic - Senior Managing Director Preferred Banking
   *  Jeff Bruce
      First Republic - Deputy Regional Managing Director

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Conference Call Participants
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   *  Ken Zerbe
      Morgan Stanley - Analyst
   * Man
   * Woman

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Presentation
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 Ken Zerbe,  Morgan Stanley - Analyst   [1]
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 All right, let's go ahead and get started. I am Ken Zerbe, the Midcap Banks Analyst here at Morgan Stanley. Our next presentation is First Republic. With us from First Republic, we have Jim Herbert, who is President and CEO. He is joined by Jeff Bruce, who is Deputy Regional Managing Director, and Martin Gibson, Senior Managing Director in Preferred Banking.

 As many of you know, First Republic has been one of our favorite overweights for quite some time, so I'm happy to have them here, and I'll turn it over to Jim.

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 Jim Herbert,  First Republic - President and CEO   [2]
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 Great, thank you very much, Ken. We're going to go through some slides pretty quickly. Good afternoon, everybody, but -- and then we're going to -- Martin and Jeff are here to take questions and some of which I'll direct at them, as well, because they're on the ground doing business in New York. So they actually can give you a better sense of what's going on than I can.

 A real quick summary of First Republic. I recognize a lot of familiar faces, so many of you know the story. But we're basically a private banking business -- both coasts, we're bi-coastal, urban. We focus on the higher net worth home loan customer, and on the wealth management cross-sell. We also follow those customers to their business and to their charitable or other passions that they have -- arts, organizations, schools, et cetera.

 We try to do relationship banking, and we have a very strong brand that's been built over the years on these customers liking the service that we deliver, which is quite differentiated, and then telling their best friends about that.

 Our markets have outperformed a bit. When you buy First Republic, you're buying into markets, first and foremost, and into a model, almost equally important, maybe more important. And that model is a service model and a cross-sell model. We do about eight or nine things with every client, and we have a service that's quite differentiated.

 First quarter was a good quarter. We've been public now since the end of 2010 when we bought the bank back from Bank of America, having sold it to Merrill Lynch in 2007. And since then it's been a pretty good run. It was also a good run going into that, actually.

 Wealth management assets are still climbing nicely in the quarter. Loan balances are up, deposits are doing well. The core earnings are coming along quite well and, most importantly, book values are creating at about 13% to 14% per annum right now.

 Investor IRR has done well. We've had about a 23% return since we took the company public in August of 1986, and since we came out from Merrill, or BofA, and went public in December, it's been 23%, too. Circumstantially, the same number.

 The way we operate the bank is simple. The client is the center of the activity. I'm going to ask Martin and Jeff to speak to this in a moment on how it really works. But a satisfied client, lots of products, eight products on the average per loan client this past year, and that is a very strong number and really results in great satisfaction.

 If I hit this again, I think we'll have a very short video that will talk to how we sell.

 (video)

 (light piano music)

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Man   [3]
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 First Republic has certainly found the recipe for success. They always put the customer first.

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Man   [4]
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 Everything is first rate with First Republic -- the technology, service, fast turnaround.

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Woman   [5]
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 First Republic Trust Company is one of the best things that ever happened to me.

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Man   [6]
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 We give the highest ratings to the quality of this bank.

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Man   [7]
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 I like First Republic's can-do attitude. Their first answer is "let's figure it out."

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Man   [8]
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 We got our mortgage through First Republic, and the process was quick and painless.

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Man   [9]
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 Everyone talks about putting the client first, but few follow through. First Republic really does.

 (video ends)

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 Jim Herbert,  First Republic - President and CEO   [10]
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 Basically, we marketed by testimonial because it's really the only way you can prove service, and we have about -- we've been very fortunate to have, now, I think about 500 or 600 testimonials done over the years by various clients. We do them every year around our Annual Report and introduce them as they are completed.

 Why do we grow? We grow, first and foremost, because the clients that we have grow. And we have very low attrition on client base. We don't have a lot of people going out the back door. We have some, of course, but not that many.

 And then our clients are in markets that are growing faster than the average throughout the country -- Boston, New York, San Francisco, LA, home market being San Francisco, about 47%. And then within that group we have basically highly educated professionals. Loan clients, 50%, 60% or greater with a graduate degree. So they are the outperformers within the markets that they operate in.

 They tend to grow. Their balance sheets grow, 6%, 8%, 9% a year. And then they get more complicated as they grow, and so that's really about half the growth of the bank every year. Everybody thinks of us as acquiring a lot of new clients, doing a lot of new things. Wrong. We don't do new stuff, hardly ever, and we acquire about half our growth is internal, and the other half is new clients. And that's quite important because the risk-taking component is not at all what it might appear when you look at the numbers.

 The clients we have are very happy with the service, and they tell like-kind friends. And that is where about 70% to 80% of our new clients come from.

 Then we also hired new relationship managers and portfolio managers that bring clients over. We opened some new offices this year. We'll open about three, I think maybe four total. And we have very focused marketing.

 Our markets have outperformed historically, certainly since the recovery, and this goes back to the first quarter of 2005. This is kind of a GDP of our markets that we have done by Rosen Consulting over at Berkeley.

 What's going on in the markets and how good are they in terms of a target? This is a study we've done for the last 10 years every other year. Cap Gemini does this for us. We're in the middle of the most recent updated one now. We should have it in about a quarter or so.

 In our market's about 21% of all households live, but 55% of all the households that have $1 million of liquidity or more -- are located. So we're in very target-rich environments. Our penetration rate in the San Francisco Bay Area, that's the eight or nine counties of the Bay Area, not the city, is about 13.5% of such households.

 In New York, we have 1.1%. That's higher now, that's two-year-old data, but we have a long way to go. So we're not intending to go into any new markets. We like the markets we're in. We can be doing these markets for decades and still growing the bank.

 The Bay Area represents 47%. Silicon Valley itself -- kind of thinking of it as the three counties -- San Francisco, San Mateo, Santa Clara is about 37% of the bank, 32%, I'm sorry, of the bank.

 We do have strong growth. This has been steady for a long time. If you went back further, you'd get about the same growth rate. We are very active secondary market participants. Let me talk about this for a moment. Basically, our core product for acquisition of clients as well as serving the clients is a home loan, a jumbo home loan. And we, basically, have been very active in the secondary market. We sell loans to all kinds of investors, we basically have six to eight bids on every package. We keep servicing almost always -- in fact, always.

 We also deliver to Fannie, and that allows us to control the balance sheet growth as well as provide a full menu for clients. It works very well. It has a lot to do with how we can control the balance sheet growth. The secondary market came back starting in 2012. We're running at about $600 million per quarter, loan sales rate starting in 2012, and we make one-half to three-quarters on the average. These numbers look a little better now because we had some extraordinary quarters in the first quarter of 2013 and the last quarter of 2012.

 What do our home loans look like? Average loan divides about 60%, average size around $700,000. Liquidity, importantly, of our borrowers is equal to the amount of the loan, roughly. Net worth is about $2.4 million. I'm focused on the median not the average. The average is obviously higher because we have some very wealthy clients.

 Credit scores are 770 plus. This has not varied for years, if you go back. And as a result of this, we have had about 5 basis points of cumulative losses in 28 years in our home lending business, and that includes loans that we keep or loans that we sell.

 Multi-family and commercial real estate, we do a fair amount of business here. Again, sub-60% LTV, that translates into debt service coverage ratios of 1:25 to 1:50 or more. These characteristics are not changing. This is several quarters in a row, several years in a row, in fact, of our loan-to-value ratios. The underwriting standards are not varying at all. We are not dropping our standards. In fact, if anything, we've tightened them slightly recently.

 Historical losses -- we've lost 16 basis points on $110 billion of originations in 28 years, cumulatively not per annum. So it's a good credit story. The core of the business is credit, service, capital.

 Chargeoff experience -- we peaked at about 48 basis points in 2009. We're very consistent in what we do. The types of lending don't change. This is about three years plus a quarter. Single family is about 70%, it's about 65% or so now. Not much change, really. Commercial business lending is going up a bit. And where we lend is not changing much -- San Francisco was 51%, now it's 47%. So it's a very consistent enterprise.

 Business banking, big deal. We basically follow our high net worth clients to the businesses that they operate in, and/or the nonprofits. Here is what our business bank -- let me go back to that for a second. Growth rates are outstripping the rest of the bank. Deposits are 4.3 dollars of deposits, mostly checking, for every dollar outstanding. That is a very profitable relationship.

 What do we do for business banking? Well, actually, number one is nonprofits. 47 -- 42%, rather, of our banking, business banking is nonprofits -- schools, arts organizations, some religious organizations, wherever our clients take us. They're sitting on the boards of those organizations, and they take us to their passion or their heart. It's very good business.

 We do private equity venture capital funds. We bank about 950 funds, and then it drops off, really, to a group of various sub-verticals, as we call them. We bank about 120 vineyards, we lend to about 30. Deposit franchise, very core business. Business deposits are about half now, and we have multiple channels, so I'll ask Martin to speak about those in a moment.

 We have preferred banking offices, as well. We have basically bought preferred banking, private banking retail. There's one about a block from here over on Park Avenue and 51st. If you go in, you'll see all sit-down banking. There's no counters. It's been that way from the beginning.

 The private wealth management is growing very rapidly, and I'll ask Jeff to speak to this in a moment. We're doing a good job of having consolidated our offering. It's an open architecture objective offering. We don't have First Republic-made products, basically. And it consists of First Republic Investment Management, an RAA-type structure, a trust company as well as a broker/dealer.

 We've done well in terms of growing it. We're at about $45 billion, $46 billion now in assets. Fee income is going up very nicely. We've managed to maintain our expense ratios rather stably. We're at around 57%, 58%, 59%. We think we can operate between 55% and 60% basically.

 Efficiency -- we have about 2.5 times as many assets per person and about 2.5 times of profit per person, yet we pay higher than average, and we operate in coastal, expensive markets. The reason that can occur is we have very good people who work very hard. We're carefully selective as to who we have in our organization. We basically also have larger average transactions. Almost everything -- checking accounts to loan sizes, and very clean assets allow you to not be distracted with trouble. We also have very low turnover, and that's actually a critical component of the success of the model.

 Core net interest margin is under a little pressure still, we're operating at about 317. We can talk more about that if you'd like. Net interest income is growing nicely. EPS is following, and book value is actually outrunning each of those.

 Performance, we talked about this. Let me come back to the private equity, we were banked by private equity folks. They are out entirely now. That happened about a year ago at this point. And, with that, let me come back to that one right there. Maybe I could turn to Martin and ask you to describe for us for a moment or two the deposit franchise both in New York but how it works throughout the country?

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 Martin Gibson,  First Republic - Senior Managing Director Preferred Banking   [11]
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 Absolutely. So, you know, I think from the product perspective, it's a similar product base across all of the different banks. We had one nuance that tends to ring quite happily with our clients, which is the ATM rebate checking account, so you can use any ATM machine worldwide for free. We rebate those fees back to you and now our wealthiest of clients are happy to get the $1.50 back, or $3.00 or $7.00 in the room, train station, more than anyone.

 So the product set is particularly the same except for, really, the ATM rebate checking where we really differentiate and stand out. And when I came to New York 14 years ago and helped construct this part of the region, is the service delivery. As Jim mentioned, the preferred banking offices are private banking personnel on the retail banking for street level. So you go in, there are no teller lines. We bake fresh cookies each day. It's more of a living room type of atmosphere when you come in and sit down at a desk and conduct, kind of, the old-fashioned way of private banking.

 We have preferred bankers in all of our markets that work with the relationship managers like Jeff to help transition new clients over to the bank. Our sole purpose is to go out and help sell the banking piece on both the consumer and the business side. We then do everything from pre-filling account opening documents, helping clients transition over their bill pay templates -- whatever it is to help that transition period be an easy transition to First Republic. And then we stay with the client throughout their life at the bank, so they're not passed off to some servicing unit in Delaware or Dubai or what have you. All of our servicing people are here and know the clients, and we have a great accountability and ownership internally, and the client feels that as well.

 And then we have a client service team who handles the day-to-day transactions, but they sit in our San Francisco office, in our LA office, in our New York office. So we have a great relationship with them as do the client, and there's one phone number, one fax number, one e-mail address that's monitored by the manager to handle all of those day-to-day transactions.

 And we coupled that personal service with the technology. We do believe that technology is important. We don't want it to ever replace the private banking feel, but we want to make sure we have that method of delivery as well. So mobile, check deposits, remote deposit, online banking, bill pay, corporate online, whatever the tools are that different businesses or consumers would like to use to deliver the service, they can do that as well.

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 Jim Herbert,  First Republic - President and CEO   [12]
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 Great, thank you. Jeff, could you describe how we basically attract new clients and then the cross-sell that goes on with wealth management?

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 Jeff Bruce,  First Republic - Deputy Regional Managing Director   [13]
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 Absolutely. It really works two different directions. Historically, we started with the individual and got to know them, they got to know our service, and they asked us whether we could take care of their businesses. So we went from the individual level up to the business level, and those end up being our deepest, stickiest, and most profitable relationships if you are able to combine both of those elements.

 Over time, we've developed more and more of a reputation in business banking, so now we sometimes are introduced to businesses by other satisfied customers. We bank the business, then we, in turn, try to penetrate down to the individuals and reach them there as well.

 So we have products like our employee or partnership loan program, which we can work with businesses to roll out across their employee base, and that ends up being very successful for us because we end up developing relationships with all those key employees, and that entre on that particular loan then gives us insight and ability to build the relationship with them, which then can translate to not just simple deposit products but investment accounts and mortgage loans and, again, deepen the relationship.

 So there's really a flow both up and down individual to business and then across from individuals introducing individuals and businesses introducing new businesses.

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 Jim Herbert,  First Republic - President and CEO   [14]
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 Great, good. Thank you. Well, with that quick summary, maybe we'll open up for questions.

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Questions and Answers
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 Ken Zerbe,  Morgan Stanley - Analyst   [1]
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 All right, so we do have some polling questions if you guys want to participate. All right, so the first one -- what is the best reason to own First Republic? Both your loan growth and EPS growth; growth management; attractive return; given very strong asset quality; growth; evaluation; or do you prefer to own other midcap banks instead?

 Far and away, the answer is that both pure loan growth and long-term EPS growth. Perfect.

 Next question -- which risk to First Republic's earnings and share price are you most concerned about? Is it slow down of loan growth given the decline of mortgage and re-fi volumes, rising from clients regulatory expenses as they approach and cross $50 billion? Another capital raise or ongoing capital raises, I guess, until they LCR another reasonably growth. And then lack of asset sensitivity relative to the other banks?

 Okay, so pretty mixed between slow down in loan growth and lack of asset sensitivity.

 Before we go to the next polling question, I'd just love to flip it over to Jim. Jim, the asset sensitivity question has come up a lot in terms of my discussions with investors. Do you guys have any desire or plans, as we start to get closer to higher interest rates or higher Fed funds that you would alter your asset sensitivity and become more asset sensitive to benefit -- ?

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 Jim Herbert,  First Republic - President and CEO   [2]
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 Well, there's two things that we're doing. Yes, so we pay a lot of attention to this. We don't think of it as asset sensitivity, we think of it as asset liability matching. But the first thing is not to be mismatched; the second thing is to write up.

 We have just sold -- we sell a lot of loans to secondary marketing. Basically, we sell all of our fixed rate 30, 15s, and 10s, a lot of 7s, some 5s. And that's picked up a lot in the last few quarters. And then we extend out the liabilities. In fact, we just completed a deal today of unsecured senior term locked in for five years. So that's an expense on the liability side.

 The mix of our lending is not going to alter very much because it's consumer driven, and they're going to go where they're going to go on the menu that we offer. We could move it around by pricing, but that's like trying to sell small cars to big-car buyers. That isn't going to work. So, basically, it is what it is.

 We tip a little bit towards asset sensitivity as we get closer to that inflection point.

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 Ken Zerbe,  Morgan Stanley - Analyst   [3]
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 Okay, and then just -- I did have another question on part A there. Another concern that I get, or question I get from investors, deals with the slowdown in the mortgage market. We obviously think the NBA is expecting 40% decline this year in applications. I know that you operate a very different model than just a traditional mortgage banking business in terms of your help for investment portfolio, but is there validity to the risk -- that because we're seeing such a slowdown in re-fi volume, that actually puts pressure on your ability to grow through new client acquisitions, because there's just less volume to be done.

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 Jim Herbert,  First Republic - President and CEO   [4]
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 Yes, yes, there is validity to that. The slowdown in refinance will slow us down. I think Jeff can comment to the velocity of our purchase finance. It's really quite strong.

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 Jeff Bruce,  First Republic - Deputy Regional Managing Director   [5]
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 Velocity of purchase finance is quite strong, and we also feel that we can compete best with purchase finance because execution rises to the top of the list of what people are searching for. In the refinance market there's more sensitivity regarding rates. And so if we're 10 or 15 basis points off, but they have a great sense that we're going to be able to perform as we promised when we promised, in a refinance market that isn't as powerful as it is in a purchase market.

 So we're seeing, actually, more interaction with clients on pre-approvals and that we're winning more of the purchase business than we would in a refinance market.

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 Ken Zerbe,  Morgan Stanley - Analyst   [6]
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 All right, let's go to the next question. In your view, what should management focus on over the next 12 months -- complying and resolving LCR, maintaining a strong loan growth through hiring lenders, building out its wealth management platform, or building out its -- or its business banking?

 All right, it looks like a pretty strong opinion that wealth management is the right thing to continue to focus on.

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 Jim Herbert,  First Republic - President and CEO   [7]
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 We agree.

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 Ken Zerbe,  Morgan Stanley - Analyst   [8]
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 Great. Maybe one question from me before we get into audience Q&A. Just in terms of expenses, you're approaching the $50 billion mark, and I think a lot of banks that we talk to, you know, as they become CCAR banks or as they are CCAR banks, there's a lot of incremental regulatory expenses. Are you guys thinking about that now? What shall we expect in terms of the expense buildout as you approach and cross over $50 billion? How does that look, over time?

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 Jim Herbert,  First Republic - President and CEO   [9]
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 That's a very good question. I think the answers were our thinking about it. We're more than thinking about it, we're taking a lot of action on it. We did, for instance, stress testing two years in advance voluntarily and ordered to understand the process and get staffed properly to do it properly, get the flow of information mechanisms in place. So the one that we just submitted under DFAS is the third time we've done it.

 We are coming up on $50 billion. It's hard to really know, but I would expect that we would be $50 billion for the quarter moving average sometime late 2015, early 2016 probably. We have some control over that, obviously, but it's not the issue around which we're running the enterprise.

 And we have beefed up our MLBSA recently with a big hire and some new systems. We're putting additional money into compliance and internal audits, you might expect. And when we go past $50 billion, whether we're a bank holding company or not, it's not too relevant, we expect to act like one, and we expect to comply with everything that is at $50 billion.

 The biggest one coming and, of course, the final rules aren't out is LCR. And that's the one that's the hardest to gauge on, but we're already buying into high-quality liquid assets, and we'll do that like we do everything else -- calmly with a ramp up assembly in advance.

 So we're trying to anticipate as much as possible in advance -- everything we need to do and to get at it, not to wait. The expenses that are -- our run rate of expenses is probably not fully there yet, but it's well on its way.

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 Ken Zerbe,  Morgan Stanley - Analyst   [10]
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 Great. Is there a question from the audience? All right, in the interest of time, I want to thank you very much. I appreciate --

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 Jim Herbert,  First Republic - President and CEO   [11]
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 Thank you very much, thank you all very much.




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