Q2 2023 Ares Commercial Real Estate Corporation Earnings Call
Good afternoon, welcome to the Ares commercial real estate Corporation's second quarter June 32023 earnings Conference call.
At this time all participants are in a listen only mode.
As a reminder, this conference is being recorded on Wednesday August 2nd 2023.
Now I'll turn the call over to Mr. Josh to them, our managing director of Investor Relations.
Good afternoon, everybody and thank you for joining us on today's conference call I'm joined today by our CEO Bryan Donohoe, our CFO Tae sik Yoon and other members of the management team.
And to our press release and the 10-Q that we filed with the SEC. We've posted an earnings presentation under the Investor resources section of our website at Www Dot Ares CRE Dot com before we begin I want to remind everyone that comments made during the course of this conference call and webcast as well as the accompanying documents contain forward looking statements and are subject to.
Risks and uncertainties.
Any of these forward looking statements can be identified by the use of words, such as anticipates believes expects intends will should may and similar such expressions. These forward looking statements are based on management's current expectation of market conditions and management's judgment.
They are not guarantees of future performance.
<unk> or results and involve a number of risks and uncertainties. The company's actual results could differ materially from those expressed in the forward looking statements. As a result, the number of doctors included those listed in its SEC filings Ares commercial real estate assumes no obligation to update any such forward looking statements. During this conference call will refer to certain non-GAAP .
Actual measures we use these measures as a measure of operations and these measures should not be considered in isolation from or as a substitute for measures prepared in accordance with generally accepted accounting principles. These measures may not be comparable to like titled measures used by other companies.
Now I'd like to turn the call over to our CEO Bryan Donohoe, Brian .
Thanks, John and good afternoon, everybody.
This morning, we reported another quarter of solid results as our distributable earnings have continued to benefit from rising interest rates as our unlevered effective yield is nearly 9%.
For the second quarter, our distributable earnings fully covered our dividend and we repurchased about 1% of our outstanding shares at pricing, which was accretive to our book value per share.
We continue to maintain strong levels of liquidity on our balance sheet, which provides us with the opportunity to drive positive outcomes on under performing properties.
Additionally, as we begin to see capital flows and some stability returned to certain sectors within the real estate market.
Our liquidity position and our access to accretive leverage should allow us to opportunistically invest in an increasingly attractive market for new investments.
During the second quarter, we focused on proactively managing our portfolio to maximize positive outcomes on our watch list assets.
We believe our team's experience across debt and equity positions us well to navigate these types of environments.
Specifically beginning in 2022 utilizing the market insights, we gleaned across the Aries platform and corporate credit and real estate equity led us to reduce our investment activity and focus on enhancing our liquidity further deleveraging our balance sheet and adding to the strength of our overall capital position.
The result of this is a net leverage ratio below 2.0 $215 million of cash and amounts available for us to draw on our working capital facility and no spread based mark to market financing.
We believe our balance sheet position provides us with multiple channels to continue to drive shareholder value over the long term.
We believe our capabilities and balance sheet flexibility are illustrated by how we are managing our $83 million senior loan collateralized by a mixed use property in Florida that we discussed on last quarter's earnings call.
We expect to complete the foreclosure and take the asset as Oreo in the third quarter.
Importantly, we do not anticipate taking a loss or impairment on the foreclosure.
As a reminder, the property exhibit stable performance underpinned by a nine plus year lease to a AAA rated government office tenants and well leased retail space with the opportunity for our retail equity colleagues to enhance the tenancy and cash flow.
Overall, the property is 90% leased and continues to generate cash flow that fully covers current interest payments given it's unlevered cash yield to our position is in the high single digits today.
The property has generated strong leasing interest.
And there are advanced negotiations with several significant tenants that have the potential to materially enhance the already strong cash flow profile of the property.
With a healthy cash flow profile and strong leasing momentum we are optimistic about the future prospects for this property.
We believe the breadth of asset management experience available with in the areas real estate platform is a key factor in both evaluating and operating this specific opportunity.
We mentioned earlier that we are starting to see some positive indications of stabilization in the commercial real estate market.
With this we believe we will begin to see opportunities for more loan originations.
Our strong overall balance sheet position alongside less competition from banks should provide us with opportunities to provide capital at historically wide spreads and we believe lower than average historical risk profiles.
Archer and acquisition activity in the banking sector capital market stability and a nascent pickup in transaction volume indicates some thawing in these markets.
With more than 250 billion of Unspent U S real estate dry powder.
And continued capital flow from international investors. The backdrop is there for a recovery across most property types.
We believe the current opportunity set will only be enhanced by the elevated level of maturities scheduled to occur in the next three years.
Given these favorable market dynamics, we're selectively finding accretive investment opportunities.
In the second quarter, we funded $80 million of new borrowings, including a $49 million senior loan commitment for an industrial property with unique cold storage capabilities that create significant barriers to new supply formation.
Our ability to provide this financing with meaningful equity behind our loan to a premier sponsor demonstrates the opportunities in today's lending environment.
We are also uniquely positioned to benefit from using available borrowing capacity on our revolving F. L. Three C O L with a legacy cost of funds, which enhance the level yield associated with the opportunities. We funded this quarter, including the industrial alone we closed.
We also continue to believe that our own stock is a compelling investment opportunity.
We repurchased 536000 shares or about 1% of our outstanding stock for an aggregate purchase price of $4 $6 million or $8 58 per share on average.
With a renewed $50 million stock repurchase authorization from our board in July we.
We are positioned to opportunistically invest further in what we believe is a compelling value in our stock.
With that tastes, let's walk through some of our financial highlights and further details on our portfolio and capital position.
Great. Thank you, Brian and good afternoon, everyone for the second quarter of 2023, we reported a GAAP net loss of $2 2 million or four cents per common share.
This loss was primarily due to a $20 1 million increase in our seasonal provision or about 37 cents per common share.
Distributable earnings for the second quarter of 2023 were $19 million or 35 cents per common share, which fully covered our regular and supplemental dividends.
Turning to our portfolio.
We ended the quarter with 53 loans held for investment.
Consisting of 98% senior loans and an outstanding principal balance of $2 3 billion.
In terms of our credit metrics are nonaccrual levels were stable quarter over quarter.
And we collected 96% of our contractual interest.
74% of our loan portfolio had a risk rating of three or better.
Which declined slightly from 78% that's up.
But the first quarter of 2023. This change primarily reflects the negative migration to loans.
Our risk rating of three two a risk rating of four.
The first of these two loans is an $18 7 million senior loan.
By a multifamily property.
On our last call.
Guys at this property experienced a payment default early in the second quarter.
The property is currently being marketed for sale by the borrower.
And based on preliminary indications of value we.
We expect that the proceeds from this sale will be sufficient to fully cover our loan balance.
The second loan that is now risk rated four.
Is it 68 9 million senior loan backed by an office property in North Carolina.
The property continues to pay interest and we are currently working through a potential loan modification with pharma.
Okay.
Our total seats a reserve at June 30 of 2023 is that a $112 million or about 5%.
Our outstanding principal balance.
Of the $112 million in reserves, 43% or 48 million.
Late two specific reserves for two loans that are risk rated five which together have an outstanding principal balance of $92 million.
The $4 million increase in the specific reserve this quarter on these two risk rated five loans was driven by further clarity around the specific outcomes of each ongoing sales process.
Specific reserves for these two assets include.
5.9 million reserve on our <unk>.
$35 million senior loan backed by our hospitality properties in the Chicago Metro area.
$42 1 million reserve on a $56 9 million senior loan backed by an office property also located in the Chicago Metro area.
Let me provide some further details on how our reserves in line with our risk ratings.
As previously mentioned, we have specific reserves of $48 million on or two loans that are risk rated five reps.
Representing 52% of the 92 million in outstanding principal balance.
Of the remaining $64 million of general reserves, another 47 million relates to the 498 million in outstanding principal balance of our eight loans that are risk rated four.
Which equate to approximately nine 5%.
The total risk rated four loans outstanding principal balance.
The remaining $17 million over total seats of reserve relates to the 1.7 billion of loans that are rated three or better equal.
Equal to about 1% of the outstanding principal balance.
And as Brian referenced we remain in a strong liquidity position with more than $215 million available capital as of June 32023, including $143 million in cash and further amounts available for us to draw on our working capital facility.
Yeah.
Our net debt to equity ratio was stable.
One nine times as of June 30 of 2023, providing us additional balance sheet strength and flexibility.
We also extended our $250 million Morgan Stanley credit facility to July 2025.
With no material changes to terms and pricing.
As a result, none of our secured financing facilities that we currently have drawn upon and initial maturities before 2025.
None of our financing is from spread based mark to market sources.
Before I turn the call back over to Brian Let me discuss our recent dividend announcement.
We are very pleased to have been able to distribute to our shareholders. A portion of the earnings benefit we derived from LIBOR floors on our loans and interest rate swaps on our liabilities.
Paying out two cents per quarter in supplemental dividends.
Since the first quarter of 2021 and for 10 consecutive quarters.
We have paid out more than $10 million to our shareholders in the form of supplemental dividends.
On top of our 33 cents per quarter regular base dividend.
Which during the same period totaled $165 million.
In comparison.
Again since the first quarter of 2021 our aggregate distributable earnings were 181 million means.
Meaning that we fully covered both our regular and supplemental dividends.
As we forecasted and in accordance with business plan. The LIBOR floors on our loans are no longer in the money.
Our interest rate swaps have mostly wound down.
After careful consideration going forward.
We believe that it is in the best interests of acre and our shareholders that rather than continuing to pay the supplemental two cents per quarter dividend.
And we instead focus on preserving capital to provide us with the opportunity to make further common share repurchases.
And originated new loan investments.
Fact, as you heard from Brian during this past quarter, we already repurchased $4 $6 million of our common shares which in dollar terms represents more than four quarters of paying out their two cents per quarter in supplemental dividends.
With that.
Let me turn the call back over to Brian for some closing remarks.
Thanks, so much tae sik.
We believe we're making steady progress on resolving our underperforming assets and our liquidity and balance sheet provide us with great Optionality.
We believe we can leverage the significant experience of the Ares platform to support underperforming assets and be more proactive in investing in the growing market opportunity.
We continue to believe it will take time for this cycle to play out and recognize there will be challenges ahead.
But because of these many advantages we believe we are well positioned to maximize outcomes and continue to deliver attractive shareholder returns on the other side of this cycle.
Let me close by saying that we are deeply grateful to our investors for the trust and confidence they've demonstrated an aries and their support of the company.
I'd also like to thank our entire team for their hard work and dedication.
With that I'll ask the operator to open the line for questions.
At this time, if you would like to ask a question. Please press Star then one on your Touchtone phone.
If you would like to withdraw your question. Please press Star then two.
Our first question comes from the line of Rick Shane with J P. Morgan. Please proceed with your question.
Thanks for taking my questions. This morning.
Look I think we're all trying to get a sense of.
Where we are in the credit cycle. It feels early we're starting to see this quarter, a higher frequency of our realized losses within portfolios.
Based upon your experience in previous cycles, how long and again trying to gauge on a quarter by quarter basis is almost impossible, but how long do you think this will persist is it a one year a headwind is it a two year headwind in terms of realized losses.
Yeah.
I appreciate the question I think it is that there are some unique attributes to this cycle and I think we've mentioned this in prior quarters, but.
Normally what we'd say at the onset of credit cycles would be.
Issues in the corporate market lead in and then.
The commercial real estate market follow and given the rapid rise in rates I think you're seeing a little bit of assimilation, there where you've seen corporate deterioration to some degree but also a more rapid.
Increase in some commercial real estate assets, having having some of those issues in real time so.
Fairly unique in that regard I'd say overarching though.
The rise in rates, which has that gravitational effect on on all assets that are that are levered outside of the office sector, you're continuing to see strong fundamentals.
Underlying are underpinning asset performance.
Your specific question on timing are hoping what we're seeing is an acceptance of this rise in rates, just being part and parcel with the market landscape and hopefully a quicker resolution on certain assets as you as you really picked through the winners and losers in the office sector and continued performance of other asset.
Classes that that werent over levered so.
I wish I could be more specific in predicting it but I think 12 to 18 months would be a good.
Good assumption from here.
Great I appreciate that thank you.
Our next question comes from the line of Sara Baack home with BTG. Please proceed with your question.
Everyone I was just hoping we could touch on the office portfolio for a minute do you think you could speak to the leasing momentum that you're seeing it does property or are there any specific properties worth highlighting that have had good news, we think or on the other side, maybe where there is significant.
Coming explorations or move out.
Things that you can give us there.
Yeah.
Yes.
The specifics will be tough, but I. Appreciate the question I think we have seen.
Generally increased traffic for again I mentioned in my my prior answer the.
Winners in the broad landscape of office and Youre seeing some of the equity office Reits reporting with with some similar narrative and certainly you've seen capital flows return and in some elements of scale to two class a institutional assets on the leasing side I'd say a couple of things what we are seeing.
Increased foot traffic things like that around certain assets.
That's coupled with a bit of a headwind in terms of leasing costs that have also increased so we're balancing those two factors.
But certainly it feels like I don't have empirical data to point to here, but from a utilization standpoint. It feels like we may have trough in terms of people going to work and it feels like especially post labor day. The momentum is there for more utilization and while the right sizing of some of these struck.
<unk> at least as well it will take some time it feels like we're finding some direction and footing broadly in the office market.
Okay.
And then apologies if I missed that if you already spoke to it but just trying to gauge the timing and I know this is a bit difficult to do but on that the 42 million specific reserve on the off the fact that in the 6 million dollar reserve in a hotel.
And when do you think that could manifest into into charge offs.
Maybe even just relative to each other roughly did.
Could you give any detail there.
Sure. Good question. Sarah This is a this is casey.
In terms of the hotel loan.
Again, I think we're further along in that process and we're hopeful to resolve that early in the third quarter.
Again, just a note of caution for us that.
During these times transactions are.
Yeah, a little less predictable in terms of timing, but we believe we're on track for third quarter.
With respect to the office loan. That's also a risk rated five in Chicago again, I think we're in a little bit of an earlier stage on that process again, we are working very very diligently to resolve that.
It's probably going to be towards the year end, if not heading into early 2024.
So were probably you know call it six months out plus or minus.
Very unlikely to be a third quarter event.
For or that office property.
If that's helpful.
Okay, great. Thank you.
Our next question comes from the line of Doug Harter with Credit Suisse. Please proceed with your question.
Oh, Thanks, you talked about the.
Potential to see some some new loan activity you know could you potentially size that you know would you expect to grow the balance sheet or is this more maintaining the size and you know how are you thinking about now where leverage levels can go with those opportunities come to fruition.
Yeah.
Yeah, absolutely I'll start and I'll, let I'll, let tae sik chime in as well I think you saw it in our prepared remarks the.
The single origination that we did see this quarter and the commentary that it does feel like there's starting to be more of an opportunity set for us and more stability around valuation and each of those things should be contributing factors I think the fact that we've got additional leverage available to us both through.
Potentially increasing from our our sub two point out but also the F. L. Three legacy CLO that we work with them, which is extremely accretive leverage, especially given the rise and spreads that we've seen over the past 18 or so months.
I wouldn't say that the market is in equilibrium yet so it will be more sporadic in nature, but I think you can assume a further increase throughout the following couple of quarters as as buyers and sellers of real estate come to agreement on price and also just that maturity wall that has been well at.
<unk> I think as kind of a headline risk, but we really see it as an opportunity so.
What we will focus on just two.
Add a little bit finer point.
Or kind of going up in credit so yes.
Yes, the spread associated with the loan that we made this quarter was probably a <unk>.
Significant increase from where it would have been 18 to 24 months ago, but south of what's available in the market just given the credit metrics associated with it but when combined with the legacy liability structure that produces a really interesting.
Yield premium to historical norm so.
I wouldn't say, it's a normalized market, but I think you can expect more of the same moving forward from here.
Great. Thanks, Brian .
Yeah.
Our next question comes from the line of Steve Delaney with JMP Securities. Please proceed with your question Hi.
Hi, everyone. Thanks for taking the question I wanted to talk a little more about the Florida mixed use property that you anticipate for closing up on just to be clear you indicated no impairment. So does that imply there's no specific reserve on this particular property at this time.
Steve. Thank you very much for your question that is correct.
Again. This is a this is a loan that we have been working very very closely on of course.
And as we mentioned this property is performing we believe very well with strong tenancy and cash flow.
We do not have any material specific reserve against this asset.
And we believe that when we do take it Oreo that we will not recognize any fair value loss upon it converting to an Oreo asset that is correct.
It sounds like this is not going to be a take back in and flip situation, though from Brian's comments I gathered that.
Your equity people you know asset management people have some thoughts about how to enhance the value. So if that's correct should we think of this as more like the hotel in Westchester that you took back a few years ago and manage that back to a profitable outcome.
I think that was a matter of two or three years. This it sounds like maybe this won't take that long just a little color around that would be helpful.
Yeah, I think theres, a little bit of subjectivity to it but I think your general approach is correct.
Our hope would be to resolve it more quickly than the Westchester Marriott situation, but as we indicated in our remarks, we are seeing.
Some potential to to improve on the cash flow and ultimate value resolution here.
And the retail team that sits more generally with our equity.
Investment vehicles, but.
Bring them to bear on this asset we think can be accretive and so we think theres some value creation out there that said, we remember are our charter as we've touched on in previous quarters, we want to get back to our core lending vehicle and.
But our equity colleagues on assets, so I think youll see us resolve this as expeditiously as possible.
Especially if we can increase that rare.
The revenue side and see is some normalization of capital market's treatment of high cash flowing assets like this.
That's helpful. Brian . Thank you so just flipping, but you mentioned core lending activities.
How would you characterize your current appetite for new loans, taking advantage of some of the higher yields that are likely available.
Are you thinking just.
Lynn.
<unk> to cover your right repayments that are coming in or is there room to to slightly grow the portfolio on a net basis here over the next couple of quarters.
I think the approach we're going to take philosophically is selectively opportunistic.
Okay, you are starting to see more opportunities come across the transom and when they fit.
The narrative in the risk profile, we want to achieve then you'll see us seek.
Seek out those types of opportunities and hopefully the result of that will be portfolio growth having to again the equity position, we sit with as well as the leverage available to us.
Tough to predict this is Ben some ebbs and flows in our market generally.
As we've said the Optionality that we feel we've created by positioning the balance sheet as we have.
It should allow us to take.
Take advantage of what we see coming over the coming months.
Great and maybe just put some numbers to what I said.
Yeah.
Yes, Im sorry, just to put some numbers to what Bryan said, we do believe that we have balance sheet room to incrementally grow the balance sheet and not just redeploy repayments.
Given the liquidity levels that we have today.
We probably have capacity call. It in the three to 400 million senior loan capacity.
So we do have room in the balance sheet to grow incremental incrementally from here.
Excellent point, Thank you will keep that in mind, when we model going forward and just lastly, I just want to say applaud the buyback I think at this point in the market where stocks are trading.
I think it's just way more effective use of that capital for the benefit of the shareholders and a more so than the two cent supplemental so thank you for for the buyback activity and that's all for me.
Yeah.
I appreciate it. Thank you thank you for that.
Our next question comes from the line of Jin Ramani with Keyw. Please proceed with your question.
Thank you very much I just wanted to ask about liability management, when you think about Oreo the.
The property you're going to take.
Into Oreo and anything else sub performing loans or are you.
Do you anticipate financing those do your current facilities accommodate financing those or are you going to pursue a separate facility.
Uh huh.
Those kinds of assets.
Yes, Thanks, David I. Appreciate the question I think the general approach would be that we will seek out the spoke financing for assets like that with the.
Overlay that that our lending partners have been.
Accommodating and flexible as we work through and put the proper structure in place.
The knowledge transfer that as you would expect occurs as you get closer and closer to taking somebody RVO is significant and can lead to more efficient financing as you map out that business plan. So the good part is we're not necessarily in a rush.
Owing to our existing financing counterparties pushing us in one direction, but we do think there's going to be some leverage pickup available to us as we work through it and bring our own expertise to bear on some of these assets. So a bit of a hybrid but I think you could expect us to ultimately.
To the extent that we think we're going to hold something for <unk>.
Longer period of time to think outside of 12 months, then we will.
Seek out specific financing for that asset.
And if you're refunding.
Performing loan at say, 70% on a credit facility you know what proportionately would change.
Clearly you have to fair value of the collateral, but let's just say.
There isn't a hit to the value of the collateral.
Are you still able to fund at 70%.
Okay.
I think there's a there's a cost benefit analysis associated with I think there is certainly is leverage available for certain assets in that in that range when.
When we think about what we're trying to achieve here, which is ultimately.
Sound balance sheet and dividend coverage, we may seek out a lower leverage option. If the pricing is about what we see in these interrupted or distant.
This intermediate in markets like like we have around US generally is there some gaps between an asset that might fit for instance, in a life insurance company bucket versus see MBS versus an alternative lender and when those gaps exist you just simply need to measure the incremental cost of capital.
Versus versus the liquidity profile of the individual position. So we'll balance all of that but certainly we believe that there is ample debt market capacity for the types of assets, we're talking about today.
And Jay maybe just to add to Brian's comments again, I think one of the advantages we have with our balance sheet.
Is just given our liquidity profile not that that is what we intend to do our hope to do but certainly we would have the balance sheet strength to hold some of the assets either unlevered for some interim period or at a lower leverage level than what we previously financed alone for so again that is one of the reasons, we have maintained the liquidity level.
It was to provide us maximum flexibility. So that we can again worked towards maximizing value you know when we.
We have to work out an underperforming asset.
Okay. Thanks for that and then recently I think there's been some chatter and various industry publications about the pick up in securitization as well as potential for Cielo has to offer you know financing of nonperforming loans or sub performing collateral.
And I was wondering if you are viewing that as a potential way to.
Yeah, I don't know what the right time is but sort of ring fence or you.
You know put a circle around the downside risk and those kinds of assets, which were you know better allowed the company to go on offense.
Yeah.
Yes, I think what you've seen us.
Execute on historically Jayde has been a pretty diverse set of financing structures. Certainly we've utilized close we've utilized warehouse a notes et cetera, and absolutely aware that.
The.
The <unk> of private capital in the capital markets alongside some stability in rates is allowing for a structured resolutions and we would absolutely keep that on the menu as we seek to resolve some of these assets I think pretty early days in terms of the resurgence of the CLO market.
Alongside general transaction activity, it's tough to say that it is.
At least a hint of green shoots to come with that stability. So agree it should be something too.
Certainly consider and pursue.
Thank you.
[laughter].
Thanks, David.
And our next question comes from the line of Derek Hewett with Bank of America. Please proceed with your question.
Good afternoon, everyone. The Morgan Stanley facility was recently extended to mid 2025, so from a high level are you seeing any change in the risk tolerance for from your Counterparties, especially since we saw that the regional bank crisis.
Earlier, this year and and for example was there any change in the Morgan Stanley .
Terms, whether it be spreads advance rates or or potentially other restricted covenants.
Derek Thanks, so much for your question.
Maybe on the second part of your question no. There were no real material changes to the terms again, we extended it out to July 2025.
In addition, we have a one year extension option built then even after that.
Really no material change in terms of the $250 million facility.
Got.
In response to maybe your first part of your question about appetite for credit risk appetite to accept certain types of loans.
I think one of the big benefits of.
We have diversified our funding sources and really focused on what we consider to be major money center banks, with whom Ares overall have excellent relationship I think we've enjoyed a very stable relationship with each of our lenders and while each of the lenders are obviously reacting.
Two what's going out in the market. We do believe that we will continue to see very strong acceptance of the type of loans that we do as collateral for our funding facilities clearly if we brought them.
A loan today that is in one of the more difficult sectors like office. For example, I think we would all have a little bit of challenges in that context, but overall.
While there is a tighter credit bucket overall.
We do think that our warehouse lender lending capacity is not a limiting factor in.
In terms of us originating new loans.
Thank you.
Yeah.
Thank you.
We have reached the end of the question and answer session I'll turn the call back over to Bryan Donohoe for closing remarks.
Thank you and I'd just like to thank everybody for their time today. We certainly appreciate the continued support of Ares commercial real estate and we look forward to speaking to you again on our next earnings call. Thanks for the time.
Ladies and gentlemen, this concludes our conference call for today, if you missed any part of today's call an archived replay of this conference call will be available approximately one hour. After the end of this call through September <unk> 2023 to domestic callers by dialing 8776606853.
Anthony International callers by dialing 20161 to seven four in Wifi for all replays. Please reference conference number 13738843, an archived replay will also be available on a webcast link located on the homepage of the Investor resources section of our website.
Okay.
Goodbye.
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Yeah.
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Yeah.
Uh huh.
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