Chemicals Monthly – Seeking Safe Harbor in the Storm

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Graham Copley / Nick Lipinski



July 16th, 2015

Chemicals Monthly Seeking Safe Harbor in the Storm

  • The last 4 weeks have seen several headlines which potentially have major ramifications for certain subsectors in our coverage. A Chinese slowdown, oil exports from Iran and more credit problems from Greece all pose a threat to different names in our coverage.
  • As oil slides and China’s slowdown appears to be more severe, prompting further stimulus, the Commodity group suffered. Outages are still a factor globally and we expect a very strong 2Q, particularly for DOW, but also for LYB. Valuations are not stretched given likely continued strong cash flows. DOW and LYB’s focus on polyethylene puts them in the lone space that Chinese exports are not undermining – China is still short polyethylene.
  • Propane has fallen significantly for the second month in a row and remains the favored US feedstock – export propane is a very attractive feedstock for those in Europe that can import (DOW). Ethane has been stable while propane fell 12% over the last month. Producers with flexibility in the US are using propane to the greatest extent possible (DOW, LYB).
  • The change of management at AXLL was seen as a positive, but was quickly overwhelmed with the PVC and caustic export increases from China and their impact on pricing. The story is no different for TiO2 and for other major commodities where China has a surplus, such as aluminum – lower Chinese energy costs have made things worse.
  • Our favorite names have not changed despite changes in valuation and the global growth outlook. EMN could be the next target of an activist given its low multiple, high cash flow and complex business, DD has made two disastrous strategic moves with the Trian fight and the Chemours spin and we think a change of leadership is inevitable we would be aggressive buyers at current low values because of that possibility – we would not buy Chemours!
  • The industrial gas names need growth and a weaker China and distracted Europe (Greece) do not suggest that strong growth is around the corner. We expect the pace of transactions to pick up here, especially for APD.
  • Research since our last monthly has included a piece on the changing fundamentals in an increasingly busy ag chem space and a piece on strategic missteps at DD.

Exhibit 1

Source: SSR Analysis

Exhibit 2

Source: SSR Analysis –
See Appendix 1
for background and see
Appendix 2
for a larger version of this table.

OverviewPitfalls and Opportunities Uncovered by the Turning Tide

There were many developments worth highlighting over the last month but we believe that three are particularly relevant to our Chemicals coverage and we highlight them below:

  1. The collapse of Chinese equities has drawn the spotlight on the country’s slowing economy and raised concerns of elevated exports as a lack of domestic consumption pushes excess product abroad. Major commodity inputs have also been affected (iron, copper, etc.)
  2. The prospect of Iranian oil exports may yet bring oil prices back into the low $40s should a deal be reached that allows the country to export in the manner that it has described.
  3. Greece has temporarily stepped back from the edge but it is evident that creditors will be taking losses at some point or Greece will departing from the Eurozone.

The AXLL activist that we mentioned last month may have won the leadership change victory, but now has to face concerns over China growth and lower China energy costs which have put even more pressure on already stressed international chlor-alkali and vinyl markets – both AXLL and OLN have underperformed as a consequence. We have voiced our concerns about China’s dubious fundamentals for several months but the country finally got some of the spotlight over the last month as its spectacular equity bull market suffered spectacular losses. While these losses seem to be a result of margin borrowing and valuations getting away from fundamentals, a certain level of scrutiny is now be levied against those fundamentals with implications for many commodities from coal to metals to petrochemicals. AXLL’s 14% decline over the last month is one symptom of the problems facing China; as consumption of caustic soda and PVC fails to grow at home, production must either be curtailed or it must be shipped internationally. The export of chemicals from a weakening China represents a threat to global chemical makers that is now being borne out in negative earnings estimate revisions and severe underperformance. This is not isolated to the chlorine chain and we see similar issues in TiO2, reflected in terrible performance from an over-levered Chemours as well as price declines for HUN and TROX. We
wrote recently on Alcoa
and aluminum, which is in the same boat.

While cash flows look high at DOW, LYB and WLK and while second quarter earnings could be very strong, especially for DOW and LYB, weaker oil is an overhang on the share prices and could remain so. Use of ample free cash will likely dictate stock performance post second quarter conference calls and we like DOW more than LYB and WLK on this basis as we think there is more opportunity for positive change. We have previously written that margins may suffer in ethylene and polyethylene should planned and unplanned outages finish up as expected in July and August. While it is hard for these names to outperform in a weaker oil market, we should note that ethane and NGL’s in the US continue to weaken, dropping ethylene production costs as they do.

DuPont is another company that we have discussed at length in recent months and we believe that the company’s valuation is now the most compelling that it has been in roughly a year as investors have become tired of management’s slow progress. The spinoff of Chemours and combat with Trian also brought extra scrutiny of the company; scrutiny that the board has done little to address. We think there is a chance that activists give it another go at these levels and this time they would likely win with a clear margin – DD is off 30% since its peak, at the point when it looked like Trian would win a board seat. DOW and APD both fared much better after engaging activists more constructively and their dialogue was rewarded with outperformance while DD has languished after its so called “victory” over Trian – Exhibit 3. We recognize that DD is on a short leash if the management team continues to miss opportunities (like those in ag – see our
recent piece
) and fails to address its shortcomings in returns generated on R&D and CapEx.

Exhibit 3

Source: Capital IQ, SSR Analysis

preferred names
have not changed despite recent headlines and volatility. We like DuPont because of its
large cost opportunity
and increasingly favorable valuation but our patience wears thin as
the company remains mismanaged
Downside may exist if the company cannot improve its R&D programs
, if it
ignores its cost opportunity
or if the company
misses out in a possible large ag industry restructure
due to its
inexpensive valuation though its complexity may weigh on shares
; and PX, based on valuation, pricing improvements coming across the gases names plus a history and outlook based on excellent cost and capital management.
PX has already fully priced in its downside and the opportunity is compelling at this price
. However, PX needs growth.


Exhibit 4 summarizes our valuation work and the subsector classifications are summarized in Exhibit 5. Revisions were mixed but they were accompanied by poor performance across the Chemicals space. The Commodity group had the most positive revisions which is apparently due to relative strength in polyethylene as ongoing outages maintain pricing even as oil tumbles. Chlor-alkali pricing has also suffered but these names have seen positive revisions as well though on a more limited basis.

Exhibit 4

Exhibit 5

In Exhibit 6, we show sector discount from normal value as measured by our valuation framework, and in Exhibit 7 we show discount by company. The subsectors have kept their positions despite some changes in valuation at the company level. Valuation dispersion within subsectors is still a factor in the Gases, Ag and Coatings spaces. Ag names remain the least expensive as a group. Coatings are still the most expensive with SHW driving much of the sector’s premium. SHW and CYT are marked in red due to their 10 year valuation highs in Exhibit 7. At the opposite end of the spectrum is MOS which trades near a 10 year valuation low.

Exhibit 6

Source: Capital IQ and SSR Analysis

Exhibit 7

Source: Capital IQ and SSR Analysis

Exhibits 8 and 9 show absolute and relative performance, respectively, of the Chemicals subsectors since the publication of our May Chemicals Monthly. Performance was positive over the last month for most of our subsectors. Ag names performed well as crops rallied due to supply and demand related factors. Commodity names underperformed the most of the group as oil tumbled and chlor-alkali remains in its trough. They still appear expensive as a group as illustrated in Exhibits 6 and 7. Though the Ag and Commodity groups represent disparate stories at opposite ends of the performance spectrum, our Chemicals companies as a whole performed at about the same level as the S&P.

Exhibit 8

Source: Capital IQ and SSR Analysis

Exhibit 9

Source: Capital IQ and SSR Analysis

Exhibits 10 through 12 show profitability at the sector, subsector, and stock level.

In Exhibit 10, we highlight several companies in green – all are at 10 year or all time peaks in return on capital. SHW therefore has some earnings support for the valuations in Exhibit 7. HUN is still inexpensive and overearning and therefore makes our Exhibit 1 screen. Coatings as a group are overearning which explains, at least somewhat, their steep valuations.

Exhibit 10

Source: Capital IQ and SSR Analysis

Exhibits 11 and 12 show the net income margin for the Chemicals sector as a whole and for the individual subsectors, respectively. Our Chemicals sector level profitability has marched higher for the second month in a row and remains elevated compared to its 5 year rolling average.
Exhibit 11

Source: Capital IQ and SSR Analysis

Exhibit 12

Source: Capital IQ and SSR Analysis

Portfolio Performance

The last month’s portfolio selections are shown in Exhibit 13. In a volatile but ultimately flat month, our performance more or less met the market’s. Volatility over the first half of the year has contributed to negative performance in the portfolios which is a departure from the success of previous years. This month, a few names had a negative impact on the long side while LYB and CF were winners on the short side. Historically, the names with favorable readings in terms of valuation and
our Skepticism Index
have produced alpha – Exhibit 14.

Exhibit 13

Source: Capital IQ and SSR Analysis

Exhibit 14

Source: Capital IQ and SSR Analysis

Industry Driver Summaries – Data/Anecdotes Behind Exhibit 1

Consumer Spending

  • Consumer spending in May was up 0.76% M/M and 3.4% Y/Y – Exhibit 15. Revisions were uniformly positive for the months of January through April.
  • After several months of sluggish data, May was a bright point for consumer spending, both in terms of the most recent figure and revisions. With the recent revisions, Y/Y consumer spending growth has averaged 3.1% this year and is now firmly above trend.

Exhibit 15 Exhibit 16
Source: BEA


  • Continued revisions paint construction in an increasingly favorable light. The figures from January through April have all been revised by ~$15 billion+.
  • May marked another strong month for construction spending. Spending was up over 8% Y/Y and almost 1% M/M. With revisions, April was up almost 6.5% Y/Y and March roughly 4.3% Y/Y. These positive numbers give some justification to strong forecasts from earlier in the year but it is unclear if they can continue in an environment where global growth concerns have rattled markets.

Exhibit 17

Exhibit 18

Source: US Census Bureau


  • Crops were up sharply over the last month, with soybeans up 10%, wheat up 16% and corn up over 23% – Exhibit 19. Heavy rains are expected to limit the yield of this year’s crops while demand is generally strong leading to a spike in prices and a 1 year high for corn.

Exhibit 19

Source: Capital IQ, SSR Analysis


  • The PMI was up again in June and now sits at 53.5. New orders ticked up from 55.8 to 56.0 but production decreased from 54.5 to 54.0. Inventories were up again, from 51.5 to 53.0. While the positive PMI number is favorable, we are skeptical of another move towards high inventories and lower production which may indicate stagnating growth.
  • The global growth outlook has deteriorated over the last month with the IMF trimming expected global GDP growth for the year to 3.3% from 3.5%. With the dollar recently stabilizing (Exhibits 23 and 24), we believe that North America will continue its role as a haven for growth and investment. Greece remains embattled with its creditors and it appears to be only a matter of time before either creditors take losses or Greece is forced out of the Eurozone – both negative outcomes. The fall of Chinese equities has taken a significant share of the headlines lately and has brought more scrutiny to the country’s growth outlook, as we wrote earlier. Commodities have also suffered from this development and we expect that China will get worse before it gets better.

Exhibit 20

Source: ISM
Exhibit 21

Source: ISM


  • The green line in Exhibit 22 is a twelve month rolling average. Cutting through the month to month volatility, we see Chemical trade volumes have been flat for the past several years. The case for US exports has again deteriorated with henry hub natural gas now trading for roughly $2.80/MMBtu and Brent hovering near $58/barrel.
  • It appears that April’s trade crash was simply volatility given the rebound we saw in May. However, we are not confident that US chemicals exports can remain high so long as low oil persists. Temporary spikes in certain commodity chemicals likely helped earlier in the year but it is hard to say that trade will remain strong in the second half of the year.
  • The USD remains strong as the global growth outlook softens and safety is sought in the debt of stable sovereigns. The Ruble is off 64% against the dollar while the Real is down over 41% year over year. The Euro is still weak with the recent Greek deal offering little support to the currency. The USD was 19.2% stronger versus the Euro in 2Q15 vs. 2Q14 and is 16.4% stronger in 3Q to date – Exhibits 23 and 24. We expect currency headwinds to cause sales and earnings downside for the full year 2015 across our space.

Exhibit 22

Source: US Census Bureau

Exhibit 23

Source: Capital IQ, SSR Analysis

Exhibit 24

Source: Capital IQ

Commodity Fundamentals


Please see our
December 2013 piece
for the way in which we think about ethylene supply/demand and our more recent
September update
. We remain concerned that high absolute pricing for chemicals are constraining growth, and this is evident in the very slow growth from 2012 to 2014 and the slightly better market we see today.

Propane is perhaps the most important element in today’s US Chemicals landscape even as the eyes of the world are drawn to China and Greece. Pricing has continued its decline and now sits at $0.33/gal as a result of oversupply which we believe cannot be rectified without a major boost to exports or a shift to propane which might not be possible given the industry’s current level of flexibility. So long as inventories remain at their current levels, propane will be the feedstock of choice. Ethane’s low cost basis is not as compelling as it once was.

Both the vinyls chain and the chlor-alkali space remain weak as a result of global oversupply, with pricing in PVC and caustic soda both particularly weak. This is one story in which China is particularly relevant. We believe that so long as China’s economy is decelerating, demand there will remain weak and the country will continue its export push. So long as China is pushing products in the vinyls and chlor-alkali chains into international markets, pricing will suffer. Poor performance in AXLL since we last published is symptomatic of this problem and we have difficulty getting constructive on that name and others so long as China continues its run of poor performance.

Outages in Europe and East Asia are still relevant but pricing in HDPE moved sideways over the last month. This is, in our view, due to the combination of oil’s slide with ongoing outages and the prospect of turnarounds coming to conclusion as soon as the end of this month as we previously wrote. Margins remain high for US producers and the case for the export of HDPE is still strong. However, it is possible, if not probable, that the window is closing if unplanned outages do not constrain supply in second half of the year.

Ethylene production is summarized in Exhibit 25 and operating rates are summarized in Exhibit 26. Note that at no point in the forecast period do we see operating rates that would suggest a tight market as in 2000 and briefly in 2005/2006.

Exhibit 25

Source: IHS, Wood Mackenzie and SSR Analysis

Exhibit 26

Source: IHS, Wood Mackenzie and SSR Analysis


The conversation in oil markets has focused on the supply side of the last month. The most significant headlines have been out of Iran where a deal regarding the country’s nuclear program may allow the country to expand its exports. It has been suggested that the country could up its exports from 1.4 million barrels/day to 2.4 million barrels/day but the timeline over which that might happen is unclear if those production estimates are realistic to begin with. Estimates are for the supply to come to market in late 2015 or early 2016 and, even with legislative and productive uncertainties, oil prices may have more downside. US inventories have been drawn down modestly over the past month – Exhibits 27 and 28 – but the focus has moved abroad at least for the time being.

Exhibit 27

Exhibit 28
Source: EIA, SSR Analysis Source: EIA, SSR Analysis

Natural gas production in the Marcellus fell for the second month in a row – Exhibit 30 and 31 – and appears to be coming off of its peak. Storage has continued building as we come out of the winter – Exhibit 29. Prices remain near $2.80/MMBtu as mild temperatures and low demand around the 4th of July have kept prices in check. Over the longer term, we question if prices can stay low when the production growth engine that is the Marcellus appears to be faltering. Production projections of over 18 billion cubic feet per day by 2H2016 now appear to be overblown. It is not clear if production is tapering as a result of temporary expansion issues, lower seasonal demand, because producers lack economic incentive to grow production as they have over the past several years or because production is currently maxed out. We believe that it is some combination of the former three.

Exhibit 29

Source: EIA, SSR Analysis

Exhibit 30
Exhibit 31

Source: EIA, SSR Analysis Source: EIA, SSR Analysis

Exhibit 32

Source: Capital IQ and SSR Analysis

Ethane remains near $0.17/gal. While ethane continues its relative stability, propane continues to provide excitement and has taken another leg down to $0.33/gal. With oversupply further depressing propane, we expect to see it move into favor at flexible crackers. We have discussed this dynamic over the last

and we have some difficulty seeing support for ethane given the favorable margins associated with propane or butane based ethylene production. Ethane has taken the backseat to propane and we expect this to continue until exports of propane grow materially or until the supply problem is otherwise remedied. The Conway – Mont Belview ethane spread has held steady once again. We do not believe that the spread is not wide enough to warrant discussion of serious inventory / supply and demand dislocations – Exhibit 34.

Exhibit 33

Source: IHS, Mackenzie Wood and SSR Analysis

Exhibit 34

Source: Midstream Business and SSR Analysis

Propane and butane are still the most attractive feedstocks in the US, especially in light of propane ongoing collapse. This is less obvious in Exhibit 35, which uses a 12 months rolling average. As mentioned on the previous page, propane is trading at around $0.33/gal in the US Gulf and is down another 12% at Mont Belvieau over the last month. Propane inventories hit another record earlier this month and currently stand at over 85 million barrels according to EIA data. We expect that crackers with the flexibility to use propane will do so as soon as possible which may alleviate some of the supply difficulties. It is possible that exports will be needed to seriously raise propane prices out of their trough. Butane has also declined again, down 1.8% over the last month and we expect to see it gaining some modest favor as a result.

Exhibit 35

Source: IHS and SSR Analysis

Basic Plastics

Polyethylene pricing has flattened as price gains associated with supply disruptions and declarations of force majeure have succumb to falling oil prices. US spot/export prices remain near $0.70/lb as ongoing outages around the globe create an opportunity to sell internationally and drive prices up at home. A significant portion of today’s outages were planned and, if everything goes according to plan, we expect to see something of a normalization in pricing and a decline in margins over the next couple of months as turnarounds conclude and capacity comes back online. The margins illustrated in Exhibit 36 have stopped their incredible climb and we expect that average margins for the full year 2015 will be lower than those observed in 2014, especially if outages are rectified as expected during July and August.

Exhibit 36

Source: Wood Mackenzie, Midstream Business, Industry Sources, SSR Analysis

Valuation Charts

The exhibits below show our mid-cycle “normal” valuation framework for the chemical sub sectors and the first exhibit (37) summarizes the results and is a repeat of Exhibit 4.
Exhibit 37

Valuation Charts – Exhibits 3840
Exhibit 38

Source: Capital IQ and SSR Analysis

Exhibit 39

Source: Capital IQ and SSR Analysis

Exhibit 40

Source: Capital IQ and SSR Analysis

Skepticism Analysis

We apply the framework from our skepticism analysis on the broader Industrials and Basic Materials sectors to the Chemical space – see
our past research for more detail
. The primary conclusions are:

  • Exhibit 41 shows each subsector’s Skepticism Index value. Since we last wrote, the diversified group has opened its moved even further upwards in terms of its SI value as the group’s PNE expanded. Coatings saw more multiple expansion after pausing last month. Exhibit 42 shows R2 by subsector, measuring the extent to which valuation is explained by return on capital. Exhibit 43 shows that the Specialty subsector has the widest divergence between ROC and PNE. In Exhibit 44, OLN now has the highest SI while HUN and ARG are both near 10 year SI highs. SHW is at its 10 year SI low.

Exhibit 41

Source: Capital IQ and SSR Analysis

Exhibit 42

Source: Capital IQ and SSR Analysis

Exhibit 43

Source: Capital IQ and SSR Analysis

Exhibit 44

Source: Capital IQ and SSR Analysis


Recent Chemicals Research

July 8, 2015 – DuPont and Chemours: Strategically Challenged

July 6, 2015 – Agriculture Musical Chairs, But With Different Music

June 5, 2015 – DuPont Question 2: Chemours is a No Win Scenario

June 5, 2015 – Skepticism + Positive Revisions = Outperformance

May 27, 2015 – DuPont – Question 1: Is the Return on R&D Investment Positive?

May 13, 2015 – The DuPont Vote – Short Term Noise – Change is Coming Either Way

May 12, 2015 – Corporate Complexity – Less Is More

May 6, 2015 – EMN – Time to Focus on the Shareholders

April 27, 2015 – DD and DOW – Backing The Activists

April 20, 2015 – Air Products is Running Out of Gas – Praxair is Refueling!

March 9, 2015 – Prices Falling, Dollar Rising – Stocks Defying Gravity

February 9, 2015 – Industrial Gases – Pricing Coming and Good for All

January 27, 2015 – US Ethylene – Who Will Blink First

January 13, 2015 – Own Goal Investing – EMN Presents Another Opportunity

January 12, 2015 – Favorites for 2015 & Industrials & Materials Methodology Review

January 5, 2015 – The Ethylene Conundrum: EMN the Value Play

December 9, 2014 – Weaker Global GDP Suggests Some Heroic Expectations/Assumptions

December 8, 2014 – LYB and DOW – A Holiday Present From Europe With Interesting Implications

December 4, 2014 – LyondellBasell and Westlake – Not Yet!

November 24, 2014 – Praxair – An Unusual GARPY Opportunity

November 11, 2014 – Eastman: A Good Story, But At Risk Of A Complexity “Own Goal”

November 6, 2014 – Capital Allocation – Why The Activists Are Where They Are

October 31, 2014 – The Power of Positive Thinking – APD and the DD read-through

October 16, 2014 – Commodity Chemicals – Overdone? Maybe Not

October 2, 2014 – DuPont Can Be a Bad Stock: If Trian is Right, But Gives Up

September 23, 2014 – Why 2015 Could Be a Short Sharp Storm for US Ethylene

September 17, 2014 – Rising Dollar and Falling Crude: Bad For Commodity Chems

September 11, 2014 – Oil: The Big Uncertainty for US Chemicals

September 9, 2014 – Marcellus Opportunity: Why We Should See More Chemical Investment

Appendix 1 – Exhibit 1 Analysis

In Exhibit 1 the following apply:

  • Green is good – Red is bad. The more intense the shade of green or red the more interesting or negative the factor looks for the sector.
  • Length of bar – wider signifies more important
  • Arrow direction – “Up” means the situation is becoming more positive from a stock selection perspective. So a green valuation bar with an upward arrow means that the stocks look cheap from a valuation perspective and they are getting cheaper. A red ISM bar with a downward arrow means that the ISM numbers suggest downside and they are getting worse.
  • Arrow size – how significant the move is.

Input Analysis

In the input analysis bar we attempt to show how important the natural gas/oil advantage is for each sector (length of bar); how positive it is (color of bar); and which direction it is moving (direction of arrow).

Demand Analysis

For each of our industry sub-sectors we have taken company by company data and generated an average segment exposure. For some companies this information is provided explicitly and for others we have taken estimates from presentations, annual reports and other sources. The segment break-downs are summarized in the charts below: Exhibits 45 to 49

Exhibit 45

Source: Company Reports and SSR Analysis

Exhibit 46

Source: Company Reports and SSR Analysis

Exhibit 47

Source: Company Reports and SSR Analysis

Exhibit 48

Source: Company Reports and SSR Analysis

Exhibit 49

Source: Company Reports and SSR Analysis

We have then grouped the categories into buckets for which we can measure growth drivers. Those groupings are summarized in Exhibit 50 below.

The first table summarizes the data in the pie charts above and then shows which market driver we use to model each end market. The second table then breaks each sub sector into these market driver buckets and then adjusts for how much business is in the US and how much is external. We add a factor which we call “trade” which brings into play the US trade balance and the strength/weakness of the dollar.

This analysis then drives the “Demand” section of the schematic in Exhibit 2.

Exhibit 50A

Source: Company Reports and SSR Analysis

  • Note that for the “trade” component, we have arbitrarily assumed that 25% of offshore sales are influenced by the US balance of trade and by exchange rates, while 75% of offshore sales are influenced by the same factors as listed above. It is more than likely that this is a different split for different sub-sectors and this will be a subject for further analysis.
  • Note also that we have done some initial correlation work to look at the impact of the factors below on revenue growth and it does show that sub-sectors with a greater exposure (in our analysis) to the ISM data (for example) have a greater correlation between the ISM numbers and demand growth. This will also be the subject of future research.

Exhibit 50B

Source: Company Reports and SSR Analysis

Valuation Analysis

The valuation analysis draws from our mid-cycle “normal value” work detailed above and our revisions work also detailed above. We have – for the moment assumed that valuation is 60% of the story and revisions is 40% for each sector. We will test this more empirically in the coming months.

Appendix 2

©2015, SSR LLC, 1055 Washington Blvd, Stamford, CT 06901. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

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