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The information content of plant closing announcements: evidence from financial profiles and the stock price reaction.

* A plant closing announcement provides information not just for the plant being closed but also for other operations and the firm as a whole. Examination of financial profiles for firms announcing plant closings indicates that closings are followed by firm-wide problems extending far beyond the closed plant itself. Closings tend to be followed by declining profitability and symptoms of retrenchment including cutbacks in employment, asset acquisition, and dividend growth. Such firm performance subsequent to the closing indicates that the information effect of the announcement should not be limited to the closed plant, but may instead extend to the entire firm.

Downward revision of cash flows by investors should result in a negative market reaction to the closing announcement, with the strength of that reaction related to the information effect of the closing for the entire firm's operations. Results of this study provide evidence of a negative stock price reaction to plant closing announcements. The stock price reaction is more negative for closing announcements of plants whose cash flows are highly related to the firm's entire operations and for plants that comprise a large portion of the firm's operations. Consistent with the analysis of financial profiles, the tests of market reaction to the announcement also demonstrate that plant closing announcements convey information not only about the particular plant being closed, but also about the firm's entire operations.

Section I of this paper examines the plant closing decision and its information content. Section II describes the data sources. Section III presents the financial profile and changes in the financial characteristics of firms surrounding annoucements of plant closings. This analysis is followed in Section IV by an examination of the impact of plant closing announcements on shareholders' wealth categorized by the reasons for plant closings, the relative size of the closing, and relatedness of the closed plant to the firm's other operations. Section V presents concluding remarks.

I. The Plant Closing Decision and Its Information Effect

A. NPV Effects of a Closing Decision and Its Information Effect

A plant closing decision is undertaken when the closing has positive net present value; that is, when the discounted value of cash flows from operating the plant is less than the expected cash benefits of closing its (Robicheck and Van Horne [14], Dyl and Long [7], and Joy [9]). When a plant is closed and idled (not sold), except for some tax benefits or salvage value of assets,(1) the only benefit is avoiding future cash flow losses. This loss avoidance is the source of positive NPV from closure.

To the extent that closed plants comprise a small fraction of the firm's operations, the NPV impact should be small and difficult to measure in an event study. Market reaction to the announcement should be attributed primarily to the information effect of the announcement, and related to changes in investor expectations of firm performance subsequent to the announcement and its consummation.

B. Information Effects of a Closing Announcement

1. The Direction of the Stock Market Reaction

Although a closing announcement indicates positive net present value attached to the closing, it also indicates that the plant in question is worthless and that any operating options (Mason and Merton [12], and Trigeorgis and Mason [17]) for future investments have become worthless as well. Unless investors had some reason to have been aware of the plant's true value, the closing announcement should cause a downward revision in cash flow expectations for at least that plant, and, perhaps, for other related plants as well. The information effect of a closing announcement would therefore be negative.

If, instead, investors had been aware of the true value of the plant or of the firm's problems, but anticipated nevertheless that the plant would remain in operation,(2) the closing announcement should be met with a positive stock price reaction. Such a reaction would be attributed to the positive NPV implied by the closing, together with expectations for changes in managerial policy that might lead to improvement in firm performance.(3) In this case, both the NPV effect and the information effect are positive.

A positive information effect from a closing announcement should ensue in the presence of two conditions: (i) evidence of problems prior to the closing announcement, and (ii) anticipation of improved performance following the announcement. First, because plant-level information is not widely available, evidence of problems must be interpreted from information available at the firm level. Therefore, the firm's financial condition prior to the announcement may provide an indication of the firm's problems.

Anticipation of improvements in cash flows and profits as a result of the closing decision is also required for a positive information effect to obtain. Realization of a turnaround in firm performance following the announcement would be consistent with higher investor expectations, giving the closing announcement a positive information effect. The converse situation, i.e., deterioration of firm performance following the closing, combined with no previous evidence of problems prior to the announcement, is consistent with a negative information effect.

2. The Magnitude of the Reaction

The magnitude of the reaction to a closing announcement depends upon both the relative size of the plant and the degree to which cash flows of the closed plant and those of core operations are related. When a plant comprises a large portion of the firm's operations, both the NPV effect of its closing and the information effect can be substantial. The information effect of closing a plant central to the firm's operations is not limited to the plant in question, but extends beyond it, causing investors to revise cash flow expectations for other operations. Evaluation of the consequences of the information effect requires recognition that a plant is not an isolated profit center, but an integral component of the firm's operations.

C. Previous Empirical Evidence

Previous studies provide evidence of a negative stock price reaction to reduced investment, abandonments, and plant closings. McConnell and Muscarella [10] find negative stock price effects associated with unanticipated decreases in capital budgeting expenditures. Negative valuation effects to announcements of project abandonments, although small, are also found by Owers and Rogers [13].(4) Blackwell, Marr, and Spivey [2] show a statistically significant negative impact on stock prices from announcements of plant closings. A particularly strong reaction is found for closing announcements motivated by lowered profitability. Blackwell, Marr, and Spivey [2] also show that firms announcing plant closings experience declines in profitability after the announcement.

Some empirical evidence of a positive reaction to project terminations is presented by Statman and Sepe [15], who examined such announcements by firms with reported losses from discontinued operations. The information effect of these announcements, conditioned on investor knowledge of losses, generates a positive stock price reaction for firms in their sample. Knowledge of losses could prompt investors to foresee future losses, unless losing operations are terminated. In the absence of such knowledge, however, investors may not have sufficient information to determine whether specific operations generate losses or whether these losses might continue in the future.

D. Testable Hypotheses

Assuming that plant closings are associated with firmwide problems, this study hypothesizes that closing announcements will be followed by deterioration in firm performance. If investors expect deteriorating firm performance, it is hypothesized that a negative stock market reaction to the closing announcement will occur. Furthermore, the magnitude of the stock price reaction to the announcement depends upon the cash-flow-relatedness of the closed plant to the firm's entire operations.

Prior research showing a negative stock market reaction indicates that the firm's financial condition prior to the closing announcement should provide limited evidence of firm-wide problems. Deterioration in firm performance following the announcement would also be consistent with a negative stock market reaction. The magnitude of this reaction should be related to the extent to which the closed plant is integral to other operations. Accordingly, a larger negative reaction should be observed for plants that are more closely related to the firm's core operations, as well as for larger plants.

The correlation between cash flows of the closed plant and those of core operations could be stronger for plants that operate as part of firm units rather than subsidiaries, and for plants that are located in the same country rather than foreign plants. Units of a firm typically represent internal growth, whereas subsidiaries more typically arise through acquisition. Until recently, the Justice Department placed strong limitations on vertical integration through acquisition or on acquisition of competing firms. Therefore, internal expansion was the predominant avenue for expanding the firm's core business while acquisitions served to provide broader diversification for the firm's operations.

Foreign plants, according to Boddewyn [3], are closed when the firm's foreign operations no longer provide competitive advantages relative to local firms or when the parent firm can better capture foreign markets through other means, including relocating foriegn operations. Foreign operations offer various arbitrage benefits, including exploiting transient cross-border differences in exchange rates or labor costs (see Baldwin [1]. When these advantages diminish, the reasons for operating a foreign plant in a specific location no longer remain valid. Such diminishing arbitrage conditions imply little about core operations. Therefore, the market reaction to a foreign closing should not be as large as the reaction to a domestic closing, and the market reaction to a closing in a subsidiary should not be as large as the reaction to a closing in a unit.

II. Data Sources

The sample of plant closing announcements was obtained by a search of the Wall Street Journal Index for announcements of plant closings from 1980 through 1986, inclusive. This search identified 982 announcements. The sample was subjected to the following criteria:

(i) The plant closing was permanent: the site was never reopened or sold to another party. Permanency of the closing was verified by the absence of a reopening or sale announcement in the Wall Street Journal Index for the period 1980-1988. [TABULAR DATA OMITTED]

(ii) The plant closing was unanticipated, with no prior published announcement of the closing possibility. The unanticipated nature of the closing was assured by the absence of information in the Wall Street Journal Index relating the performance of the firm to the potential for a plant closing.

(iii) Securities of the announcing firm were traded on either the NYSE or Amex at the time of the announcement.

(iv) The plant closing was voluntary; it was not prompted by safety, environmental, or regulatory considerations. Moreover, the closing was not attributable to political or social reasons; e.g., closing of operations in South Africa.

(v) No contaminating announcements were reported between ten days prior to and ten days subsequent to the plant closing announcement. The Wall Street Journal Index was searched for any contaminating information effects, such as earnings or divided announcements.

Application of these criteria reduced the sample of 982 announcements to 344 announcements. This set was reduced further to 282 announcements made by 187 firms for reasons such as missing CUSIP numbers, missing estimation interval information on the CRSP tapes, or missing CRSP data on the announcement date. In the case of study of financial profiles, the number of announcing firms was reduced to 134, because of the absence of financial statement information on the COMPUSTAT Industrial File for the designated period. Exhibit 1 contains statistics for sample firms in Panel A and statistics for sample announcements in Panel B.

Notable is the relatively large size of the firms making closing announcements, as measured by total employment in Panel A, and the small relative size of the closings, as measured by layoffs due to the closing in Panel B. The NPV impact of the decision should be relatively small, because the plants do not comprise a substantial portion of the firm's operations.

Using the published announcement in the Wall Street Journal, we categorized the sample of 282 announcements according to two criteria: the location of the plant and its relation to internal corporate structure. Both categorizations serve as measures of relatedness between the closed plant and other operations. Because foreign plants serve mainly to exploit arbitrage opportunities, they are not as closely related to core operations as domestic plants. Plants of subsidiaries and affiliates operate in legal organizations separate from the parent firm and should also be less related to core operations.

We further categorized closing announcements according to the reasons for the plant closing.(5) Categorization allows differentiation between economy-wide or industry-wide circumstances and firm-specific circumstances. While extra-firm reasons, which include economy-wide or industry-wide circumstances, should be well recognized by investors, intra-firm reasons may be unanticipated.

Extra-firm reasons include: industry-related conditions, such as introduction of innovative technology in the industry, excess productive capacity in the industry, or low demand for the industry's products; and foreign competitive pressure on the industry. Often no extra-firm reasons were reported.

Intra-firm reasons include: unprofitable operations and product-related circumstances, such as new product introduction, product termination, high inventory of obsolete products, and/or low demand for the firm's product; and restructuring of the firm's operations.

III. The Financial Profile of Firms Announcing Plant Closings

Financial information was obtained from the COMPUSTAT Annual File for seven years: four years prior to the closing, the year of the closing, and two years following the closing. Information for all seven years was available for 134 firms. The firm's financial condition following the closing is examined to see whether the closing is followed by improved performance or deteriorating performance.

A. The Financial Measures

The examination is based upon a broad set of measures that includes (in addition to a profitability measure specified by Blackwell, Marr, and Spivey [2]), measures of activity, leverage, and liquidity, as well as measures indicating the investment and dividend policy of the firm.

At least one measure represents each of the factors of financial performance identified by Chen and Shimerda [5] and by Gombola and Ketz [8], with the exception of factors associated with receivables or inventory intensiveness. The factors and associated variables include profitability (operating income(6) to sales and earnings per share), financial leverage (total debt to total assets(7)), asset turnover (sales to total assets), cash flow (cash flow from operations(8) to assets), and liquidity or asset structure (working capital to total assets).(9)

Measures of investment (gross plant), production (total number of employees), and dividend policy (dividends per share) allow inference of management's expectations of future prospects. Examining changes in gross plant over time is equivalent to examining the result of a firm's capital budgeting policy. The firm's employment level measures the extent to which fixed plant is utilized. In conjunction with expenditures for property, plant, and equipment, the measure also indicates the firm's substitution of labor for capital.

B. Intertemporal Changes in Financial Measures

The intertemporal analysis helps us determine whether changes in firm condition following announcements of plant closings tend to indicate deterioration or improvement. In addition, the intertemporal analysis seeks to determine the extent to which the closing might have been anticipated from firm performance prior to the announcement.

Exhibit 2 shows, for each year studied, the number of firms in the sample that show an increase, a decrease, or no change in each financial measure relative to the previous year. This statistic forms the basis of a test for year-to-year changes in the financial measures, the sign test described by Conover [6]. The test statistic is the number of positive observations out of the sum of positive and negative observations.(10)

There is little indication of financial problems prior to the year of the closing. To the contrary, significant increases in earnings per share are shown between four years prior to the closing announcement and three years prior to the announcement. The only clue that could be interpreted as indicating problems prior to closing is a decline in working capital, which could signal only a stricter working capital policy.

Significant changes occur in the year of the closing announcement. Operating income to sales shows a statistically significant decline for the year of the closing announcement. The following year, another significant decline in operating income to sales is accompanied by a significant decline in earnings per share. The year following the announcement also shows more declines than increases in both sales to assets and cash flow to assets, although these decreases are not statistically significant.

With a decline in profitability and working capital, some change in dividend growth did occur. Instead of statistically significant increases in dividends per share for the fourth year prior to the announcement, later years show no significant increases in dividends per share. No improvement in the proportion of increases is shown even for two years after the announcement.

Cost-cutting measures are also apparent, with the number of employees significantly decreasing for the announcement year and for each of the two years following the announcement, reaching a low point two years after the announcement. Declines in employees are not matched by declines in gross plant, however. Statistically significant increases in gross plant are shown for each year of the study, although the level of significance declines following the announcement.

C. Cross-Sectional Comparisons of Financial Measures

Changes in financial measures across time, as shown in Exhibit 2, may be attributable to industry-wide factors rather than firm-specific factors. In order to control for industry-wide factors, sample means of financial measures are compared to means of a matched sample of firms that did not announce a plant closing during the sample period. The pairing is based on industry grouping, which is measured according to four-digit SIC code, and size, which is measured by total assets during the year of the closing announcement. Means of the variables for firms announcing plant closings,(11) for the set of matched firms, and t-values for a test of differences in these means are reported in Exhibit 3.

Perhaps the most striking difference reported in Exhibit 3 is in the profitability measure, operating income to sales. For the year following the plant closing announcement, the mean for companies announcing plant closings is less than one percent while for the matched companies it exceeds four percent. The difference in means is significant at the 0.01 level. This difference remains significant two years following the closing announcement. The cash flow measure follows a similar pattern. Therefore, there is no evidence to suggest that the closing should be associated with improved profitability or improved cash flows for the entire firm.

The decline in growth of capital investment reported in Exhibit 2 becomes striking when placed against the backdrop of capital budgeting policy for the matched sample of firms. As late as one year prior to the announcement, mean gross assets for announcing firms exceed those of the matched sample. For the announcement year and for each of the four following years, mean gross assets are less for the sample of announcing firms than for the matched sample, although differences are not statistically significant.

Prior to the closing announcement, the closing firms employ a significantly larger amount of debt in their capital structure than do the matched firms. After the closing announcement, differences are no longer statistically significant, although the difference maintains the same direction. Therefore, there is an indication, albeit weak, that the closing firms become somewhat less aggressive in their capital structure decisions following the closing announcement.

Taken together, the evidence in Exhibits 2 and 3 indicates that sample firms experienced no significant problems prior to the closing announcement. Following the closing, the evidence points to considerable problems, particularly with the operating profitability measure. Therefore, results reported in Exhibits 2 and 3 are consistent with the premise that the announcement effect of the closing precedes declines in performance. Such an information effect should produce a negative stock market reaction.

IV. Shareholder Wealth Effects From Plant Closing Announcements

A. Methodology

We used standard event study methodology (Brown and Warner [4]) to examine the stock market reaction to plant closing announcements. Prediction errors (PEs) were calculated based on the market model with coefficients estimated with OLS for a period that begins 200 days prior to the announcement and ends 60 days before the announcement. The test statistic [Z.sub.t] for the average prediction errors (APEs) is based on the standardized prediction error ([SPE.sub.it]) calculated as:

[Z.sub.t] = [SPE.sub.it]/[n.sup.0.5].

In addition, the announcement effect is examined via two distribution-free approaches: comparison of the number of negative prediction errors to the number of positive prediction errors (the sign test), and the test of significance for the Wilcoxon signed ranks test, both of which are described in Conover [6].

B. Results

1. The Total Sample

Exhibit 4 reports the results of the event study analysis for various intervals. The two-day APE for the [-1,0] period is -0.582 percent, a result statistically significant at the 0.01 level. The nonparametric Wilcoxon test indicates a significance level of 0.062 for the two-day announcement period.

Cumulative prediction errors shown in Exhibit 4 do not show evidence of significant prediction errors immediately after the announcement, including days +1 through +10. Therefore, there appears to be a quick market adjustment to the information release with no evidence of a readjustment or of additional information effects immediately following the announcement.

2. Effects of Reasons for Closings and Relative Plant Size

Panel A of Exhibit 5 reports two-day prediction errors for announcements classified according to intra-firm (company-specific reasons) and extra-firm reasons (related to conditions in the industry and economy). For extra-firm reasons, the prediction errors are not statistically significant. Industry-wide or economy-wide effects are anticipated more than firm-specific effects.

In contrast to extra-firm reasons, intra-firm reasons are associated with significant negative prediction errors. Reasons associated with the firm's product and other reasons that are firm-specific in nature are associated with negative prediction errors. The reason of unprofitable operations is also associated with negative prediction errors, although such errors are significant only at the 0.10 level. In contrast, the reason for restructuring is associated with positive reaction, but not with statistically significant prediction errors. Shareholders might consider restructuring a valid reason for closing a plant that does not cause a negative revaluation of the firm's future cash flows.

Panel B of Exhibit 5 reports prediction errors according to the relative size of the plant closing, measured by the number of employees laid off as a percentage of the total employment in the firm. Results for the relative size measure strongly support the hypothesis that larger relative closings are associated with a greater market reaction. Plant closings with large layoffs as a proportion of total employment show very large negative prediction errors that are significant at the 0.01 level. In contrast, announcements of plant closings with a small proportion of total employees laid off show a small positive, but not statistically significant, prediction error.

3. Effects of Relatedness

Differences in market reaction according to proxies for cash flow relatedness between the closed plant and the firm's entire cash flows are documented in Exhibit 6. These proxies include plant location (foreign or domestic), and internal corporate structure (unit versus affiliate or subsidiary). Prediction errors for closing announcements of domestic plants are negative and significant at the 0.01 level. In contrast, closing announcements of foreign plants, although also negative, are only half the size of those for domestic plants and are not significant even at the 0.10 level.

The other proxy for relatedness, internal corporate structure, shows similar relationships. Prediction errors for closing announcements of plants held by units are negative and significant at the 0.01 level, while closing announcements for plants held by subsidiaries and affiliates, although negative, are less than one-third as large and are not significant even at the 0.10 level.

V. Summary and Conclusions

This study demonstrates that a plant closing announcement provides information not just for the plant being closed but also for other operations and the firm as a whole. A problem with product demand or cost of production may eventually be manifested in closing part of the firm's operations. Unless investors had been previously aware of the plant's prospects or the firm's problems, the closing announcement provides a signal causing investors to revise their estimates of the plant's cash flows downward. Problems leading to a plant closing may not be limited to that single plant, but may affect the entire firm's operations. Investors may therefore revise their prospects for other related operations downward as a result of the plant closing information.

An examination of changes in firm financial condition following the announcement indicates problems that are firm-wide, not just plant-specific. Firms announcing closings encounter decreased profitability in the announcement year and the year following the announcement, together with declines in employment, asset acquisition, and dividend growth. These manifestations of firm problems observed in their financial profile are consistent with observed negative stock price reaction to the closing announcement.

The stock price reaction is strongly negative and statistically significant for closings of larger-size plants relative to the size of the firm, for domestic plants, and for plants operated by units of the announcing firm. All three attributes indicate a closer relationship to the firm's other operations. For plants that comprise a small part of the firm's operations, or that operate peripherally to the core business, such as foreign plants or plants in subsidiaries, or those that close because of industry or economy-wide reasons, the stock market reaction is insignificant.

Financial profiles and the stock market reaction are consistent with the hypothesis that a closing announcement leads investors to believe that deeper problems may have beset those firms that closed plants, and that a plant closing may provide valuation information about the entire firm, not just the facilities to be closed.

(1)Positive cash inflows either by sale to higher value owners or by recognition of tax benefits remain a possibility, but these situations do not apply to our sample.

(2)Full anticipation both of plant value and its closing should not be met by any market reaction.

(3)Statman and sepe [15] exemplified such a positive stock market reaction by the Texas Instruments announcement of discontinuation of its beleaguered home computer business.

(4)Owners and Rogers [13] differentiate between abandonment announcements associated with write-offs and those not associated with write-offs. a small positive insignificant reaction was observed at the abandonments associated with write-offs.

(5)Because managers are the source for information on reasons, we acknowledge the potential for a moral hazard problem. At the same time, the information that managers provide should be credible in light of the firm's financial information released in the short-term and the disciplinary actions of the market for corporate control in the long-term.

(6)Income is measured as operating income before extraordinary items (COMPUSTAT Item 18).

(7) Both debt and assets are measured at book value.

(8)Cash flow from operations includes adjustments for all accrual and deferral items. It is calculated according to the algorithm explained by Gombola and Ketz [8].

(9)The reader may note that income to sales, sales to assets, and debt to assets combine to form retrun on equity. Within the framework known as the DuPont model, these components of ROE can be used to diagnose firm problems.

(10)Assuming no ties, the test statistic is normally distributed with mean of N/2 and standard deviation of [square root of N/4], where N is the number of observations in the sample.

(11) Some of the measures, such as EPS, are not comparable across the two samples and therefore are not included in this comparison.

References

[1.] Y.C. Baldwin, "The Capital Factor: Competing for Capital in Global Competition," in Competition in Global Industries, M. Porter (ed.), Boston, Harvard Business School Press, 1986, pp. 184-223.

[2.] D. Blackwell, M.W. Marr, and M.F. Spivey,"Plant Closings and the Value of the Firm," Journal of Financial Economics (August 1990), pp. 277-288.

[3.] J.J. Boddewyn, "Theories of Foreign Direct Investment and Disinvestment: Like or Unlike?" Journal of International Business Studies (Winter 1983), pp. 23-35.

[4.] S.J. Brown and J. Warner, "Using Daily Stock Returns: The Case of Event Studies," Journal of Financial Economics (January 1985), pp. 3-31.

[5.] K.H. Chen and T. Shimerda, "An Empirical Analysis of Useful Financial Ratios," Financial Management (September 1981), pp. 51-60.

[6.] W.J. Conover, Practical Nonparametric Statistics, New York, John Wiley and Sons, 1971.

[7.] E.A. Dyl and H.W. Long, "Abandonment Value and Capital Budgeting: Comment," Journal of Finance (March 1969), pp. 88-95.

[8.] M.J. Gombola and J.E. Ketz, "A Note on Cash Flow and Classification Patterns of Financial Ratios," Accounting Review (January 1983), pp. 105-114.

[9.] M.O. Joy, "Abandonment Values and Abandonment Decisions: A Clarification," Journal of Finance (December 1976), pp. 1225-1228.

[10.] J.J. McConnell and C.J. Muscarella, "Corporate Capital Expenditure Decisions and the Market Value of the Firm," Journal of Financial Economics (June 1985), pp. 399-422.

[11.] S. Majd and R.S. Pindyck, "Time to Build, Option Value, and Investment Decisions," Journal of Financial Economics (January 1987), pp. 7-27.

[12.] S. Mason and R. Merton, "The Role of Contingent Claims Analysis in Corporate Finance," in Recent Advances in Corporate Finance, E. Altman and M. Subrahmanyam (eds.), Homewood, IL, Richard D. Irwin, 1985, pp. 7-54.

[13.] J.E. Owers and R.C. Rogers, "Valuation Implications of Abandonment Decisions," Working Paper, University of Massachusetts, 1988.

[14.] A.A. Robicheck and J.C. Van Horne, "Abandonment Value and Capital Budgeting," Journal of Finance (September 1967), pp. 577-589.

[15.] M. Statman and J.F. Sepe, "Project Termination Announcements and the Market Value of the Firm," Financial Management (Winter 1989), pp. 74-81.

[16.] J.S. Strong and J.R. Meyer, "Asset Writedowns: Managerial Incentives and Security Returns," Journal of Finance (July 1987), pp. 643-661.

[17.] L. Trigeorgis and S. Mason, "Valuing Managerial Flexibility," Midland Corporate Finance Journal (January 1987), pp. 14-21.

[18.] J.W. Wansley and W.R. Lane, "A Financial Profile of Dividend Initiating Firms," Journal of Business Finance and Accounting (Fall 1987), pp. 425-436.
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Title Annotation:Issues in Corporate Investments
Author:Gombola, Michael J.; Tsetsekos, George P.
Publication:Financial Management
Date:Jun 22, 1992
Words:4989
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