The following discussion and analysis of financial condition and results of operations should be read in conjunction with the unaudited condensed consolidated financial statements and related notes included in this Quarterly Report on Form 10-Q, the
TestEquity Acquisition, LLCand 301 HW Opus Holdings, Inc.(conducting business as Gexpro Services) audited consolidated financial statements and accompanying notes included in the Company's Form 8-K/A as filed on June 15, 2022, and the Lawson Products, Inc.audited consolidated financial statements and accompanying notes included in DSG's Annual Report on Form 10-K filed for the year ended December 31, 2021.
References to “DSG”, the “Company”, “we”, “us” or “our” mean
Organization and grouping of companies
May 5, 2022, Distribution Solutions Group, Inc.("DSG"), a Delawarecorporation formerly known as Lawson Products, Inc., changed its corporate name from " Lawson Products, Inc." to " Distribution Solutions Group, Inc." Distribution Solutions Group, Inc.is a specialty distribution company structure providing value added distribution solutions to the maintenance, repair and operations ("MRO"), original equipment manufacturer ("OEM") and industrial technology markets. DSG has three principal operating companies: Lawson Products, Inc.("Lawson"), TestEquity Acquisition, LLC("TestEquity") and 301 HW Opus Holdings, Inc., conducting business as Gexpro Services ("Gexpro Services"). The complementary distribution operations of Lawson, TestEquityand Gexpro Services were combined in the Mergers for the purpose of creating a specialty distribution company enabling each of Lawson, TestEquityand Gexpro Services to maintain their respective high-touch, value-added service delivery models and customer relationships in their specialty distribution businesses under the leadership of their separate business unit management. The DSG leadership team provides oversight to the separate leadership teams of each of the operating companies. This structure enables the combined company to leverage best practices, back-office resources and technologies across the three operating companies to help drive cost synergies and efficiencies. The combined company has the ability to utilize its combined financial resources to accelerate a strategy of expansion through both business acquisitions and organic growth. Refer to the section entitled "Organization" in Note 1 - Nature of Operations and Basis of Presentation in Part 1. Financial Statements, which section is incorporated herein by reference, for description of the TestEquity Merger and Gexpro Services Merger consummated on April 1, 2022.
Our three main operating companies
Lawson is a distributor of products and services to the industrial, commercial, institutional, and governmental maintenance, repair and operations ("MRO") marketplace. Lawson distributes MRO products to its customers through a network of sales representatives throughout the
Context and operations
Lawson delivers quality products to customers and offers them extensive product knowledge, product application expertise and Vendor Managed Inventory ("VMI") services. Lawson competes for business primarily by offering a value-added service approach in which highly trained sales representatives manage the product inventory for customers. The VMI model makes it less likely that customers will run out of a product while optimizing their inventory levels. Lawson ships products to its customers in all 50 states,
Puerto Rico, Canada, Mexicoand the Caribbean.
Vision/Strategy – Lawson’s vision is to be our customers’ first choice for maintenance, repair and operations solutions that improve their operational performance. Lawson plans to achieve its vision by working closely with its customers to maintain and improve their operations by providing quality products, superior service and innovative solutions.
Sales Drivers – The North American MRO market is highly fragmented. Lawson competes with several national distributors as well as a large number of regional and local distributors. The MRO activity is impacted by the
36 -------------------------------------------------------------------------------- Ta ble of Contents strength of the manufacturing sector of the
U.S.economy which has been affected by the COVID-19 pandemic. DSG believes that the Purchasing Managers Index ("PMI") published by the Institute for Supply Managementis an indicative measure of the relative strength of the economic environment of the industry in which Lawson operates. The PMI is a composite index of economic activity in the United Statesmanufacturing sector. DSG believes that a measure of that index above 50 generally indicates expansion of the manufacturing sector while a measure below 50 generally represents contraction. The average monthly PMI was 54.8 in the second quarter of 2022 compared to 60.8 in the second quarter of 2021. Lawson's sales are also influenced by the number of sales representatives and their productivity. Lawson plans to continue concentrating its efforts on increasing the productivity and size of its sales team. Additionally, Lawson drives revenue through the expansion of products sold to existing customers as well as attracting new customers and additional ship-to locations. Lawson also uses an inside sales team and an e-commerce site to generate sales.
Background and Operations - Based out of
Moorpark, California, TestEquityis a large, comprehensive provider of electronic test solutions in the United Statessupporting the aerospace, defense, automotive, electronics, education, and medical industries. TestEquitydesigns, rents and sells a full line of high-quality environmental test chambers. In addition to a large array of test and measurement products, TestEquityalso offers calibration, refurbishment and rental solutions and a wide array of refurbished products. TestEquitycontinues to benefit from ubiquitous electronification of all types of products across most industries including IOT, EV, and 5G.
Techni-Toolis one of the industry's largest solder, soldering equipment and electronic production distributors. Techni-Tooloffers a wide range of products to support electronic production as well as compliance testing. In addition to the approximately 80,000 of products offered, Techni-Toolalso provides vendor managed inventory solutions and dedicated technical support. Jensen Tools, as a top distributor for the electronics MRO customer base, has access to approximately 400 suppliers and over 70,000 products. Jensen Toolsoffers private label Jensen branded hand tools that have been developed over years of customer usage and manufactured to a specified and demanding tolerance level and is viewed as a leader in the industry. Jensen Toolsemploys a dedicated team of engineering, operational and sales professionals who focus on designing and building quality tool kits for its customers. Vision/Strategy - TestEquityintends to grow sales organically, pursue acquisitions and continue to expand and improve its service offerings to its customers. In particular, TestEquitystrives to improve its digital experience, with a consistent approach for all of its brands. TestEquityintends to seek to increase its market share through continued expansion of product lines and greater penetration of the eCommerce market, enabled through investment in key digital talent and leverage of the existing TestEquityand TEquipmentplatforms. TestEquityexpects to benefit from its improved integrated organization and processes, driving improved gross margin and financial operating leverage. Sales Drivers - Across both the test and measurement and electronic production supplies businesses the North American market is highly fragmented with competitors ranging from large global distributors to national and regional distributors. TestEquitybelieves that the PMI is an indicative measure of the relative strength of the economic environment of the industry in which TestEquityoperates. The PMI index is a composite index of economic activity in the United Statesmanufacturing sector. TestEquitybelieves that a measure of that index above 50 generally indicates expansion of the manufacturing sector while a measure below 50 generally represents contraction. The average monthly PMI was 54.8 in the second quarter of 2022 compared to 60.8 in the second quarter of 2021. TestEquitymanagement focuses on the internal metric of Sales per Day ("SPD") and Day Adjust Growth ("DAG"). The SPD calculates and compares TestEquity'stotal sales divided by the number of selling days, adjusted for weekends and holidays. A selling day generally represents a business day in which TestEquityships products to its customers. The DAG represents the percentage increase or decrease in the SPD for a defined period of time. 37
Specifically in respect of its
Electronics Production Suppliesbusiness, the current semi-conductor chip shortage, due in significant part to the COVID-19 pandemic, is negatively impacting TestEquity'sbusiness as such chips are key elements to the electronic production process. TestEquityanticipates that recovery of this important part of its customers' supply chain may not occur until 2023. Gexpro Services Gexpro Services is a world-class global supply chain solutions provider, specializing in the development of mission critical production line management, aftermarket and field installation programs. Gexpro Services provides comprehensive supply chain management solutions, including a full technology suite offering of vendor managed inventory, kitting, global logistics management, manufacturing localization and import expertise, value engineering and quality assurance. Gexpro Services' end-to-end project management is designed to support manufacturing OEMs with their engineered material specifications, fulfillment, and quality requirements to improve their total cost of ownership. Gexpro Services has manufacturing and supply chain operations in over 32 Service Center sites across nine countries including key geographies in North America, South America, Asia, Europe, and the Middle East. Gexpro Services serves customers in six vertical markets, including renewables, industrial power, consumer and industrial, technology, transportation, and aerospace and defense. Background and Operations - Gexpro Services was formed in November 2019and, in February 2020, acquired the "Gexpro Services" business from French distributor Rexel S.A. via a carve-out acquisition. Gexpro Services has now fully separated its "Gexpro Services" operations from Rexel and operates as a stand-alone organization with its own leadership team, operating activities, financial systems and team members.
As a leading distributor and service provider in the OEM market, Gexpro Services has around 3,100 suppliers offering around 60,000 products. These products are inventoried and supplied by 32 locations in
Vision/Strategy - Gexpro Services intends to grow organically through market share expansion primarily through new production introduction, increased sales of products and services to existing customers and expansion of its customer base. Gexpro Services believes that its services benefit its customers by helping them reduce their direct and indirect procurement costs and total cost of ownership for high volume, low value Class C parts, and that its services can help drive substantial cost savings for its customers. Additionally, Gexpro Services intends to grow its business through strategic, accretive acquisitions, and through continued improvement in service and product offerings to its customers. Sales Drivers - Gexpro Services believes that the PMI Index is an indicative measure of the relative strength of the economic environment of the industry in which Gexpro Services operates. The PMI index is a composite index of economic activity in
the United Statesmanufacturing sector. Gexpro Services believes that a measure of that index above 50 generally indicates expansion of the manufacturing sector while a measure below 50 generally represents contraction. The average monthly PMI was 54.8 in the second quarter of 2022 compared to 60.8 in the second quarter of 2021
Key Factors Affecting Our Results of Operations and Financial Condition
Supply chain disruptions
Along with the broader economy, we continue to be affected by rising supplier costs caused by inflation and increased transportation and labor costs. This results in challenges in acquiring and receiving inventory in a timely fashion and fulfilling customer orders, which has offset some of the sales gains we recorded in 2022 compared to 2021. The supply chain disruptions have also led to higher product costs which have contributed to lower gross margins as a percentage of sales compared to the prior year. We have instituted various price increases during 2021 and 2022 in response to rising supplier costs, as well as increased transportation and labor costs.
Impact of COVID-19 on human capital
The Company believes that its response to the COVID-19 pandemic demonstrated its ability to focus on the safety of its team members while continuing to service its customers. Lawson,
TestEquity, and Gexpro Services were deemed essential businesses early in the pandemic, which allowed them to continue to operate their facilities. While there were some limitations on the ability to physically visit customer locations, the Company continued to service various customers via phone and electronic communication channels and other technological means, while instituting procedures to help maintain 38 -------------------------------------------------------------------------------- Ta ble of Contents compliance with applicable social distancing guidelines in respect of in-person operations. The Company currently has the majority of its corporate workforce working through a combination of in the office and remote settings and continues to monitor local, state and federal COVID-19 requirements so that its business operations and sales representative activities operate in accordance with these rules.
Impact of COVID-19 on financial performance
Various events related to COVID-19 may impact revenue, product sourcing, sales functions, and customers' ability to pay timely. While the overall business environment has been recovering, the pandemic negatively impacted the Company's financial performance in 2021. Specifically in respect of
TestEquity, the current semi-conductor chip shortage, due in significant part to the COVID-19 pandemic, is negatively impacting TestEquity'sbusiness as such chips are key elements to the electronic production process. TestEquityanticipates that recovery of this important part of its customers' supply chain may not occur until 2023. Cyber Security Incident In February 2022, DSG became aware that its computer network was the subject of a cyber incident potentially involving unlawful access. DSG engaged a cybersecurity forensics firm to assist in the investigation of the incident and to assist in securing its computer network. Because of the nature of the information that may have been compromised, DSG was required to notify the parties whose information was potentially compromised of the incident as well as various governmental agencies and has taken other actions, such as offering credit monitoring services. DSG has not incurred material costs and, at this time, is unable to estimate the total cost of any remediation that may be required.
Significant Accounting Policies and Use of Estimates
We have disclosed our significant accounting policies in Note 2 – Summary of significant accounting policies to the unaudited condensed consolidated financial statements. You will find below information on the accounts requiring more significant estimates.
Inventory Reserves - Inventories principally consist of finished goods stated at the lower of cost or net realizable value using the first-in-first-out method for the Lawson and
TestEquitysegments and weighted average for the Gexpro Services segment. Most of our products are not exposed to the risk of obsolescence due to technology changes. However, some of our products do have a limited shelf life, and from time to time we add and remove items from our catalogs, brochures or website for marketing and other purposes. To reduce the cost basis of inventory to a lower of cost or net realizable value, a reserve is recorded for slow-moving and obsolete inventory based on historical experience and monitoring of current inventory activity. Estimates are used to determine the necessity of recording these reserves based on periodic detailed analysis using both qualitative and quantitative factors. As part of this analysis, the Company considers several factors including the inventories length of time on hand, historical sales, product shelf life, product life cycle, product category and product obsolescence. In general, depending on the product category, we reserve inventory with low turnover at higher rates than inventory with higher turnover. At June 30, 2022, our inventory reserve was $9.2 million, equal to approximately 3.5% of our gross inventory. A hypothetical change of one percent to our reserve as a percent of total inventory would have affected our cost of goods sold by $2.5 million. Income Taxes - Deferred tax assets or liabilities reflect temporary differences between amounts of assets and liabilities for financial and tax reporting. Such amounts are adjusted, as appropriate, to reflect changes in enacted tax rates expected to be in effect when the temporary differences reverse. Significant judgment is required in determining income tax provisions as well as deferred tax asset and liability balances, including the estimation of valuation allowances and the evaluation of uncertain tax positions.
Impairment of goodwill –
39 -------------------------------------------------------------------------------- Ta ble of Contents The first step in the multi-step process to determine if goodwill has been impaired and to what degree is to review the relevant qualitative factors that could cause the fair value of the reporting unit to decrease below the carrying value of the reporting unit. The Company considers factors such as macroeconomic, industry and market conditions, cost factors, overall financial performance and other relevant factors that would affect the individual reporting units. If the Company determines that it is more likely than not that the fair value of the reporting unit is greater than the carrying value of the reporting unit, then no further impairment testing is needed. If the Company determines that it is more likely than not that the carrying value of the reporting unit is greater than the fair value of the reporting unit, the Company will move to the next step in the process. The Company will estimate the fair value of the reporting unit and compare it to the reporting unit's carrying value. If the carrying value of the reporting unit exceeds its fair value, the Company will record an impairment of goodwill equal to the amount the carrying value of the reporting unit exceeds its fair value, up to the total amount of goodwill previously recognized. Business Combinations - We allocate the purchase price paid for assets acquired and liabilities assumed in connection with our acquisitions based on their estimated fair values at the time of acquisition. This allocation involves a number of assumptions, estimates, and judgments in determining the fair value, as of the acquisition date, of the following: •intangible assets, including the valuation methodology, estimations of future cash flows, discount rates, recurring revenues attributed to customer relationships, and our assumed market segment share, as well as the estimated useful life of intangible assets; •deferred tax assets and liabilities, uncertain tax positions, and tax-related valuation allowances; •inventory; property, plant and equipment; pre-existing liabilities or legal claims; and •goodwill as measured as the excess of consideration transferred over the net of the acquisition date fair values of the assets acquired and the liabilities assumed. Our assumptions and estimates are based upon comparable market data and information obtained from our management and the management of the acquired companies. We allocate goodwill to the reporting units of the business that are expected to benefit from the business combination. Valuation of Earnout Derivative Liability - The Company's earnout derivative liability is classified as a Level 3 instrument and is measured at fair value on a recurring basis. The fair value of the earnout derivative liability is measured using the Monte Carlo simulation valuation model using a distribution of potential outcomes on a monthly basis for the year ended
December 31, 2022. Inputs to that model include the expected time to liquidity, the risk-free interest rate over the term, expected volatility based on representative peer companies and the estimated fair value of the underlying class of common stock. The significant unobservable inputs used in the fair value measurement of the earnout derivative liability are the fair value of the underlying stock at the valuation date and the estimated term of the earnout arrangement periods. Generally, increases (decreases) in the fair value of the underlying stock and estimated term would result in a directionally similar impact to the fair value measurement. Revenue Recognition - For reporting purposes, the Lawson segment has two separate performance obligations including products and vendor managed inventory services. The allocation of product and service revenue as well as the estimation of service costs requires judgments and assumptions including the standalone selling prices, the period of time that it takes for the service obligation to be fulfilled and the amount of time spent on vendor managed inventory services during the sales process. Changes in various assumptions could increase or decrease the allocation of service revenue and related costs; however, would not materially impact total reported revenues or reported operating income.
Factors Affecting Comparability with Prior Periods
Our results of operations are not directly comparable to prior results for the periods presented due to the Mergers that were completed on
April 1, 2022. The Mergers were accounted for as a reverse merger under the acquisition method of accounting in accordance with the accounting guidance for reverse acquisitions as provided in Accounting Standards Codification 805, Business Combinations ("ASC 805"). Under this guidance, TestEquityand Gexpro Services were treated as a combined entity as the accounting acquirer for financial reporting purposes, and DSG was identified as the accounting acquiree. This determination was primarily made as TestEquityand Gexpro Services were under the common control of an entity that owns a majority of the voting rights of the combined entity, and therefore, only DSG experienced a change in control. Accordingly, the unaudited condensed consolidated financial statements as of June 30, 2022and December 31, 2021and for the three and six months ended June 30, 2022and 2021 reflect the results of operations and financial position of TestEquityand Gexpro Services on a consolidated basis, and the results of operations of DSG's legacy Lawson business are included only subsequent, and not prior, to the April 1, 2022Merger Date. 40
-------------------------------------------------------------------------------- Ta ble of Contents Non-GAAP Financial Measures The Company's management believes that certain non-GAAP financial measures may provide users of this financial information with additional meaningful comparisons between current results and results in prior operating periods. Management believes that these non-GAAP financial measures can provide additional meaningful reflection of underlying trends of the business because they provide a comparison of historical information that excludes certain infrequently occurring, seasonal or non-operational items that impact the overall comparability. These non-GAAP financial measures should be viewed in addition to, and not as an alternative for, the Company's reported results prepared in accordance with GAAP.
Non-GAAP Adjusted EBITDA
Management believes Adjusted EBITDA is an important measure of the Company's operating performance. We define Adjusted EBITDA as operating income plus depreciation and amortization, costs related to the execution of the Mergers, stock-based compensation, severance costs, amortization of fair value step-up resulting from the Mergers, acquisition related costs, and other non-recurring items. The following table provides our calculation of Adjusted EBITDA for the three and six months ended
June 30, 2022and 2021:
Non-GAAP Operating Profit to Adjusted EBITDA Reconciliation (unaudited)
Three Months Ended June 30, Six Months Ended June 30, (in thousands) 2022(7) 2021 2022(7) 2021 Operating income
Depreciation and amortization
14,746 4,466 22,335 8,921 Stock-based compensation(1) 4,013 - 4,013 - Severance costs(2) 953 17 1,409 20 Merger transaction costs(3) 5,790 367 7,232 527 Inventory step-up(4) 1,622 - 1,622 - Acquisition related costs(5) 334 806 1,337 1,035 Other non-recurring(6) 82 20 106 130 Adjusted EBITDA
$ 31,653 $ 11,144 $ 45,155 $ 18,354
(1) Charge mainly related to stock-based compensation, part of which varies according to the Company’s share price.
(2) Includes severance pay related to measures taken in 2022 and 2021.
(3) Merger transaction costs related to the negotiation, review and execution of merger agreements relating to the mergers.
(4) Lawson inventory fair value upward adjustment resulting from reverse M&A accounting.
(5) Charge for acquisition-related costs, unrelated to the Mergers.
(6) Other non-recurring costs include acquisition integration costs and other non-recurring items.
(7) Includes results of operations of Lawson subsequent to, but not prior to, the
Management uses operating income and Adjusted EBITDA to evaluate the performance of its reportable segments. See Note 19 - Segment Information of our unaudited condensed consolidated financial statements within Part I. Item 1. Financial Information for additional information about our reportable segments. The following table provides Adjusted EBITDA by reportable segment: 41
Three Months Ended June 30, Six Months Ended June 30, (in thousands) 2022 2021 2022 2021 Adjusted EBITDA Lawson(1)
$ 9,405$ - $ 9,405$ - TestEquity 8,647 3,680 14,138 5,938 Gexpro Services 11,915 7,464 19,926 12,416 All Other 1,686 - 1,686 - Consolidated Adjusted EBITDA $ 31,653 $ 11,144 $ 45,155 $ 18,354
(1)Includes results of operations of Lawson subsequent to, but not prior to, the
Additional Information – Lawson Non-GAAP Adjusted Operating Income and Non-GAAP Adjusted EBITDA
For management to discuss Lawson's operating results on a comparable basis, Lawson's historical, pre-merger components of operating income have been provided separately in the table below. In addition, Lawson's GAAP results of operations were adjusted to include the results prior to the Merger Date in order to reflect the total operating activities attributable to Lawson for each period presented. Management believes this historical information provides the most meaningful basis of comparison for Lawson's operations, is more useful in identifying current business trends, and is important for the user of our financial statements in understanding Lawson's business. Refer to Note 1 - Nature of Operations and Basis of Presentation and Note 3 - Business Acquisitions within Part I. Item 1. Financial Information of the unaudited condensed consolidated financial statements for information about the Mergers. These amounts are not considered to be prepared in accordance with GAAP, have not been prepared as pro forma results under applicable regulations, may not reflect the actual results we would have achieved had the Mergers occurred at the beginning of 2021, and should not be viewed as a substitute for the results of operations presented in accordance with GAAP. Lawson's historical operating results prior to the Mergers were obtained from the unaudited condensed consolidated financial statements included in DSG's Form 10-Q filed for the quarterly periods ended
June 30, 2021and March 31, 2022. Lawson Non-GAAP Adjusted Results - Calculation of Supplemental Information (Unaudited) (in thousands) Three Months Ended June 30, 2022 Three Months Ended June 30, 2021 Pre-Merger Adjusted GAAP Pre-Merger Adjusted Lawson Operating Income GAAP Results(1) Results(2) Results(3) Results(1) Results(4) Results(3) Revenue $ 107,334$ - $ 107,334$ - $ 94,861 $ 94,861Cost of goods sold 50,552 - 50,552 - 44,960 44,960 Gross profit 56,782 - 56,782 - 49,901 49,901 Selling, general and administrative expenses 59,344 - 59,344 - 47,458 47,458 Operating (loss) income $ (2,562)$ - $ (2,562)$ - $ 2,443 $ 2,443Lawson Adjusted EBITDA(5) $ 9,405 $ - $ 9,405$ - $ 7,779 $ 7,779
(1) Operating income prepared in accordance with GAAP, which includes the results of operations of Lawson since the
(2) All Lawson operating results for the three months ended
(3) Lawson operating results adjusted for period-to-period comparability. These non-GAAP results represent Lawson’s total operating activities for the three months ended
(4)Lawson's results of operations for the three months ended
June 30, 2021, which occurred prior to the April 1, 2022Merger Date and were not included in GAAP operating results under reverse merger acquisition accounting. See Note 1- Nature of Operations and Basis of Presentation and Note 3 - Business Acquisitions within Part I. Item 1. Financial Information of the unaudited condensed consolidated financial statements.
(5) Refer to the Non-GAAP Adjusted EBITDA section above for a reconciliation of GAAP results as Adjusted EBITDA and Operating Income.
Ta ble of Contents (in thousands) Six Months Ended June 30, 2022 Six Months Ended June 30, 2021 Pre-Merger Adjusted GAAP Pre-Merger Adjusted Lawson Operating Income GAAP Results(1) Results(2) Results(3) Results(1) Results(4) Results(3) Revenue
$ 107,334 $ 104,902 $ 212,236$ - $ 188,191 $ 188,191Cost of goods sold 50,552 49,371 99,923 - 87,882 87,882 Gross profit 56,782 55,531 112,313 - 100,309 100,309 Selling, general and administrative expenses 59,344 44,435 103,779 - 93,610 93,610 Operating (loss) income $ (2,562) $ 11,096 $ 8,534$ - $ 6,699 $ 6,699Lawson Adjusted EBITDA(5) $ 9,405 $ 8,042 $ 17,447$ - $ 16,267 $ 16,267(1)Operating income prepared in accordance with GAAP, which includes Lawson's results of operations from the April 1, 2022Merger Date through the six months ended June 30, 2022. (2)Lawson's results of operations for the three months ended March 31, 2022, which occurred prior to the April 1, 2022Merger Date and were excluded from GAAP operating results under reverse merger acquisition accounting.
(3) Lawson operating results adjusted for period-to-period comparability. These non-GAAP results represent Lawson’s total operating activities for the six months ended
(4)Lawson operating results for the six months ended
(5) Refer to the Non-GAAP Adjusted EBITDA section above for a reconciliation of GAAP results as Adjusted EBITDA and Operating Income.
Composition of operating results
The following results of operations for the three and six months ended
June 30, 2022and 2021 include the accounts of the TestEquityand Gexpro Services combined entity, as the accounting acquirer. The results of Lawson have been included only subsequent, and not prior to, to the April 1, 2022Merger Date. 43
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