Tuesday, April 6, 2010

Why I am short First Solar

(The following is an extract from Bronte Capital’s client letter. I thought it deserved wider circulation. It also provides grist to Felix Salmon who described shorting – and in the context by implication me – as socially useless. I think that was harsh – but not necessarily in this case. I will write an article in the future on socially useful short selling.)

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Case study: our short on First Solar

Investing in technology stocks has lots of traps for neophytes – and by-and-large we are neophytes so we do not do very much of it. We however spend a lot of time thinking about it primarily because we are scared of what technology can do to other businesses. (The demise of many low-tech newspapers provides a good demonstration of why – as investors – we should think about technology.)

Technology offers value creation like few other industries. In Australia Cochlear has created enormous value and improved the world. It can literally plug a bionic ear into someone's brain-stem and get them to hear. And the stock has paid about 20X – which is better than anything in our portfolio. Many of the biggest fortunes were made in technology. But technology – and specifically technological obsolescence has thrown many a fine company to the wolves. Palm for instance is likely to go bankrupt even though the concepts it pioneered are in everyone's pocket.

We do however have a framework to hang around our (limited) technology investments. A technology, to be a really great investment, must do two things. It must change part of the world in a useful way – a big part of the world is better of course – but you can be surprisingly profitable in small niches. And it must keep the competition out.

In technology the competition is remorseless. In most businesses the competition might be able to do something as well as you – and it will remove your excess profit. People will build hotels for instance until everyone's returns are inadequate but not until everyone's returns are sharply negative. Even in a glutted market a hotel tends to have a reason to exist – it still provides useful service. And someday the glut will go away so the hotel will retain some value.[1] In most businesses the game is incremental improvement. If you get slightly better you can make some money for a while. If the competition gets slightly better you will make sub-normal returns until you catch up.

In technology the threat is always that someone will do something massively better than you and it will remove your very reason for existence. Andy Grove – one of the most successful technologists of all time (Intel Corporation) – titled his book “Only the paranoid survive”. He meant it.

If your technology is obsolete the end game is failure – often bankruptcy. Palm will fail because Palm no longer has a reason to exist. If we wait 20 years Palm will be even more obsolete – but the hotel glut will probably have abated. Nothing left in Palm is likely to have any substantial value. Businesses that produced plenty now, produce nothing then.

Surprisingly, changing the world looks like the easy bit. Plenty of companies do it. The problems are in keeping the competition out. Only a few do that (Microsoft, Google are ones that seem to). Hard drive makers changed the world (they allowed all that data storage which made things like digital photography and internet multi-media possible). But they never made large profits – and they trade at small fractions of sales.

The limited technology investments we have are not driven by any real understanding of the technology. Sure we try – but if you ask us how to improve the laser etching on a solar panel then we will not be able to help. The driver of our investment theses in almost all cases is watching the competition.

A simple example is Garmin. We have a small short position in what is a very fine company. Garmin – once a small avionics company - led the mass-marketing of satellite navigation and allowed John – without stress – to find his son's Saturday sports game. Sat-nav it seems has saved many marriages and meant that school sports teams do not run short players because dad got lost.

Garmin has over a billion dollars cash on the balance sheet – and that cash represents past profits. It has changed the world – and thus far it has been well remunerated.

The only problem is that they can't keep the competition out. Nokia has purchased a mapping company. Iphone now has a Tom-Tom app, downloadable for $80 in Australia. Soon sat-nav will be an expected application in every decent mobile phone. Google has mapping technology too and will embed it into their android phone. Eventually the maps will be given away because people might book hotels using their sat-nav device whilst they are travelling. [It is darn useful to know where a decent hotel with a spare room is when you are on the road.]

Garmin has a great product. They have improved my world. The only problem is that they can't sell their product at any price that competes with “free”. Garmin's business is going the same direction as Palm. Bankruptcy however is only a remote possibility – they have a billion dollars on the balance sheet and unless they do something really stupid on the way down they will remain a profitable avionics business.

Is it fair that Palm is facing bankruptcy? Or that Garmin is being displaced? We don't think so – but then capitalism is not necessarily moral or fair – but it does produce goods and services quite well. We don't invest on the basis of fair – we invest to make you good returns.

The solar industry – and the possible failure of the good

First Solar is a company that improved the world. It drove the cost of production of solar cells to quite low levels and made utility-scale solar farms viable with only modest subsidies. There are some places where solar is now viable without subsidies.[2]

Our biggest short position though is First Solar – a company we have little but admiration for. There is a distinct possibility that First Solar's business will fail in the same way as Palm or Garmin. It won't be fair – but fairness has nothing to do with it. Like Garmin it probably won't go bust because it has a billion dollars in liquid assets on the balance sheet – assets which represent past profits.

Moreover we suspect that First Solar's profits are about the same as the rest of the industry put together. The stock still trades with a high teens trailing price-earnings ratio – a fading growth stock. It hardly looks like a failure. It is a strange conclusion to come to. So we should explain how we got there. To do that we need to explain how a solar cell works.

How a solar cell works

To make a solar cell you need three things.

1). A substance which is excited (i.e. spits off electrons) when a photon hits it.

2). A layer which separates the electrons. This layer is usually a “semiconductor” which means that electrons go through one way and cannot go back.

3). Something at the back which conducts the electrons away.

Thin film versus wafer

Traditional solar cells were made with a semiconductor ingot cut to a thin sheet. On one side it was “doped” with a substance that kicks out electrons. The other side was laced with wires to conduct the electrons away. This was expensive.

There were generally two types of ingot – monocrystalline – where the wafer structure was perfect or near perfect and polycrystalline which had visible crystals in the wafer. Monocrystalline wafers are primarily used for computer chips (where atomic level imperfections are problematic) and are expensive.

Polycrystalline silicon is cheaper. For most large-scale uses polycrystalline wafers were sufficient. These have about a 17 percent conversion rate – which means that 17 percent of the photon energy that strikes them is turned into electricity.

The ingot itself was a substantial part of the cost of a photovoltaic cell. Polycrystalline ingot used to sell for $450 per kg.

First Solar (and others) developed a process for making solar cells with considerably less semiconductor material. They have a Cadmium Telluride process which vapor-deposits semiconductor at atomic level thickness and comes up with a cell that is now exceeding an 11 percent conversion ratio.

This company is a technological wonder. Glass goes in on one end of the manufacturing process and comes out as solar cells at the other with next to no human intervention. Labour is used only when it comes to putting frames around the glass and for similar tasks.

This was revolutionary – it made cheap solar panels and hence made possible commercial scale plants like this 1.4 megawatt roof installation in Germany. This is enough to supply a few hundred households – not earth shattering – but a complete revolution in the solar industry.

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We can think of few companies which have pushed a technology so far and with such high environmental benefits. Companies like this will allow us to maintain a modern lifestyle whilst addressing greenhouse issues.

Still for all the benefits of First Solar’s cells, they are inferior in many important ways to a polycrystalline cell. Their efficiency is lower – which means you do not get as much solar energy off the constrained roof space. Secondly, whilst they save a lot on the semiconductor part of the manufacturing process they have to use more glass, more wires etc to generate the same amount of solar electricity. Each cell generates less electricity too so inverters, connectors, installation all cost more with thin film. Thin film also degrades over time. First Solar warrants their performance over their lifetime – but with the warranty being for lower levels of performance in the second decade of operation (google the Staebler-Wronski effect for a non-trivial explanation). Thin film does however have some advantages in low light - keeping a slightly greater proportion of their peak capacity.

Indeed the main advantage of thin film is cost – and that cost advantage has been driven by the cost of the semiconductor component. After all ingot did cost $450 per kg.

That cost advantage made First Solar absurdly profitable – and they used that profit to grow into a behemoth. Revenue has grown from $48 million to over $2 billion. Gross profit (before selling and administrative costs) has grown to over $1 billion. We do not want to tell you how far the stock ran for fear of invoking insane jealousy. This stock would have made Berkshire Hathaway shareholders jealous.

But remember – all of that was predicated on a cost advantage (almost all other things being inferior). And that cost advantage is predicated on expensive semiconductor material.

Competition cometh

To make money in technology you need to do two things. Firstly you need to change the world (which First Solar clearly did) and secondly you need to keep the competition out. Alas very few businesses manage the second trick.

The competition came in a couple of forms. Firstly it came from Applied Materials. Applied Materials, or AMAT (as the company is known) is the most important company in the world you have never heard of. It is the dominant maker of capital equipment that goes into semiconductor factories and it is thus the company that – more than any other – provides the kit to keep Moore’s Law active.

AMAT has tried competing head-on with First Solar in the thin-film space. AMAT developed the vapor deposition equipment that made large-screen LCD televisions possible. This entails deposition in large sheets (5.6 square meters) which are then cut down into several large screen TVs. An imperfection in the vapor deposition shows on the TV as a bad pixel.

AMAT appropriated this technology for solar. The silicon semiconductor is not as efficient as First Solar’s Cadmium Telluride technology – and it is equally subject to the Staebler-Wronski effect, however they can do much larger panels than First Solar (with comparably lower wiring, inverter and balance of system costs). AMAT’s thin-film business could do some damage to First Solar – but it is unlikely to kill it. (Indeed AMAT appears to be de-emphasizing that business for the reason discussed below.)

Far more important have been developments in the wafer business. AMAT (often the protagonist) has developed wire saws for cutting wafers thinner and thinner. They are now 80 microns thick. These wafers are so thin that they flutter down in air and break if held on their side. AMAT will of course sell the whole kit for handling these wafers – including laser etching material and other steps in the manufacturing process. Much less semiconductor is needed in the wafer business.

But worse – the price of ingot has fallen – and spot prices are now $55 per kg – which is a lot less than $450. The cost of ingot is still falling. First Solar’s advantage is entirely dependent on the fact that they use much less semiconductor than wafers – an advantage that disappears entirely as wafer prices fall. At that point all of First Solar’s many disadvantages will shine through.

We are trying to work out the cost-structures of the polycrystalline manufacturers – but it looks to us that the extra glass and other balance of system costs that First Solar panels have are getting close now to completely removing the advantage of low semiconductor material usage.

If that happens though, First Solar is toast. It probably won’t file bankruptcy because it has so much in past profits to fall back on – but it will be every bit as obsolete as a Palm organizer is now or a Garmin car navigation system might be in five years.

We do not wish failure on First Solar – and if we are right it could not have happened to a nicer company (no irony intended). Capitalism is not fair – and technology investment is particularly unfair.

We don’t make money from fairness. We make money from getting the business analysis right and betting on (or against) the right business – and in this case we are betting against the most successful company in a massively important growth industry.

If we are right (and we think we are) then we will make money from the demise of a company that has much improved the world. We like to think our business is noble. And it is sometimes – but in this case we can see why people dislike short-sellers. Their opinion however is not our business.


[1] Unfortunately the hotel is usually mortgaged – and the value often reverts to the debt holder.

[2] One way amuses us greatly. Walmart started putting solar cells on the rooftops of many of their super-centers in the Southern United States. They did this originally because of implicit subsidies. However the test centers showed something quite interesting. Good solar panels turn quite a lot of the energy hitting the rooftop into electricity which is conducted away. That energy does not wind up as heat in the building – and the cooling load of the building went down. The rooftop solar installation may not have been justified by the electricity output alone – but combined with lower cooling bills it worked a treat. [Addendum. This footnote is anecdotal from good source rather than published... many people have asked us about it - and a few have said they have heard this sort of thing before but they would like hard data... I apologize as I am unable to provide...]

32 comments:

Anonymous said...

Very insightful analysis. First Solar needs to develop an alternate technology to adjust to the new reality. I don't know if they have any tricks up their sleeves. I hope they do. Of course, other companies may have even better tricks.

Kid Dynamite said...

"To make money in technology you need to do two things. Firstly you need to change the world (which First Solar clearly did) and secondly you need to keep the competition out. Alas very few businesses manage the second trick. "

great great quote, John.

Potato said...

John, another excellent, insightful article.

What about political risk? As a former long in FSLR, there was always the risk that governments would pare back their solar subsidies that the sector relies on... but on the short side, I imagine that there must be some concern that the US will get religion about solar power.

Too remote to worry about?

The other question is about the wafer business: what is their manufacturing volume like, and how long will it take them to ramp up under the new silicon pricing to start meaningfully hurting FSLR?

BGW said...

Sound analysis. My limited understanding of game theory is that the incumbent firm, earning monopoly profits is compelled to invest all of its profits to defend its position. For example purchasing patents or poaching the most talented.

Is it that tech executives are poorly educated or merely seek to extract short term profits?

C. Fuzzbang said...

For the reasons outlined, FSLR is a great 'long term' short. But we just pulled our short ahead of the German FIT reduction. I hope to put it back on in mid Q2 but I'm hearing of strong demand right now. Perhaps I'm being too cute.

It has been a great business but I can't look at a company like this with such huge margins and believe that they can maintain them for long.

The one wrinkle for FSLR is their ability to reduce cost (COGS/MW). They have been masterful operators but we're trying to figure out if reductions are slowing. There were some 1-timish items on the last quarter that were questionable.

PlanMaestro said...

Not sure if the shorting will succeed but it sure was an insightful and fun article.

Anonymous said...

I've been to those factories where robots are making solar panels. A modest sized factory, maybe 15k s.f., can crank out 1 panel every 40 seconds and operate 24/7.

For less than the price of a Lexus or Mercedes you can put solar panels on your house and buy a Nissan Leaf. You will never need to go to the gas station again. You can cut hydrocarbons from your diet (except for flying). Mercedes and Lexus are nice but going to the gas station SUCKS no matter how rich you are.

taxloss said...

Not sure why you say that this short is 'socially useless'. The idealised job of an investment manager is to allocate capital to companies that can use it, but equally to take it away from companies that are likely to destroy it.

If your analysis of First Solar is correct, then it will no longer be fulfilling a 'socially useful' function, and should have capital taken from it and allocated to companies that can produce something beneficial, socially or otherwise.

Anonymous said...

surely First Solar with its market positioning and its solid balance sheet would be in an excellent position to find the next best solution for general solar technology

if First Solar can reinvent the process once, who says they can't do it again

don't be too quick to short a market leader!

Craig said...

John, great post. Do you have any evidence of financial deterioration such as exploding inventories? I love a good story but it's not enough to short. Too many things can happen before it plays out.

Anonymous said...

You'll never produce a 1, 2 or 10 bagger, shorting companies like FSLR.

You are about yo be wrong in the shorts. Again.

anon,

R. Dobbs

Anonymous said...

"if First Solar can reinvent the process once, who says they can't do it again."

I suppose you are talking about management's strong capital allocation ability.

I drove by their HQ in Phoenix last month. It looks like something out of a SiFi movie. I actually thought it was a NASA space shuttle launch site. Not sure who's HQ is fancier FLSR or TASR.

Craig said...

John, can you post any evidence that FSLR financials are deteriorating ie. bloated inventories? Otherwise it's a great story but maybe not a great short.

Sorry if you see multiple posts. Google kept saying "error" each time I submitted.

Anonymous said...

Looks like I picked the wrong week to quite drinking.

-Steve Mc Croskey

Anonymous said...

Here are couple of advantages of Cd-Te over Poly-Si:
1. Can generate electricity even under dim/overcast conditions - this can extend electricity generation time by about 2 hours.
2. For the stated efficiency in Poly-Si panels, they have to be perpendicular to sun. Ever wondered why SPWRA claims their "tracking technology" makes them superior? This adds additional costs to the panels. Cd-Te can be placed horizontal to the ground. No panel movement needed.

You mention about AMAT's A-Si - the major public company using that technology, ENER's factories are running at 30-40%. IMHO, A-Si is done. With $1.60/watt cost, doubt it will see sunshine.

Ever considered capex/watt in to your equation? X-Si is 50-70% more than Cd-Te.

Ever considered project financing costs in to your competitive advantage equation?

Ever considered which supplier has complete capability to deliver a solar plant? Unfortunately, in future no one really cares cost/watt. The question would be what would be cost/KWhr under PPA agreemetns.

Ever considered which company owns land which can be easily connected to grid in to equation? Why do you think OptiSolar won such massive deals with PG&E but had <50MW capacity when acquired?

Ever considered the fact solar wafer processing costs run around 70-90c/watt in to equation - what this means is that even IF Poly prices goes to $0, these companies will have 70-90c/watt costs?

Well, being short FSLR isnt a discovery you are making here, with 40% short interest - there are 2 specific reasons stock is underperforming peer group:
1. They dont have capacity in 2010. Blame Mike Ahearn for being so conservative. But 2011+ this argument does not apply.
2. Poly Prices have come down to $50/kg. Hey, they got only $50/kg down to go to 0 and FSLR has to cut cost by just 10-13c/watt to clear off this 'ooooh poly prices are falling through the floor' concern.

H

g.schwarz said...

Well, congratulations to your research. But aren't you a little late to the shorting show on this one?

Others started shorting FSLR beginning of 2008 as soon as it became obvious that both Germany was going to cut back its subsidies for solar energy and at the same time chinese competition was around the corner.

Both margins and revenues will very probably be deteriorating further imho but i do not have the guts to put on another short right now.

CrocodileChuck said...

Your call on First Solar is directionally correct. But this has nothing to do with the spot price of silicon ingot. This kind of PV technology will never pan out per the promises of its proponents. Why?

Thermodynamics.

Sunlight is everywhere and 'always on' within 30 degrees of the equator. BUT: 1) the power of ambient sunlight is of the order of one watt per sq m. By way of a household example, the power of a portable hair dryer is one watt per SQUARE CENTIMETER. So the problem isn't the conversion rate of the PV panel or expanse of film per se-its the diffuse nature of sunlight itself. 2) The second problem with PV: once you build the hardware, THEN it must be installed, on roofs or wherever, and wired up to the house or bldg, then to the grid. This is significant, and will mean that this technology is only 'economic' with subsidies from government.

ps there are other solar technologies however, that are economic.....

IF said...

CrocodileChuck: good to see that you follow Gregor and the videos he posts. Unfortunately you don't even cite Bill Gross properly (no attribution, incorrect facts & numbers).

http://gregor.us/solar/thoughtful-solar-guy/

Anonymous said...

Long time listner, first time caller. I'm really interested in what you normally have to say, but I think that you're a little wide of the mark on a few things here John.

Staibler-Wronski effect only pertains to hydrogenated amorphous silicon (i.e. what the AMAT lines make), not CdTe, which aside from being a completely different chemistry is crystalline. Reliability is always a concern, however you shouldn't tar all thin film PV with the same brush.

Given the low efficiencies (which really hurt cost through balance of systems) there isn't much future in amorphous silicon. First solar continue to lower costs, while the drop in the Si price has allowed the c-Si suppliers to drop prices too, either way a-Si is going nowhere, probably why AMAT is getting out of the game.

FSLR can at least try to keep the competition out of CdTe with their patent portfolio, one of the advantages of being in the game so long, and also being the big guy. What they can't keep out is a completely different technology, CIGS.

Anonymous said...

The main reason this post is incorrect is because First Solar continues to find ways to improve its efficiency and decrease its module costs over time. Crystalline solar, on the other hand, has hit a wall in terms of efficiency improvements, and cost reductions are coming from only very slight further reductions in polysilicon costs, and from reductions in margins for the crystalline solar food chain.

Your assessment is probably correct for 2H10, and part of 2011, but then when crystalline solar runs out of costs to cut, FSLR will still be able to reduce costs through efficiency improvements.

bustem said...

When it comes to technology, there is a high degree of uncertainty. There will always be firms that come and go, in any industry, and it's impossible to predict who will adapt and who will fail. Of course there are the Palms, but there also companies like Apple, who have adapted and ventured into new markets. In addition, the notion that in order to make money you need to "change the world" is pure fallacy--a classic misconception. If a company cannot extract a profit from the value it delivers, then it will fail. A good example is Youtube, which is currently losing about a million bucks in cash per day. Much to my dismay, nothing in life is ever free. While Youtube's storage cost for one video may be a penny or two, that adds up when you have millions of videos up all the time.

As for shorting Garmin, everyone knows they have a maturing market--the analysis you offer is well known and baked into the current share price. In fact, it looks like the market has already valued Garmin's PND segment at zero (or perhaps even at a negative value).

Anonymous said...

Can anyone name a commodity-producing industry whose constituents traded at a sustained level of enterprise value to replacement cost of capacity in excess of 1x?

RDub said...

@ Bustem: PND business for GRMN is definitely not valued at 0 or negative value...assuming 9x EBITDA for other businesses it is probably valued at 5 - 6x EBITDA. Not pricey but not zero either.

Anonymous said...

Looks like I picked the wrong week to quit smoking.

-Steve McCroskey

Anonymous said...

Simply brilliant.

狂猪 said...

Hi John,


How do you determine when it is the right time to short?

The analysis above presents the case of why First Solar is loosing it's cost advantage. However, that is very different from making the case that shorting First Solar now is the right investment timing.

I think time is on the side of First Solar and it is strongly against the short sellers.

First, we have to assume First Solar management is competent and is very aware of all the challenges identified in your analysis. As such the company will attempt to address these challenges. Since the company is financially strong, there are a wide number of options and, very importantly, the time needed to execute these options. Over time, as these options are explored, many events can stuff the short seller. Heck, FSLR probably can just buy some of it's competitors.

My second concern is rising tide lifts all boat. Right now, the recovery in the economy is picking up steam everyday and along with it energy demand. Furthermore, green energy in particular is getting a lot of attentions. The tide is rising strongly and it will be a while before the tide goes out again.

Unless the upside is really compelling, I normally hate the idea of having time working against me.

At any rate, you've probably already considered these. Perhaps you can elaborate a bit more on your decision making process for the timing of shorting fslr.

Anonymous said...

John, a couple of mistakes to point out om an otherwise insightfull article. The first is in talking about the labor in the FS factory, FS modules are frameless, the is no cost in a frame or in labor. Secondly the cost of an invertor is the cost of an inverter, and it doesn't care what type of panel made the DC power, large scale invertors cost are determined by rating (say 10 mW) no mater if a billion modules are feeding them. FS, just through ecomies of scale can purchase and install the BOS cheaper than the competition.

Isam Laroui said...

Leaving fondamentals aside, technically the stock looks like it could break out in a hurry. I would strongly advise a stop-loss. Don't fall in love with your story, it's the stock we're talking about here.

Anonymous said...

Looks like I picked the wrong week to stop sniffing glue!

-Steve McCroskey

Larry_P said...

I suggest the author clarify his cost figures, regarding semiconductor cost/ingot. The materials involved are different, and their costs are *wildly* different.

Silicon is a commodity material, and many sources exist. However *Tellurium*, used in fistSolar's CdTe solar cells, is one of the rarest elements on earth, and there are only a few suppliers (mostly copper refineries, selling an {increasingly precious} by product.)

Anonymous said...

Apparently, FS has someone with title of "Director of Disruptive Technologies" to keep an eye out for emerging solar technologies. So yes, I would say a) this is a smart management team and b) they are well aware of the threats out there. With their strong Balance Sheet I would think if they needed to they could buy some of these emerging technologies to bolster their competitive position even further.


here is a relevant quote I found from greentechmedia...

First Solar's Rafi Garabedian, Director of Disruptive Technologies, spoke at a recent OIDA event in Santa Clara, California and reviewed the First Solar roadmap out to 2014. Here are some of the numbers:

* 2014 roadmap goal of 52 cents per watt at the panel level -- accomplished through efficiency gains and improvements in throughput
* 14% module efficiency in 2014
* Capex at 65 cents per watt factory capacity.

Garabedian explained that First Solar sees the solar industry currently in a "transition market" where we are dependent on subsidies and compete against peak power plants. They believe that if they achieve their roadmap numbers -- we can move from the "transition market" to a "sustainable market" and compete directly with baseload power.

Other numbers from First Solar

* It takes only 2.5 hours for the factory to go from glass to module
* 2012 production capacity will be 2 gigawatts
* Energy Payback Time (EPBT) is .65 .8 years (EPBT includes manufacturing and installation). Garabedian challenged the silicon guys to lower their silicon consumption to keep up with the First Solar EPBT.
* Q1 conversion efficiency was 11.1 percent, Q1 manufacturing cost was 81 cents per watt, Q1 revenue was $568 million

Garabedian said, "What looks disruptive to a VC might not look disruptive to us."

Dave said...

walmart funded first solar. first solar isn't all about technology. they get it in terms of the "business model", thats they have to be the lowEST cost player in a commodity business. Thats why they not only keep lowering the price, but they give it back to customers so installed base are captive and prevent new entrants. first solar is at a point where they have scale and they are the biggest as well as cost/price leader, so the fair comparison here is probably costco or ryanair. the short case seems to be a very superficial/incorrect analysis of the "moat"

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