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WET SEAL INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations
[September 11, 2014]

WET SEAL INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations


(Edgar Glimpses Via Acquire Media NewsEdge) Management's Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with our unaudited condensed consolidated financial statements and the notes thereto. The following discussion and analysis contains forward-looking statements. Forward-looking statements include statements that are predictive in nature, which depend upon or refer to future events or conditions, and/or which include words such as "believes," "plans," "intends," "anticipates," "estimates," "expects," "may," "will," or similar expressions. In addition, any statements concerning future financial performance, ongoing strategies or prospects, and possible future actions, which may be provided by our management, are also forward-looking statements. Forward-looking statements are based on current expectations and projections about future events and are subject to risks, uncertainties, and assumptions about the Company, economic and market factors and the industry in which we do business, among other things. These statements are not guarantees of future performance and we undertake no obligation to publicly update any forward-looking statements, whether as a result of new information, future events or otherwise.



Actual events and results may differ materially from those expressed or forecasted in forward-looking statements due to a number of factors. Factors that could cause our actual performance, future results and actions to differ materially from any forward-looking statements include, but are not limited to, those discussed in "Risk Factors" included in our Annual Report on Form 10-K for the fiscal year ended February 1, 2014, in our other filings with the Securities and Exchange Commission, and elsewhere in this Quarterly Report on Form 10-Q.

All forward-looking statements included in this Quarterly Report speak only as of the date of this Quarterly Report.


All references to "we," "our," "us," and "the Company" in this Quarterly Report on Form 10-Q mean The Wet Seal, Inc. and its wholly owned subsidiaries. All references in this Quarterly Report on Form 10-Q to "fiscal 2013" and "fiscal 2014" mean the fiscal years ended February 1, 2014 and ending January 31, 2015, respectively.

Executive Overview We are a national multi-channel specialty retailer selling fashion apparel and accessory items designed for female customers aged 13 to 27 years old through our stores and e-commerce websites. In the first and second quarters of fiscal 2014, we operated two nationwide, primarily mall-based, chains of retail stores under the names "Wet Seal" and "Arden B." At August 2, 2014, we had 531 retail stores in 47 states and Puerto Rico. Of the 531 stores, there were 480 Wet Seal stores and 51 Arden B stores. Our merchandise can also be purchased online through the websites of each of our chains.

On April 24, 2014, we committed to a plan to wind down the operations of our Arden B brand (the "Plan") due to the long-term financial under-performance of the business. As of August 2, 2014, we operated 51 Arden B stores. As of August 3, 2014, 30 of the Arden B stores became Wet Seal Plus stores, 18 of the Arden B stores became Wet Seal stores, one of the Arden B stores continues to operate under the Arden B name, but will transition to carrying Wet Seal product, and the 2 remaining stores continued to operate as Arden B stores until their closure in August 2014. We anticipate closing down the Arden B website in the third fiscal quarter of 2014. As of August 2, 2014, we have evaluated the applicable accounting guidance for discontinued operations due to the wind down of the Arden B operations and concluded that for the second quarter of fiscal 2014, the Arden B segment should be reported as part of the results from continuing operations. Arden B cash flows will cease by the end of the third quarter and we will not have any significant continuing involvement with the Arden B segment and, therefore, the Arden B segment will meet the conditions to be reported as a discontinued operation beginning in the third quarter of fiscal 2014. We maintain our intellectual property rights in the Arden B brand and affiliated trademarks and are exploring opportunities to preserve or monetize those rights.

The total amount of charges incurred in our condensed consolidated statement of operations during the 13 and 26 weeks ended August 2, 2014, in connection with the winding down of the Arden B brand, including charges for employee severance and retention plans, transitioning the stores from Arden B to Wet Seal merchandise, lease amendment and early termination fees, and non-cash asset impairments, was $0.5 million and $4.3 million, respectively. We estimate the amount of charges to our condensed consolidated statement of operations that will result in future cash expenditures during the remainder of 2014 fiscal year, comprised of a store employee retention plan and lease amendment and early termination fees, will be approximately $0.4 million. As of August 2, 2014, we also estimate that we will incur future cash expenditures during fiscal 2014 and 2015 of approximately $0.3 million that will not affect our condensed consolidated statement of operations, which are comprised of reimbursements to landlords of unamortized tenant allowances upon our early termination of certain leases for former Arden B store locations.

We consider the following to be key performance indicators in evaluating our performance: Comparable store sales-For purposes of measuring comparable store sales, sales include merchandise sales as well as membership fee revenues recognized under our Wet Seal division's frequent buyer program during the applicable period.

Stores are deemed comparable stores on the first day of the month following the one-year anniversary of their opening or significant remodel/relocation, which we define to be a square footage increase or decrease of at least 20%. Stores that are remodeled or 25-------------------------------------------------------------------------------- Table of Contents relocated with a resulting square footage change of less than 20% are maintained in the comparable store base with no interruption. However, stores that are closed for three or more days in a fiscal month, due to remodel, relocation or other reasons, are removed from the comparable store base for that fiscal month as well as for the comparable fiscal month in the following fiscal year.

Beginning with the first quarter of fiscal 2014, we began including ecommerce sales in our comparable store sales results and have revised the second quarter of fiscal 2013 comparable store sales results included herein to also include e-commerce sales. Comparable store sales results are important in achieving operating leverage on expenses such as store payroll, occupancy, depreciation and amortization, general and administrative expenses, and other costs that are at least partially fixed. Positive comparable store sales results generate greater operating leverage on expenses while negative comparable store sales results negatively affect operating leverage. Comparable store sales results also have a direct impact on our total net sales, cash and working capital.

Average transaction counts-We consider the trend in the average number of sales transactions occurring in our stores to be a key performance metric. To the extent we are able to increase transaction counts in our stores that more than offset the decrease, if any, in the average dollar sale per transaction, we will generate increases in our comparable store sales.

Gross margins - We analyze the components of gross margin, specifically cumulative mark-on, markups, markdowns, inventory shrink, buying costs, distribution costs and store occupancy costs. Any inability to obtain acceptable levels of initial markups, a significant increase in our use of markdowns or in inventory shrink, or an inability to generate sufficient sales leverage on other components of cost of sales could have an adverse impact on our gross margin results and results of operations.

Operating (loss) income - We view operating (loss) income as a key indicator of our financial success. The key drivers of operating (loss) income are comparable store sales, gross margins and the changes we experience in operating costs.

Cash flow and liquidity (working capital) - We evaluate cash flow from operations, capital expenditures, liquidity and working capital to determine our short-term operational and long-term capital financing needs.

Business Segments We currently report our results as two reportable segments representing our two retail divisions. Although the two operating segments have many similarities in their products, production processes, distribution methods, and regulatory environment, there are differences in most of these areas and distinct differences in their economic characteristics. As a result, we consider these segments to be two distinct reportable segments. As discussed further in the Executive Overview, we are winding down the Arden B business.

Wet Seal. Wet Seal is a junior apparel brand for girls who seek fashion apparel and accessories at affordable prices, with a target customer age range of 13 to 23 years old. Wet Seal seeks to provide its customer base with a balance of trend right and fashion basic apparel and accessories that are budget-friendly.

Arden B. Arden B is a fashion brand at affordable prices for the contemporary woman. Arden B targets customers aged 24 to 34 years old and seeks to deliver differentiated contemporary fashion, dresses, sportswear separates and accessories for many occasions of the customers' lifestyles.

We maintain a Web-based store located at www.wetseal.com, offering Wet Seal merchandise comparable to that carried in our stores. We also maintain a Web-based store located at www.ardenb.com, offering Arden B merchandise comparable to that carried in our stores. Our e-commerce stores are designed to serve as an extension of the in-store experience and offer an expanded selection of merchandise, with the goal of growing both e-commerce and in-store sales. We continue to develop our Wet Seal website to increase its effectiveness in marketing our brand. We do not consider our Web-based business to be a distinct reportable segment. The Wet Seal and Arden B reportable segments include, in addition to data from their respective stores, data from their respective e-commerce operations.

26-------------------------------------------------------------------------------- Table of Contents Current Trends and Outlook Our soft sales trends that started in the second half of 2013 continued through our second fiscal quarter of 2014, with continued softness in mall traffic, an intense promotional environment throughout the specialty retail apparel segment, weakness in retail trends and in fast fashion merchandise in general, and challenging economic conditions, especially for our middle and lower-middle income target customers, contributing negatively to our retail sales. Our comparable store sales decreased 12.4% during the 13 weeks ended August 2, 2014, driven by an 11.1% comparable store sales decrease in our Wet Seal division and a 22.8% comparable store sales decrease in our Arden B division during its wind down. Our comparable store sales declines, along with merchandise margin weakness from efforts to compete in the current promotional environment, has resulted in significant operating losses and use of cash in operating activities in each of the past four fiscal quarters. See Liquidity and Capital Resources herein for further discussion.

The Wet Seal division's comparable store sales decrease was primarily attributable to a decrease in transaction volume and a decrease in average dollar sales per transaction, which was driven by a decrease in average unit selling price, partially offset by an increase in units purchased per customer.

The Arden B division comparable store sales decrease was primarily attributable to a decrease in transaction volume and a decrease in average dollar sales per transaction, which was driven by a decrease in average unit selling price from wind-down clearance events, partially offset by an increase in units purchased per customer.

Our combined e-commerce net sales compared to the prior year quarter, which is included in calculating our comparable store sales, increased 11.4% for the 13 weeks ended August 2, 2014, including a 25.1% increase at Wet Seal and a 24.6% decrease at Arden B due to the wind down of the Arden B business. Since the implementation of our new Demandware ecommerce platform in November 2013, we have shown improved mobile traffic and mobile conversion rates compared to periods before implementation. Improving the mobile shopping experience for our customers continues to be a key element of our ecommerce growth strategy.

Store Openings and Closures For fiscal 2014, we currently expect to open 9 new Wet Seal stores, primarily in outlet and off-mall centers, and close approximately 48 stores upon lease expiration in fiscal 2014. Of the 48 stores expected to close, 33 are Wet Seal stores, and 15 are Arden B transition stores temporarily operating as Wet Seal or Wet Seal Plus stores. In August 2014, we converted 30 Arden B stores into Wet Seal Plus stores, 18 Arden B stores into Wet Seal stores and 1 of the Arden B stores continues to operate under the Arden B name, but will sell Wet Seal product, and the 2 remaining stores continued to operate as Arden B stores until their closure in August 2014.

Excluding the Arden B stores that were converted to Wet Seal or Wet Seal Plus stores, at Wet Seal, we opened 4 new stores and closed 2 stores during the 13 weeks ended August 2, 2014. At Arden B, we closed 3 stores during the 13 weeks ended August 2, 2014.

Critical Accounting Policies and Estimates Our condensed consolidated financial statements were prepared in conformity with accounting principles generally accepted in the United States of America ("U.S.

GAAP") for interim financial information and the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by U.S. GAAP for complete financial statements.

The preparation of financial statements in conformity with U.S. GAAP requires the appropriate application of accounting policies, some of which require us to make estimates and assumptions about future events and their impact on amounts reported in our condensed consolidated financial statements. Since future events and their impact cannot be determined with absolute certainty, the actual results will inevitably differ from our estimates.

We believe the application of our accounting policies, and the estimates inherently required therein, are reasonable. Our accounting policies and estimates are reevaluated on an ongoing basis, and adjustments are made when facts and circumstances dictate a change. Our accounting policies are more fully described in Note 1, "Summary of Significant Accounting Policies" and in Management's Discussion and Analysis of Financial Condition and Results of Operations included in our Annual Report on Form 10-K for the fiscal year ended February 1, 2014.

The policies and estimates discussed below involve the selection or application of alternative accounting policies that are material to our condensed consolidated financial statements. Management has discussed the development and selection of these critical accounting policies and estimates with the Audit Committee of our Board of Directors.

27-------------------------------------------------------------------------------- Table of Contents We have certain accounting policies that require more significant management judgment and estimates than others. These include our accounting policies with respect to revenue recognition, merchandise inventories, long-lived assets, stock-based compensation, accounting for income taxes, legal loss contingencies, insurance reserves and warrants and embedded derivatives liabilities. There have been no significant additions to or modifications of the application of the critical accounting policies described in our Annual Report on Form 10-K for the fiscal year ended February 1, 2014, except for the following updates for our critical accounting policies for long-lived assets, accounting for income taxes, legal loss contingencies and warrants and embedded derivatives liabilities.

Long-Lived Assets We evaluate the carrying value of long-lived assets for impairment quarterly or whenever events or changes in circumstances indicate that the carrying value of such assets may not be recoverable. Factors that are considered important that could result in the necessity to perform an impairment review include a current-period operating or cash flow loss combined with a history of operating or cash flow losses and a projection or forecast that indicates continuing losses or insufficient income associated with the realization of a long-lived asset or asset group. Other factors include a significant change in the manner of the use of the asset or a significant negative industry or economic trend.

During the 13 and 26 weeks ended August 2, 2014, and August 3, 2013, we recorded $12.7 million, $20.1 million, $0.3 million and $1.9 million, respectively, of impairment charges. Additional information required by this item is incorporated herein by reference to Note 1, "Summary of Significant Accounting Policies," to the condensed consolidated financial statements included elsewhere in this report.

Accounting for Income Taxes We have approximately $165.0 million of federal NOLs available to offset taxable income in fiscal 2014 and thereafter, subject to certain annual limitations based on the provisions of Section 382 of the Internal Revenue Code. Our effective tax rates for the 13 and 26 weeks ended August 2, 2014, were approximately negative 0.1% and 0.3%, respectively, despite our net loss. These effective rates are due to certain state income taxes for fiscal 2014 that are not based on consolidated net income. We expect a negative 0.3% effective income tax rate for fiscal 2014, although a number of factors could cause our actual effective tax rate for fiscal 2014 to differ from our expected effective tax rate. Additional information required by this item is incorporated herein by reference to Note 1, "Summary of Significant Accounting Policies," to the condensed consolidated financial statements included elsewhere in this report.

Legal Loss Contingencies We are subject to the possibility of various legal losses. We consider the likelihood of loss or the incurrence of a liability, as well as our ability to reasonably estimate the amount of loss, in determining loss contingencies. An estimated loss contingency is accrued when it is probable that a liability has been incurred and the amount of loss can be reasonably estimated. We evaluate current information available to us to determine whether such accruals should be adjusted and whether new accruals are required. As of August 2, 2014, we have accrued less than $0.1 million for loss contingencies in connection with the litigation matters discussed in Note 7, "Commitments and Contingencies," to the condensed consolidated financial statements included elsewhere in this report.

Future developments may require us to adjust the amount of this accrual, which, if increased, could have a material adverse effect on our results of operations or financial condition.

Warrants and Embedded Derivatives Liabilities During the first quarter of 2014, we issued $27.0 million of senior convertible notes and warrants to purchase up to 8,804,348 shares of our Class A common stock to a single institutional investor, with proceeds to us, net of $1.9 million of deferred financing costs, of $25.1 million. The senior convertible notes were initially recorded net of a discount of $5.6 million, reflecting the fair value of the warrants and embedded derivatives within the senior convertible notes on the issuance date. The $5.6 million debt discount will be amortized through interest expense on the consolidated statements of operations, using the effective interest method, over the term of the senior convertible notes. The $1.9 million of deferred financing costs will be amortized through interest expense on our condensed consolidated statements of operations over the term of the senior convertible notes.

The $5.6 million fair value of the warrants and embedded derivatives are recorded within long-term liabilities on the condensed consolidated balance sheets. The warrants and embedded derivatives are marked to market quarterly, with any change recorded as an adjustment to the carrying value of these liabilities and the gain or (loss) on warrants and derivatives liabilities recorded in the condensed consolidated statements of operations. The change in the value of the warrants and embedded derivatives liabilities from time to time cannot be predicted and may be significant, which could have a significant effect on our financial results. Events that could cause the valuation to change include changes in our stock price and the risk free interest rate. The fair value of the 28-------------------------------------------------------------------------------- Table of Contents warrants and embedded derivatives from the issuance date to the end of the second quarter declined $2.9 million. Accordingly, this amount was recorded as a gain on warrants and derivatives liabilities in our condensed consolidated statements of operations.

The initial senior convertible note and warrants were exchanged in September 2014 for the Exchange Note and the Exchange Warrant as more fully described under Management's Discussion and Analysis - Liquidity and Capital Resources - Subsequent Events.

Recent Accounting Pronouncements The information required by this item is incorporated herein by reference to Note 1, "Summary of Significant Accounting Policies," to the condensed consolidated financial statements included elsewhere in this report.

Results of Operations The following table sets forth selected condensed consolidated statements of operations data as a percentage of net sales for the periods indicated. The discussion that follows should be read in conjunction with the table below: 13 Weeks Ended 26 Weeks Ended August 2, 2014 August 3, 2013 August 2, 2014 August 3, 2013 Net sales 100.0 % 100.0 % 100.0 % 100.0 % Cost of sales 78.2 70.4 79.2 70.2 Gross margin 21.8 29.6 20.8 29.8 Selling, general, and administrative expenses 30.5 28.7 31.3 27.7 Asset impairment 10.5 0.2 8.4 0.6 Operating (loss) income (19.2 ) 0.7 (18.9 ) 1.5 Interest expense, net (1.0 ) - (0.7 ) - Gain on warrants and derivatives liabilities 2.1 - 1.2 - (Loss) income before provision for income taxes (18.1 ) 0.7 (18.4 ) 1.5 Provision for income taxes - - 0.1 - Net (loss) income (18.1 )% 0.7 % (18.5 )% 1.5 % Thirteen Weeks Ended August 2, 2014, Compared to Thirteen Weeks Ended August 3, 2013 Net sales 13 Weeks Ended Change From 13 Weeks Ended August 2, 2014 Prior Fiscal Period August 3, 2013 ($ in millions) Net sales $ 121.2 $ (16.0 ) (11.7 )% $ 137.2 Comparable store sales decrease (12.4 )% Net sales for the 13 weeks ended August 2, 2014 decreased primarily as a result of the following: • A comparable store sales decrease of 12.4%, which included impact of an internet sales increase of 11.4%, or $0.8 million, to $8.1 million this year from $7.3 million last year, partially offset by; • An increase in number of stores open, from 525 stores as of August 3, 2013, to 531 stores as of August 2, 2014.

The comparable store sales decrease during the 13 weeks ended August 2, 2014 was due to a 5.5% decrease in comparable store average transactions and a 7.1% decrease in comparable store average dollar sale per transaction. Comparable store average dollar sale per transaction decreased mainly due to a 10.2% decrease in average unit retail prices, partially offset by a 2.8% increase in the number of units purchased per customer.

29-------------------------------------------------------------------------------- Table of Contents Cost of sales 13 Weeks Ended August Change From 13 Weeks Ended August 2, 2014 Prior Fiscal Period 3, 2013 ($ in millions) Cost of sales $ 94.8 $ (1.8 ) (1.9 )% $ 96.6 Percentage of net sales 78.2 % 780 bps 70.4 % Cost of sales includes the cost of merchandise; markdowns; inventory shortages; inventory valuation adjustments; inbound freight; payroll expenses associated with buying, planning and allocation; processing, receiving and other warehouse costs; rent and other occupancy costs; and depreciation and amortization expense associated with our stores and distribution center.

Cost of sales during the second quarter of fiscal 2014 when expressed as a percentage of net sales increased due primarily to a decrease in merchandise margin of 560 basis points as a result of higher markdown rates in both the Wet Seal and Arden B divisions and an increase in occupancy costs as a percentage of net sales of 210 basis points, primarily due to the deleveraging effect of our comparable store sales decline.

Selling, general, and administrative expenses (SG&A) 13 Weeks Ended August Change From 13 Weeks Ended August 2, 2014 Prior Fiscal Period 3, 2013 ($ in millions) Selling, general, and administrative expenses $ 36.9 $ (2.5 ) (6.3 )% $ 39.4 Percentage of net sales 30.5 % 180 bps 28.7 % Our SG&A expenses are comprised of two components. Selling expenses include store and field support costs, including personnel, advertising and merchandise delivery costs, as well as e-commerce processing costs. General and administrative expenses include the cost of corporate functions such as executives, legal, finance and accounting, information systems, human resources, real estate and construction, marketing, loss prevention and other centralized services.

Selling expenses decreased $0.7 million to $29.8 million in the second quarter of fiscal 2014. As a percentage of net sales, selling expenses were 24.6% of net sales, or 240 basis points higher than the comparable prior year period.

The following contributed to the current quarter decrease in selling expenses: • A $0.7 million decrease in store and field wages and benefits due to controlled store payroll hours; • A $0.5 million decrease in inventory service due to a physical inventory count conducted in the prior year period but not the current year period; and • A $0.1 million net decrease in other selling expenses.

The decreases in selling expenses were partially offset by the following increases: • A $0.4 million increase in advertising and marketing expenditures due to efforts to build our e-commerce business; and • A $0.2 million increase in store and field bonuses primarily due to store employee retention bonuses for the Arden B stores transitioning to Wet Seal and Wet Seal Plus stores.

General and administrative expenses decreased $1.8 million from the prior year quarter, to $7.1 million. As a percentage of net sales, general and administrative expenses were 5.9%, or 60 basis points lower than a year ago.

The following contributed to the current quarter decrease in general and administrative expenses: • A $0.8 million decrease in other general and administrative expenses related to the $0.7 million gain on the settlement of the SERP liability and $0.1 million in other miscellaneous income; • A $0.5 million decrease in legal fees and legal settlement charges due to resolving litigation in the prior year; • A $0.3 million decrease in bonuses due to operating performance; and • A $0.4 million decrease in various expenses including corporate wages and benefits, audit fees, and reduced travel.

The decreases in general and administrative expenses were partially offset by the following: 30-------------------------------------------------------------------------------- Table of Contents • A $0.2 million increase in depreciation primarily due to recently placed in service internet re-platforming software and hardware.

Asset impairment 13 Weeks Ended August Change From 13 Weeks Ended August 2, 2014 Prior Fiscal Period 3, 2013 ($ in millions) Asset impairment $ 12.7 $ 12.4 4,133.3 % $ 0.3 Percentage of net sales 10.5 % 1030 bps 0.2 % Based on our quarterly assessments of the carrying value of long-lived assets, during the 13 weeks ended August 2, 2014, and August 3, 2013, we identified certain retail stores and corporate assets with carrying values of their assets, including leasehold improvements, furniture, fixtures, and equipment, in excess of such assets' respective forecasted undiscounted cash flows. Accordingly, during the second quarter of fiscal 2014 we reduced their respective carrying values to their estimated fair market values, resulting in non-cash charges of $12.7 million compared to charges of $0.3 million in the second quarter of fiscal 2013. Of the $12.7 million in impairment charges for the 13 Weeks Ended August 2, 2014, $0.1 million was for Arden B stores.

Interest expense, net We incurred interest expense, net, of $1.2 million during the 13 weeks ended August 2, 2014, and less than $0.1 million during the 13 weeks ended August 3, 2013. The increase in interest expense was due to the interest expense and deferred financing cost amortization for our senior convertible debt and warrants.

Gain on warrants and derivatives liabilities We recorded a non-cash gain of $2.5 million for the decrease in fair value of our warrants and derivatives liabilities in the second quarter of fiscal 2014.

Provision for income taxes 13 Weeks 13 Weeks Ended Change From Ended August August 2, 2014 Prior Fiscal Period 3, 2013 ($ in thousands) Provision for income taxes $ 29 $ 10 52.6 % $ 19 As a result of our evaluation of the realizability of our net deferred tax assets as of February 2, 2013, we concluded, based upon review of all evidence, that it was more likely than not that our deferred tax assets will not be realized and we recorded a valuation allowance against our deferred tax assets.

Accordingly, we did not record a tax benefit for pretax losses during the 13 weeks ended August 2, 2014. We recognized a provision for income taxes that resulted in an effective tax rate of negative 0.1% during the 13 weeks ended August 2, 2014 for federal and state income taxes. This effective rate is due to certain state income taxes for fiscal 2014 that are not based on consolidated net income. We have net operating loss carryforwards (NOLs) available, subject to certain limitations, to offset our regular taxable income.

Segment Information The following is a discussion of the operating results of our business segments.

We consider each of our operating divisions to be a segment. In the tables below, Wet Seal and Arden B reportable segments include data from their respective stores and e-commerce operations. Operating segment results include net sales, cost of sales, asset impairment and store closure costs, and other direct store and field management expenses, with no allocation of corporate overhead, interest income or expense.

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