Yesterday, China Merchants Bank (CMB) released its 2023 annual report, which showed a decline in operating revenue but an increase in net profit, with one-third of the profits distributed as dividends. Today, CMB's stock price surged over 3%, strongly leading the overall upward trend of bank stocks, seemingly indicating that the capital market is quite satisfied with the data in CMB's report. However, after carefully studying CMB's annual report last night, I do not want to follow the sell-side approach by selectively praising only the positive aspects and being overly optimistic. Because, under a relatively challenging fundamental environment, it would be contrary to logic for a pro-cyclical industry like banking to experience an improvement in operating conditions against the market trend. Overall, the reality reflected in this annual report is: First, from a macro-environment perspective, challenges outweigh opportunities. Second, from an actual operations perspective, difficulties outweigh achievements. Of course, I should add that I am not singling out CMB's data. To be honest, as one of the best commercial banks in China, the difficulties mentioned below, if multiplied by two, represent the general situation among banking peers; meanwhile, the achievements mentioned, if discounted by 70%, roughly reflect the industry's average level. Therefore, the focus is more on using a specific case to illustrate the general situation, discussing the actual conditions of the banking industry, and understanding the real state of the macro and microeconomy through the banking sector, as the banking industry often serves as an early indicator of economic changes. I have summarized ten points, as follows: Point 1: Cost reduction and efficiency improvement are real, but the clawback of performance-based compensation is more bark than bite. Point 2: Operating revenue is the foundation, and banks' profitability has weakened. Point 3: The growth in net profit has been "squeezed" out. Point 4: The alarming trend of "deposit termification." Point 5: Potentially decelerating insurance revenue. Point 6: Banks have fueled the bond bull market, and the bond bull market has, in turn, saved the banks. Point 7: Setting sights overseas. Point 8: The rapid contraction of non-standard assets, corresponding to the reduction of non-standard financing in real estate and local government debt swaps. Point 9: The decline in real estate financing. Point 10: Various other points. Let's begin.
Point 1: Cost reduction and efficiency improvement are real, but the clawback of performance-based compensation is more bark than bite. In 2022, CMB had 113,000 employees, with employee costs totaling CNY 70.6 billion, resulting in an average per capita cost of CNY 625,000. In 2023, CMB had 116,500 employees, with employee costs totaling CNY 70.35 billion, resulting in an average per capita cost of CNY 604,000. While the number of employees increased by over 3,000, employee costs decreased by over CNY 200 million, meaning the average compensation per person decreased by over CNY 20,000. The cost reduction aspect of "cost reduction and efficiency improvement" is certainly real, although compared to other industries, this reduction is relatively modest. The situation in 2024 is expected to be even more challenging. The number of employees will likely continue to increase slightly and passively (due to more campus recruitment than resignations). However, if you are a wealth management manager, just consider how quickly insurance revenue began falling since Q4 2023, how much trailing commission has decreased since fund fee reductions mid-last year, and how much net interest margins have shrunk amid deposit price wars; you will then understand how much further income might drop in 2024. We will discuss this later in the operational analysis. Another point often highlighted by the media is the so-called "clawback of performance-based compensation," where previously paid performance bonuses are recalled for various reasons, including compliance issues. CMB's annual report shows that this was applied to 4,414 individuals, totaling CNY 43.29 million, which amounts to less than CNY 10,000 per person – truly a case of much ado about nothing. However, it is worth noting the recent trend on Xiaohongshu, where many sales staff from third-party wealth management companies related to Zhongzhi Group are being forced to return commissions. I estimate that for anyone who previously sold such products, especially self-financing types, and particularly salespeople at third-party wealth management companies, the "good days" are yet to come. Regarding this issue, I fully support such actions. Point 2: Operating revenue is the foundation, and banks' profitability has weakened. Cost reduction does not solve fundamental problems; enhancing efficiency is the only true path to development. No company can build a century-old enterprise by simply cutting two months' worth of employee bonuses. In terms of operating revenue, CMB generated a total of CNY 339.1 billion in 2023, which is over CNY 5.6 billion less than in 2022, representing a decline of 1.64%. More importantly, as I've mentioned before, banks ultimately have only two primary means of generating profit. One is net interest income – essentially, the total income from loans extended and investments made, minus the interest paid on deposits, i.e., the net interest margin. This segment experienced negative growth of 1.6%. The other is non-interest income, commonly referred to as fee-based income, such as revenue from distributing funds, insurance, and wealth management products, as well as management fees earned by the bank's affiliated fund companies and wealth management subsidiaries, etc. This segment also experienced negative growth of 1.6%. This means that both core business segments experienced negative growth. The decline in net interest income indicates that banks' net interest margins are contracting. The fundamental reason is that in a cycle of declining returns on capital across society, asset prices are falling, but the cost of liabilities (deposit interest rates) is actually rising, as will be discussed below. The decline in non-interest income indicates that this business, which theoretically can scale infinitely without consuming capital (a bank selling CNY 100 billion or CNY 10 trillion in funds faces no inherent capacity constraint), has not only lost its growth momentum (the capital market previously valued CMB at 2x P/B largely due to this segment's historical 30% annual growth rate) but has instead become a shortfall in revenue targets. Taking a broader view, the profitability of banks reflects the average profitability of all enterprises in society combined. This suggests that this average profitability is declining, and the situation is likely even more challenging for other banks. Point 3: The growth in net profit has been "squeezed" out. Those reading media flashes might notice that while CMB's operating revenue showed negative growth, its net profit was positive. How is that possible? Operating revenue decreased by CNY 5.6 billion, but net profit increased by CNY 8.7 billion. Where did this net positive swing of approximately CNY 14.3 billion come from? Simplifying the bank's net profit calculation by excluding some minor items, it can be roughly described by the following formula: Net Profit = Net Interest Income + Non-interest Income - Business and Management Expenses - Credit Impairment Losses - Income Tax As mentioned above, net interest income and non-interest income, which constitute operating revenue, decreased by a combined CNY 5.6 billion. Business and management expenses, covering employee salaries and various operating costs, were reduced by about CNY 1.6 billion. Meanwhile, income tax paid increased by CNY 2.8 billion this year. Combining the impact of these items results in a negative effect of approximately -CNY 6.8 billion on net profit. So, how did net profit反而 increase by +CNY 8.7 billion? The answer lies in a substantial reduction in credit impairment losses, which were provisioned by nearly CNY 15 billion less. This almost accounts for the difference. What are credit impairment losses? Simply put, if a bank lends out CNY 10 billion with an average lending rate of 5%, it earns CNY 500 million in income. If it estimates a potential default rate of 1% on that CNY 10 billion portfolio (meaning 1% might become non-performing loans), it prudently sets aside CNY 100 million from its CNY 500 million income as a provision to cover potential future losses from that CNY 100 million in NPLs. Could it choose not to provision? Yes, but that poses a problem. Banking is a cyclical industry. During good times, profits might be very high, leading to large bonuses for employees and dividends for shareholders. However, if the economic fundamentals deteriorate and companies start defaulting, the bank might lack the capacity to cover those bad loans, leading to significant profit volatility. If the losses are substantial enough, the bank could theoretically become insolvent. Therefore, banks must set aside more provisions during prosperous times. Why did CMB's credit impairment losses decrease significantly this time? According to the annual report, the major contributors were a reduction in provisions for receivables from同业和其他金融机构款项 (interbank and other financial institution receivables) and off-balance-sheet expected credit losses, which decreased by nearly CNY 14 billion combined. Focusing on one: what are off-balance-sheet expected credit losses? Some reports suggest that CMB's private banking division, for some higher-risk distribution projects, might use the bank's own funds to cover risks. This falls under off-balance-sheet expected credit losses. Originally, as off-balance-sheet distribution business, these should not impact the bank's profit and loss statement. However, for various reasons, provisions were made previously. Now, by provisioning less in this area, profits are effectively released. This explains why operating revenue can be negative while net profit turns positive. It's a case of using provisions from prosperous years to support performance in leaner years. Point 4: The alarming trend of "deposit termification." As mentioned, CMB's operating revenue experienced negative growth this year. Operating revenue is divided into net interest income and non-interest income. Net interest income, simply put, is (Loan Income + Investment Income from bonds, etc.) minus Deposit Costs. We can see significant pressure on loan income itself. The average corporate loan rate decreased by 0.10%, the average personal loan rate decreased by 0.42%, and bill discounting rates fell by 0.47% (this is also why bill volumes dropped significantly in January-February – the yields became too low and unattractive). Meanwhile, investment income from bonds, etc. (the coupon part), increased significantly, by over 20%. Why? Simply because if loans are hard to place, the bank invests more in bonds. This returns to the logic discussed before: even banks like CMB are being squeezed out of the loan market and are thus actively or passively increasing their allocation to bonds, fueling the bond bull market. But what is more alarming is the significant increase in deposit costs. We often hear that there were four rounds of deposit rate cuts in 2023. Logically, banks' deposit costs should have decreased. However, I have consistently argued that banks' deposit costs are too high, and the biggest risk currently is excessively high deposit rates, necessitating further and rapid cuts. The underlying reason is the massive shift from demand deposits to time deposits. In CMB's deposit structure, the proportion of corporate time deposits rose from 22% to 24.7%. Even more striking, the proportion of personal time deposits surged from 14.87% to 20.4%, an increase of nearly 6 percentage points. And this is CMB, renowned for its strong settlement deposit base. The situation is even more pronounced at other banks. CMB's own summary of the reasons is clear. On the corporate side: The economic recovery fell short of expectations, corporate confidence recovered slowly, the utilization rate of corporate funds remained low, investment and financing willingness was insufficient, leading to less derivation of demand deposits (correlate this with the recent letter from a branch regarding negative growth in corporate deposits during the "good start" period). On the personal side: Capital market volatility and increased household savings demand, particularly for medium to long-term time deposits. CMB mentions that the trend of deposit termification may persist, and market competition is likely to intensify. This means the process of rising actual deposit costs for banks may continue. In response, CMB will strictly control the addition of high-cost deposits, even suggesting that if interbank certificate of deposit (NCD) rates are lower temporarily, issuing NCDs might be preferable to attracting personal time deposits. This underscores why I have consistently emphasized the need to reduce household deposit rates. When households flock en masse to the deposit market, it indicates that deposits offer disproportionately high value compared to other assets. This essentially amounts to a subsidy from the broader economy to depositors. Rates should be cut quickly to restore market balance (though exchange rates are a constraint). Point 5: Potentially decelerating insurance revenue. While CMB is often perceived as strong in fund distribution, insurance is actually the pillar of its non-interest income. In 2023, total distribution income was CNY 28.5 billion, a year-on-year decrease of 7.9%. Specifically, income from fund distribution was about CNY 5.2 billion, down 21% year-on-year. This was due not only to difficulties in selling new equity funds (losing upfront subscription fees of around 1.2%) but also the fee cuts for publicly offered funds mid-last year, where management fees for active equity funds dropped from 1.5% to 1.2% (a 20% cut). Since banks typically receive about 50% of trailing commissions, the revenue from existing assets also fell by roughly 20%. Income from wealth management product distribution was about CNY 5.4 billion, down 18% year-on-year. The main reason is that while the scale of WMP distribution might still be growing positively, the products sold are predominantly low-margin, high-volume cash management and fixed-income products. Sales of products with upfront fees and higher trailing commissions, like fixed-income-plus products and equity FOFs, have been weak. Income from trust distribution was CNY 3.2 billion, down 19% year-on-year. This is easily understood given the severe challenges facing the entire trust industry. Were it not for the rise of family trust structures, this number would likely be worse. The only segment showing growth was insurance distribution income, totaling CNY 13.6 billion – more than the sum of fund, WMP, and trust distribution income – with a year-on-year increase of 9.33%. However, the严峻 reality is that starting from Q3 2023, insurance pricing was adjusted downward, coupled with recent new regulatory opinions requiring universal life insurance rates to be further compressed below 3%. This reduces the inherent attractiveness of insurance pricing. Furthermore, requirements for "报行合一" (alignment of reporting and operations) mean lower handling fees for banks. Consequently, insurance revenue undoubtedly began to decline significantly starting in Q4 2023. CMB's annual report also implicitly mentions that this revenue stream is expected to face significant challenges in 2024. Recently, there has been much discussion about the potential end of implicit guarantees for insurance products. We should await official information and potential legal amendments. However, one thing is certain: within financial products, those that sell exceptionally well often harbor underlying risks. The true price of each product is determined at its launch. This risk is ultimately borne either by the client, the distribution institution, or the management company. Just as easily attracted time deposits lead to high deposit rates, hurting banks. Behind the booming sales of insurance, the ones likely to get hurt are the insurance institutions themselves, because such high rates will inevitably cause long-term interest spread losses for them. Therefore, the deceleration in insurance revenue actually represents a release of accumulated risks. But this deceleration will also bring new shocks to the overall wealth management business of banks. So far, few alternative revenue sources are visible. Point 6: Banks have fueled the bond bull market, and the bond bull market has, in turn, saved the banks. As mentioned in the interest income section above, banks found it difficult to extend loans and increased their allocation to bonds. The coupon income from this segment grew by 22% year-on-year to CNY 80.8 billion, supplementing bank interest income. However, this represents linear growth and is largely a substitution for loans, so its overall impact should be viewed in that context and is not particularly surprising. Another noteworthy aspect is the bank's trading book, which includes gains from trading bonds and publicly offered funds, as well as unrealized gains (capital gains). As mentioned in the non-interest income section, apart from insurance, all other distribution incomes fell sharply. Total distribution fee income fell by 7.9% year-on-year. Management fee income from the bank's wealth management and fund subsidiaries also fell by 7.9%. Income from credit card installment plans, etc., fell by over 8%. Yet, overall non-interest income declined by less than 2%. Why? Unrealized gains on bonds contributed significantly to revenue. This is not recorded as interest income but as non-interest income. In the accounts, this falls under "investment income" and "fair value change gains," covering investments in bonds and bond funds, etc. This combined item increased by over CNY 6 billion, filling the gap left by the decline in fund revenue, etc. Therefore, the increase in allocations to bonds and bond funds by banks' proprietary funds not only helped drive the bond bull market through配置 demand but also, in turn, the bond bull market helped salvage the banks' profit statements for the year. However, it is crucial to monitor: in a environment of rapidly falling interest rates, the coupon income (interest income) from the bulk of bond investments will decline rapidly upon maturity and reinvestment. Furthermore, given the current term spreads and credit spreads, how much potential for capital gains (non-interest income) remains? In other words, banks profited handsomely last year and in the first two months of this year. But what about going forward? What is the strategy then? Excessively low interest rates are generally not favorable for banks and insurers. Point 7: Setting sights overseas. I will be brief on this point, highlighting three aspects. First, CMB's net exchange gains in 2023 were CNY 4.1 billion, up 14.78% year-on-year, primarily due to increased gains from foreign currency transactions. As two-way exchange rate volatility increases, the disparity in foreign exchange trading capabilities among different banks will likely become more pronounced. Second, serving corporate clients' overseas expansion needs represents an incremental revenue source. CMB mentioned aiming to become the "primary settlement bank" and "first-contact bank" for client cross-border business. It served 75,000 corporate clients for cross-border payments, a year-on-year increase of 14.03% on a comparable basis. This involves not only promoting the concept of exchange rate risk neutrality to corporate clients but also providing tailored solutions for exchange rate risks faced by clients in their main business scenarios. It provided hedging services to over 6,000 enterprises, emphasizing online service capabilities. It also noted that the online penetration rate for corporate foreign exchange services reached 75% last year, up 10 percentage points year-on-year. As Chinese companies' overseas expansion demands surge significantly, service capability in this area will be crucial for maintaining corporate client stickiness. Third, regarding individual overseas needs, this logically should be covered under wealth management and private banking descriptions, but it was not mentioned at all, except for a brief reference to QDII product creation in the custody section. This is understandable, but in practice, all banks should focus on this business. Even considering political correctness, appropriate global asset allocation is a path already taken in other countries for ultra-high-net-worth, high-net-worth, and even ordinary clients, and there is little need for secrecy. Point 8: The rapid contraction of non-standard assets, corresponding to the reduction of non-standard financing in real estate and local government debt swaps. Comparing the figures: In 2022, the balance of CMB's proprietary investments in non-standard assets was CNY 127.7 billion. In 2023, this figure was CNY 87 billion. A sharp contraction of over CNY 40 billion. The logic behind this is simple. The two largest creators of non-standard assets are: 1) Real estate developers, who can no longer issue non-standard products as there are few buyers, and 2) Local government financing vehicles (LGFVs). Since the local government debt swap program began last year, the issuance of new non-standard assets plummeted, and existing non-standard assets are being rapidly replaced by lower-cost on-balance-sheet loans. This is a core reason for the relatively strong growth in medium to long-term corporate loans and the rapid contraction of non-standard financing in the January-February 2024 aggregate financing data. Delving deeper, against this backdrop, as a client, you should understand: 1. When banks purchase these non-standard assets, they can hold them in their proprietary account (using the bank's own capital, with profits accruing to the bank) or allocate them to their wealth management subsidiaries for inclusion in wealth management products (with profits going to clients, and the bank earning management fees). Now, with a shortage of supply, particularly for high-quality non-standard assets, and proprietary desks themselves lacking assets, there is little left for wealth management subsidiaries to配置. Combined with the earlier ban on agreement deposits, the supply of low-volatility assets (like non-standard assets and agreement deposits, which are valued using the amortized cost method) for wealth management products will decrease further. This forces a transition towards mark-to-market valuation. Consequently, the various products you purchase will experience relatively higher volatility. You must learn to tolerate this volatility and embrace the further wave of net asset value-based products. 2. The media might report that some non-standard products, like trust plans, are in short supply, with insufficient quotas, implying a buying frenzy if available. I advise you to think carefully: Would truly good companies currently need to finance through high-yield non-standard channels? Are companies relying on non-standard financing likely to be good companies? The average corporate loan rate is only around 3-point-something percent. If you are buying non-standard products offering returns of 6-7%, how will these companies repay? You are chasing high yields, but could they be after your principal? Imagine happily receiving high interest for three years, only to be told in the fourth year that the product's payout is suspended. Would you be happy or sad then? Don't say you weren't warned. Point 9: The decline in real estate financing. This can be viewed from three angles. First, CMB's annual report shows that its on-balance-sheet loans and real estate bonds total nearly CNY 400 billion, a year-on-year decrease of 13.9%. Off-balance-sheet distributed products related to real estate total CNY 250 billion, a year-on-year decrease of about 17%. The reduction on the bank's asset side directly reflects the reduction in financing for real estate enterprises, indicating the scale of the decline. Second, CMB's total non-performing loans (NPLs) amount to CNY 61.5 billion, split roughly equally between corporate and personal clients. Of the CNY 31 billion in corporate NPLs, CNY 17.2 billion are real estate NPLs. The NPL ratio for real estate increased from 4% in 2022 to 5.26% in 2023, indicating a further deterioration in quality. Third, regarding personal demand, CMB's assessment is that after the adjustment of existing mortgage rates, the interest rate differential between new and old loans has narrowed, which has somewhat mitigated early repayments. However, due to declining investment returns in the current market, it is expected that mortgage prepayments will remain at relatively high levels in 2024 compared to recent years. CMB also mentioned its measures: to meet the reasonable financing needs of real estate enterprises regardless of ownership type on an equal footing, increase support for non-state-owned real estate enterprises, and enhance services for the "三大工程" (three major projects) like affordable housing and the development of the housing rental market. The actual situation in this area requires continued monitoring. Point 10: Various other points. 1. Bank annual reports include messages from the Chairman and the President. Often, you'll find significant overlap. Typically, the Chairman's message focuses more on strategy, challenges, shareholder returns, Party building, and risks. From CMB's Chairman's message this time, the four mentioned challenges are "insufficient effective demand, overcapacity in some industries, weak social expectations, and numerous risk hazards" – all very pragmatic. Strategically, it mentions the need for "forward-looking and strategic vision to promptly assess and respond to the three trend changes: interest rates, real estate, and demographics." Readers can interpret this themselves. 2. Two sentences from the President's message were particularly striking: First, "Risk management capability determines how far we can go." Second, "Extensive development driven solely by scale is unsustainable, and the effect of '100-1=0' in risk management is becoming more evident." Nowadays, this holds true for both finance and manufacturing. Pursuing size at all costs will inevitably lead to losses. The "100-1=0" risk effect is simple: if a branch engages in numerous transactions but incurs one major NPL, that branch could effectively be crippled for 5-10 years. Therefore, risk management capability determines sustainability. While generating new revenue is difficult, it is also crucial to minimize the use of previously set-aside provisions, converting them into profits where possible. 3. NPL formation amount for retail loans (excluding credit cards) was CNY 9.16 billion, an increase of CNY 848 million year-on-year. NPL formation amount for credit cards was CNY 38.7 billion, an increase of CNY 1.88 billion year-on-year. The decline in household income is accompanied by an increase in personal loan NPLs, particularly for credit cards, whose primary users are younger people. Furthermore, metrics for credit cards – including active cards, active accounts, transaction volume, interest income, and non-interest income – all declined year-on-year, reflecting the downturn in consumption scenarios. 4. NPL recovery might become a critical function in banks' future. CMB alone recovered CNY 11.2 billion in cash last year. For many branches, rather than laboring over low-return business, it might be more effective to leverage available resources to recover more NPLs. 5. Impact of the new capital rules: Effective January 1, 2024, the new capital rules were implemented. According to CMB's understanding, the capital charge for credit business generally tends to decrease under the new rules, reflecting regulatory support for credit. In contrast, the capital charge for financial market business increases slightly, reflecting the determination to further reduce interbank activities. Banks should optimize their structure based on the priority of capital charges. However, the reality is that credit growth is weak, forcing banks to do more financial market business. This means the new capital rules' impact on boosting credit this year is likely limited. The main effect will be internal adjustments within financial market business itself, favoring allocations to government bonds over credit bonds, which is one of the core logics we mentioned driving the government bond bull market. 6. In 2023, CMB's distribution of non-monetary publicly offered funds totaled CNY 297 billion, down 11.4% year-on-year. However, it was also mentioned that sales of relatively stable bond fund products recovered somewhat sequentially in the second half of the year. While this is somewhat a necessity, as discussed above, with the declining attractiveness of insurance, the supply cut-off of non-standard assets, and the gradual stripping of WMPs' net value stabilization tools, net asset value-based bond products are likely to become the cornerstone asset class for household allocations in the future. The following image pertains to some other banks, not specifically CMB. 7. A highlight in wealth management was the creation of a 24-hour supermarket for cash management products. This is essentially the only product category where wealth management can currently achieve significant differentiation on a large scale. 8. Custody business is certainly facing difficulties. Because upstream sales are weak, funds are flowing back from off-balance-sheet asset management products requiring custody to on-balance-sheet deposits that do not require custody. In the coming years, the biggest potential growth area for custody, as I mentioned before, lies in collaborating with other bank departments and fund companies to改造和升级 (restructure and upgrade) existing products amidst the scarcity of new product supply. 9. Investment banking bond underwriting has become a relatively poor business model. Reasons include: 1) Overall supply decline as companies are reluctant to add leverage, reducing bond issuance demand; 2) Issuing clients lack diversification needs, leading to a "winner-takes-all" trend; 3) In a phase where corporate clients have strong bargaining power, their cost requirements are too high, leading to diminishing underwriting revenues, sometimes even losses on deals. CMB's bond underwriting is considered relatively good among peers, but not only did the underwriting volume decline by 5%, the underwriting income, categorized under "other fee income," plummeted by nearly 40%. 10. Regarding pensions, apart from a figure on account openings, the report had little else to discuss. This is a common industry-wide situation, awaiting the next cycle. 11. For private banking业务, CMB underwent significant organizational restructuring. This year's discussion was rather general, but the overall trend might be that private banking departments will focus more on client marketing and relationship management, while the selection of products across the bank will be centralized under specific departments like wealth management for unified management.
Finally, some additional explanations. First, in a overall downward trend where the logic is to compare who is less bad, the banking sector is certainly not the worst compared to other industries. It at least has policy support protecting its downside. CMB, in particular, is a very well-operated company at this stage. Second, the historical under-allocation to banks by public funds means that, given mandatory lower allocation limits, banks have become a good safe-haven asset, attracting fund inflows. Third, CMB's previous drop from CNY 50 to CNY 25 was due to the slowdown in fee-based income growth, temporarily disproving the growth narrative for wealth management institutions, leading to a valuation re-rating from a growth blue-chip to a traditional financial firm. The current rally in bank stocks overall is based on the premise that a good, well-operated commercial bank with controllable NPLs and no falsification should not trade below 1x P/B for an extended period. Therefore, CMB's move from 0.7x P/B to 0.9x P/B represents a valuation correction, a process that may not be over yet. Fourth, CMB remains one of the best commercial banks in China, possibly the best, and this is not in question. To reiterate, the difficulties mentioned above are macro, cyclical, and industry-wide issues, not specific to CMB itself.
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