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Operator
Good afternoon, ladies and gentlemen, and welcome to the Kenexa Corporation's third quarter 2008 earnings conference call.
At this time all participants are in listen-only mode.
Following the presentation we'll provide a question-and-answer session and instructions will be provided at that time on how to queue for questions.
I'd like to remind everyone that this conference is being recorded.
I'd like to turn the conference over to Mr.
Don Volk, Kenexa Chief Financial Officer.
Please go ahead, sir.
- CFO
Thank you, Paul.
With me today is Rudy Karsan, our Chief Executive Officer, and Troy Kanter our President and Chief Operating Officer.
Today we'll review Kenexa's third quarter 2008 results and provide guidance for the fourth quarter and full year 2008, then we'll open up the call for questions.
Before we begin, let me remind you that this presentation may contain forward-looking statements that are subject to risks and uncertainties associated with the company's business.
These statements may concern, among other things: guidance as to future revenues and earnings, operations, transactions, prospects, intellectual property and the development of products.
Additional information that may affect the company's business and financial prospects, as well as factors that would cause Kenexa's performance to vary from our current expectations are available in the company's filings with the Securities and Exchange Commission.
Also I'd like to remind you that today's call may not be reproduced in any form without the expressed written consent of Kenexa We may refer to certain nonGAAP financial measures on this call.
I will discuss the reconciliation of adjusted numbers of GAAP numbers and a reconciliation schedule showing the GAAP versus nonGAAP is currently available on our company website with the press release issued earlier today.
Our website is located at www.Kenexa.com.
I'll now turn the call over to Rudy Karsan.
Rudy?
- CEO
Thanks, Don, and thanks to all of you joining us on the call to review our third quarter results.
Back on September 10th we revised revenue and profitability outlook for the quarter and our full year 2008 based on two factors: the increasingly difficult macro economic environment and strengthening of the US dollar which negatively impacts our reported revenue given the fact that international operations have been the fastest growing component of our revenue.
Our results for the quarter were consistent with our revised outlook, however the business environment deteriorated even worse than expected as turmoil in the financial markets during the last few weeks of the quarter, created a situation in which customers paused to evaluate the status of the global economy and the market.
While we see a segment of consumers moving ahead with new deals and strategic projects, the level of scrutiny placed on any and all investments is at the highest level we've seen in all our years of being in business.
We've said in the past that we believe the talent management market would face strong headwinds if the unemployment rate were to reach 5%.
We've not only passed that level, but there are now fears that the unemployment rate may reach the upper single digit range in the quarters ahead.
Our business is clearly feeling the impact of the macro economic environment and the short-term slow down in the talent management market.
That said, our business has a solid foundation and we remain well positioned for the long term.
We have significant critical mass, a global presence, strong balance sheet, and a business model that enables us to generate significant profitability and cash flow.
We're staying true to a commitment we have reiterated many times, namely, in the most difficult of times we'd make the tough decision to continue delivering a profitability and cash flow to ensure the long-term health of Kenexa.
To that end we recently took action to reduce our workforce by approximately 11% to 12% in an effort to align the cost structure for the lower revenue run rate we expect to see in the fourth quarter.
This was a difficult decision, but we are in a difficult macroeconomic environment.
Importantly, these cuts will not slow our product delivery commitments or development plans and our service delivery and customer support efforts will continue to receive the highest level of commitment and focus as this is an area that is core to our company, our culture, our values, and our competitive [defenciation].
It is uncertain when the business environment will improve, but we're managing our business with the view that the macro economic environment will remain challenging throughout 2009.
We'll continue to monitor the health of the global economy in order to drive investment decisions across our business, as well as to take appropriate actions to balancing delivering profitability and cash flow for our shareholders with ensuring we're well positioned to drive long-term growth.
If we look at the details of the business, the core ATSB is clearly holding in the best on a relative basis at the moment.
More details are making it through the funnel in this area and our customers are continuing to renew at a high rate.
We estimate that the ATS related component for our business was up on a quarter-after-quarter basis during the quarter.
The results are worth pointing out that we believe our competitive win rate while already high have improved noticeably in this area over the course of the past several quarters.
We believe the primary drivers of this has been our investment in R&D ,in particular relative to the significant enhancement of our [brashering] offerings which we believe is now clearly the best of breed offering for the high end of the marketplace.
In the past we have shared with you the ARPU segment of our business, given the structure of the engagement, was the most exposed to slow down and hiring of economic trend.
To this point more than 25% of our RFPO clients have frozen hiring and there is a chance that number could climb.
This obviously reduces our revenue that is tied directly to the number of employees we hire.
To provide increased data on our ARPU business, revenues in 2Q were approximately $18.5 million and we currently expect to do around $12 million in ARPU revenues during the fourth quarter.
As we've discussed before, our ARPU revenue is not 100% service-based.
It also includes software and content to a degree.
We expect to continue providing a specific ARPU revenue on a quarterly business, at least as long as the economic environment remains challenging and uncertain.
It is also important to reiterate the key reasons that we remain firmly committed to this business, in spite of the short-term decline in revenue.
First, our overall profitability is enhanced by our ARPU business.
Second, it provides Kenexa with domain expertise that no other talent management software company has.
Third, in many cases we're able to bundle our software and content into the overall relationships.
And finally, this brings significant value to our customers.
Kenexa appreciates that the revenue associated with this business can be more variable than a pure subscription model, however we firmly believe that the ultimate winners in the talent management space will deliver not only software and content, but there will be a requirement to have services expertise and an outsourcing offering available to our clients.
As such, we'll continue to invest in this business and aggressively pursue new customer relationships.
The final area of the business that I would point out relates to our content and service.
In this case we've seen a segment of customers delay implementation and projects to the extent possible, but on the other hand we continue to see a high level of interest in our solutions and signing up new customers, which is evidenced in part by the overall number of customers we added in the quarter.
Turning to some of the key metrics that we normally report.
We added over 40 preferred partner customers during the quarter.
This compares to over 50 preferred partners added last quarter to over 40 preferred partners added during the year-ago period.
The sequential decline reflects the slow down in decision making I was referring to at the beginning of my remarks.
It also shows that there are a good number of deals moving forward.
On the talent acquisition side of our business, we closed business with customers such as CIBC, [emmett mining], Kona, GMac, Kohl's, autotrader.com and TransGlobal.
As it relates to our employee retention solutions, we closed business with customers such as Health Plus Michigan, South Florida Water, Bridge Products and Community Transit.
Our growing customer base provides Kenexa with a growing opportunity to expand our relationships over time.
Our [PQ] metric which measures the average annual revenue contribution of our top 80 customers was over $1.4 million during the third quarter, which is consistent with last quarter's level and up from $1.1 million during the year-ago quarter.
While the expected flattening of this figure, during the current environment, the value that Kenexa brings to customers is reflected by the fact our PQ metric has seen [a keger] of 40% over the course of the last five years.
As Kenexa demonstrates value, we see customers expanding the commitment to Kenexa as our strategic talent management vendor.
When the economic environment does stabilize, and it will, and improve as it will, we continue to believe that Kenexa will be a primary beneficiary.
We believe that optimizing talent management purchases are considered a top long-term strategic priority for a growing number of companies, and while short-term uncertainty has created strong headwinds, long-term demand drivers aren't going to change any time soon, mainly the aging of the workforce, declining tenure, globalization, skill shortages and employee mobility, just to name a few.
While it is clear that our general talent business environment, like our customers is cautious right now, we are very bullish in Kenexa's position within the market.
At our analyst day September 10th, we noted that the size of the pipeline and the verbal selection stage was at an all time high.
This continues to be the case.
We're confident that we'll close on many of these deals in a growing number of other opportunities when the economic environment improves and companies increasingly move forward with new projects.
Kenexa is highly differentiated by our business model that combines software, content and services, and we continue to enhance our market position.
On the product front, Kenexa continues to heavily invest in our products, which is evidenced by our being recognized as one of the market leaders in the area of e-recruitment software by the Gartner Group during the last quarter.
During the third quarter, our SimSJT solution earned one of "Human Resource Executive Magazine's" 2008 top HR products of the year.
In addition we continue to expand the scope of our value proposition, most recently with introduction of Kenexa Learning Management Solutions.
Kenexa is the only talent management vendor that can serve as a single source of recruiting, onboarding, assessment, learning, performance management, career development, succession planning and the employee life cycle service solutions.
In summary, we believe Kenexa is well positioned to weather the storm, but to also continue building on a strong market position as a result of our differentiated value proposition, expanding sweeter solutions, large global footprints and industry leading domain expertise.
Talent management is a good long-term market and we're a good market leader.
I'll now turn it over to Don, to review our third quarter results and fourth quarter outlook in more detail.
Don?
- CFO
Thanks, Rudy.
Let me begin by reviewing our results for the third quarter starting with the P&L.
Total revenue for the third quarter was $54 million in line with our revised guidance of $54 million to $56 million.
Total revenue increased 15% on a year-over-year basis, while it decreased 4% on a sequential basis.
From a geographic perspective, our revenue mix of domestic versus international revenue was consistent with the previous quarter at 74% to -- and 76%.
The sequential decline in international revenue was driven primarily by the strengthening of the US dollar.
Within total revenue, subscription revenue was $43 million, representing growth of 13% on a year-over-year basis and a decrease of 2% sequentially.
Subscription revenue was 80% of total revenue, which is at the high end of our targeted mix of the high 70% to 80% range.
In the spirit of providing extra data, relative to our RPO business, we will further share RPO's contribution to our subscription revenue.
RPO represented approximately $9 million of our subscription revenue in the third quarter, keeping in mind that RPO engagements also include technology solutions in many cases.
Our clients typically purchase multiyear subscriptions with an average length of approximately two years.
During the third quarter, renewal rates declined from 90% plus range to high 80% range.
The decline in renewal rates was predominantly related to a renewal that was delayed for a couple months.
To be clear, based on our discussions we firmly believe this client will ultimately renew their relationship with Kenexa.
The remaining $11 million of our total revenue in the third quarter came from other and professional services which increased 28% over last year, but declined 14% compared to the second quarter of 2008.
The sequential decrease in our other revenue was driven by two primary factors: first, the slow down in consulting revenue, and second, the slow down in hiring leading to reduced success fees with our RPO customers.
Both of these are a side effect of the more challenging economic environment.
Turning to profitability, we'll be providing nonGAAP measures for each third quarter 2008 expense category which includes stock-based compensation charges associated with the implementation of FAS 123(R) and the amortization of intangibles associated with previous acquisitions.
All comparisons will be using the nonGAAP current period results.
NonGAAP gross margin was 70% in the quarter, consistent with the level in the second quarter and compared to 71% in the year-ago quarter.
NonGAAP sales and marketing expense came in at $10.2 million or 19% of revenue, consistent with the level of the second quarter and up slightly from 18% in the prior quarter.
NonGAAP R&D expense came in at $3.6 million or 7% of revenue, which is consistent with our long-term target of 6% to 9% and comparable to 7% last quarter, but down from 10% in the year-ago quarter.
Of note, the sequential decline in reported R&D spend was driven by the US dollar/rupee exchange rate as a significant portion of our R&D is executed in our low cost, offshore location.
NonGAAP G&A expenses were approximately $11 .7 million or 22% of revenue, which is an increase of 21% in the previous quarter and 19% in the prior year quarter.
During the quarter, our G&A expense included approximately $100,000 in charges, related to our Indian office move to [Visak].
As previously discussed, these charges are being recognized throughout the year of 2008.
We do not expect to incur these charges in 2009.
Our nonGAAP income from operations was $10.3 million for the quarter, consistent with our guidance of $10.3 million to $10.6 million and representing a 19% nonGAAP operating margin.
During the third quarter, nonGAAP tax rate for reporting purposes was 22%, resulting in nonGAAP net income of $8.2 million.
Based on 22.8 million shares outstanding, nonGAAP diluted earnings per share were $0.36 consistent with our revised guidance and an increase from $0.33 in the year-ago quarter.
Turning to our results on a GAAP basis, which include $1.3 million related to the allocation of stock-based compensation and $1.5 million related to the amortization of intangibles, associated with previous acquisitions, the following were expense levels determined in accordance with GAAP: cost of revenue, $16.5 million, sales and marketing, $10.3 million, R&D, $3.8 million, and G&A, $12.7 million.
For the third quarter, GAAP income from operations was $7.5 million.
Net income applicable to common shareholders was $5.4 million resulting in GAAP diluted EPS of $0.24.
A reconciliation of nonGAAP to GAAP expenses and income from operation can be found in our press release and current report on form 8K filed with the SEC.
Kenexa has cash, cash equivalents and short-term and long-term investment of $43.9 million at September 30, 2008, a decrease of $5.4 million from the end of the prior quarter.
The decrease in cash was due to approximately $8 million used to pay contingent consideration associated with prior period acquisition.
During the quarter the company generated $8.7 million in positive cash from operations and used approximately $5 million associated with capital expenditures.
Accounts receivable DSO were 65 days at the end of the quarter compared to 65 days at the end of the prior quarter and 60 days at the end of the year-ago quarter.
Our deferred revenue at the end of the quarter was $37 million, down from $38.7 million at the end of the prior quarter and up from $35.1 million entering the year.
I'd now like to turn to guidance for the full year and the fourth quarter of 2008.
For the fourth quarter 2008, we expect the following: revenue to be $45 million to $47 million.
We currently estimate that our fourth quarter subscription revenue will be flat to slightly down with the just-reported quarter with the sequential decline being driven primarily by our other revenue.
It is also worth noting that within the sequential decline, approximately $3 million is due solely to adverse movement and effects based on recent exchange rates.
To put in perspective, the decline in total revenue run rate from approximately $56 million in the second quarter to $46 million at the mid point of our guidance in the fourth quarter, approximately $3 million relates to the adverse impact of the strengthening US dollar on our reported revenue with approximately $6 million to $7 million due to the slow down of RPO revenue.
This also shows how the technology solutions component to our business has been relatively resilient during the economic down turn.
With the completion of our headcount reduction, we currently expect to deliver 14% to 15% nonGAAP operating margin at our current targeted revenue level which translates to nonGAAP operating income of approximately $6.3 million to $7 million.
Assuming a 22% tax rate for reporting purposes and 22.6 million shares outstanding, we expect our diluted nonGAAP earnings per share to be $0.22 to $0.25.
Our full year 2008 outlook based on our just reported third quarter results and fourth quarter guidance is total revenue of $203.6 million to $205.6 million, nonGAAP operating income of $36.6 million to $37.3 million.
Assuming a 22% tax rate for reporting purposes, and 22.9 million shares outstanding, we expect our diluted nonGAAP EPS to be $1.29 to $1.32.
As a reminder, our full year 2008 guidance includes a one-time charge related to the opening of our new office space in India, which we have incurred throughout the year.
Of note, our fourth quarter and full year 2008 nonGAAP guidance excludes the impact of restructuring charges associated with the previously mentioned headcount reduction.
We currently estimate that the restructuring charge will be in the range of $2 million to $2.5 million.
In summary, we have taken action to put Kenexa in position to continue delivery solid profitability and cash flow during this very challenging economic time period.
We will continue to manage with this focus, the microeconomic environment will eventually improve and we believe Kenexa will emerge with an even stronger market position.
We'd now like to turn it over to the operator to begin the Q&A session.
Operator?
Operator
Thank you.
(OPERATOR INSTRUCTIONS) And we'll pause for just a moment.
(OPERATOR INSTRUCTIONS) And we'll go first to Peter Goldmacher with Cowen and Company.
- Analyst
Hi, guys.
Hey, Rudy, when you talk a little bit about your optimism in the business, once the hopefully the economy settles down, what sort of things are you going to be looking for, what sort of early cues will you start looking for before you invest in the business?
And maybe before you answer that, if you could talk a little about as you're going through headcount reductions, what areas you're focusing those on.
Thanks.
- CEO
If you look at the headcount reductions, our focus is primarily on G&A positions and noncustomer facing positions.
We left research and development and customer facings virtually untouched.
As part of the reduction, there was nonproductive salespeople were also, or what I would consider bench-type salespeople were also reduced.
So that number now, which I think we had at some point over 130 salespeople with quotas, we're now between 100 and 110.
The signs that we will see or that we will judge that we are now starting to bottom out, is when our verbals start dropping.
So what we call our stage five, starts to reduce, and move into signage while the pipeline still remains somewhat robust.
In terms of development and investing in the product suite, we have continued to invest very heavily in this.
If you look at between '07 and '08, our average spend on R&D has climbed and I expect that it may continue to climb into 2009 as well.
So our commitment to innovation, our commitment to products remains unchanged.
- Analyst
Okay, great, thank you.
Operator
Our next question will come from Sasa Zorovic with Goldman Sachs.
- CAO
Hi.
This is [Yu Jone] on behalf of Sasa Zorovic.
A couple of questions.
Could you comment on customer churn that you saw in the last quarter?
And the second question is, could you also comment on the pay back period of your new contracts, any new contracts that you got signed over last quarter?
Thanks.
- CEO
As far as our renewal rates are concerned, for the first quarter ever, we dropped below 90% into the high 80%s.
And this was primarily due to a customer in Europe that delayed their renewal which we fully expect to come on and get us back above the 90% going into the future.
I'm sorry, I didn't quite understand the second question.
- CAO
The second question was pay back period for new contracts, any new contracts you had.
Are the contract terms differing, is there any pricing pressure you're seeing due to competition?
- CFO
No, the terms are staying pretty much the same and we're not experiencing as much, we're not seeing pressures from competition, we're seeing more pressures in the marketplace.
- CAO
Okay, okay, thank you.
Operator
Next we'll take a question from Steve Koenig with Key Bank Capital Markets.
- Analyst
Hi, guys, this is actually Justin [Bandion] for Steve.
I wanted to ask you about the RPO business, and specifically what sort of volatility do you see in your results going forward into 2009?
On previous calls you've spoken about contracts that may renew.
I'm just wondering what renewals are up there and what possible scenarios we might see in the RPO business?
- CEO
So the, there was a renewal that is scheduled to have taken place in the back half of the year that we talked about.
That renewal will not happen.
There are no other renewals for 2008.
For 2009, beginning in the second quarter, we have five renewals, Don, or is it four?
- CFO
Four.
- CEO
Four renewals , most of them are in the back half of the
- Analyst
Okay, that's great.
And then for contracts that are not being renewed but I get the sense that there may be some quarter-to-quarter adjustments that going on.
For the RPO customers that you have, how guaranteed are those cash flows?
Do they have the ability to strengthen the size of the contract?
- CFO
The number we gave you in -- excuse me, in the subscription number, those are the numbers that are contractually obligated for the customers.
Additional amounts in revenue go into other revenue from our success fees.
So it's the success fees that are shrinking due to the economic environment.
- Analyst
Okay, great.
And then, just as a final follow-up, for those success fees, how much volatility could you conceivably see going forward or what's the range in success fees that you've been having quarter-to-quarter?
- CEO
We have seen a steady deterioration of that number from Q4 of 2007.
We don't have a sense of where the bottom might be.
- Analyst
Okay, thank you very much.
- CEO
Yes.
Operator
(OPERATOR INSTRUCTIONS) Next from Tom Ernst with Deutsche Bank.
- Analyst
Hi, good evening.
Thanks for taking my question, this is actually [Amet Nambari] for Tom Ernst.
You talked about the macro slow down, were there specific verticals in which you saw a greater slow down than others, and which verticals do you think are more -- holding up better?
- CFO
Across the board we're seeing clients take pause.
Obviously there's stuff in the financial services that was hit harder than some of the other verticals, but we're really seeing it across most of the verticals that we serve.
- Analyst
Okay.
And slightly different topic, in terms of continuing to invest in your R&D, what specific areas are you targeting to broaden your portfolio?
- CFO
We feel that we have the most complete portfolio in the marketplace now.
The focus is really on our brass ring platform as well as additional modules platforms and our 2X platform as we continue to build out more robust releases in each category.
- CEO
We're hoping to use the learning annex solution in Q3, which we're hoping to see pick up into next year.
- Analyst
Okay, thank you.
Operator
Our next question comes from Richard Davis with Needham & Company.
- Analyst
Hey, thanks, two questions.
One, were you guys using another firm's learning management system or is this something new to your customer?
So if I were a customer, do I get a call from the salesman and say, hey, look we have a new learning management system?
Second question is, you do have, as you said, several financial services customers.
When these guys merge, what is the process that you guys go through?
You must put like a SWAT team over in Wachovia, or Merrill, whatever, and say, hey, how can we make sure we're beneficial to you guys?
Can you talk about strategy-wise, obviously we don't know the outcomes but help people understand how you approach that.
- CEO
So, let's answer the first question, your answer is accurate.
We do have our salespeople calling and saying this is a learning management system, you're on performance management or you're on this or you're on that, how would you like to try it, or how would you like to install it, etc.
That's an accurate statement.
As far as the game plan on M&A activity between -- not just financial companies, but in general.
In general what we find is our apps don't get touched for the first six to nine months upon the signing of a major acquisition.
And we've got past examples of that of Wachovia taking over South Trust and World Savings Banks.
We didn't see a lot of change initially.
Now we, for example at Merrill Lynch, where BFA has taken over, we don't know.
The reality of the situation is there's a lot of jostling that takes place within the merged entity.
So to a vendor you don't hear or see much of credible valuable for the first three to four months following the merger.
Once that shakeout is completed, most organizations go through a step-by-step best of breed and then decide on, okay, we are going to keep this app and this and that.
The exceptions that we've seen is when companies decide to trade on their own brand names, like we've seen in the retail operation, or where there might be certain geographical distributions.
Did that answer your question?
- Analyst
Yes.
I know it's an unanswerable question, but I was curious how you thought about it.
Thank you very much.
- CEO
You're welcome
Operator
Our next question is from Ross MacMillan with Jefferies.
- Analyst
Hi guys.
This is [Havish Spironi] for Ross.
Quick question, one if you saw any FX impact in the quarter.
And two, if you could talk a little about margins next year, given a significant dip in margin switches you have in your guidance for the fourth quarter.
Thanks.
- CEO
I think as Don put it, given the pull detail on the FX, Don, do you want to add more color.
- CFO
Was that the first question, about FX?
- Analyst
Yes, in the third quarter.
- CFO
As you well know, probably between the, between the June 30th numbers and current numbers, FX has dropped about 20%, the dollar has strengthened against the euro and the pound.
And we've taken that into consideration for our Q4.
It's dropped about 12% in -- just from the month of September.
So that that's how we relate that.
As far as going into 2009, we haven't given guidance to 2009, but we feel like we are managing the company for profitability and cash flow, trying not to jeopardize the customer position and the service.
But going into 2009, we expect to get our operating percentages up to where they've been in the past or slightly below that.
- Analyst
Okay, thanks, guys.
Operator
(OPERATOR INSTRUCTIONS) Our next question comes from Ariel Sokol with Wedbush.
- Analyst
Hi guys, good afternoon.
Certainly applied increased transparency with respect to the RPO business.
Just a couple quick questions over here.
Just kind of thinking very high level, one, what kind of repercussions for your business are you seeing given Taleo's acquisition of Vurv?
Did you acquire any Vurv customers or are there any expectations of doing so over the next several quarters?
- CFO
Let's see, we were able to pick up a number of very talented executive and salespeople, and we are, again, it's a very competitive marketplace, specifically on that applicant tracking product category.
There are a number of renewals pending that of course we're actively pursuing.
- Analyst
Great.
And the next question, this market is very challenging for a number of companies, many private vendors who compete in your space.
What are your thoughts about acquisitions moving forward over the next year, taking advantage of some of the companies that may have some trouble with [VC] financing?
- CEO
We're going to be opportunistic on acquisitions.
One of the things that we've noticed is the private valuations haven't dropped as dramatically as the public valuations.
I think we're trading at whatever enterprise value for like three or four times EBITDA.
We haven't been able to find too many three to four times EBITDA to make it accretive for us.
We'll keep hunting, and when the math makes sense and the strategy makes sense it and it gives us one of three things: more geography, stronger solutions, or offerings, I should say, and more verticals, we'll then pull the trigger.
- Analyst
Okay.
And the last question, if you could speak in regards to, you spoke to APS and RPU, how are the other businesses doing?
For example, how is performance management doing given the challenging times?
- CEO
We're up quarter-over-quarter on that as well, like the APS.
So the software business suppose, the consulting business is flat to slightly down and the RPU business is down.
Okay thank you for your time.
Operator
(OPERATOR INSTRUCTIONS) Having no further questions in the queue, I'd like to turn it back to Rudy Karsan for any closing comments.
- CEO
Thanks, Paul.
So I guess, in summary I'd like to say thanks for joining the call.
We realize we have competition today in this time slot.
And for those that joined the call we do appreciate your time.
We do appreciate the continued support from the street.
And as I said in my prepared comments, the tide will turn.
Look forward to talking to you a quarter from now.
Good night.
Operator
Once again, that does conclude our conference call for today.
And we thank you for your participation.
Have a great day.