• Roger chats with Gary Rollo to discuss why Megaport is a holding in the Montgomery Small Companies Fund. Watch here.

Wesfarmers shareholders wait for return on takeover

Wesfarmers shareholders wait for return on takeover

Wesfarmers’ $20 billion purchase of the Coles group is Australia’s biggest takeover, but Roger Montgomery says shareholder value has being destroyed. Read transcript.

INVEST WITH MONTGOMERY

Roger is the Founder and Chief Investment Officer of Montgomery Investment Management. Roger brings more than three decades of investment and financial market experience, knowledge and relationships to bear in his role as Chief Investment Officer. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.

This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.

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47 Comments

  1. Looks like a lot of analysis well made has failed to predict what has actually happened.

  2. I loved all the discussion about Wesfarmers and Coles acquisition. I have no idea why they bought other than the advisors made a huge amount in fees and are now retired, and there were massive egos in the room. Still they have it and what’s worth? Without the coal assets and other interests of Wesfarmers, not a lot according to the market. Its very hard to put a valuation on such a massive single asset as Coles. Its great cash flow, but who would buy it if Wesfarmers wanted t sell it? The ACCC would be across it if a foreign buyer emerged and other than Rose Hancock, not many people have the money required. Basically they paid a little less than one year’s revenue, so the revenue has grown, so maybe its now worth about $35 billion. But again, who would buy it.

  3. What’s Important is return on Incremental Capital.

    As at last annual report WES’s return on (Funds employed – Goodwill) was 18.4% so long as this remains above their cost of capital they will be creating wealth on the approx 20% of earnings that they look like they will be retaining going forward.

    Over time their ROE will climb towards their return on incremental equity.

    Value.able formula assumes a frozen return on equity and would as such greatly undervalue WES in comparison to anybody that takes into account forecast growth in Return.

    My FIRST PASS valuation is $32.18 IF(if.if.if….) the growth rates in the analysts forecast are accurate.

    Now remember – don’t be nasty too me just because my valuation is different. I’m just providing a perspective of ROE growth to think about – not picking a fight.

    • Ok Gavin I will be kind.

      IMHO if you minus goodwill from your calculations then you don’t take into account the true return on funds employed.

      using this approach I think you should subtract the goodwill from the equity and then do your numbers.

      Your can’t have the equity including goodwill in your Eqps but deduct it for ROE or ROFI.

      It just does not work.

      It’s like saying I have 6 apples so I can swap the for 6 lamborghinis

      BTW you have inadvertently flagged a goodwill write down because there ROE will be very good once the fantasy items of goodwill disappear from their balance sheet

      Just MHO.

      • Hi Ash

        I am not ignoring goodwill from my value calculation.

        I do ignore it though when I assess the economics of a business. What is important is the return on incremental investments going forward.

        The earnings power of a business is not the same as historical ROE when purchase-accounting adjustments have been made. Over time historical ROE will move towards the return the company makes on new incremental investments. I allow for this changing ROE in my valuation calculations and the value. able formula doesn’t, which accounts for the large discrepancy in valuations.

        The basis for my thinking is non-other than WB. His letters are littered with how to think about purchase-accounting adjustments. Recent examples, from this year’s letter “Some of the businesses enjoy terrific economics, measured by earnings on unleveraged net tangible assets” and from the 2008 letter “This motley group, which sells products ranging from lollipops to motor homes, earned an impressive 17.9% on average tangible net worth last year. It’s also noteworthy that these operations used only minor financial leverage in achieving that return. Clearly we own some terrific businesses. We purchased many of them, however, at large premiums to net worth – a point reflected in the goodwill item shown on our balance sheet – and that fact reduces the earnings on our average carrying value to 8.1%”.

        Some of his early letters were a lot more explicit on how to deal with purchase-accounting adjustments, though he now seems to be happy to simplify earnings power down to return on unleveraged net tangible assets.

        Please don’t take this discussion as an endorsement of WES. I don’t hold it.

      • Describing economic power this way, as Buffett does, is not the same as endorsing it as a method for valuing a company. Of course however the two are linked. A very high rate of return on tangible assets is simply another way to point out a high level of economic goodwill. With reference to specific treatment for economic goodwill, Buffett has also always said to not amortise it and carry it at full value. In terms of accounting treatment, automatic amortisation doesn’t occur any longer and we have an impairment instead. Having said that, you can very easily incorporate RONTA into the valuation approach. You will end up with a higher ‘ROE’ and a lower equity figure. And remember Buffett also said find a manager who can growth equity at 15% per annum and you will do well. Further, in every talk I have given for the last year or so, I have talked about return on incremental equity being an indication of ROE’s trajectory. Go and listen to some of the ASX podcasts where I have discussed this. In the end though your returns will not come from working out the value to be $3.50 or $3.60 but from being able to buy at $1.80. Beyond that be careful about precision. And don’t forget the avoidance of Myer and iSoft amongst others and the selection of MMS, MCE, FGE, DCG, ORL et. al was all using ROE and nothing any more sophisticated. A very high ROE also means that the business has some valu.able asset off the balance sheet – economic rather than accounting goodwill.

      • Hi Roger

        You Said “Further, in every talk I have given for the last year or so, I have talked about return on incremental equity being an indication of ROE’s trajectory”

        I hope this does not indicate that you think I am having a go at you.

        I implicitly value the change in ROE because it can have major impacts on valuation in SOME cases. In WES’s case it does make a big difference and that is what I was pointing out.

        Otherwise I agree with everything in your response. Especially about the simplicity of the Value.able proposition and the need for MOS.

        At the end of the day the valuation exercise is far less significant than choosing the right business to invest in.

        Cheers
        Gavin

      • What I can’t comprehend in my mind with this valuation technique is this….

        I have the choice of buying two businesses in the same industry, both have a market cap of $10b, both are expected to grow at 7% pa in perpetuity, both have similar debt, are market leaders, you get my drift… If I purchase one share in either company I receive EPS of $2, and both pay a dividend of $1.60.

        The only difference is one of these businesses has a ROE of 30% and the other 10%. So in the past perhaps the original owners ‘wasted money’, but that means nothing now. Lets say all the old managers have gone so we can avoid ‘wouldn’t you want to avoid a business that wasted money’.

        So eventhough the future earnings power of the companies are identical, and I receive the same dividends, using the Value.able approach one company is probably worth double the value of the other… I don’t understand this.

        anyone agree/disagree..please explain… am I missing something?

      • i fear you might be confusing equity with market capitalisation

        but if you are not….

        then in the above example, assuming similar valuation assumptions are applied, the company with the higher market cap would have a much smaller equity base

        in the example you give I would much rather own the one with the higher ROE because what you describe above is a point in time

        if you had looked at the above company 5 years ago the market cap of the higher ROE company would have been comparatively much smaller, and in the future, the market cap will be comparatively much larger

        the choice is therefore easy

      • Gavin,

        Sometimes I indulge in a valuation based on RONTA and NTA for companies that exude competitive advantage without big ROE, but with big goodwill.

        Eg – BRKA . Their historical ROE actually surprised me when I first crunched the numbers.

        I also agree that there are some businesses who have rapidly expanding ROE and using a metric which requires a “perpetual” ROE can be tricky.

        Eg – NVT (ROE seems to have stalled for the moment but they have an amazing business model which should see future growth – hate their P/O ratio though but they don’t need the cash)

        In these situations, where the share price is effectively pricing big ROE expansion beyond historical, ROE(incremental) serves as a decent guide, but I’m yet to crack the code.

        Dan

      • Hi Dan.

        To get an economic perspective rather than just an accounting perspective on the economics of a business I use FCFF/ (funds employed less non-amortised Intangibles).

        I don’t use these inputs for my valuation model though because equity spent on Intangibles needs to be accounted for. Within my valuation model, changes in future profitability (ROE or hoverer you chose to define it) are given a value to reconcile future economic potential with current accounting picture.

        Methods to accommodate ROE change is covered in most valuation text books if you really want to go there. Otherwise Value.able formula is probably the easiest approximations of more complex valuation methods that I have seen.

        But in my view (which I give for free and is probably overpriced) some discrepancies do arise.

        Some examples:

        Because of Purchase-accounting adjustments, the value.able formulae undervalue WES. But the rest of the Value.able proposition would probably send this one through to the keeper anyway. So no big deal.

        To a large extent NVT’s growth is funded by non-interest bearing pre-payments so it can sustainably grow ROE. Because of the growing ROE, NVT gets undervalued by the value.able formula and this is more problematic because the rest of the Value.able proposition suggests this stock is well worth considering. (at worst though this is just an opportunity cost). [I disclose an interest]

        The real potential issue for Value.able formula limitations exist in companies where ROE is falling. FGE is a case in point. I have just very recently sold out of FGE because I believe its ROE will fall and it now exceeds my valuation by too much to justify the rest of my opinions. (Thanks Roger for the Montgomery Spike).

        Don’t forget that disagreement in valuations make a market.

      • I think when I used NTA as an anchor for valuation I rationalised it on the basis that valuable intangibles would show up in the numerator of the ratio and hence would show up in the valuation. I submit this for scrutiny.
        A few years ago when I was back at uni I preached from those valuation textbooks. It was a case of the visually impaired leading the blind. I do remember residual income methods and the like – I just adopt a screening metric which incorporates conservative estimates with a view to competitive advantages, and try to avoid downward trending businesses.
        Agree that FGE has the potential to become one of the above, given that they are now chasing larger contracts with smaller margins. What do you think of the possibility of a corresponding uptick in asset turnover? I probably need to do more digging in respect of their fleet requirements, but I think they have potential to become a big ticket blue collar engineer with big ROE, albeit with smaller margins. EG – MND.

      • Dan

        Your NTA ratio seems fine too me. I only use the one I outlined in preference because I trust cash more than an accounting derived profit figure and it eliminates differences in financial structures.

        FGE – I have no real Idea what Forge’s future may be and that’s part of my problem. I have been to some extent an uneasy holder of FGE over different issues but they were bought cheap and remained cheap according to my valuations until more recently. But once they got above my valuation I decided to exit because I simply would not be a strong hand during any market correction or business interruption and felt that I should direct my funds to where I had a stronger hand. If FGE does become the next MND I won’t begrudge it, its success but I won’t regret selling either. (Well not too much anyway)

      • Just a thought on current accounting goodwill treatment & impairment.

        Accounting goodwill arises as a result of companies paying above the fair value (liquidation value) for the assets it is buying. Whether it is a good or bad acquisition is up to us to decide.

        Assessment on impairment of goodwill is subjective (surprise, surprise). As long as management can justify that forecast earnings are greater than value of the acquiring company (including goodwill), there is no impairment. Best part is forecast earnings can be based on 5 years without being questions by auditors, and some industry use forecast earnings of > 10 years. And we all know the limitations of forecast earnings, especially that far out into the future.

      • Hi Joab,

        Accounting goodwill is very different to economic goodwill. Economic goodwill is usually not reflected on the balance, hence high rates of return on equity. Accounting goodwill has the opposite effect on return on equity. Fairfax produces low single digit ROE. A low ROE suggests a high asset value on the balance sheet. When the one of the biggest assets is goodwill, it may be worth questioning its carrying value. Fairfax generates a 5.7% return on equity. Last year’s profit was about the same as 2004 but contributed equity has risen from $1.1 billion in 2004 to $4.7 billion last year. Is an asset of $2bln called goodwill reasonable? The auditors test must change.

      • The ‘great accountants’ I have seen are the ones who can ‘balance the book’. They leave the tough decisions of running a business to someone else. That’s one of the reason why I don’t think I will ever be a ‘great accountant’.

        As an ex-auditor, there’s not much they can do. They can ‘audit’ the valuation calculation provided my management (i.e. ensure there are checks and balances), but the critical part they can’t audit are the assumptions used.

        If management suggests there’s exponential growth following the ‘synergies from the acquisition’ and assumptions are overly optimistic. It’s management’s representation. There are basic accounting rules around estimating future cash flows, but nothing I can see that ensure accountants/auditors will respond rationally like an investor.

      • MannySorbello
        :

        I have quickly crunched Westfarmers 2010 numbers (I have never followed Westfarmer and I haven’t netted off one offs etc, it was just a very quick health check). There are three indicators that gets the tick Return on NTA, Net-debt to Equity and Free Cash flow per share. However, Return on: Equity, Total capital, Fixed Assets, and Total Assets are all under 7%, also EBIT Interest cover less than 6 times. These numbers indicate to me that they paid too much for Goodwill/Intangible assets (Coles acquisition) because the return on the tangible assets is not good. Also D&A was nearly a $1billion and PPE was $1.6 billion in 2010 and $1.5 billion for 2009. Not to mention the Intrinsic Value I got was half the current share price. IMO, I see no reason to own this company. Cheers Manny

  4. I am having trouble with working out what are great companys. For WES I got
    2005 2010 Difference
    Profit $618,000,000 $1,565,000,000 $947,000,000
    Equity $3,082,000,000 $24,694,000,000 $21,612,000,000
    ROE 20.1% 6.3% -14%
    Debit $1,221,000,000 $5,049,000,000 $3,828,000,000
    NO of Shares 407,000,000 1,157,000,000 750,000,000

    Can see things are not going well. However with WOR (rated A1 in March Money Mag by Roger) I got
    2005 2010 Difference
    Profit $57,000,000 $291,000,000 $234,000,000
    Equity $380,000,000 $1,830,000,000 $1,450,000,000
    ROE 15.2% 15.9% 0.7%
    Debit $71,000,000 $746,000,000 $675,000,000
    NO of Shares 205000000 245000000 40000000

    Does look good to me. What am I missing? (In plain simple terms please)

      • Hey Angela,
        I have had a quick look at both companies and here are a few things for you to think about:
        1)
        For WOR:
        Profit in 2005 = $57m
        Profit in 2010 = $291m

        Equity in 2005 = $384m
        Equity in 2010 = $1839m

        Therefore, for the addition $1455m that has been added to the company, WOR have been able to generate a return on that incremental capital of 16% (234/1455) which is much better than you can get in a bank

        For WES:
        Profit in 2005 = $618m
        Profit in 2010 = $1565m

        Equity in 2005 = $3082m
        Equity in 2010 = $24694m

        Therefore, for the addition $21612m that has been added to the company, WES have been able to generate a return on that incremental capital of 4.4% (947/21612) which is less than you could have gotten in a bank account over the past five years.

        This is one of the reasons WES is worth a lot less than WOR

        2) A second thing you should think about has to do with the breakdown of equity in each company. Firstly, having a look at WOR:

        Equity in 2005 = $384m
        Of that equity, retained earnings = $68m (~18%)
        share capital = $315m

        In 2010, equity = $1839m
        of that, the retained earnings are now $694m or about 38%
        Therefore, equity is increasing because WOR is able to retain it’s earnings and generate a decent return on them of 16%.

        But let’s have a look at WES:
        Equity in 2005 = $3082m
        Of that equity, retained earnings = $1003m (~32%)
        share capital = $2014m

        In 2010, equity = $24694m
        of that, the retained earnings are now $1414m or about 6%

        Therefore, the business is growing but they’re doing it by issuing more and more shares which is a bad thing, compounded by the fact that the ROIC is less than what you get in a bank account.
        Hope this gives you some more to think about.

      • Great post Jason, looking forward to seeing how long it takes WES to write down the coles aquisition. For such a high profile takeover and a company that was known for its financial prudence it will be one giant kick in the guts for their shareholders and there would need to be some type of fall out.

  5. Hi Roger and students

    Can someone help me understand…. if MLD has total debt that is higher than its equity and way above the 25% benchmark do you consider that a major issue. If you look at FGE it is only around 7%.

    Looking forward to any responses.

    Darren

  6. Hi everyone

    My 11 year old son noticed me reading Roger’s book for the second time and wanted to know about it. He’s now keen to buy some shares, he asked me to work out IV for Village roadshow VRL, wants to be a director down the track!

    EPS 4.85
    PR 0%
    ROE 15% RR 10%

    Could someone please check this because I came up with an IV of $10.06 and they are trading at around $3.50, what am I missing.

    Thanks
    Deb

    • That EPS figure doesn’t look right. Where did you get it from?
      I thought it was ~74cents.

    • Hi Deb B

      RR of 10% looks a little low. Perhaps 14% is more appropriate? POR of 0% might not be realistic (they have announced an interim div of 20c).

      I have not looked into VRL in any detail, but a quick scan of Commsec suggests they have a fair amount of debt.

      Cheers
      Adam W

    • Hi Deb,

      It is great that your son wants to learn about shares. I wish I had been this interested earlier in life and I had read everything about Buffett, Lynch, Fisher and Montgomery.

      My IV is very different to yours.
      EQPS – 4.89
      POR of 19% (I used this figure as they have a history of paying dividends although there wasn’t one last year. It is not a great sign that their dividend payout has been getting lower the past few years and nothing last year. Just to be conservative I have average the payout rate over the last 3 years.) I am always conservative because I know when I have a top company at good Margin of Safety I know I can invest and sleep at night!
      ROE of 14.4 but used 10% ROE for my calculation becuase their ROE was only 5% last year so the company has to do another 14-15% before I consider using 12.5 or 15%
      RR – 14% because it just isn’t a great company – high debt, equity reducing, NPAT all over the place for the last 5 years. It just is a very risky company.
      All this gives me an IV of $2.86 and a rating of 14 out of 15 on my scale, which would equal a C4 on Roger’s rating.
      Hope this helps Nic.

    • From a quick review, some observations are: high debt to equity ratio, the company is paying dividends, so your assumption of 0% is not correct, and the stability of earnings record is poor – it is therefore hard to assume 15% ROE is sustainable (have only achieved this 4 out of the last 10 years).

      I agree with the valuation based on your inputs, but there are other factors to consider before even undertaking a valuation to work out whether the company is worthy of investing in. This is the danger of just using the formula, and skipping the messages in the rest of the book!

    • High Deb,

      Track record is terrible,

      15% ROE and zero payout wont continue.

      If you can get hold of it have a read of Adam Schwab’s book “pigs at the trough”

      • Thanks everyone for their insights, I think I’ll steer him into something else. After posting I noticed the debt levels, scary!

        Thanks Ash I’ll try to find this book somewhere.

  7. Hello to All,

    I was looking at running an IV for 2010 and 2011 for CSL. With the US in recovery I wanted to see if I can get a rough idea of the value of the company. I have not even looked into the buyback yet but wanted to just test my valuation numbers based on posts from on this blog from a while back.
    From what I’ve seen most people had it calculated at around $28 and $29 for 2011. I only came up with $28 by using 20%ROE and 10%RR for 2011. When looking at their forecast earnings and also their half year report their ROE seems to be more in the 17.5% – 18% ROE table. Based on that my IV was near the $23 dollar mark…using 10%RR.
    I know this is now outdated bc of the share buy back but I was just surprised that my calculations were so far off….

  8. Hi all,

    Looking for critic on the following;

    After reading Rodgers book (thanks again Rodger) I, like allot of others I suspect opened an excel spread sheet and started playing with numbers. Now that I am comfortable with my end product I find myself using 10%RR on everything. This gives me an even playing field when comparing companies and a base comparison relative to the bank account example in Value_Able. From here I vary the discount to IV that I would like to pay for a company. An example here would be 10% discount for WOW and a 30% discount for ORL.

    I would like your thoughts and comments on how I may benefit from returning to the range of RR’s as found in Value_Able.

    Wayne

    • Hi Wayne,

      I would say, because not all industries/companies/marketplaces are created equal.

      Some companies although great companies, are operating in riskier environments to others so i believe would warrant a higher required return to make up for this extra risk. Would you consider Woolworths and BHP to have the same risk profile?

      The RR to me is like an interest rate which i vary according to the risks associated and the margin of safety is the insurance policy.

      My opinion is that by using a RR that takes into accounts the risks and then seeking a further margin of safety below that i am more comfortable in protecting my investment.

      Using a RR of 10% and then altering the Margin of safety required i don’t think would be enough to compensate for the risk. But each to his own.

    • hi wayne

      i suggest using 12% for most companies except maybe for WOW, CSL, PTM, COH, ARP and the likes. these are companies with consistent 10 year history of solid returns.
      with regards to margin of safety the bigger it is the better. minimum should be 30% regardless of what company unless future IV is rising at very high clip.

      hope that helps.

  9. My IV’s seem too low – have I entered some figures wrongly here? (data from Etrade) :

    Code: WES
    Price: 31.15

    INPUT:
    ……….. EqPS .. Shares … DPS … EPS … RR
    Next Yr … 21.74 .. 1157.00 … 1.488 .. 1.887 .. 14
    Curr Yr … 21.34 .. 1157.00 … 1.250 .. 1.355 .. 14
    Prior Yr … 20.96 .. 1157.00

    OUTPUT:
    ………….. IV .. .. ROE . NPAT .. POR
    Next Yr … 12.76 … 9 .. 2183.259 .. 79%
    Curr Yr … 8.69 …. 6 .. 1565.000 .. 92%

  10. Hi Roger,

    I ran some numbers and it is quite scary,

    The Boffins are repeatedly too high on the upside. I just updated my figures (BWT not a company I follow) but I was really surprised how far forecasts have fallen since September)

    Can’t possible do anything but fall on current performance
    .
    To get IV at current share price requires an unrealistic future increase in profits…

    They just overpaid for Coles and we will see write-offs and big ones no matter how well they run Coles.

    All the Value.able Grads and under Grads are just happy to say ………………AVOID ………….AVOID ………………AVOID

    • hey ash,

      they are definately destroying value there return on roic is below their cost of capital and as is roe relative to the cost of capital.
      i have been waiting for a write down for sum time i just don’t think management want to admit over paying. ( i don’t follow them either).

      • Possibly why they are looking to sell the coal assets – hide the write down of the coles acquisition

  11. MannySorbello
    :

    Hi Roger, It appears you have been misquoted or the ABC has done a typo “Since then you’ve put in another $20 billion to generate that additional $20 billion of profit…” Hands down you do it every time if that were the case 100% ROE… LOL Cheers Manny

  12. Hi Roger
    Have been a shareholder of WES until discovering Value.Able. I noticed that despite their share price outperforming WOW, they kept meeting resistance at around $34-$35, despite “a great report”.
    I believed that this is as high as it will get, and thus sold out some time ago.

    I suspect it will be years,if ever, that I consider WES again as investment quality
    Cheers
    Jim

  13. Hi,

    Not directly related to this blog post, but I have a general query regarding the recent FGE announcement – Management Transition Plan, in particular the statement regarding the Put Options.

    “Put Options – each of the Founding Directors will have the right but not the obligation to require Clough to purchase some of their equity interests, comprising a total of 750,000 shares and 2,500,000 options in the Company, at an equivalent share price of $5.60 per share under a put option, subject to certain conditions, including the appointment of another non-executive director to the board of Forge in accordance with the Transition Plan, the Founding Directors adhering to the terms and conditions of the Agreement and subject to Clough obtaining all requisite approvals in relation to the acquisition of the securities under the Foreign Acquisitions and Takeovers Act and not breaching Chapter 6 of the Corporations Act. The put options in relation to a total of 750,000 shares and 1,750,000 options are exercisable between 2 and 6 January 2012. The put option in relation to the remaining 750,000 options is exercisable between 23 and 27 April 2012”

    I am intrigued to understand the logic and reasoning as to why these Put Options were created and with such a low strike price. Based my current understanding the company has bright prospects. I see it unlikely that the SP will drop below $5.60, unless of course something seriously goes wrong. The only near term event that I can think of that may go wrong is the transition management plan, and maybe these Put Options are insurance for the existing directors?

    Also interestingly the period when these options can be exercised are only within a small window of a few days 2-6 Jan 2012 for the shares, and 23-27 Apr 2012 for the options.

    Interested in thoughts of the wider community as to what is happening here.

    Cheers

    Robert

  14. Roger, why post a pdf of screen captures of the article rather than linking to the article itself?

    • I have been caught out before with linking to external sites. URLs change, media is archived, then all of a sudden links on my site return a “this page cannot be found” error. By linking to PDFs I can guarantee the links will be active indefinitely.

      • Definitely the best way to go. It is infuriating and inordinately common for people to link to things that have moved or no longer exist. Roger your method may be a little bit more work for you, but it maintains the integrity of your blog and is a credit to you.

        All the best

        Scott T

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