Fundao

Getulio
Vargas
The effect of
knowledge management
on firm performance

Global business management

Under supervision of: Prof. G. Sarfati

04-04-2011

Guilherme Luttikhuizen dos Santos

Rotterdam School of Management, Erasmus University

1
Introduction
- If HP knew what HP knows, we would be three times as profitable.
Hewlett-Packard CEO Lew Platt

In turbulent and global business environments, one of the most important sources of sustainable
competitive advantage is knowledge (Hlupic et al., 2002: 90-91). Knowledge is very critical, as it turns
out that companies often are missing out on key business opportunities by failing to exploit
knowledge effectively (KPMG, 2003: 8). Considering that knowledge workers and their productivity
are the most valuable asset of the 21st century firm (Drucker, 1999: 79), managing knowledge
becomes increasingly more important.

How organizations should manage that knowledge has recently become an area of fierce debate
among academics and practitioners worldwide. Hazlett et al. (2005) argue that the knowledge
management field is in a stage of pre-science, which is characterized by the existence of many
competing schools *of thought+, each coalescing around a different paradigm (Kuhn, 1970: 16). They
state that the two main disciplines that contribute to the knowledge management field are the fields
of information systems and management. While the field of information systems focuses mainly
on the technology that makes knowledge management possible, the field of management holds a
socio-organizational view of knowledge management, focusing on people, with a particular focus on
group dynamics (Hazlett et al., 2005: 37).

However, the universal purpose of knowledge management is to enhance knowledge processing in

the expectation that such enhancements will provide better quality solutions (knowledge), which, in
turn, may ceteris paribus, when used, improve worker effectiveness and the bottom line (Firestone
& McElroy, 2005: 189). Some authors (e.g. Zack et al., 2009; Darroch, 2005) argue that knowledge
management practices enhance innovation, which is positively related to the bottom line of a firm.
However, how and to what extent the bottom line is affected by knowledge management remains
unclear, but is one of the most fundamental questions of knowledge management. Thus, the
research question of this paper is:

What is the effect of knowledge management programs on the financial performance of firms?

In order to answer that research question, the paper starts with a theoretical framework of the
relevant literature in the knowledge management field. Afterwards, a methodology is developed,
after which the results are presented. The paper concludes with a discussion of findings and areas for
future research.

2
Theoretical framework
The theoretical framework discusses knowledge, knowledge management, knowledge management
systems, and firm performance related to knowledge management.

Knowledge

Ever since the Greek era, philosophers wrestle with the question of how to define knowledge (Alavi
& Leidner, 2001: 106-107). In his seminal paper about knowledge creation, Nonaka (1994: 15) defines
knowledge as justified true belief. According to McDermott (1999: 106), knowledge is the residue
of thinking and comes from experience that we have reflected on, made sense of, and tested against
others experience. He goes on to say that from the point of view of the person who knows,
knowledge is a kind of sticky residue of insight about using information and experience to think.

Knowledge is not the same as information. Nonaka (1994: 15) mentions that information is a flow of
messages, while knowledge is created and organized by the very flow of information, anchored on
the commitment and beliefs of its holder. According to Alavi & Leidner (2001: 107), data is raw
numbers and facts, information is processed data, and knowledge is authenticated information.

Nonaka (1994: 16) distinguishes 2 types of knowledge: tacit and explicit. Tacit knowledge has a
personal quality, which makes it hard to formalize and communicate. Tacit knowledge is deeply
rooted in action, commitment, and involvement in a specific context. On the other hand, explicit
knowledge is knowledge that is transmittable in formal, systematic language (Nonaka, 1994: 16).
Nonaka (1994: 19) then came up with a model that shows how knowledge is created by the
interchange between tacit and explicit knowledge, enacted through the sequential processes of
socialization, externalization, combination and internalization. See figure 1 below.

Figure 1: the SECI model (Nonaka, 1994: 19; van Baalen, 2010: 69)

3
Increasingly, the creation of new organizational knowledge is becoming priority for managers
worldwide. Firms must not only process existing information, but they have to create new
information and knowledge in order to be competitive (Inkpen & Dinur, 1998: 454; 466). Knowledge
is developed by individuals, but organizations play an important role in articulating and amplifying
that knowledge (Nonaka, 1994: 14), making organizations repositories of knowledge (Inkpen &
Dinur, 1998: 456).

The 5 biggest challenges of knowledge for practitioners are (KPMG, 2000: 11):
- Information overload;
- Lack of time to share knowledge;
- Failure to use knowledge effectively;
- The difficulty of capturing tacit knowledge;
- Reinventing the wheel.

Knowledge management

There are many definitions of knowledge management (KM). In this paper, knowledge management
refers to the process of creating, capturing and using knowledge to enhance organizational
performance (Bassi, 1997). Knowledge management emphasizes the importance of knowledge for
organizations and its pivotal role in achieving competitive advantage (Hlupic et al., 2002: 90). Even
though the importance of KM is widely recognized, in practice, spendings on knowledge
management programs still lags behind. Average spendings of large companies on knowledge
management programs is less than 2% of revenues (KPMG, 2003: 4).

Ruggles (1997) argues there are three primary knowledge activities in organizations:
- Knowledge generation (the creation of knowledge);
- Knowledge codification (the storage and categorization of knowledge);
- Knowledge transfer (the transfer of knowledge between people, departments or firms).

These knowledge activities have to be managed, and according to Hansen et al. (1999), there are two
strategies for doing this: codification and personalization. In a codification strategy, knowledge is
carefully codified and stored in databases, where it can be accessed and used easily by anyone in the
company (Hansen et al., 1999: 1). In this strategy, knowledge is codified with a people-to-
documents approach: the knowledge is extracted from the person who developed it, made
independent of that person, and then reused for several purposes. Once knowledge is codified, it can
be reused many times at a very low cost. Thus, companies using a codification strategy rely on the
economics of reusing codified knowledge. An example of a firm using this strategy is Ernst & Young,
who reuses codified knowledge with several clients (Hansen et al., 1999: 3). In a personalization
strategy, knowledge is closely tied to the person who developed it and is shared mainly through
direct person-to-person contacts (Hansen et al., 1999: 1). This strategy focuses on dialogue between
people, instead of on knowledge objects in a database. Knowledge that cant be codified is
transferred in brainstorming sessions and 1-on-1 conversations. This strategy relies on the logic of
expert economics. An example of a firm using this strategy is McKinsey, which offers highly
personalized advice (rich in tacit knowledge) to their clients (Hansen et al., 1999: 3). The role of IT in
both technologies is that computers store knowledge in the codification strategy, and they help
people to communicate the knowledge in the personalization strategy (Hansen et al., 1999: 1-2).

4
Knowledge management initiatives are often introduced in a firm by senior managers or executives
(KPMG, 2000: 9) in order to enhance innovation (Meso & Smith, 2000: 226). Contextual factors that
can influence the success of KM initiatives are: top management and leadership support,
organizational culture, strategy, organizational structure, processes, technology infrastructure,
training & education of employees, incentives to participate in KM, the team responsible for the KM
program, and how KM is measured (Conley & Zheng, 2009).

When KPMG (2000: 7) surveyed executives of large organizations, 38% of respondents said their
organization had a knowledge management program, and 30% said their organization was in the
process of setting up one. However, KM is not only for multinationals. Hutchinson & Quintas (2008)
found that although some SMEs engage in formal KM, with formal KM structures, language and
concepts most small and medium businesses often manage knowledge informally, meaning that
they do KM without using the formal structures, concepts and languages of KM. After all, many small
and medium firms manage knowledge unconsciously, without the expensive knowledge
management systems used by multinationals and without using the knowledge management label.
Thus, most small and medium firms simply manage what they know, instead of doing knowledge
management (Hutchinson & Quintas, 2008).

The 3 key challenges for the future of KM in practice are (KPMG, 2003: 5):
- Taking advantage of unexploited business opportunities;
- Extending knowledge management across customers, suppliers, and partners;
- Assuring successful implementation.

The second point has become a big trend in knowledge management recently: KM initiatives shift
focus from internal knowledge sharing (within the firm) to external knowledge sharing (with
customers, suppliers, and partners; KPMG, 2003: 11).

Knowledge management systems

Hlupic et al. (2002: 91) mention that an important reason why knowledge management is becoming
increasingly popular is that the capabilities of contemporary information systems make the
codification, storing, generation and exchange of information and knowledge, easier than ever.
Modern technologies (or tools) make KM much easier. In the context of organizations, KM tools (or
systems) refer to information and communication technologies that gather, index, and structure the
corporate memory of an organizations employees (Downing, 2004: 167). These KM systems are
generally a class of information systems applied to managing organizational knowledge (Smuts et al.,
2009: 70). A report by KPMG (2000: 3) suggests that most companies see KM as a purely
technological solution, and that the IT department is the department that financially contributes the
most to the setup of a KM program (KPMG, 2000: 10).

The most relevant technologies for knowledge management are: wikis (Wagner, 2004), the Internet,
an Intranet, data warehousing & data mining, document management systems, decision support,
groupware, extranets, and artificial intelligence (KPMG, 2000: 16). According to the KPMG report
(2000: 17), the Intranet is the most effective in helping managing information, while the Internet is
the least effective. However, implementation of these technologies always brings a lot of challenges.
As Hasan & Crawford (2003: 192) put it: there are probably no simple IT solutions to organizational
knowledge management efforts.

5
Knowledge management and firm performance

Organizations with a KM program are better off than those firms without one (KPMG, 2000: 1). Firms
with a KM program: (1) complain less about reinventing the wheel, (2) can access particular customer
data faster, and (3) can access agreed methodologies for business processes faster (KPMG, 2000: 1).
In addition, most firms who engage in knowledge management believe that their knowledge
management efforts will lead to either: (1) new ways of working, (2) increased market share, (3)
additional business opportunities, (4) increased share price, (5) reduced costs, or (6) increased profits
(KPMG, 2000: 2). However, in a subsequent survey (KPMG, 2003; 4), only 50% of respondents
reported clear financial returns from their KM program.

The three-tier framework of Firestone & McElroy (2005: 190) explains how KM programs enhance
the bottom line.

Figure 2: the three-tier framework of Firestone & McElroy (2005: 190)

A literature review reveals that the methods for accurately measuring firm performance in KM can
be categorized in 4 categories: financial measures, intellectual capital, tangible & intangible benefits,
and balanced scorecard (Lee & Choi, 2003: 190). It has been argued that firms with a knowledge
management capability use resources more efficiently; thus they are more innovative and thus they
perform better (Darroch, 2005; Zack et al., 2009). These authors did not find a direct relationship
between knowledge management and financial performance, but found that this relationship was
mediated by innovation. However, these authors relied on surveys where respondents indicated
their perception of firm performance as linked to their perception of the level of knowledge

6
management engagement. This is a severe limitation of these studies. As far as I know, no study has
directly linked financial measures (stock price, price-earnings ratio and R&D expenditure are some
important metrics in the context of knowledge management; Huang et al., 2007) to KM programs.
This leaves a gap in the literature that this study will try to fill. Another methodology than
abovementioned authors will be used to test the relationship between KM and financial
performance. Thus, the hypothesis of this study is as follows:

Hypothesis 1: the implementation of a knowledge management program increases the financial

performance of the firm

Methodology
This study examines the effect of the implementation of a knowledge management program on firm
performance. The hypothesis is tested by selecting two cases and looking at the specific year that a
KM program was put in place in that firm. Thus the research design of this study is a multiple
longitudinal case study. The 3 years before and 3 years after the implementation of the knowledge
management program are compared. Variables that will be compared are stock price, price to
earnings ratio, net revenues, change in net revenues, R&D expenses (both absolute and relative to
revenue) and most importantly, the revenue per employee. These figures are found in the annual
reports of these firms. Firms with a KM program have more possibilities to share knowledge and thus
to take advantage of business opportunities (KPMG, 2003: 8). Thus, it seems plausible that the
revenues per employee (total revenues / number of employees) will rise in firms that implement a
KM program. The stock price is taken from the first week of the year, and the P/E ratio is thus
calculated for the first week as well (share price in the first week / annual earnings per share).

Case selection

The cases of PepsiCo and Danone Group are used. Both cases are valid to use because they
implemented a KM program recently. They are big firms, listed on the stock exchange, so financial
data is easily available. Both firms are global and both operate in the food & beverages industry,
which makes comparing easier. Below the KM programs in these firms are introduced.

PepsiCo

PepsiCo is a multinational in foods & beverages, with annual revenues of $ 57,8 billion and 294.000
employees worldwide (PepsiCo, 2010b: 15; 41 ). With all these employees, knowledge sharing is
critical. PepsiCo (2007: 38) states that unplanned turnover [of employees] could deplete our
institutional knowledge base and erode our competitive advantage. In 2005, PepsiCo implemented
a new KM program with a new knowledge management system, called ATG KnowledgeCenter
(PepsiCo, 2010: 7). Knowledge management in PepsiCo started in 1999, with the implementation of
the knowledge management system Tivoli. In 2002, this system was substituted by a new system
called Knowlix, due to unsuccessful results. For the same reason, Knowlix was substituted in 2005 by
ATG KnowledgeCenter, one of the most advanced knowledge management systems available today
(www.atg.com). PepsiCo has been using ATG KnowledgeCenter ever since.

7
Some authors argue that social activity in a global company often is mediated through technology,
and that technology is the most important instrument to engage in knowledge management
(Venters, 2006). Thus, substituting the knowledge management system (which brings new ways to
create, store, access & transfer knowledge, and is often announced by top management as a
complete revolution) is almost the same as a new KM program. A new knowledge management
system also brings new technological frames (Orlikowski & Gash, 1994), since employees will have
different assumptions, expectations and knowledge about the new knowledge management system.

The current knowledge base in the KM system of PepsiCo contains 11.000 original solutions for
problems that employees might experience (PepsiCo, 2010: 8). New solutions can be uploaded by
everyone in the firm. If a customer calls PepsiCo with a problem, the helpdesk can search in the
database for an existing solution. If no solution exists yet, the helpdesk employee has to upload his
own solution to the KM system, so other employees can profit from this information (PepsiCo, 2010:
8). PepsiCo (2010: 11) states that this KM system reduces training time needed for employees,
making them more productive.

Danone Group

With almost 15 billion in revenues and 80.976 employees in 2009, the Danone Group is a French
multinational in food, fresh dairy products and bottled water (Danone, 2009). Like many other global
firms, Danone is facing a knowledge management dilemma due to its size, organizational culture and
structure. In the end of the year 2002, Danone introduced a KM program called the Networking
Attitude (Edmondson et al., 2008). It was an informal way for employees to share knowledge with
each other. Danone created so-called marketplaces and sharing networks as informal ways to
facilitate knowledge sharing (Edmondson et al., 2008). Danone also initiated co-building events,
where employees from various business units came together to share existing practices and even to
create new ones through networking. Danone (2009: 49) says the aim of the Networking attitude
was to accelerate sharing of best practices among business units. It strengthened personal
networks and facilitated knowledge sharing with colleagues (Edmondson et al., 2008). Employees
slowly started to build their own topic related communities that moved from a top-down
management push to a bottom-up approach. This means Danone makes use of various communities
of practice, which are defined as people bound by informal relationships who share common
practices (Pan & Leidner, 2003: 72).

Validity issues

Construct, internal, and external validity issues will be discussed. Construct validity measures
whether the constructs actually measure the thing they are said to measure (Fisher, 2009: 295). This
is less relevant, since only financial metrics from annual reports are measured. Of course, these
financial metrics have construct validity. Thus, construct validity is high. Internal validity measures
whether the evidence presented justifies the claims of cause and effect (Fisher, 2009: 296). This is
very questionable, since firm performance is determined by many factors; thus attempts to trace
causality to any single factor (such as a KM program) are risky (Lee & Choi, 2003: 181-182). Thus,
internal validity is low, but possibly higher than in the abovementioned studies of Darroch (2005) and
Zack et al. (2009). External validity concerns whether the findings apply to other people or situations
(Fisher, 2009: 297). Case studies in general have low external validity, but having multiple sources of
data increases validity (Bryman & Bell, 2007).

8
Results
Table 1 & 2 below present the results for PepsiCo and Danone.

Table 1: PepsiCo metrics (PepsiCo annual reports 2002-2008; stock price from finance.yahoo.com)

2002 2003 2004 2005 2006 2007 2008

Stock price in $ 48,45 42,86 45,77 52,45 59,60 62,95 77,78
P/E ratio 28,83 20,90 19,72 19,71 19,86 18,62 21,13
Net revenues 25,112 26,969 29,261 32,562 35,137 39,474 43,251
(in $ millions)
Net revenues -6,8% 7,4% 8,5% 11,3% 7,9% 12,3% 9,6%
change
R&D 315 322 325 340 344 364 388
expenditures
(in million $)
R&D 1,25% 1,19% 1,11% 1,04% 0,98% 0,92% 0,90%
expenditures as
% of revenues
Number of 140.000 143.000 153.000 157.000 168.000 185.000 198.000
employees
Revenue per 179.371 188.594 191.248 207.401 209.148 213.372 218,439
employee in $

It can be seen that the stock price has been rising significantly since the introduction of the program.
The net revenues have continued a growing trend, although the growth has accelerated a bit since
the introduction of the KM program. R&D expenditures have grown after 2005, but R&D
expenditures as a percentage of revenues have fallen, because relative revenue growth has been
bigger than the growth in R&D expenditures. It can be seen that the introduction of the KM program
has substantially increased the revenue per employee in the first year of introduction.

Table 2: Metrics for Danone Group (Danone Group annual reports 1999 2005)

1999 2000 2001 2002 2003 2004 2005

Closing stock price 59 80 69 64 65 68 88
for the year in
P/E ratio 12,1 15,6 72,6 12,5 17,9 42,7 16,2
Net revenues (in 13,293 14,287 14,470 13,555 13,131 13,700 13,024
millions)
Net revenues 5,7% 7,5% 1,3% -6,3% -3,1% 4,3% -4,9%
change
R&D expenditures 122 125 126 133 130 131 123
(in million )
R&D expenditures 0,92% 0,87% 0,87% 0,98% 0,99% 0,96% 0,94%
as % of revenues
Number of 75.965 86.657 100.560 92.209 88.607 89.449 88,184
employees
Revenue per 174.988 164.868 143.894 147.003 148.194 153.160 147.691
employee in

9
It can be seen that the stock price has grown and shrunk between 1999 and 2005. The net revenues
have been more or less the same. The R&D expenditures have risen slightly, but the increase is not
significant. The relative R&D expenses have increased, and the increase is more significant: in all
years after the introduction of the knowledge management program, the relative R&D spendings are
higher than in any of the 3 years before the knowledge management program introduction. The
revenue per employee was falling significantly in the years before the introduction of the program.
However, since the introduction of the program, the revenue per employee has became more stable,
and has even seen a slight increase.

Discussion and conclusion

Firms are implementing knowledge management programs and technologies to increase their
effectiveness, efficiency, and competitiveness (Schultze & Leidner, 2002: 214). A knowledge
management program gives a firm more possibilities to share knowledge and thus to take advantage
of business opportunities (KPMG, 2003: 8). New business opportunities means new and more
possibilities to increase revenue. In addition, knowledge management programs can reduce costs, for
example by reducing average customer service helpdesk call times, reducing the R&D cycle, or by
sharing best practices (Yelden & Albers, 2004; Fenton & Albers, 2007). With possibilities for
increasing revenues and reducing costs, it can be expected that the revenues per employee increase
after the implementation of a knowledge management program. In addition, firms that engage in
knowledge management use resources more efficiently, and thus would be more innovative, which
results in better firm performance (Darroch, 2005). This could be visible in R&D expenses, both
absolute and relative as a percentage of revenues.

It is found that absolute R&D expenditures in both PepsiCo and Danone Group have indeed grown in
the years after the introduction of the knowledge management program. While relative R&D
spendings were significantly increasing in Danone, they were decreasing in PepsiCo, due to a bigger
relative increase in net revenues. The growth in net revenues of PepsiCo has accelerated a bit since
the introduction of the knowledge management program, which is consistent with the findings of
Darroch (2005). In Danone, net revenues remained more or less the same in the period before and
after the introduction of the Networking attitude. However, this does not say that much about the
effectiveness of a knowledge management program. Firm performance is determined by many
factors; thus an attempt to trace causality to any single factor (such as a knowledge management
program) is risky (Lee & Choi, 2003: 181-182).

In both Danone Group and PepsiCo, the introduction of a knowledge management program has
increased the revenue per employee, although in the case of PepsiCo the increase was significant. It
is difficult to say if this increase is due to knowledge management practices. In PepsiCo, the number
of employees increased dramatically, but the revenues increased even relatively more, increasing the
revenue per employee. In Danone, both the total revenue and the number of employees have fallen
slightly in the year of the knowledge management program introduction and in the next year.
Because the number of employees has fallen faster than the revenues, the revenue per employee
increased after the introduction of the program.

10
It can be concluded that it is hard to measure the effectiveness of a knowledge management
program with financial measures like revenue or stock price. The revenue per employee metric gives
a better idea, and this study shows some evidence to suggest that a knowledge management
program increases the revenue per employee. However, the findings are not conclusive, as there are
many factors that influence employee and corporate productivity, and thus the revenue per
employee. Besides, the number of employees differed over time in the discussed cases. As a final
note, it should be stressed that knowledge management programs have more benefits than just
financial benefits. There are intangible benefits that cant be measured with financial analysis, such
as happy customers. In the end, those can be even more important for a firm.

Practical implications

The practical implications of these findings lean toward a favorable view of implementing knowledge
management programs. This is consistent with findings from many other authors (e.g. Brusoni et al.,
2001; Hlupic et al., 2002; Zack et al., 2009; Huang et al., 2007) who stress the importance of using
knowledge management programs to improve firm performance and gain competitive advantage.

Further research

Further research is needed to uncover the effect of knowledge management programs on firm
performance. It is suggested that further research takes a look at the financial implications of
knowledge management programs in small- and medium sized firms, where the number of
employees is more stable.

11
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Danone (2002), Danone Group annual report 2002, available at: http://media.corporate-
ir.net/media_files/irol/95/95168/annualreports/AnnualReport2002.pdf

Danone (2003), Danone Group annual report 2003, available at: http://media.corporate-
ir.net/media_files/irol/95/95168/annualreports/AnnualReport2003.pdf

Danone (2004), Danone Group annual report 2004, available at: http://media.corporate-
ir.net/media_files/irol/95/95168/sustainability/RRS_2004_EN.zip

Danone (2005), Danone Group annual report 2005, available at: http://media.corporate-
ir.net/media_files/irol/95/95168/sustainability/RRS_2005_EN.zip

Danone (2009), Danone Group annual report 2009, available at: http://media.corporate-
ir.net/media_files/IROL/95/95168/Annual_report_09.pdf

KPMG (2000), Knowledge management research report 2000, KPMG Consulting

KPMG (2003), Insights from KPMGs European knowledge management survey 2002/2003, January
2003, KPMG Consulting

PepsiCo (2002), PepsiCo annual report 2002, available at http://www.pepsico.com/Download/2002-

Annual-English.pdf

PepsiCo (2003), PepsiCo annual report 2003 available at http://www.pepsico.com/Download/2003-

Annual-English.pdf

PepsiCo (2004), PepsiCo annual report 2004, available at http://www.pepsico.com/Download/2004-

Annual-English.pdf

PepsiCo (2005), PepsiCo annual report 2005, available at http://www.pepsico.com/Download/2005-

Annual-English.pdf

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PepsiCo (2006), PepsiCo annual report 2006, available at http://www.pepsico.com/Download/2006-
Annual-English.pdf

PepsiCo (2007), PepsiCo annual report 2007, available at http://www.pepsico.com/Download/2007-

Annual-English.pdf

PepsiCo (2008), PepsiCo annual report 2008, available at http://www.pepsico.com/Download/2008-

Annual-English.pdf

PepsiCo (2010), Knowledge engineering: know what we know, 8 April 2010, available at
www.hdiaustin.org/presentations/PepsiCoKnowledge.ppt

PepsiCo (2010b), PepsiCo annual report 2010, available at:

http://www.pepsico.com/Download/PepsiCo_Annual_Report_2010_Full_Annual_Report.pdf

Ruggles, R. (1997), Knowledge tools: using technology to manage knowledge better, Ernst & Young
Center for business innovation working paper, April. Found in: Hlupic, V., A. Pouloudi, G. Rzevski
(2002), Towards an integrated approach to knowledge management: hard, soft, and abstract
issues, Knowledge and process management, vol. 9, no. 2, pp. 90-102

Presentations

Baalen, P. van (2010), Managing knowledge and innovation: lecture 1, Rotterdam School of
Management, Erasmus University, 27 October 2010, PowerPoint presentation

Websites

http://finance.yahoo.com

www.atg.com

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