Sierra Wireless' (SWIR) CEO Jason Cohenour on Q4 2016 Results - Earnings Call Transcript

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Sierra Wireless, Inc. (NASDAQ:SWIR) Q4 2016 Earnings Conference Call February 9, 2017 5:30 PM ET

Executives

David Climie - Vice President of Investor Relations

Jason Cohenour - President and Chief Executive Officer

Dave McLennan - Chief Financial Officer

Analysts

James Kisner - Jefferies

Mike Walkley - Canaccord Genuity

Steven Li - Raymond James

Paul Streep - Scotia Capital

Paul Treiber - RBC Capital Markets

Howard Smith - First Analysis

Richard Tse - National Bank

Operator

Good afternoon. My name is Cheryl, and I will be your conference operator today. At this time, I would like to welcome everyone to the Sierra Wireless Q4 2016 Earnings Results Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. [Operator Instructions]

Thank you. David Climie, you may begin your conference.

David Climie

Thanks, Cheryl, and good afternoon, everybody. Thank you for joining today's conference call and webcast. With me today on the call is Jason Cohenour, our President and CEO; and Dave McLennan, our Chief Financial Officer.

As a reminder, today's presentation is being webcast and will be available on our website following the call. Today's agenda will be as follows. Jason will provide a review of our third quarter results, Dave will then provide a more detailed overview of our quarterly and year-end financial results as well as our guidance for our first quarter 2017, following that Jason will provide a brief summary, and then we’ll finish with a Q&A session.

Before we get started, I will reference the company's Safe Harbor statement. The summary of the Safe Harbor statement can be found on page two of our webcast and is now being displayed.

Today's presentation contains certain statements information that are not based on historical facts and constitute forward-looking statements. These statements include our financial guidance and commentary regarding the longer term outlook for the business. Our forward looking statements are based on a number of material assumptions including those listed on page two of the webcast presentation which could prove to be significantly incorrect.

Additionally, our forward looking statements are subject to substantial known and unknown material risks and uncertainties. I draw you attention to a longer discussion of our risk factors in our annual information form and management’s discussion and analysis, which can be found on SEDAR and EDGAR, as well as other regulatory filings. This presentation should also be viewed in conjunction with our press release.

With that, I will now turn the call over to Jason Cohenour for his comments.

Jason Cohenour

Thank you, David, and good afternoon, everyone. I’ll start with the summary of our fourth quarter 2016 results. Overall, Q4 financial results were above our expectations. Consolidated revenue was $163 million, up 12.5% on a year-over-year basis. Solid revenue combined with improved gross margin and good cost management led to profitability results that exceeded our expectations with adjusted EBITDA of $15.5 million and non-GAAP EPS of $0.27.

During the quarter, we also continued to see good new product introduction velocity, launching three new gateway products and entering LPWA module trials with key OEMs and operators. New customer program acquisition activity was also quite strong in the quarter in each of our BUs.

You also may have noticed that we announce today that VW, the world's largest carmaker, has selected Sierra Wireless to provide 4G embedded solutions to connect Volkswagen cars to its Car-Net service. I will elaborate a little bit more on this important new customer in the OEM solutions section of the presentation.

And finally, we've been making a good progress on the integration of GenX and Blue Creation, the two companies we acquired in the second half of 2016. We are excited to have both teams fully onboard contributing in a positive way and strengthening our strategic position in key segment and technology areas of the IoT ecosystem.

Taking a closer look at the business segment performance in the fourth quarter and starting with OEM solutions, revenue in our OEM solutions segment was $135.2 million, up 11% compared to Q4 of 2015 and also up 6% sequentially. As expected, we saw normalized demand from key existing customers and programs as well as contribution from new programs. Non-GAAP gross margin was solid in Q4 at 31.2%.

With the closing of the Blue Creation acquisition in November, we've added Bluetooth, BLE and industrial Wi-Fi talent and products to our OEM mix. Blue Creation also brings a proven protocol stack for both Bluetooth audio and data applications, which provides us with some very interesting product integration opportunities down the road.

Overall, we intend to leverage the Blue Creation team and products to expand our position with OEMs around the world. Integration activities are under way and we’ve started to introduce Blue Creation products to select Sierra customers and channels.

Q4 was also a strong design win quarter both in terms of volume of wins and total estimated lifetime value. Anchoring our strong design win activity was Volkswagen where we won our second 4G connected car program. Key to securing both of these wins was our Legato embedded software platform, which has enabled faster development of the telematics control units and excellent cross platform software leverage.

Both of the TCU platforms will connect drivers to the VW Car-Net suite of services that includes driver safety, enhance navigation, vehicle health monitoring and remote access to car functionality such as climate control. We expect that the two TCU platforms will be made available across a broad range of VW models sold in major markets around the world.

While the two separate design win awards occurred nearly one year apart, program development for both TCUs is happening in parallel. We expect to commence shipping several variants of our AR7 LTE embedded modules in support of both programs starting in the second half of 2018.

Moving to enterprise solutions, in the fourth quarter, revenue on our enterprise solutions business grew 27% year-over-year to $21 million. Q4 enterprise revenue includes the first full quarter of contribution from GenX, which we acquired in August of 2016. Non-GAAP gross margin for the enterprise BU was a solid 52.1%, which was up from the previous quarter. Enterprise team continue to keep a robust pace on new product velocity launching three new gateways during the quarter thereby enhancing our market position in key segments.

Our new high-power MG90 is seeing solid initial traction from first responder, transit, and field service customers. The MG90 is the world's fastest vehicle router providing high-speed secure connectivity with dual LTE advanced links, support for the FirstNet LTE Band 14, Gigabit Ethernet and Gigabit Wi-Fi.

We also launched the FX30 in Q4, the industry's smallest programmable IoT gateway for the industrial segment. The FX30 also incorporates our Legato embedded application platform, which allows our customers to easily build and embed their own differentiating applications and to rapidly connect their industrial assets to the AirVantage cloud and back-end systems.

We also added LTE advanced capability to our successful RV50 without sacrificing its market-leading low power consumption spec. The new RV50X now supports download speeds of up to 300 megabits per second and 21 LTE bands enabling easy global deployment in North America, Europe and Asia. Our stronger product line up and investments in sales and marketing are also leading to growing new customer win activity. And during Q4, our enterprise BU won deals across several of its key targeted segments.

Now onto cloud and connectivity services. Cloud and connectivity revenue in the fourth quarter, which is comprised mainly of recurring service-based contracts, was $6.8 million. On a constant currency basis, revenue in cloud and connectivity was up modestly on a year-over-year and sequential basis. However, the relative strength of the U.S. dollar to the Swedish krona and the euro, the predominant currencies of our CCBU revenue, created some FX headwinds against revenue. Cloud and connectivity gross margin in Q4 was 39.3% and was negatively impacted by a few nonrecurring charges.

New customer acquisition activity continued to ramp in the fourth quarter significantly expanding our customer program pipeline. Design wins in Q4 were the strongest of the year and covered several of our targeted segments. We also continue to see good cross BU deal collaboration with roughly 50% of our new wins originating in the OEM or enterprise business unit.

We're also pleased to see that most of the new cloud and connectivity customers are adopting our patented Smart SIM technology launched earlier in 2016. Smart SIM technology enables us to deliver the highest quality of connectivity service available while also closely managing our cost of service. We also continue to expand our global services footprint with additional wholesale agreements.

I will now turn the call over to Dave, who will provide more detail on the Q4 financial results and our guidance for Q1 of 2017.

Dave McLennan

Great. Thanks, Jason, and good afternoon to everybody. Please note that we report our financial results on a U.S. GAAP basis. However, we also present non-GAAP results in order to provide a better understanding of our operating performance. As a reminder, a full reconciliation between our GAAP and non-GAAP results is available in our press release.

Focusing on fourth quarter results, revenue of $163 million was in line with our expectations and included a full quarter of contribution from GenX, which acquired in August and a small contribution from Blue Creation, which we acquired in November.

Q4 earnings were ahead of our expectations. On a GAAP basis, net earnings were $15.7 million or $0.49 a share and non-GAAP net earnings were $8.8 million or $0.27 per share. Adjusted EBITDA on the fourth quarter was $15.5 million. The stronger than expected earnings performance was driven by improved gross margins and a continued focus on sound OpEx management, specifically on gross margin.

On a GAAP basis, Q4 gross margin was 42.2%. This includes a change in the estimate of our accrual on intellectual property royalty obligations resulting in a $14.4 million reduction in cost of goods sold. We have a variety of IP license agreements in place and we expense the costs associated with these agreements in our cost of goods sold every quarter. Where we don't have – where we have not licensed IP, we have estimated that royalty obligation related to this unlicensed IP and have accrued accordingly on products sold every quarter. You see the cumulative effect of this accrual on our balance in accrued royalties.

Our change in estimate is based on the Cuba developments in the IP licensing landscape, including present legal cases that have helped to define what a potential licensor can charge for its IP. A $14.4 million reduction in our Q4 cost of goods sold has 2 components. The first is an amount of $13 million relating to the one-time reduction effective October 1, 2016 in our accrued royalty obligations on our balance sheet. This one-time reduction in cost of goods sold has been removed from our non-GAAP results and explains the significant difference between our GAAP and non-GAAP gross margin in Q4.

The second component of the $14.4 million reduction in cost of goods sold is a $1.4 million reduction of the IPO accrual using our new estimate on products sold during the fourth quarter. This amount is included in our non-GAAP results for Q4 as it relates to products sold in the quarter. This new estimate will apply on a per unit basis to products sold in future quarters as well. With this reduction, our accrued royalty balance is now seen at $27.2 million.

Taking these items into consideration, our non-GAAP gross margin in Q4 was 34.3%. This is up by 200 basis points sequentially from Q3 and was driven by the $1.4 million favorable impact of the change in IP accrual estimate on products sold during the quarter. This added 90 basis points to Q4 GM. And continued product cost reductions where we've made some really good progress with broadly based cost reductions that have positively affected gross margin in the quarter.

These initiatives include reduced manufacturing costs with our contract manufacturing partners including benefits from bringing on an additional high volume manufacturer and using our balance sheet to carry more inventory, which results in a reduction in our contract manufacturing costs. Also, a reduction in our bill of materials through a variety of purchasing initiatives. And finally, lower warranty cost due to reduced failure rates and more efficient RMA processes, which reduced the cost to repair products under warranty.

Our non-GAAP operating expenditures were lower than we expected going into the quarter primarily driven by lower costs associated with the R&D development parts and certification costs as well as the timing of certain other R&D expenditures.

Non-GAAP earnings per share of $0.27 was above our guidance range and reflects the combined favorable impact of the $1.4 million resulting from applying the new IP accrual estimate on products sold during the quarter as well as the favorable product cost reductions and lower than expected operating expense expenditures discussed earlier.

Looking at key non-GAAP metrics in the fourth quarter compared to the same period in 2015 and Q3 2016, on a year-over-year basis, revenue increased by 12.5% percent, OEM revenue increased 11.2% reflecting normalized demand from certain of our larger established OEM customers and programs as well as contribution from new programs.

Enterprise solutions revenue was up 27.1% year-over-year, which includes a full quarter of contribution from GenX. In cloud and connectivity services, revenue in Q4 2016 was similar to prior year's period. On a sequential basis compared to Q3 of this year, total revenue increased 6.2%. This increase was driven by a 5.8% increase in OEM revenue and a 10.8% increase in enterprise revenue.

Looking at adjusted EBITDA and non-GAAP EPS, in Q4 we realized significant improvement in EBITDA and EPS on both a year-over-year and sequential basis. The improvement in profitability reflects the stronger revenue as discussed above combined with better gross margins and a continued focus on cost management. This demonstrates business model leverage as we grow the business.

Q4 2016 adjusted EBITDA of $15.5 million represents a 9.5% margin compared to $6.3 million or 4.4% margin a year ago and $9.7 million or 6.3% margin compared sequentially to Q3. Similarly, earnings per share in Q4 of 2016 follows the same pattern.

Moving onto key non-GAAP metrics for the full year 2016 compared to 2015, revenue increased 1.3% year-over-year to $615.6 million, OEM revenue decreased 1.3% reflecting lower demand from some of our larger customers during the first three quarters of the year partially offset by contribution from new programs. This was followed by normalized demand in the fourth quarter from large customers and continued contribution from new programs.

Enterprise solutions revenue increased 13.3% in 2016, which includes GenX and contribution from new products launched throughout the year. In cloud and connectivity services, revenue was up 29.2% in 2016 compared to 2015 including a full year contribution from Maingate, MobiquiThings and Accel Networks all of which were acquired in 2015.

2016 adjusted EBITDA increased modestly year-over-year reflecting slightly lower operating income offset by higher amortization. EPS declined from $0.80 in 2015 to $0.68 in 2016 again reflecting slightly lower operating income in 2016 and higher income tax expense. During 2016, we reported cost recoveries in Q1 and Q2 related to two legal settlements. These legal recoveries results in a favorable impact of $3.8 million in cost of goods sold and $400,000 in operating cost.

We continue to have a strong cash position and the company is debt free. We ended 2016 with $102.8 million of cash. In Q4, we consumed $9.2 million of cash. We had some significant working capital demands in the quarter, which drove our operating cash flow to negative $1.4 million. And you may recall we had the opposite effect in Q3 where we generated a significant amount of cash from changes in our working capital.

After capital expenditures of $4.3 million, our Q4 free cash flow was negative $5.7 million. We utilized a further $2.9 million on the acquisition of Blue Creation and we purchased and canceled $4 million worth of shares under our NCIB program. Other items generated $3.4 million to end the quarter with a balance of $102.8 million.

For the full year, we generated free cash flow of $29.5 million. We used $8.8 million to acquire GenX and Blue Creation and we also bought back for the full year $10.2 million worth of our shares under our NCIB program and purchased $4.2 million worth of our shares to fund our restricted share stock compensation program.

Moving onto guidance. In Q1 2017, we're expecting a year-over-year improvement in our financial results with the revenue in the range of $152 million to $161 million. This reflects normal seasonality in our business. We expect gross margin percentage in Q1 to stable to slightly down sequentially and OpEx to be sequentially up given the normal seasonality of our marketing event expenses as well as targeted investments in sales and R&D programs. We expect non-GAAP earnings per share in the range of $0.13 to $0.20 and we expect our tax rate in Q1 to be in the low-to-mid 20s as a percentage.

And with that, I will turn the call back to Jason to summarize.

Jason Cohenour

Thank you, Dave. So to summarize, we had a strong finish to 2016 returning to revenue growth and delivering profitability that was ahead of our expectations. In the year 2016, we continue to strengthen our customer program pipeline winning many new programs across our three business units and adding marquee names such as VW to our customer roster. Continued strong cross BU collaboration resulting in a growing number of device to cloud solutions wins was also a highlight during the year.

We also continue to launch new market leading products and services that strengthened our overall strategic position in the IoT market. We expect that our new products, new services, and new customers will be key to driving future growth and we continue to be excited about the growth opportunity ahead.

We are the clear global leader in cellular connectivity solutions for the Internet of Things. Our three business segments expose us to a large and valuable market opportunity. And we believe that we are better positioned now than ever before to capture a significant share of this opportunity. We also plan to stay active in M&A that supports our device to cloud strategy and that helps us to accelerate long-term growth and value creation for shareholders.

Thank you very much. And with that, Cheryl, we can – that concludes our prepared remarks and you can now open line for questions.

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from James Kisner of Jefferies. Your line is open.

James Kisner

All right. Thanks guys and nice job on the quarter and guide.

Jason Cohenour

Thank you.

James Kisner

So just – [indiscernible] a little bit here, but, I mean, in the past you guys have given annual guidance sort of at least a rough idea what the year might look like, I don't – I'm just wondering did you choose not to do that because of just the chopper year last year, was your visibility still not that good or – I mean, the Street has you up on mid-single digits, I don't know if that's reasonable or do you think that perhaps the quarter is going to increase through the year, just any thoughts at all qualitatively around the outlook beyond Q1?

Jason Cohenour

I will take that James. Hi, this is Jason. So, yes, we did provide annual guidance last year. Normally, we don't by the way, so that was a bit of a departure for us providing annual guidance. We did so because we ended 2015 in a weak fashion and provided weak guidance for Q1 and what we thought we saw at the time was a rapid recovery, so we provided annual guidance at that point in time. I think it's safe to say that that annual guidance came back to bite us and shareholders, so we're being a bit more cautious.

With respect to annual guidance, it is not our norm and for now we continue to be focused on providing guidance one quarter at a time. It is certainly our expectation that we are out of the ditch we drove into at the end of 2015, in the beginning of 2016. We’ve seen a return to normalized demand from some of the big customers we were having challenges with in late 2015. And I think we've – and I think now that we’re seeing that normalized demand pattern and having a regular contribution from new programs, I think we are comfortable with where we are, we have cautious optimism looking forward, but we don't want to overheat expectations either.

James Kisner

That helps a lot. So I want to sort of hop back in the Wayback Machine for a minute. In 2015, you guys talked about some elephants that you were hunting in something similar to an auto, I’m kind of wondering if this Volkswagen win was one of those and are you getting better visibility to kind of seeing some of those revenue in – maybe also some additional large wins that you are fighting for right now that could bear fruit here in late 2017 or in calendar 2018?

Jason Cohenour

Sure, sure. Yes, you did pickup on the VW wins. As you noticed, we indicated there are two wins, one of which we announced, we didn’t announce the name, but we announced that we had one – the company's largest design win ever in the fourth quarter of 2015 with a large international OEM, so now you know that was Volkswagen. And about a year later, we were awarded a second program with the Volkswagen.

So we now have two programs going through development in parallel with Volkswagen with planned start of production late 2018. And in the automotive business that's about the biggest elephant you can land, so we're pretty excited about that. And yes, we continue to compete for others. We do need to be careful, I will be candid, James, I mean, these automotive programs take a tremendous amount of capacity to execute properly on. We don't want to be victims of our success and miss execute on these key program. So I would say we are – while we continue to compete for very large automotive programs, we’re doing so in a very targeted way.

James Kisner

Okay. Is it – just to clarify and I will pass it, I mean, what is the intersection of the stuff in eCall, obviously that’s a European initiative, I’m just wondering does this satisfy some of those requirements of eCall and that's part of what's driving this design in, frankly, I don't know TCU stands for, I have to admit that, but maybe you could clarify what that is I’m unsure.

Jason Cohenour

Sure. Yeah, so, TCU is telematics control unit, it is the most conventional architecture for a connected car and – so our modules go into this TCU control unit, which get embedded in the car on the manufacturing line. Yes, this implementation enables VW to be eCall compliant with all of their cars, but it also is – and by the way it’s a 4G connection, so 4G connection is a bit overkill for just being eCall compliant, so the 4G connection also enables a lot of these other value add services. So think of it as a multipurpose devices, yes, it can do eCall, but it also provides all these other driver convenience features as part of the Car-Net service.

James Kisner

That's a great clarification and again congrats and I will pass it on.

Jason Cohenour

Thank you.

Operator

Your next question comes from Mike Walkley of Canaccord Genuity. Your line is open.

Mike Walkley

Great. Thank you. Jason, it’s great to see the OEM solutions business kind of rebounding to exit the year and growth looks good. Can you kind of walk us through which verticals you're seeing coming back on a year-over-year basis and if the strength of broad based across your customers or whether certain verticals that are driving it or geographies?

Jason Cohenour

Thanks, Mike. So on verticals, I would characterize it as broad base and it does move around a bit quarter to quarter. One quarter we will have a strong energy quarter, the next quarter we might have to be a little bit stronger in networking, so that moves around a little bit. I would say automotive continues to be a theme and in the next three-plus years we think it’s going to be a – continue to be a very important theme and a key driver of growth. I would say more recently from a regional standpoint, we've been having much better success in Europe. Europe, as you may recall, couple years ago was a tough sledding for us and following the launch of some new products and kind of a rejuvenated focus on sales and marketing in Europe, we've seen some very nice growth trajectory going on in that region over the past several quarters.

Mike Walkley

Great. That’s helpful. And then we met with you guys at CES, you’ve been showing off the enterprise solutions approved portfolio, what kind of organic growth do you think that business can do in 2017 with the improved portfolio? Do you think it still grows faster than the overall business?

Jason Cohenour

Well, I’ll be careful not to be specific on a growth rate, but, yes, we do believe that given the rejuvenated product portfolio, some of the assets we picked up through acquisition plus pretty meaningful investments in sales and marketing and we’ve completely re-architected the go-to-market strategy there and particularly around the indirect channel. Our view is all of those initiatives put together should driver a growth rate that is higher than the corporate growth rate in 2017 and beyond for that matter.

Mike Walkley

Great, that's helpful. And one last question for me and I will pass it on. Dave, I just want to get a little more clarity on the sustainability of the better gross margins, so are these licensing fees completely coming out based on new information that you’ve received from an ongoing IP or is it just based on some the new laws that you just decided you guys are over accruing, so you can maybe help clarify and then if we should see kind of these higher level of gross margins sustain, that would be great. Thank you.

Dave McLennan

Sure. It’s Dave here, Mike. So lots of – it’s a very topical area, IP. Just to clarify, these aren’t licensing fees, these are accruals for our estimate of the value of the property that we aren't licensing. And we took a good hard look at this both internally and with external advisors and we just saw a cumulative effect of various developments both on the legal side, several present legal cases that really help to define what the fair value of intellectual property was. We've seen the industry gel around some licensing concepts, so armed with that we took a hard look at how we're accruing and reduce the estimate based on the cumulative effect of that analysis. And so that new level of estimate will be applied to our products going forward, so we accrue on a product unit by unit basis, so we will be applying that lower estimates on – we did that in Q4 and on future products as well.

Jason Cohenour

I'll add that in addition to that though we've been attacking every element of the COGS structure and we – and that was also a key contributor during Q4 to the gross margin over performance, I'll say, and that goes right to the way we manage our supply chain Mike and you probably saw our inventory tick up as an example, so we are actually taking more inventory on our balance sheet in return for lower cost of goods through our contract manufacturers. We are attacking every element of the bomb, we’re attacking warranty, so we're seeing significantly lower return rates as well as a lower cost to repair and all of that is helping us to drive the overall cost of goods down and we do see that as sustainable.

Now a word of caution don't overheat expectations on gross margin percentage because as you know lots of moving pieces. I think we are doing great work on the cost side, but of course mix is also a key factor right. So mix can cut two ways and as new high volume programs come into the mix as an example that could have a dampening effect on gross margin. So, very pleased with the gross margin performance in Q4, looks like a very good outlook for Q1, but word of caution don't overheat expectations here for the balance of 2017 because there’s just too many moving pieces.

Mike Walkley

Understood. Nice to see the leverage in the model. Thank you.

Jason Cohenour

Okay.

Operator

Your next question comes from Steven Li of Raymond James. Your line is open.

Steven Li

Thank you. Jason, how should we think about the margin profile of these elephant size deals, do they put any significant pressure on your young gross margin?

Jason Cohenour

Yes, in a word. Yeah, I mean, there's kind of a direct relationship Steven on – there's an inverse relationship to gross margin percentage and volume generally. Higher the volume, lower the gross margin percentage. Of course we think it's accretive to gross margin dollars. We know it’s accretive to gross margin dollars, but we will dampen gross margin percentage.

Steven Li

Right. So, give your earlier comments, is that going to offset that pressure, so net-net we may end up being flattish on your gross margins for OEM?

Jason Cohenour

Well, I'm not sure what timeframe you're referring to, but clearly when an elephant like Volkswagen comes to market in the late 2018 and through 2019, that’s a very high volume program, which will, I predict, have a dampening effect on overall gross margin. Now, between now and then are we launching high volume programs, of course, we’re launching high volume programs all the time and that’s the kind of word of caution I gave to Mike. Just be careful not to overheat expectations given unusually strong short-term gross margin percentage performance here because there are moving pieces. We're going to continue to be vigilant obviously on the cost of goods sold side, we're going to be continue to be vigilant on growing high margin businesses faster than the overall business, but you also can't ignore that there’s growth opportunities in high volume OEM customers as well and as those come into the mix, that will have a counter balancing effect.

Steven Li

Okay. That's great. And then on the cash flow, Dave, it was a little weak this Q1. Any color – is that the inventory comment that Jason made?

Dave McLennan

Yeah, that was certainly a large part of it Steven. So you saw us have a little bit of negative operating cash flow that was all driven by – if you take out the change in inventory and the impact that had on our cash flow, we would have been nicely positive.

Steven Li

And so that's here to stay right, so we shouldn’t expect that to reverse in future quarters?

Dave McLennan

Yeah, I mean, think of it as we – think of it as a bit of a flow concept right, I mean, it’s – there will be ins and outs, but I think we've level set here – around here.

Steven Li

All right. Great, thanks.

Operator

Your next question comes from Paul Streep of Scotia Capital. Your line is open.

Paul Streep

Great. Maybe just to continue on the last question, I guess, Dave, we were looking at it and thinking some of this might have been from the acquisitions, if it is indeed on inventory, it seems odd that you didn’t made the decision to take on more inventory onto the balance sheet, is this for specific segment of the businesses? It's not a huge number on the balance sheet, but it is just a big move relative what we thought. Thanks.

Dave McLennan

Yeah, it is specific to – we're using our – in the theme of product cost management and product cost reductions, we’re using our balance sheet to improve our product cost structure and one of the ways we're doing that is we're taking on some inventory here that allows us to extract lower markup and MVA costs from our contract manufacturers.

Jason Cohenour

That’s inventory that would normally have been on our contract manufacturers’ books. So to move from their books onto ours.

Dave McLennan

So think of it as used in our balance sheet to improve our cost structure.

Paul Streep

Got it, okay. [indiscernible] okay. The one other quick one I'd have is enterprise, Jason, it looks like – it looks like – estimating here it looks like at least a third of that portfolio turned over in the last few months, is the reason we shouldn't have sort of 30%-plus organic growth this year or maybe even higher?

Jason Cohenour

I’d love to see that, but I wouldn’t want to set that expectation.

Paul Streep

What is the replacement, I guess, is where I’m going with the questions, is it just replacing?

Jason Cohenour

Well, some, yes. Yes, some of it is – some of these new products are successor products. The MG90 our great example, it’s replacing a product we call the OMG, I know it’s an awful name as it means other things to other people, but – so that is a – picture that product or think of that product as a successor product. So, now, are some of the products attacking new segments, also absolutely, so it exposes us to a bigger market opportunity and that is built into our growth expectation for the business. So like I said combination of new products in a business line that you may recall was a bit product poor right. So new products now a completely rejuvenated product line up notwithstanding some of them are successor products but completely rejuvenated product line up and even if it's just a successor by the way gives you chance to take share right as well right. So rejuvenated product line up completely re-architected go-to-market model plus investments in sales and marketing and that is all in our expectations around a growth rate that is higher than the corporate average. But don't wire in 30% into your 2017 model.

Paul Streep

Should I hockey stick the back end of the year or is it fair to think about this. Just given that those products actually whether it's public safety or industrial presumably they’ve got a longer lead time like I know you talked and we talked last quarter as well but making the investments in the sales side you now get the product but it's going to in certain cases you get RFPs there to win. Should I be thinking about this is sort of a back half loaded lift in addition to sort of the nice sequential growth you’re implying your shower.

Jason Cohenour

No, I don't - we're not thinking about it like a hockey stick and then I’ll back away because I've already shared too much but you know we think these things layer on top of each other and I think that our expectation is for continued steady year-over-year growth and a full year growth rate that is above the corporate growth rate.

Paul Streep

Got it. Thank you.

Jason Cohenour

Okay.

Operator

Your next question comes from Paul Treiber of RBC Capital Markets. Your line is open.

Paul Treiber

Thanks very much. I was just hoping you can bridge between your comments on the design win momentum that you're seeing in cloud and connectivity and the revenue, and just excluding FX for a moment what's your expectation for organic growth in that business in 2017?

Jason Cohenour

Well, from my comments, Paul, it was modest on a constant currency basis and our expectation is that it will go higher than modest of course. And we think it'll be certainly higher than we've experienced - well not certainly, we expect it will be higher than we've experienced, the growth rate will be higher than we’ve experienced so far. And with respect to design wins, you do need to think about cloud and connectivity design wins almost like OEM design wins. While many of them are OEM design wins. So there is a significant gestation for most deals, there's a significant gestation period after the win before it turns into first deployments. And then post first deployments, you hopefully get the benefit of a snowball effect as customers continued to rollout subscribers for the solution that they’ve built based on our products and services. So it takes a little while to build, takes a little while to launch and then every deal takes a little while to build is the way to think about that business.

Paul Treiber

And then with the deals that you're winning in that space, what’s the typical time period? Is it 12 plus months before you think you'll see that ramp?

Jason Cohenour

Yes, it’s easily 12 months. Think of it just like an OEM deal and as you know design win to launch in OEM land 12 months almost at a minimum right longer of course if it's an automotive deal but 12 months at a minimum and the cloud and connectivity business is very much a line there because several of the new customer wins we are getting are indeed OEMs.

Paul Treiber

Okay. I just want to switch to HARMAN. So a couple months ago Samsung announces acquiring HARMAN. Could you clarify you did size of the magnitude of HARMAN in terms your own revenues and then you had any feedback from them in terms of how the relationship will go now being part of Samsung.

Jason Cohenour

So I'll start with the second question first. The external positioning of HARMAN is that you have already seen is exactly what we have heard directly from them which is that Samsung will run that – that business will run as a standalone subsidiary. Dinesh Paliwal will continue to run that business. I think they're still planning on calling at HARMAN for the foreseeable future. So I would think about, I'm thinking about HARMAN now for the foreseeable future as an independent business and obviously a key Tier 1 partner. Now for us, we are - we've done projects with HARMAN, the largest and most prominent as I think you know is Fiat Chrysler where we've had significant success. It is a key I would say Fiat Chrysler is a significant contributor to our revenue that we ship to HARMAN. And we do expect that in successor Fiat Chrysler programs, we will be involved. I'm not sure if that helps you, but think about it that way. Regardless of who the Tier 1 maybe.

Paul Treiber

In regards to Volkswagen, is Volkswagen - their agreement direct with Volkswagen or does it go through a Tier 1 like HARMAN?

Jason Cohenour

That's a great question. We were selected by Volkswagen and Volkswagen will select a Tier 1 to build the TCU. Now a large part of the TCU design is being done by Volkswagen internally and then that design will be turned over to their selected Tier 1 partner who will finish the job and manufacture the TCU with our call it mandated module inside.

Paul Treiber

And then in regard…

Jason Cohenour

By the way this is exactly the model we strive for in every case where we get selected by the OEM as opposed to playing jump ball with a variety of Tier ones, right. So when we're doing our sales job well, we are convincing the car OEM to select us ahead of selection of the Tier 1. So in this case, it look great.

Paul Treiber

And in regard to Volkswagen using Legato, is there any – should we think about in terms of having any direct revenue impact to Sierra or is that more of a differentiator for your product and perhaps increasing the stickiness of the modules.

Jason Cohenour

Yes, I think about it as the latter, Paul.

Paul Treiber

Okay. Thank you. I’ll pass the line.

Jason Cohenour

Yes, okay.

Operator

[Operator Instructions] Your next question comes from Howard Smith of First Analysis. Your line is open.

Howard Smith

Yes, thank you and nice to end the year on a very positive note.

Jason Cohenour

Thank you, Howard.

Howard Smith

Congratulations on that. Question, I just wanted to follow up on the cloud and connectivity. You talked about the long gestation period of some of these wins. But if you think about it geographically, are you seeing differences in patterns of either growth or ramp between the European geography and the America.

Jason Cohenour

Yes, Howard, I the preponderance of our cloud and connectivity franchise is in Europe. It's where the strength of our network is centered, the strength of our acquired customer base and the strength of our wholesale agreements. And that's not to say we're not doing work in the U. S. We are and we're winning customers in U.S. but clearly the center of strength for that business is in Europe. And as you might expect, that's where the majority of new customer wins are taking place.

Howard Smith

Okay, and then just a quick bookkeeping question regarding the tax rates. You got to low-to-mid 20s for Q1. I assume and I know you're not giving broad guidance for the full year but there's nothing special or abnormal that you'd be accruing a different tax rate in Q1 then for expected future period.

Jason Cohenour

That's right, Howard. Our expectations for the full year will be aligned with the Q1 rate.

Howard Smith

Okay, thank you.

Operator

Your next question comes from Richard Tse of National Bank. Your line is open.

Richard Tse

Hi, Jason. I’m not sure you've covered this but – did you mention the pace of design wins across all business units relative to last year and is that accelerated or is it pretty much at the same pace here.

Jason Cohenour

Yes, I did not mention the pace. I did not compare the 2016 pace of design wins with the 2015 pace of design wins. But I would – broadly, I would say think about OEM as roughly consistent and in the other 2BUs up. So overall new customer win, volume and LTV up mainly and the increase mainly driven by enterprise and cloud and connectivity.

Richard Tse

Okay. That's helpful. And then great to see those VW wins. Can you give us a bit more color in terms of what differentiate your solution relative to some of the other players in the market that allows you to win those deals.

Jason Cohenour

Yes, sure. As is typical Richard it's a variety of factors, Legato was key to winning that deal because Legato is open source Linux base embedded platform. Developers get the devices, day one they can start developing, they don't have to do a Linux board support package that could take months, they don’t have to built connectors. All of this stuff is already built into Legato. So that was a key factor in enabling us to win program number one. Another key factor of course was that while we gave a very I would say credible and compelling technical solution from a schedule and execution and manufacturing quality standpoint, and it's one of those programs that pressurize from a schedule standpoint so that helped us both our position on the hardware side as well as Legato in enabling them to move faster on software development. Legato was an even bigger factor in program number 2 because as you might expect in program number one lots of software was developed on top of Legato. That software you want to leverage for program 2 and we were in a unique position to be able to offer that leverage through our Legato platform. So that was a very key factor in win number 2.

Richard Tse

Okay, great. That's helpful. And then finally, can you maybe comment on whether there has been any meaningful changes in the competitive landscape? Obviously it sounds like you’ve got an edge here with Legato but is there anything else or changed out there.

Jason Cohenour

Not a whole lot. I will point out one consolidation move was made fairly recently, u-blox announced their intention to acquire SIMCom. SIMCom is one of the call it smallish Chinese challengers. We don't think that materially affects our competitive landscape but it is interesting to see a consolidation move made. Beyond that Richard, I would say not a whole lot of change. I would say over the past two years, the enterprise space has become more competitive than it had traditionally been. So even while we are I think executing now at a much higher level, the competition is two. And so that’s a factor even as we return to stronger growth in that area of our business, we are facing a competition which is a put a somewhat of a governor on the growth rate we can attain quickly there.

Richard Tse

Right, thank you.

Operator

Your next question comes from Paul Treiber of RBC Capital Markets, your line is open.

Paul Treiber

Hi, just a follow-up, just in regards to the royalty accrual, I do assume it's non-cash and so in months in building up the balance sheet for but was there any contention with the IP supplier regarding a claim and liability on your product that led to the accrual to begin with.

Dave McLennan

No, Paul. It’s Dave here, Paul. No, this was not given by a specific claim or anything. This was really driven by external changes in the landscape such as - over the years we've seen several President legal cases that has really helped to define what a fair rate is for license work and can charge for their IP. And also gelling around – the industry is gelling around a different concept of the value in IP, not necessarily off of the ASP of a product, but off of the system that actually implements the technology.

Paul Treiber

So, historically, on this accrual, you never paid cash against it and going forward you probably didn't either expect to?

Dave McLennan

Well, we have – in the past where we have may be taken a license and had to settle for past sales or something like that, we would have used the accrual because that's exactly what the accrual was there for. So in the past, we have – it has turned into cash in some instances, cash expense in some instances.

Paul Treiber

Okay, I see. Thanks. Thanks for clarifying.

Jason Cohenour

Okay.

Operator

There are no further questions at this time. I will turn the call back over to the presenters.

Jason Cohenour

Great. Thank you very much, Cheryl. Okay, everybody, thank you so much for joining today's call. And as is usual, management is available here in our headquarters office should you have any a follow-up questions. Cheryl, you can now terminate the call.

Operator

This concludes today's conference call you may now disconnect.

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