Apple (AAPL) has been able to show record-breaking EPS in the recent quarter. This allowed the company to allay some of the concerns of Wall Street. The stock has also seen a reasonable jump post-earnings. However, the company reported a substantial decline in operating income. The operating income declined from $26.27 billion in the year-ago quarter to $23.34 billion. The decline in operating income was compensated by lower income tax provisioning. There was a decline in the provision of income tax from $6.96 billion to $3.94 billion.
Apple has also benefited from 377 million lesser outstanding shares compared to the year-ago quarter due to rapid buybacks. It will be very difficult for Apple to show EPS growth on a YoY basis from next quarter as it already made lower income tax provisioning in all the quarters of 2018. A falling EPS will certainly reduce the bullish sentiment around the stock and could lead to further correction.
Gains from external sources
Apple had to provide significant discounts in the holiday quarter to boost sales. This was one of the main reasons behind a decline in operating margin. The operating margin in the recent quarter was 27.69% while it stood at 29.76% in the year-ago quarter. This decline of 207 basis points, along with a decline in revenue, led to fall of $2.92 billion in operating income.
Source: Apple Filings
The massive fall in operating income would have led to a bearish momentum in the stock. However, the company also benefited from a much lower provision for income tax of $3.02 billion. The lower provisioning of income tax has made up for the entire decline in operating income.
The decline in provisioning for income tax in the recent quarter has also been much higher than the previous quarters of 2018.
Provision for income tax. Quarter ending:
December 2018: $3.94 billion, December 2017: $6.97 billion, Decline: 43.5%
September 2018: $2.3 billion, September 2017: $3.2 billion, Decline: 28.2%
June 2018: $1.77 billion, June 2017: $2.6 billion, Decline: 32.1%
March 2018: $2.35 billion, March 2017: $3.7 billion, Decline: 36.5%
We can see that the percentage decline in provision for income tax has been highest for the recent quarter. If the provision for income tax in the recent quarter was the average of previous three quarters or 32%, the net income would be lower by about $800 million. This would have led the EPS to come at $4.07 instead of the reported $4.18 and also lower than the consensus $4.17. If Apple reported $4.07 EPS instead of $4.18, it could have certainly led to a significant correction in the stock.
EPS in next quarter
The headline EPS number is very important for the market. The ability to beat the consensus EPS estimate helps in building a bullish sentiment around the stock. Showing YoY EPS growth is also quite important for Apple. The last time Apple showed YoY EPS decline in 2016, there was a over 30% correction in the stock.
In the next quarter, Apple will be facing tougher comparisons because the year-ago quarter had already reported a lower provision for income tax. Apple will not be able to meaningfully reduce the income tax provisioning compared to the year-ago quarter. Hence, the net income will be substantially lower which in turn will reduce the EPS for the next quarter.
Apple’s EPS for the quarter ending on March 2018 or Q2 2018 was $2.73. In the recent earnings, Apple showed a decline of 207 basis points in the operating margin. Tim Cook has mentioned in the earnings call that Apple will give discounts in international markets where the local currency has declined significantly compared to the dollar. This will further pressure the operating margin, and with no boost from income tax provisioning, Apple could show a bigger decline in net income and EPS.
Apple’s falling operating income will become more important over the next few quarters. If the company reports further decline in revenue from any region or there is significant shrinking of the operating margin, we will see a major downward revision of EPS estimates. Although the current valuation multiple is reasonable, a falling EPS will increase this multiple in the near term. Investors need to look at the possible decline in EPS to gauge the ideal pricing for the stock.
Apple has been able to report its highest ever EPS in the recent quarter. However, the EPS number was lifted upwards by lower provisioning for income tax. The decline in provision for income tax from the year-ago quarter has been 44%. This is much higher than what we saw for the previous three quarters.
From the next quarter, Apple will have to face tough comparisons as a tailwind as further reduction in income tax provisions will not be there. A rapidly declining operating income can cause a substantial decline in net income and EPS. Apple has been able to show YoY EPS growth for the past nine quarters. Declining EPS in the next few quarters will be a major headwind for the stock which can lead to a significant correction in the stock.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.