Apple (NASDAQ:AAPL) will be facing a number of headwinds in the current quarter which should chip away at the earnings per share. Wall Street is already estimating a big fall in EPS in the current quarter. A weaking of margins and EPS can build bearish sentiment around AAPL stock.

The company offered huge discounts on iPhones in the last few days. There have been reports that several third-party platforms have given discounts up to $300 on this year’s flagship iPhone models. This will certainly lead to a big hit on the margins. The recent launch of services has been underwhelming. It would be difficult for these services to move the needle in the near term. 

AAPL stock saw a major correction the last time Apple reported a big decline in earnings per share. We could see a similar scenario in this quarter. Netflix (NASDAQ:NFLX) was the highest grossing app on App Store. The margins in this quarter will also face headwinds with the departure of Netflix from App store. In the last quarter, operating margin fell by 207 basis points from the year-ago quarter.

We should see a bigger fall in operating margin due to discounting pressure. In 2018, Apple had the advantage of high savings on income tax provisioning. This won’t be present in 2019 on a YoY basis which should negatively impact EPS and Apple stock.

Big Discounts 

It seems that Apple’s management is going all-in to prevent a situation where they have to revise revenue estimates down. The impact of the last downward revision in early January was quite extreme. The easiest option to improve revenue is to give discounts. Apple seems to be doing just that in China and other international regions.

In the first few weeks of January, there was a major discount on iPhone XR in China. In the last few weeks, there have been reports that bigger discounts are now being offered on all the iPhone models. For iPhone XS Max, the discount by Suning.com, a major Chinese electronic retailer, is as high as 2,000 yuan ($300). This level of discount is possible only when Apple would have given a lower price to wholesale sellers.

Other retailers like Pinduoduo (NASDAQ:PDD) and JD.com (NASDAQ:JD) are also offering heavy discounts. The discounts will end up hurting the bottom line of the company.

The iPhone segment contributes over 60% to the total revenue base. Hence, even a few percentage point decline in the margin from this segment can have a major impact on the margins and EPS. Even if the company can show stabilizing of revenue, a big fall in EPS will inevitably lead to a correction in Apple stock.

EPS Estimates

Apple’s operating margin has fallen in 12 out of the last 13 quarters. The last quarter saw operating margin decline of 207 basis points.

Falling operating margin did not lead to a big hit on EPS in 2018 because Apple benefited from a reduction in income tax provisions. From this quarter, Apple will face tougher comps in this metric because it had already reduced income tax provisions in the year-ago quarter.

Lower operating margin, big discounts and tougher comps can lead to a much lower earnings per share compared to year-ago quarter. Wall Street consensus estimates are already on the decline. If Apple is not able to match even the low-end of EPS estimates, it will lead to significant bearish sentiment towards the stock.

Continuous fall in EPS estimates in the last few week

Source: Yahoo Finance

Apple was able to beat consensus EPS estimates in all the four quarters of 2018. One of the major reasons behind this was the rapid reduction in income tax provisions.

In the last quarter, income tax provision was $3.9 billion while in the year ago quarter it was $6.9 billion. This 44% reduction in income tax provision helped in boosting EPS. Eventually, Apple was able to beat the consensus EPS estimate by 1 cent. One of the reasons for a bullish rally in Apple stock since the last quarterly earnings is consensus-beating EPS delivered by the company.

However, this would be very difficult from this quarter because the company would be facing tougher comparison from the year ago quarter. In the last few weeks, there has been continuous decline in EPS estimates. It now stands at $2.37. The year-ago EPS for March-ending quarter was $2.73. The EPS estimate for the current quarter range from $2.12 to $2.49. If Apple is not able to meet even the lower end of this EPS range, it will lead to a big correction for the stock.

Netflix Moving Out of App Store

This will be the first quarter when Netflix is not be contributing to Apple’s App Store. Management has often mentioned the marginal impact of departure by any major app from the App Store. But we should remember that any contribution from Netflix was probably pure profits for Apple.

Estimates suggest that Netflix would be saving close to $250 million in commission payment to iOS. This is equal to $60 million for one quarter. Apple’s operating income in the last quarter was $16 billion. Hence, the departure of Netflix from App store equates to around 40 basis point hit for the company.

This is a big headwind in the current quarter when we look at other factors affecting the company.

Investor Takeaway

Apple is going to face a perfect storm as it reports the quarterly earnings in the next quarter. It will not have the benefit of lower income tax provisions compared to year ago quarter. The company has given huge discount in international regions to boost sales. The departure of Netflix would also be a 40-basis-point headwind for the operating margin.

Overall, we could see a correction in Apple stock unless the management can show strong growth potential from any other segments. The underwhelming launch of new services will also be a negative factor of Apple stock for the near term.