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Services Growth Isn't Helping Apple's Bottom Line

By Timothy Green - Updated Apr 24, 2019 at 10:16PM

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Weak demand for iPhones is just too much to overcome.

Check out the latest Apple earnings call transcript.

Apple's (AAPL -0.29%) earnings per share reached an all-time high of $4.18 in its fiscal first quarter, edging out analyst expectations and blunting the blow from tumbling iPhone sales. Total revenue fell 5% from the prior-year period, with iPhone revenue slumping 15%.

This per-share earnings growth was not driven by the company's much-touted services business, which grew revenue by 19% to $10.9 billion and posted a gross margin of 62.8%. Instead, it was a lower tax bill and Apple's massive share buyback program that pushed the bottom line higher. Without those two items, profits would have tumbled even more than revenue.

A rose-gold iPhone XS from the front and back.

Image source: Apple.

Unimpressive earnings growth

The company's $4.18 EPS in the first quarter represents year-over-year growth of about 7.5%. That growth was entirely due to the progress made in reducing its share count via share buybacks. Diluted share count has declined by roughly 7.5% over the past year, driven by tens of billions of dollars spent on share buybacks. In the first quarter alone, Apple poured $8.8 billion into repurchasing its own shares.

EPS would have been just $3.87 if not for the buybacks, down about $0.02 from the prior-year period.

A much lower tax rate also helped push up Apple's profits in the first quarter. It was able to lower its tax bill by more than $3 billion compared to the prior-year period, paying a tax rate of 16.5%. That's about 9 percentage points lower than its tax rate in the first quarter of last year.

If the tax rate had remained the same in addition to adjusting for buybacks, its EPS would have been just $3.44 in the first quarter. That would have represented a year-over-year decline of 11.6%.

Parts of the services business are likely cash cows for the company. The App Store is probably wildly profitable, and the payment Apple reportedly receives from Alphabet's Google to make Google the default search engine in the Safari web browser is about as high margin as it gets. But none of that was enough to offset the negative effect from tumbling iPhone sales in the first quarter.

Revenue and profits will keep moving lower

Apple will continue to pay a lower tax rate, but the year-over-year benefit disappears in the second quarter. No more multibillion-dollar boost to the bottom line. Buybacks will continue to help per-share earnings, but that likely won't be enough to drive earnings growth on its own.

In its second quarter, Apple expects to produce between $55 billion and $59 billion of revenue, down from $61.1 billion in the prior-year period. That's a 6.7% year-over-year decline at the midpoint, an even worse result than the first quarter.

Though Apple didn't provide earnings guidance, it did give enough information to calculate it. Using the midpoint of Apple's revenue, margin, expense, and tax guidance, second-quarter net income should come in around $10.9 billion. That's down a whopping 21% year over year. EPS will fall by less thanks to buybacks, but it still won't be pretty.

Apple could certainly outperform its guidance. But with the iPhone business in a deep malaise, and with the services business heavily dependent on the iPhone, don't expect results to impress anytime soon.

Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Timothy Green has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), and Apple. The Motley Fool has the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. The Motley Fool has a disclosure policy.

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