By Philip Elmer-DeWitt
January 20, 2009

On Wednesday, when Apple announces its fiscal 2009 first-quarter earnings, the business press will rush to report the key metrics: number of units sold for Macs, iPods and iPhones, as well as overall company sales, earnings, and gross margins.

But according to some long-time Apple watchers, what really matters tomorrow is whether reporters and analysts will fail — once again — to recognize the rapidly growing value of Apple’s hidden revenue stream.

That revenue stream — roughly 40% higher than the one everybody is focused on — flows from the sales of iPhones, which grew 583% in fiscal year 2008. Most analysts, however, don’t include it in their reports to clients because it isn’t recorded in Apple’s books.

The problem stems from a decision that Bullish Cross‘ Andy Zaky calls “one of the worst in Apple’s history.” Rather than recognize income from sales of the iPhone in the quarter in which it is collected, Apple spreads it out over eight quarters — the life of a typical iPhone contract.

Deferred earnings: Appleā€™s hidden revenue bonus

The result of this so-called subscription accounting is that revenue from the iPhone in any one quarter is like an iceberg: we only see the tip of it. The other 7/8ths are sitting in Apple’s coffers, waiting to be parceled out in future earnings reports.

The failure of traders to take those 7/8ths into account is one of the reasons — along with concerns about the CEO’s health and the global economic slowdown — that Apple’s (AAPL) share price has fallen in just over a year from $202 to the low $80s.

“What we have here,” wrote Zaky on Monday in a post entitled How the iPhone and Poor Apple Management have contributed to the Downfall of Apple, “is a perfect recipe for media misrepresentation, analyst confusion and market disorientation regarding Apple’s fundamentals.”

The day Apple released its iPhone revenue bomb

In October, Apple finally addressed the problem. Making a rare telephone appearance in an Apple’s quarterly earnings call with reporters and analysts, Steve Jobs tried to focus their attention on Apple’s so-called non-GAAP (generally accepted accounting practices) earnings.

“Because by its nature subscription accounting spreads the impact of iPhone’s contribution to Apple’s overall sales, gross margin, and net income over two years, it can make it more difficult for the average Apple manager or the average investor to evaluate the company’s overall performance. As long as our iPhone business was small relative to our Mac and music businesses, this didn’t really matter much. But this past quarter, as you heard, our iPhone business has grown to about $4.6 billion, or 39% of Apple’s total business, clearly too big for Apple management or investors to ignore. Hence our introduction today of non-GAAP financial results alongside our reported GAAP results.

As you can see, the non-GAAP financial results are truly stunning. By eliminating subscription accounting, adjusted sales for the quarter were $11.68 billion, 48% higher than the reported revenue of $7.9 billion, while adjusted income was $2.44 billion, 115% higher than the reported net income of $1.14 billion. Adjusted net income that is more than double our reported income — if this isn’t stunning, I don’t know what is, all due to the incredible success of the iPhone 3G.” (transcript)

Apple’s stock jumped 18% in after-hours trading as some traders realized that the analysts they follow had underestimated Apple’s earnings by nearly $3.8 billion.

For many Apple investors, the key question tomorrow is whether Apple will sufficiently emphasize adjusted earnings in their quarterly report. For example, will they compare adjusted earnings for this quarter with the same quarter last year, giving analysts — for the first time — a metric by which they can report year-to-year non-GAAP growth?

Zaky wants the company to drop generally accepted accounting practices altogether. He writes:

“Apple should immediately cease giving GAAP-based earnings guidance and instead offer guidance on adjusted earnings. If Steve Jobs really wants the market to shift its focus from Apple’s GAAP-based earnings to real earnings, then he really needs to start offering guidance on an adjusted basis – a practice that several other tech companies already employ.” (link)

Below the fold: Zaky’s charts comparing Apple’s adjusted price-to-earnings and price-to-cash ratios to those of Google (GOOG), Amazon (AMZN), RIM (RIMM) and other major tech companies. Needless to say, he believes that given Apple’s growth rate and balance sheet, its shares are vastly undervalued.

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