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Icahn's Apple bet is all about buybacks

Of all the obstacles that could impede investor Carl Icahn's hopes for Apple shares to double in value, one of the most overlooked may be a 68-year-old economist who has spent a fair amount of time opining about technology-stock valuations.

That would be Federal Reserve Chair Janet Yellen.

The problem is that rising interest rates, coupled with a well-known quirk of U.S. tax law, could make it harder, or at least more expensive, for the world's most valuable company to comply with Icahn's pleas to increase the pace at which Apple buys back shares.

Carl Icahn
Getty Images (L) | David Grogan | CNBC (R)
Carl Icahn

Last week, when Icahn published his latest missive to Apple CEO Tim Cook, the iffy assumptions Icahn made about Apple's ability to reach a stock price of $240—by cracking new markets and continuing to hit blockbuster product sales numbers—were widely dissected.

But less time was spent on the real key to Icahn's Apple love: His base case for Apple bullishness is all about the buybacks.

"We are not here recommending stocks; that's not what we do," Icahn told CNBC. "My area is, interest is, to go in and see them buy more stock back. It has been very helpful to the company. They just upped the buyback by $50 billion. I think they should up it by more. That's all I'm saying. Because they certainly have enough money to do whatever the hell they want to do, anyway."

Icahn noted that he had already, in his opinion, helped the company to once increase its buybacks and said, "That's all I'm trying to do again. To push them to buy more."

"For the last few years, buybacks have been very effective because of low interest rates. The math will change against them if interest rates begin to rise." -Amit Daryanani, RBC Capital Markets analyst

Icahn's argument hinges on Apple's $188 billion of cash and investments, but the 79-year-old billionaire knows that 88 percent of that money is outside the U.S. and can't be repatriated to buy back shares from U.S. investors on U.S exchanges without paying 35 percent of it in taxes.

The workaround so far has been for Apple to borrow money against all that offshore cash, which has let the company buy back almost $34 billion of stock in the last year, RBC Capital Markets analyst Amit Daryanani said. And that's where Yellen comes in.

"For the last few years, buybacks have been very effective because of low interest rates," Daryanani said. "The math will change against them if interest rates begin to rise."

Read MoreThis sector is now a value bet after the Fed rate panic

The numbers are fairly straightforward. Apple is expected to generate about $60 billion of free cash flow this year, but since only about 36 percent of its sales are in the U.S., most of the new profit is overseas.

That more or less caps the amount of stock Apple can buy back with new U.S. cash flow at a bit more than $10 billion a year, just over 1 percent of its $750 billion market capitalization, if Apple also pays its $12 billion dividend out of U.S. cash flow. The company's buybacks to date have mostly been funded with the $39 billion it has borrowed since 2013, at interest rates that have recently been as high as 3.45 percent.

If interest rates begin rising in earnest, then the cost of borrowing money to buy back shares rises, Daryanani said. With investors taking the minutes of the Fed's April meeting, released yesterday, as a sign that domestic rates will begin rising by late this year, the Fed could inadvertently throw a little bit of extra cold water on Icahn's idea.

Icahn's iffy assumptions

The tax- and interest-rate wrinkles add more complications to Wall Street's rather bewildered reaction to Icahn's open letter to Apple, the third in a series Icahn has written since beginning to assemble his Apple position in 2013.

Icahn's latest missive argues that the world's most valuable company is worth $1.4 trillion, almost double its current market value and about the annual output of South Korea. But to get there, Icahn makes a series of unprovable assumptions about Apple's entry into new businesses, like cars, watches and TVs, and attached a price-to-earnings multiple to the whole company 60 percent higher than Apple sports now.

"All these new categories taken together (along with those of which we may be unaware) represent one of the greatest growth stories in corporate history, as well as one of the greatest opportunities ever for a company to invest in itself by repurchasing its shares," Icahn wrote.

Icahn said his Apple price target doesn't depend on milking the cash cow of more buybacks, but nearly everything else about Icahn's analysis is sharply higher than Wall Street forecasts, UBS analyst Steven Milunovich pointed out.

Icahn thinks next year's iPhone revenue will be 1.8 percent lower than Milunovich's estimate, but that iPads will generate 17 percent more sales than UBS expects, Milunovich said in a note to clients.

The newer the product, the bigger the spread between Street expectations and Icahn's.

Icahn projects that the Apple Watch will generate almost 17 percent more unit sales than analysts expect in fiscal 2016, or $8 billion worth of extra sales of iPods, watches and other non-iPhone and iPad devices, Milunovich said. Apple's ultra-HD TV set—which hasn't even launched and a recent Wall Street Journal report alleged has been canceled—will bring in $15 billion next year, according to Icahn.

Read MoreThese charts point to record highs for Apple: Technician

"We're most interested in Icahn's ability to imagine what could be, compared with typical incrementalist thought," Milunovich said. But, he added, the "stock has to hit $150 before $240."

Nowhere is the difference between Wall Street's and Icahn's views more stark than in their assessment of Apple's nascent, highly secretive car business.

Icahn's letter says Apple can push its way into the car market by capitalizing on the development of electric-car batteries, a movement driven not by Apple but by Tesla Motors.

"Apple is poised to enter and, in our view, dominate two new categories (the television next year and the automobile by 2020) with a combined addressable market of $2.2 trillion," Icahn wrote. "[This is] a view investors don't appear to factor into their valuation at all."

He's right. They don't.

Like Milunovich, Morgan Stanley analysts Katy Huberty and Adam Jonas declined to assign any value to Apple's auto business in a Feb. 24 report. Among the reasons why: It could take Apple as long as 10 years to build its own car, though partnerships with existing car makers could arrive sooner, they wrote. The company is also known for taking many years to pursue new markets while it tinkers with its product, as it has in TVs, they said.

Read More10 steps to understanding Apple's car plans

On top of all of this, Icahn argues that Apple is worth 18 times earnings rather than the 10 to 11 times earnings it currently commands.

"It just makes no sense that this company should be at 10 times earnings when you have a number of companies that are questionable in the S&P [500]," Icahn said. "They're making earnings because of low interest rates in many cases. Those earnings are going to be affected by a strong dollar in the negative way. And yet those things are selling at 18 times earnings."

Icahn has already made more than $3 billion on his 53-million-share Apple stake, which he began to build in 2013. At $130 a share, his position is worth nearly $7 billion.

But getting it to $14 billion soon will take a lot of smarts and a bit of luck—and just maybe some help from the Fed.

"It's amazing that Icahn can't be content with the move in the stock he's had," Daryanani said.

By Tim Mullaney, special to CNBC.com