Does Edward Lampert Know What He is Doing with Citi?

The recent news that billionaire investor Edward Lampert has purchased 15 million shares of Citi stock through one of his hedge funds has a lot of people looking at Citi. Why did Lampert purchase this stake? What does he see in Citi?

Lampert is known as a value investor. He buys companies that he believes are undervalued. He has made his fortune doing this with such companies as Kmart, Sears and AutoZone. Is Citi undervalued today?

At the current price of $55 dollars a share, Citi is valued in the marketplace at $272 billion dollars. Lampert reportedly got into Citi at an average price of a bit under $50 a share, so he's already made a 10% profit. But is Citi still undervalued at $272 billion?

Let's take a quick look at Citi's 2006 annual report and see.

In 2006 Citi reported total net income of $21.5 billion dollars. If we divide that number into Citi's current valuation of $272 billion we get a 12.7 price to earnings ratio for Citi.

Roughly $9.2 billion of Citi's earnings came from its international operations. How much is Citi's international operations really worth? If we multiply the $9.2 billion by 12.7 we end up with roughly $117 billion. But is that really what Citi's international operations are worth?

In most stock markets around the world the price to earnings ratios are higher than 12.7. In some cases, like in Japan, much higher than 12.7. If Citi decided to strategically realize the worth of its international operations they would almost certainly be worth considerably more than $117 billion.

If Citi sold some or all of its international operations to the public in each of the markets it operates in it would receive far more than $117 billion for those operations. Another way to look at this is to say what if Citi sold off 10-20% stakes in each country it operates in for its holdings in those countries through the stock markets in those countries.

For example: in Mexico, Citi reported net earnings of almost $2 billion dollars in 2006. If Citi sold off a 20% stake in their Mexican holdings in the Mexican stock market they would probably realize at least 15 times the $2 billion in earnings, or roughly $6 billion dollars. It's not out of the question that Citi could receive 20 times their earnings which would result in $8 billion dollars for a 20% sale.

If Citi did this strategically around the world when each international stock market is at a high, they could realize the same on their entire international operations. At 15 times earnings that valuation would be $138 billion. At 20 times earnings it would be $184 billion. I think its fair to say that Citi's international operations are worth roughly $150 billion dollars today.

That would mean the rest of Citi's operations in the United States and Canada are currently valued at just $122 billion dollars. Citi's total net income in 2006 was $21.5 billion dollars. Subtracting the international operations of $9.2 billion and we are left with $12.3 billion. So Citi's domestic operations are valued at just 10 times their 2006 earnings.

If Citi sold off their domestic operations they would realize far more than 10 times earnings on those operations. The domestic business includes Citi's highly profitable credit card operations in the United States. I think it's fair to say Citi would realize at least 12.5 times it's domestic earnings or $154 billion. That's $32 billion more than the current valuation.

If Citi realized 15 times domestic 2006 earnings the value would be $185 billion, or $63 billion more than the current valuation. That's roughly $13 more dollars than the current price of $55. Meaning, if all my calculations are fair and accurate, Citi is undervalued today in the market by roughly 10-20%. And that is based upon 2006 earnings. Any increase in 2007 earnings means Citi is undervalued even more.

It certainly seems to me that Edward Lampert knows what he is doing with Citi.