A glass-half-full merger

It is a measure of how optimal and opportunistic Westpac's timing is that the premium it is offering St George shareholders in the agreed merger of the two banks is even more modest than expected.

On the terms unveiled today – 1.31 Westpac shares for each St George share – Westpac values St George at $18.6 billion, or $33.10 a share. That's a premium of 28.5 per cent to its closing price last Friday and only 23.7 per cent to its three-month volume-weighted average price.

Less than six months ago, however, St George shares were trading at the offer price. While Westpac shares were also trading higher in mid-December, had the current offer been made at that time the premium would have been only about 14 per cent and the bid would have been dismissed out of hand by St George and the market.

In the context of the sub-prime crisis, of course, six months is a long and worrying time. For an in-market bank merger, a premium somewhere in the mid-20 per cent range is quite skinny. Westpac's Gail Kelly isn't being overly generous to her former charge.

That's partly because Westpac can afford to be parsimonious and partly because it can't afford not to be.

St George, as everyone now knows, has been made vulnerable by the sub-prime crisis. It has a lower credit rating than its major bank rivals and therefore a materially higher cost of funds. The longer that differential exists the less competitive St George will become. In that sense the Westpac bid offers St George continuing relevance and stability at the cost of its independence.

Westpac couldn't, however, shower St George shareholders with the largesse that usually accompanies bank mergers because it is proposing an integration model that differs greatly from the usual template for mergers.

The Westpac team was coy about the expected merger benefits at today's media briefing, saying only that it would be net present value positive for both sets of shareholders and earnings accretive for Westpac shareholders within three years.

The reason the deal remains dilutive until year three is the up-front costs of extracting synergies but, more particularly, the strategy of limiting cost reductions to back-office and head office functions. By maintaining the St George and BankSA brands and ruling out any net branch closures or reduction in the ATM networks, Westpac has turned its back on what is generally the core benefit of in-market bank mergers – the elimination of duplication in the distribution networks.

Where most bank mergers eventually produce savings of about 40 per cent of the cost base of the acquired bank, the acquisition of St George could be expected to generate conventional cost synergies of perhaps half that level. That would limit Westpac's capacity to pay a big price, although it would also have made the proposal far more attractive to St George's board, management and shareholders and therefore will have reduced their expectations.

The major benefit of leaving the parallel distribution networks intact is that it avoids the riskiest part of any in-market merger, the dislocation to customers and inevitable leakage of customers and revenue.

So for Westpac, the appeal of the deal is that it acquires St George relatively cheaply, lowers the integration risk, makes some savings by removing a larger proportion of the non-customer-facing aspects of St George and, by bringing its credit rating to bear on St George's funding needs, probably saves about $50 million a year on funding costs.

The funding arbitrage is not only the factor that motivated St George to embrace the offer but is one of the clear synergistic benefits that will flow from the merger.

Kelly also seems to see virtue in simple size. With the exception of Victoria, she says Westpac would become the number one bank in every state and have the largest distribution footprint in the country. It would also create a much bigger wealth management business.

The primary benefits of scale appear to be the ability to spread investment costs across a larger platform and to manufacture and distribute a broader range of products that can be distributed through the larger number of channels.

Until Westpac produces more detailed numbers on the synergies (expected in a couple of weeks), the dollar gains from scale benefits aren't quantifiable, although Westpac did say that the overall cost synergies would lead to a cost-to-income ratio for the combined bank of less than 40 per cent.

The level at which Westpac has pitched its premium and the approach it plans to take to integration probably mean that, even with the share price premium Westpac enjoys over the rest of the sector, a rival offer from a bank looking to extract more conventional synergies can't be ruled out.

The would-be partners have, however, entered "no shop", "no talk" and "no due diligence" agreements that would mean a counter-bidder would get no cooperation from St George. That's not an insurmountable obstacle – the Australian banks know each other intimately – but it does confer an advantage on Westpac, particularly as it also has Kelly, who created the modern St George, in its camp.

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