Westpac: back the acquirer

Many of you will know I have struggled to recommend Westpac since my finger got stuck in the security door of the Rose Bay branch of the Bank of New South Wales when I was three years old. Thirty two years later I have just about got over that trauma but I still have the scars to remind of "closing time" at Westpac.

With petrol prices skyrocketing and being the owner of two V8 cars I have decided to catch the train to work a few days a week. It's actually quite good fun for the one stop I am on the train. On the way to Edgecliff Station I walk past a shopping centre. At the front of the shopping centre there is a Westpac branch and less than 50 metres away a St George branch. Both have ATMs and both look as appealing as each other to the potential customer. Of course, having a mind that is never truly switched off from the stockmarket, I couldn't help but think after seeing this that the Westpac/St George merger made sense and there must be some way of making money out of it.

Only two days before Westpac's bid I had recommended shorting St George because I thought the result was horrible and the capital position inadequate. I thought consensus earnings risks were clearly to the downside. The stock looked sick and I never foresaw another bank lobbing a bid for St George in the near term. However, it shows I'm no insider and without trying to justify a wrong call the fact the St George board recommended the Westpac deal so quickly perhaps suggests I was right about St George's capital position and near-term earnings outlook.

The scoreboard now reads Westpac 2, Charlie 0. They got me with the branch security door and they got me on the St George short campaign.

After being caught on the wrong side of St George, I was wondering how I should approach this transaction from here? What is the low risk way of getting involved in the biggest bank deal in Australian history and generating some index-beating returns? The answer is buying the discounted scrip of the acquirer, Westpac.

Buying the acquirer strategy

I have had quite a degree of success playing these giant merger deals via buying the discounted shares of the acquirer. In the Wesfarmers/Coles Myer deal I recommended Wesfarmers as the low-risk entry into the deal, while I have consistently recommended BHP as the low-risk way of playing the BHP/Rio deal. Both those strategies have worked well.

My thinking is that the acquirer, particularly if they are using scrip, is usually heavily discounted by risk arbitrage players who short the acquirer and go long the acquired. Local long-only funds also sell the acquirer because they think the stock will underperform the index during the merger process and its machinations.

At the right discounted acquirer entry price, I see these as "heads you win, tails you win" situations. This has worked particularly well in BHP and it will work in Westpac.

BHP/Rio, the playbook on Westpac/St George

I think the BHP/Rio playbook is the playbook for Westpac/St George. However, Westpac has one significant advantage over BHP in that the St George board has recommended the deal. Westpac also has fewer potential regulatory issues, in my view. That means this strategy of buying discounted acquirer scrip is even lower real risk.

In the early stages of all-scrip based takeovers the risk arbitrage funds take control of the scrip of the acquirer and the acquired. The target usually trades at a premium to the offer, be that offer recommended or not, on hope that another player will enter the bidding or the current offer will be sweetened. Risk arbitrage funds seem to be happy to pay 5% over the offer to buy a seat at the table. This is exactly what happened in the first few weeks of the BHP/Rio bid.

Also, in the early stages all the analysts who never predicted the takeover all come up with "what if" scenarios about who could pay more or who can spoil the deal. Look, I am not in a position of strength either on that basis, but you won't see me writing fanciful "what ifs" about who could pay more. The analysts will also focus on the lack of "break fee” and how it is easy for another player to enter the fray. Institutional shareholders of the target will go public on the "inadequacy" of the offer.

The financial press will also get involved with their view of the next developments and the premium to the offer will remain for the first two months. However, the highest premium is usually in the first few weeks. After that, the "instant gratificationists" get bored and move on to another trade.

News from the companies involved will be limited as they seek regulatory approval and the deal will start going quiet; particularly if no other player shows interest. Time starts working in the favour of the acquirer and the premium to the offer will narrow again as the risk arbitrage funds reassess the upside in the trade and the funding costs of having it on. This is exactly what has happened in BHP/Rio. While Westpac/St George is a shorter-dated event than BHP/Rio, it is worth remembering that Westpac/St George will drag on for about six months before shareholders get to vote on the scheme of arrangement. There should be no doubt that time is the friend of the acquirer and the enemy of risk arbitrage funds.

As we get closer to the scheme’s voting date, the market ratio will move to parity or below the offer price. The risk arbitrage funds will get nervous about the deal getting voted through. You can see the BHP/Rio deal is now trading at a 7.5% discount to the offer, which roughly equates to the funding cost of holding the trade until March next year, when it gets voted on.

This "heads you win, tails you win" strategy in the acquirer's scrip is based on the fact the shares should appreciate if the acquirer is successful on the terms they have offered and the fact the shares should rally if for some reason (regulatory, etc) that the acquirer is unsuccessful in their bid. It's also based on the fact that a successful deal will see the market focus on the "new" index weight of "mergeco". However, the whole strategy revolves around buying the acquirer's shares at the right price on a standalone basis. The acquirer's shares have to be cheap on a standalone basis. We are not buying the acquirer’s shares on any view of synergies or upside from the transaction. That, and the index weight uplift, is the "cream" on the cake if the deal is completed.

In the BHP/Rio deal we solely focused on BHP as a standalone investment proposition. That strategy has worked very well and I believe it will also work well in this Westpac/St George transaction. Not only has BHP risen strongly in absolute terms, it has also outperformed Rio by 10%. This could easily also occur in this Westpac example from these low share prices.

Westpac, standalone value

On today's prices Westpac is cheap as a standalone investment. It is trading on a 2007-08 price/earnings (P/E) multiple of about 11.3 times and dividend yield of about 6.3%. On 2008-09, where there may be relative anaemic growth of 5% for Westpac, the stock is on a P/E of about 10.7 times and dividend yield of about 6.7%. The return on equity is 23% in both years. Whatever you think of banks or the NSW economy, you can hardly say on a forward P/E of 10 times and prospective dividend yield of 6.7% that Westpac is expensive.

The stock has been de-rated with the sector then de-rated again for the St George bid by risk arbitrage funds. In effect you are buying a discount to a discount. It appears wholesale funding costs have peaked and paying a 10 times multiple for a stock that is fundamental to the growth of the Australian economy is not a demanding multiple. You are also clearly paying nothing for chief executive Gail Kelly's skill. In fact, you are getting her thrown in for free in the current P/E.

I don't think there's too much debate about the current value in Westpac scrip. I have not seen one analyst or fund manager describe Westpac at current prices as "expensive". The consensus is that the stock is cheap. That is the right view as a standalone investment proposition. In my view there should be an easy 15% "total return" generated over the next 12 months in Westpac shares from these prices as a standalone investment. It's easy to see 10% capital growth and a minimum 5% yield over the next 12 months. It's not hard to envisage Westpac shares being $2 higher than today's prices, but we all forget that nowadays that is a 10% gain. A 15% total return over the next 12 months will beat the broader industrial market.

"Mergeco": the cream

Now let's look at "mergeco" and see what extra upside there is in Westpac shares. Let's explore the potential for cream on the cake. In my view there is substantial amount of cream if this deal is successful.

Firstly, the Westpac/St George merger will create the largest financial services player in the country, with 10 million customers, 1200 branches, 2700 ATMs and scale to match almost all banking segments and the series of charts below emphasise.

Changing the sector landscape in a single transaction

Westpac appears to have quickly seized the opportunity given St George's weak interim profit and relative share price. Westpac believes the merger of the two companies will result in a stronger balance sheet that will mitigate operational and market risks, provide greater access to funding and position the financial services platform for further opportunities created by the dislocation in capital markets.

St George's strategic attributes include superior service culture and branch productivity, strategic growth options in Queensland and Western Australia, leadership position in the middle market segment and significant wealth capability, bringing a further $38 billion in funds under administration.

It's worth noting that the deal will create the 18th largest bank in the world. The combined ASX200 index weight would also be a significant at 5.25%. In index weight terms, Westpac/St George would overtake Commonwealth Bank and become Australia's second-largest index weight stock. I highly doubt that Australian fund managers are at the combined index weight in "mergeco", and that is a point worth remembering.

Significant value creation

Bulk of cost savings to come from middle and back office. My estimates indicate Westpac will be able to extract substantial cost synergies from the proposed merger. This is despite the latter's already low cost ratio and the undertaking by Westpac not to reduce branch or ATM numbers in net terms. Westpac's ability to extract value is largely due to the redundant St George head offices in the CBD and Kogarah, and duplication in the middle and back office functions (that is, Operations & Processing and Support) of both banks, which account for about 41% of combined costs.

Westpac could extract 40% of St George's cost base. Recent experiences in integrating banking operations (Commonwealth Bank and State Bank NSW, Bank of Queensland and Home) suggest functional cost synergies will arise as follows:

• 80% of Operations & Processing costs (based on savings in IT, communications, procurement and workflow process redesign especially within Westpac's mortgage processing centre);
• 85% of Support costs (mainly head office); and
• Only 10% of Frontline costs (limited to CBD branch overlaps and rolling out best-of-breed delivery channels).

$450 million pre-tax cost savings possible

This implies Westpac could extract 40% of St George's cost base (compared with Commonwealth’s 58% before the effects of 2–5% customer leakage, and Bank of Queensland's 40% with no leakage). This is a reasonable outcome when assessed against the cost base of its business segments; that works out to be roughly 44% of the retail bank and 75% of institutional and business banking (after allocating centre costs). Total synergies, including savings on funding costs, should add about $450 million to pre-tax earnings. At the agreed price of about $32, the transaction is expected to be earnings per share accretive within three years of merger completion. Including cost synergies from St George, the transaction value appears substantial in light of the post-merger P/E multiple of under 10 times.

Portfolio effect to reduce required capital for non-credit risks. While unquantified at this stage, there is additional benefit to be derived from the capital adequacy front. Putting the two banks together increases the surplus amount of capital allocated to market, operational and other non-credit risks. Risk assessment on a portfolio basis suggests some capital will be freed up from the proposed merger.

Intimate knowledge of SGB and the integration process

Westpac knows the intrinsic value of its acquisition. I am confident Westpac will be able to quickly build an IT bridge between the two companies and integrate the respective operations within two or three years. In addition to Gail Kelly's intimate knowledge of St George, Westpac should also benefit from the experiences of Peter Clare (head of Consumer Financial Services) who was responsible for integrating Commonwealth Bank's Colonial acquisition.

Additional synergies from up-streaming SGB capabilities

St George experiences to benefit Westpac as well. Providing the brand and operational independence of St George are retained, there is every reason to believe Westpac will benefit substantially from the acquisition of the smaller bank. This is similar to Commonwealth Bank's relationship with its subsidiary ASB, where the upstream transfer of capability in retail banking operations (such as cost management, customer retention and cross-sell) has created substantial value for the parent bank.

The up-streaming process in this case will represent a form of culture change that should greatly rejuvenate Westpac.

Cost saving opportunities within Westpac

Revitalised cost culture to add $400 million in value. There are cost improvement techniques that could be migrated from St George to benefit Westpac's bottom line.

These include increasing the efficiency of its Adelaide mortgage processing centre and ancillary functions in procurement, cash management and workflow processes. Assuming a 25% success rate in closing the cost gap between the two banks amidst the integration process, the value to Westpac is estimated at $400 million.

Reducing retail banking churn

Increased retail customer stickiness to add $580 million in value. Under Kelly's leadership, St George reduced its home loan customer churn rate by 1000 basis points to 16% over six years. This is the equivalent of increasing customer tenure by nearly three years, saving on origination costs and improving balances at the same time. I estimate each half-year improvement in home loan customer tenure will result in $8 million of origination costs saved. The improvement in retaining retail customers should increase value by $580 million.

Reducing business banking churn

Increased business customer stickiness to add $1200 million in value. Similar to the retail business, a lower churn in business banking adds to revenue growth through higher balances and reduces origination costs that would have been necessary to make up for lost business. Westpac's churn rate in this segment is about 18%, compared with St George’s 4%. Given a 50% probability of success, the migration of this expertise to Westpac could retain up to $8 billion in business loans over three to five years and add $1200 million to value.

"Mergco" price target $30 over 24 months

My $30"mergeco" 24-month price target is net of expected transaction costs and undertakings, and includes the effect of dilution from the scrip bid (715 million new shares to be issued). It suggests that a large proportion of the value will come from synergies: efficiency and productivity gains from both banks. The price target is further supported by prospects of future participation in sector consolidation, both here and overseas (given its global scale).

Deal breaking risk minimal

A counter-bid is unlikely. The greatest risk facing Westpac strategically, but not a risk to its share price, is a counter-bid by a major bank. However, this appears unlikely given the different strategic directions being pursued by these banks at present:

• ANZ could be ruled out given its preferred strategy of becoming a super regional bank and objective of increasing its Asian earnings to 20% of the group total by 2012;
• Commonwealth Bank is also considered a less likely bidder given it has already invested heavily in infrastructure, service and sales. To pursue St George at this time would suggest its retail banking strategy may not be as effective as it should be (however, I would expect Commonwealth Bank to capitalise on any disruption during the integration phase and cherry-pick the dissatisfied customers); and
• While acquisitive NAB is capable of pulling a few surprises, I believe it will remain focused on banking (particularly agribusiness) and wealth management in developed countries.

"Head em up"

Westpac at current prices is a classic "heads you win, tails you win" proposition. I think absolute downside is extremely limited and upside ranges from 15% over the next 12 months as a standalone entity, up to around 35% total return over 24 months when it is successful in its St George bid. The time is right to buy Westpac shares from risk arbitrage shorters. Buying the acquirer's discounted scrip is working well in these situations and it will work again in Westpac. Westpac/St George will truly become the “Bank of New South Wales” again. I think there is significantly more upside in Westpac’s shares than St George’s shares from current prices.

In a market where we are struggling to find large-cap industrial ideas, Westpac is a low risk buy.

Charlie Aitken, a director of Southern Cross Equities, may have interests in any of the stocks mentioned.