Westpac: bigger but no better value

PORTFOLIO POINT: Swallowing St George will certainly make Westpac much bigger, but it adds no value to shareholders.
The merger between Westpac (WBC) and St George Bank (SGB) was approved on November 13 with 95% of St George shareholders agreeing to the merger. The merged Westpac and St George, which will begin trading on the ASX on December 1, is likely to overtake the Commonwealth Bank (CBA) as Australia’s largest financial intermediary.

Under the merger, St George shareholders will receive 1.31 Westpac shares for every St George share they hold. The real question on December 1 is what will Westpac look like after absorbing St George? And what is a reasonable estimate of what the company’s shares will be worth?

Assumptions

Before estimating what the combined group will be worth on a per-share basis and how Westpac will look after the merger with St George, we have made the following assumptions.

The first is the actual conversion price. While we know the conversion ratio has been set at 1.31, if we assume at the time of conversion Westpac shares are trading at $20, Table 1 shows the total number of shares outstanding pre and post the merger. With these figures, we can calculate the actual price Westpac has paid for St George.

1 There were 566.5 million St George shares. At a conversion ratio of 1.31 Westpac shares for each
St George share (566.6 million x 1.31), it is estimated that 742.2 million new Westpac shares will be
issued under the merger, valuing St George at $14.844 billion.

As shown, Westpac management will have paid about $14.84 billion for St George and issued about 742.2 million new shares. Based on Westpac having 1894.8 million shares prior to the merger, the number of shares will balloon to 2637 billion for the merged group.

The second assumption we have made is what Westpac will potentially earn in 2009. Based on current external research that combines forecast earnings for Westpac and St George adjusted for integration expenses and synergies, consensus analysts are forecasting a 2009 NPAT of $4,751 million.

The third assumption to be made is how much shareholders will receive in 2009 as a dividend. Westpac stated in its Scheme Booklet that it intends to maintain a dividend payout of 70%.

If we have a forecasted NPAT of $4751 million in 2009, a 70% payout ratio would see the merged group distribute about $3325 million to shareholders in 2009.

The final assumption to be made is how much capital will be raised and how many new shares will be issued as part of the business’ ongoing dividend reinvestment plan (DRP).

Westpac’s 2008 annual report shows that 27% of shareholders participated in the bank’s DRP. Assuming a similar level of participation in the dividend reinvestment plan in 2008-09, $897.8 million of new capital will be raised. If we assume a reinvestment price of $20 per share, a further 44.9 million shares will be issued.

Based on the above assumptions, in 2009 we estimate a total amount of $15,741.8 million in new capital will be raised and 787.1 million new ordinary shares issued. These totals are shown in Table 2.

Westpac and St George post merger

The aim of most mergers is to extract efficiencies, increase profits and create value for shareholders, ultimately resulting in either a rising share price or increased distributions of income, or both.

What will the merger deliver?

We can see from the one-year forecast (Column '2009F’ in Table 3) under new ordinary share capital that Westpac paid $14,844 million for St George, raised an additional $897.8 million through the DRP (total $15,741.8) and we estimate will retain a further $1426 million in after-tax profits – a total of $17,167.8 billion in new capital. In return, consensus analysts are forecasting an incremental increase in profits of $892 million or a low 5.2% return on equity. Note that this is approximately what investors can obtain from the very online bank accounts both Westpac and St George provide risk-free with government guarantees!

Shareholders’ equity is estimated to increase from $17,848 million to $35,015.8 million in 2008-09 – an almost doubling in the business’ equity base. With this dramatic increase in equity and such a low return on incremental capital, underlying profitability (NROE) is forecast to fall to 24%.

Looking further into the future, from the end of 2007 to 2010, current consensus NPAT is estimated to increase by $1.3 billion (from $3451 billion to $5398 billion). This estimated incremental return is representative of the expected merger synergies and future growth in the underlying businesses. While an additional $1.9 billion dollars sounds like a fantastic outcome, it would surprise most to find that we estimate Westpac will require $19.8 billion in order to produce this additional profit. As a shareholder, would you be happy with a 9.6% return on incremental equity?

It should therefore not surprise investors to see that the fall in profitability is even more pronounced in 2009-10. Table 4 illustrates underlying business performance (NROE) is expected to decline to 19.8% and we estimate the business to be worth about $22.07 per share, or about $19.50 in today’s terms.

Rationale of merger

While we post some sobering figures here, the merging of Westpac and St George will undoubtedly deliver benefits.

Westpac will be able to offer a broader range of products and services to a larger customer base through a combined distribution system. Its capabilities in wealth, insurance and institutional banking will be enhanced.

Following the merger, Westpac is expected to maintain its AA credit rating. Hence, the St George business is able to obtain wholesale term funding at a lower cost.

Shareholders will benefit from the increased scale of the combined business, which could lead to reduced operating costs through greater economies of scale. The combined business will have Australia’s largest branch network, Australia’s second-largest ATM network and be Australia’s largest provider of wealth platforms by funds under administration.

Westpac expects pre-tax savings to be approximately 20–25% of St George’s total operating expenses by the third year after completion of the merger. This equates to approximately $273.6–346.5 million. These synergies will be achieved through combining support functions and product processing operations, and combination of head offices, procurement and service contract savings.

To obtain these synergies however, the business will incur approximately $700 million of integration costs and plans exist to cut about one-quarter of St George’s cost base, with union estimates of up to 5000 job losses from back office and corporate office areas of both banks. Westpac’s deposit base will be boosted by the addition of St George. Deposits as a funding source have become important given the current credit crisis. This is vital in funding future asset growth.

Westpac aims to minimise loss of market share by not reducing ATM and branch numbers and retaining the St George brand for consumer and business banking.

In fact, the merger has come with some strict conditions from Treasurer Wayne Swan. Westpac is required to maintain the existing number of Westpac and St George branches and ATMs. It must also retain all Westpac and St George retail banking brands, including Bank SA, maintain dedicated management teams for St George and Westpac retail banking distribution, and retain a corporate presence in the southern Sydney suburb of Kogarah.

The merged group will have about:

• 10 million customers.
• More than 2700 ATMs.
• 1200 branches.

It will become Australia’s largest financial intermediary amongst the four pillars.

Risks of the merger

A risk presented by the merger is a potential decrease in the merged group’s Tier 1 capital adequacy ratio compared to Westpac on a stand-alone basis. St George has $1.2 billion of hybrid equity instruments, forming part of its Tier 1 capital, which will be redeemed by Westpac on implementation of the merger. Based on external research, assuming that Westpac does not issue replacement hybrid instruments, the Tier 1 capital adequacy ratio could fall to 7.25%, below the 7.8% reported in its 2008 annual report.

Budgeted synergies may not be realised, or the realisation may be delayed. Risks include unexpected costs or difficulties to integrate the information technology platforms, consolidation of head office and back office functions and higher than expected levels of customer attrition.

The credit rating of the merged group may be downgraded. If this occurs, the cost of wholesale term funding will increase.

Summary

While the merged entity will have a larger balance sheet and capital base, as well as broader access to funding markets making it better placed to withstand systemic shocks, this analysis at least gives us a feel for how the business will look.

Due to declining economic performance, the value of Westpac shares does not rise substantially in the next two years. Indeed, the increase in intrinsic value is not better than might occur for Westpac without merging.

Although the final merged entity represents one of the largest changes to the Australian financial sector for decades, it does not appear to immediately offer shareholders value-add.

Russell Muldoon is a senior analyst with Clime Investment Management.