An Analysis of the Takeover of the Bank of Melbourne

An Analysis of the Takeover of the Bank of Melbourne

by Westpac Banking Corporation

Julian Buckley*

Rayna Brown*

*Centre of Financial Studies

University of Melbourne

Melbourne 3010

ph: 03 83447661

fax: 03 9349 2397

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Abstract

A striking aspect of the recent wave of bank mergers has been the lack of consensus between academics and bankers as to the benefits of such mergers. The empirical research suggests the value gains anticipated from such mergers have not been realised. Piloff and Santomero (1998) state that a new thread in the literature, which seeks to understand individual cases, may help to resolve the quandary. This paper reports a case study analysis of the 1997 acquisition of Bank of Melbourne Ltd by Westpac Banking Corporation Ltd; specifically it examines the size of the premium paid and the wealth effects of the merger.

It is found that regardless of how the pre-offer value of the equity of Bank of Melbourne is calculated, a sizeable premium over value was implicit in Westpac’s offer. However, the finding of positive abnormal returns for a value-weighted portfolio of the target and bidder companies over different event horizons, suggests that the market perceived the merger as wealth enhancing.

Acknowledgments:

The authors wish to thank Rob Brown, Kevin Davis and David Robinson for comments on earlier drafts.

Draft: May 2000

Please do not quote

An Analysis of the Takeover of the Bank of Melbourne

by Westpac Banking Corporation

1. INTRODUCTION

Over the past two decades, the financial services sector in Australia has experienced considerable regulatory and structural change. One feature of this change has been the exit of various regional and state banks.[1] In 1996, the Australian Government established the Financial System Inquiry (“the Inquiry”) to consider the impact of deregulation and make recommendations regarding future regulatory structure.

One of the principal recommendations of the Inquiry was relaxation of bank takeover laws.[2] Prior to the Inquiry, the Australian Government had a stated policy (known as the “six-pillars” policy) which prevented a merger between any of the big four banks and the two largest life assurance funds in Australia. [3] Although the Inquiry recommended the abolition of this policy,[4] the Australian Treasurer has since reaffirmed the government’s opposition to any merger between the big four banks.

The Australian Competition and Consumer Commission (ACCC) has been a long-standing advocate of retaining at least one major regional bank in each state. In Victoria, the Bank of Melbourne was the last of the regional banks, and thus under ACCC policy, it appeared unlikely that the takeover bid by Westpac would be approved. [5] The ACCC’s approval of Westpac’s bid therefore represents a significant relaxation of its previous attitude towards mergers involving regional banks.

It is likely that there will be further applications for mergers in the Australian banking sector.[6] The unprecedented level of consolidation in United States - where the number of operating banks has declined by 30% since 1990 - is said to be motivated by the belief that gains can occur through expense reduction, increased market power, reduced earnings volatility and scale and scope economies (Piloff and Santomero, 1998). For regional Australian banks mergers may also provide a degree of operating diversification[7] thereby potentially alleviating their reliance on the market conditions of a single state.

A striking aspect of the recent wave of bank mergers has been the lack of consensus between academics and practitioners as to the benefits of such mergers. There are two broad but distinct streams in the literature on mergers and acquisitions. The first relates to an examination of the motivation for undertaking mergers, traditionally considered to be either the maximisation of shareholders wealth or managerial hubris. The second involves studies to determine the wealth effects of mergers. If managers act to maximise shareholders’ wealth, then a merger can be seen as adding value to both target and acquirer through the creation of ‘synergies’ that produce economic gains and hence increase wealth. Berger et al (1998) attribute the value-maximising gains from consolidation to two possible sources: an increase in market power and hence the ability to set prices, or an increase in efficiency.

Empirical studies of bank mergers use either operating performance analysis or event studies to examine the wealth effects of mergers. Event studies are designed to capture the financial market’s expectations of the overall performance results of mergers, whereas operating performance studies focus on the ex post changes in profitability and efficiency measures due to the merger. As discussed by Piloff and Santomero (1998) and Rhoades (1994) the empirical evidence suggests that the expected efficiency gains have not been realised. In an attempt to reconcile the research findings with the empirical reality, a new thread has appeared in the literature (Piloff and Santomero,1998, p. 60). Whereas previously studies involved only large samples, an interest has emerged in understanding the processes and outcomes of individual cases.[8]

In presenting an analysis of the merger[9] between Westpac Banking Corporation Ltd[10] and Bank of Melbourne Ltd this article falls within this new thread in the literature. This paper addresses two issues. Firstly, the extent to which Westpac’s offer included a premium over firm value and secondly, the size of the wealth effects accruing to shareholders of the two banks around the announcement of the merger. An examination of the wealth effects accruing to shareholders of both firms may partially reveal managerial motives for undertaking the merger.[11] Where shareholders of the acquiring firm earn positive abnormal returns around the merger announcement date, this signals that the market expects the merger to be value-creating. Conversely, zero or negative abnormal returns to those shareholders around the announcement may be seen as a reflection that the market questions the gains from the merger. The market may believe that there are no real benefits from the merger, or perhaps that the merger was undertaken primarily in order to maximise managerial utility. It may also indicate that target shareholders gain at the expense of bidding shareholders.[12]

A better understanding of the processes and outcomes of the Westpac and Bank of Melbourne merger may assist in the decision making of regulators and shareholders in future merger proposals.

The organisation of the paper is as follows. Section 2 contains brief descriptions of the institutions involved in the case study. Section 3 provides an overview of the data sources and methodology. Section 4 reports the results of the analysis and Section 5 contains a brief conclusion.

2. INSTITUTIONS INVOLVED

2.1 Institutional Characteristics

The Bank of Melbourne was established in July 1989, following the granting of a banking licence to the RESI-Statewide Building Society. The bank was listed on the Australian Stock Exchange on 13 July 1989.

The Bank of Melbourne operated primarily as a specialist retail bank, with its branch network and operations concentrated predominantly in Victoria, although there were also branches in capital cities of various states in Australia. In May 1996, the Bank of Melbourne acquired the Victorian business of Challenge Bank from Westpac for $659.7m.[13] Following this acquisition, the Bank of Melbourne became the fourth largest regional bank, and the eighth largest of all listed banks in Australia. Immediately prior to the takeover offer by Westpac, the Bank of Melbourne had 9.6% of the Victorian lending market, 11.6% of the Victorian deposit market, and a network of 125 branches, the majority of which were located in Melbourne.[14]

As a former building society, the Bank of Melbourne’s principal business activities had traditionally been lending in the residential property market. However, increased competition within this market saw the Bank of Melbourne’s operating profit after tax and preference share dividend fall from $84.1 million (for the year ended 30 June 1996) to $78.1 million the following year.[15] The Bank of Melbourne’s interest margin fell by 0.56% to 2.74% over the same period.[16] To a large extent, the declining margins were driven by the impact of competition from mortgage originators[17] in the home-lending market. This increase in competition prompted the Bank of Melbourne to undertake a degree of diversification in its activities, primarily into the area of commercial lending.[18]

Westpac Banking Corporation is one of the four major banks in Australia, and is engaged in a variety of banking and financial services, including general banking, investment management and insurance. It consists of three general business groups: Australian Banking Group, Institutional and International Banking Group, and Australian Guarantee Corporation. As at 1st August 1997, Westpac was ranked fifth in terms of market capitalisation on the Australian Stock Exchange (Bank of Melbourne Information Memorandum 1997, p 69). Prior to making the takeover offer, Westpac acquired the Western Australian-based Challenge Bank in December 1995. The Victorian business of Challenge was sold to the Bank of Melbourne in May 1996 for $659.7m.[19]

In 1997, Westpac had 212 branches in Victoria, including a large number of rural branches; its share of the deposit market was 9.1% and its share of the lending market was 8.6%.[20] Westpac’s primary business activity in Victoria was commercial and rural lending.

2.2 The Offer

On 3rd April 1997, Westpac announced a bid to acquire 100% of the Bank of Melbourne’s issued capital. The total consideration of the bid was approximately $1.43 billion.[21] This amounted to a nominal offer of $9.75 per ordinary share, comprising a special fully franked dividend from the Bank of Melbourne of 90 cents per share,[22] coupled with the choice of either $8.85 in cash, or a combination of cash and Westpac shares.

Following the announcement of the offer, Bank of Melbourne shares traded in a range between $9.60 and $9.80. Bank of Melbourne ordinary shares had not traded in this range in the seven years since listing in 1989, to immediately prior to the announcement of Westpac’s proposal. Indeed, after reaching a peak of $9.50 in November 1996, the share price had subsequently fallen to $8.00 in February 1997, following a reduced profit announcement.[23] The price remained in the range of $8.00-$8.30 until the day before the takeover announcement.

At $9.75, the offer price represented a 19% premium over the average price of $8.22 realised in the week prior to the announcement, and a 20% premium over the closing price of ordinary shares one month prior to the announcement.

The merger had yet to be approved by the three branches of the regulatory process, the Australian Competition and Consumer Commission (ACCC), the Reserve Bank of

Australia (RBA) and the Federal Treasurer. Following extended negotiations, it was

announced on 25th July 1997 that both the RBA and the Federal Treasurer had given in principle approval to the acquisition. Further, the ACCC had ruled that the proposed merger did not contravene s 50(1) of the Trade Practices Act 1974.[24] As such, the ACCC approved the proposal, subject to certain written undertakings. Bank of Melbourne ordinary shareholders voted on the proposal on 29th September 1997, with a minimum of 75% of the vote required for acceptance of the offer; over 96% approved the takeover proposal.[25]

3. METHODOLOGY AND DATA

3.1 The Premium

The premium may be described as an enticement offered by the bidder to the target to ensure that the merger proceeds. A premium is offered in most mergers. Brown et al. (1997) report that the average bid premium paid to target shareholders in Australia is 19.7%.[26]

The methodology adopted is to measure the premium as the ratio of the offer price to the book value of the target firm. This measure is the banking industry standard in the United

States (Palia, 1993, p.93) and has been used in the majority of studies that have measured premiums in bank mergers.[27] The valuations use information contained in annual accounting statements and in consensus earnings and dividend forecasts obtained from BARCEP. The cost of capital to be used is obtained from the Independent Expert’s Report in the Bank of Melbourne Information Memorandum 1997, prepared by Grant Samuel.

Monthly share price data are obtained from the price relatives file of the Australian Graduate School of Management (AGSM) Australian share price and price relatives database. Daily stockmarket data is obtained from IRESS, with dividend adjustments made from data obtained from the AGSM price relatives database. The All Ordinaries Accumulation Index is used to proxy for the market return.

It is important to note that the size of the premium, calculated on the basis of historical cost used in accounting figures, may be distorted, since assets and liabilities are not marked to market on the balance sheet. It is tempting to dismiss this limitation, because it is industry practice to use this accounting measure, and because many of a bank’s assets and liabilities are recorded at close to market value, and are relatively short term. However, it is difficult to draw inferences regarding how accurately the market value of a bank is represented by book value, particularly with the increasing usage of off-balance sheet instruments (such as derivatives) for hedging and other purposes.

To mitigate this limitation, a number of valuations are used to determine the range within which the value of the target lay prior to the merger. In conjunction with the above accounting-based premium and the observed share price premium,[28] these valuations will provide a consensus as to whether a premium was paid.

Van Horne and Helwig (1966) suggest that only current earnings and the dividend payout ratio are significant factors in the valuation process for small bank stock. More recently, Mukherjee and Dukes (1989) conclude that other factors such as growth in earnings and risk factors may offer explanatory power in the valuation process. For this reason, the pre-offer market price is calculated using three models: a dividend discount model, a price/earnings multiple and the residual income valuation model.[29] Consideration of earnings, dividends, growth and risk factors are incorporated into the three valuation models.

3.2 Wealth Effects

The wealth effects of the merger are examined by analysing the abnormal returns received by both target and bidder shareholders around the first public announcement date of the merger. Such analysis will reveal the market’s expectations regarding the incremental effect of the merger on the wealth of shareholders of each firm. In addition, the value-weighted, consolidated sum of the abnormal returns to both bidder and target shareholders will be examined, to allow assessment of the market’s initial valuation of the single post-merger firm as opposed to that of the two separate pre-merger firms.[30]