Gail Kelly, Westpac: reshaping the big four

Euromoney magazine, October 2008

There are big entrances, and then there’s Gail Kelly. In February, she started work as chief executive of Westpac, one of the so-called Big Four banks that dominate Australia’s financial landscape. Just three months later, she struck a transformational $18 billion deal for Westpac to acquire another bank – and not just any bank, but the one she’d just left, St George. The merger will create the largest bank by market capitalisation in the Southern Hemisphere.

Clearly, Kelly likes to hit the ground running. But there are several other things that make it interesting and unusual to find her in the CEO’s corner office of Westpac’s inspirational new HQ on Sydney’s Kent Street, overlooking the old Darling Harbour wharfs. Most obviously, there’s the fact that she’s a woman: the only female chief executive of an Australian blue chip company, and arguably the only truly significant female corporate executive in the country since the departure of long-standing Qantas chair Margaret Jackson. One assumes she’s also the only mother of triplets (four children overall) to be a major bank CEO anywhere in the world.

Then there’s the fact that, despite 11 years working in Australia, her accent today is not Sydney but southern Africa: she was born in Pretoria, South Africa, in 1956, only arriving in Australia to take up a position with the Commonwealth Bank in 1997. Her banking career began not with an Aussie big four but with South Africa’s Nedcor Bank; she only became an Australian citizen in September 2001.

This mercurial rise in a foreign country has been characterised by a deep belief in the power of a brand. (It’s fitting that her first job in Australia, at the Commonwealth Bank, was as general manager of strategic marketing, and she left that bank as head of the customer service division.) Kelly doesn’t talk numbers much, or ratios, or big business: it’s about people, customers, advocacy and brands, and on this vision her Westpac tenure will stand or fall. Indeed, one could argue that Kelly is in some measure a brand herself, and there has rarely been a merger of such importance that has seemed so crucially connected to one individual.

To understand what appealed to Westpac in appointing her to replace David Morgan, it’s instructive to look at just what she did to St George during her time there. When she became CEO and managing director in 2002, St George was certainly not in trouble or badly run, but it was a little-remarked second-tier player. It was considered a likely takeover target for one of the big four lenders, with substantial shareholder National Australia Bank considered the most likely candidate when she arrived.

Instead, St George grew considerably on every measure under Kelly’s tenure: assets, profitability, market valuation and prestige. Assets more than doubled, to over A$100 billion, between her arrival and departure, and profits more than doubled too, to over A$1 billion, with return on equity climbing from 16.6% to 23.2% at a time when the cost to income ratio declined. St George boasted double digit earnings per share growth in every year under Kelly’s watch. Business banking and wealth management enjoyed especial improvement.

In particular, Kelly worked hard to position St George as a community-based bank – its roots were as a building society – with customer satisfaction levels higher than its bigger peers. (The research group Roy Morgan put customer satisfaction at over 80% by the time of her departure.) But, while appearing local, it also became a viable national alternative to the big guys, capitalising on the increasingly noxious individual sentiment towards the big four and suggesting a more personal and reliable experience was available elsewhere. A popular advert during Kelly’s time used to depict someone at a barbecue being asked what he does for a living. When he says he’s a banker, there’s a horrible silence and everything stops. When he says the bank is St George, everyone is relieved and carries on again.

So when Westpac decided on Kelly last August, she had made St George more or less impregnable to takeover. The irony is that, by the time she turned up for work at Westpac six months later, the global credit market had changed so dramatically that it was back in play – by now to her benefit.

It’s unlikely that, back in August, with the Australian stock markets still enjoying a multi-year bull run and the banks in their best ever condition, Westpac’s board settled on Kelly in the hope or belief that she could effect the takeover. Instead, they probably hoped for two things.

One was to continue the excellent work done at Westpac by David Morgan, a 17-year veteran of the bank who spent nine of them as CEO. It is hard now to recall just what a mess Westpac used to be: the A$1.6 billion loss it logged in 1992 was at the time the worst ever recorded by any Australian corporation, and it required widespread redundancies and a dip into company superannuation (as pensions are called in Australia) to keep the place viable. The acrimony of the AGMs around that time remain the stuff of legend.

Morgan brought to the top job a certain Friends-Romans-Countrymen bombast, a master of the rhetorical flourish at press conferences, but in fact he was broadly conservative in his approach, and the fact that Westpac has come out of sub-prime and the credit crunch in better shape than any other major Australian bank so far is to Morgan’s credit. Impaired assets represented just 0.25% of total committed exposure in the third quarter and that result disclosed no new troubled assets, unlike any of the other three major banks.

Under Morgan’s watch the bank undertook a number of important acquisitions and grew dramatically in wealth management, which has been the holy grail of Australian banking in the decade to date. In August, in a market update, Kelly was able to predict 6-8% cash earnings growth for the 2008 financial year and revenue growth of 8-9%, an enviable situation for any bank CEO in this environment and a particularly good one to inherit now. “They are certainly in a far more solid state than any of the other banks in Australia,” says Peter Vann, a portfolio manager at Constellation Asset Management in Sydney.

The other aspiration in appointing Kelly was no doubt to make Westpac loved again. All Australian banks have tried to reinvent themselves in a more cuddly image in recent years – the Commonwealth Bank in particular has spent a fortune on rebranding itself – but it would be hard to say any have really succeeded. More than anything, Kelly offers the prospect of truly getting through to the customer again.

“I’m someone who is a big believer in the power of brands, the power of distribution,” she tells Euromoney. “That’s where banks need to focus a whole lot more, and to strengthen and empower their touch points with the customers. It’s driven by a vision of transforming the way customers experience financial services within Australia; it’s driven by a vision of seeking to earn all of our customers’ business, to really deepen relationships with customers in a very fundamental way.”

This is a characteristic Kelly response: in half an hour of discussion she uses the word “vision” 12 times and “brand” 15. Another keyword is advocacy. “Within Australia, customers have traditionally not had a high regard for banks, and particularly major banks,” she says. “I have a vision of turning that round and having customers who become advocates for the brand and suite of products we have within Westpac, who are delighted by the support and advice that they receive from their bank. They feel their bank is actually working with them, and is a partner with them and has a deep relationship with them and is seeking to help them actually fulfil their life goals.”

This might seem like hot air if she hadn’t already made it work once. An engaging people person – she is certainly the only bank executive to compliment Euromoney’s correspondent on his tie in the last 15 years – the zest of her delivery can occasionally invite cynicism. “There’s a lot of polish, and you have to get past that to see what’s behind it,” says Vann. But he, like many others, has done so only to find that there’s substance behind the appearance, and he is very positive on the merger.

The big question, though, is whether Kelly’s success at St George can be replicated on the bigger stage of a big four bank – and in particular whether St George can keep its appeal when subsumed into that bank. In some measure, St George thrived on its underdog, alternative, community status: that, surely, can’t be reproduced in a bank of Westpac’s scale?

Kelly thinks she can pull this off because of the way the merger will be conducted. Unusually, there will be almost no evidence of a merger at the front end. She has pledged that even if a Westpac and St George branch happen to sit next to each other, neither will be closed; they’ll continue as they were in order to ensure continuity of experience for the customer. “We’re not going to be positioning ourselves to the St George customer as the big Westpac with the little St George subsidiary,” she says. “St George is an alternative, it’s a fighting brand, a people focused-brand, a community-focused brand. We want to retain that. We might even build that distinctiveness even further.”

This is a big claim, particularly coming from Westpac. In 1997 it acquired Bank of Melbourne, keeping the rights to the name and logo and pledging at the time to retain the brand; instead, the name has long since disappeared completely. Kelly brings this up herself. “There’s a level of not surprising cynicism you have in a marketplace, questioning that Westpac’s said this before,” she says. “There’s that kind of commentary that you can’t really be serious that you’ll keep two branches even if they are alongside each other. But I believe in the power of brands and I believe they do stand for different things.”

Besides, she can claim that St George has managed to keep a differentiated brand within its group, with Bank SA, a South Australian enterprise. “Most Bank SA customers wouldn’t have any idea that the bank is actually owned by St George,” she says. “They see it as Bank SA. That’s who they deal with.” And this is the theory of the Westpac-St George merger: that the synergies behind the scenes, in IT and other back office areas, will remove the need to merge the front end too.

But one could argue that Kelly wants to have her cake and eat it here. The merger documents call for a 20-25% saving of the St George cost base in the next two to three years, without a single branch closure. Achieving this ambitious double-act is predicated on an eye-catching projection: that the merger will cause no more than 5% customer attrition.

Challenged on this, Kelly is convinced she’s right. “My hope, the plan, is less than five per cent,” she says. “My hope is actually none at all.” That is not how bank mergers typically go (although Westpac likes to refer to the Royal Bank of Scotland/NatWest merger in 2000, which apparently did have a less than 5% attrition rate), but then bank mergers rarely look like this. “We are setting it up from day one to say everything you experience in your current relationship with St George will be maintained, plus more.” Besides, she says, the cost numbers are not aggressive. “Traditional mergers could get anywhere up to 40% of the target’s cost base. 20 to 25 is actually quite a modest target relative to traditional targets.” If she gets the reduction she wants that will already equate to about A$340 million, not just through IT but things like combining the human resources, risk, finance and marketing functions for the group. A significant advantage, and especially relevant with the state of today’s credit markets, is that St George’s single-A credit rating would be replaced by Westpac’s AA, giving it cheaper funding in the capital markets.

What’s striking about this merger is how much its success is perceived to be reliant on one individual. It’s not over the line yet: although St George and Westpac signed a merger planning agreement on May 13, and a merger implementation agreement on May 16, it is only this month [OCTOBER] that a scheme booklet containing full details of the proposed deal is arriving on the doorsteps of St George shareholders, who will then vote in early November.

Whether they vote in the affirmative is seen as having a great deal to do with the trust that Kelly built up among that constituency when she was St George CEO. “She is very level headed and friendly, and goes out of her way to accommodate shareholders and find out what they think,” Peter Morgan, founder of 452 Capital, one of Australia’s most powerful boutique fund managers, told the author when Kelly was still at St George. “She has produced that results that have effectively saved the company from being gobbled up, without resorting to silly acquisitions.”

Kelly describes her unusual status in this deal as “a unique set of circumstances,” and its timing as “just a confluence of events. Every single major bank, and Westpac absolutely amongst them, has had files on St George. St George has been an attractive acquisition opportunity for Westpac for a long period of time and I’ve no doubt that that’s the case with other major banks as well.” A year or so ago, valuations made such a pitch a big stretch for any of the big four, but things have changed. “I was appointed to Westpac in August last year, and it was a very different environment at that point…. I kicked off in February, and one goes into the files again and dusts them off and says: do any of these opportunities that we’ve looked at in the past now make more sense because of what’s happening globally?”

The deal itself was struck on scrip, with an offer of 1.31 Westpac shares for every St George share. The pros and cons of this arrangement for St George shareholders have drifted and wobbled with market gyrations since May. Initial calculations were based on the Westpac closing price on May 9, at which point if both companies’ interim dividends were counted out, it represented a 28.5% premium for St George shareholders. By early September, though, that premium had almost completely eroded: although Westpac, after losing almost a quarter of its value between May and July, was by the time of writing almost back to the same level as at the time of the bid, St George has moved up over 25%, almost exactly the same as the initial premium.

Investors will therefore have to make a call on whether Kelly’s charisma and track record are enough to make them go with the deal despite the diminished financial appeal.

Analysts by and large seem to think it a no-brainer. “We expect even the most stalwart bears on bank M&A will see the merits of the deal as it becomes increasing obvious the financial and operational outcomes of this merger will be unlike any other bank deal in the last two decades,” wrote Macquarie analyst Tom Quarmby in August. Deutsche’s Ross Brown is less impressed, writing: “We find that whilst banks almost without exception deliver on their cost saving targets, often it is achieved at the expense of organic productivity improvements, as resources are diverted to integrating the acquired bank.” Consequently he doubts the revenue synergies will come through as quickly as Westpac predicts.

Shareholder opinion is always difficult to gauge, but if anything the clinching factor is likely to be St George’s uncertain funding outlook in the continuing credit crunch (although a A$1.05 billion mortgage-backed capital raising in early September, which took care of 40% of the bank’s funding needs for fiscal 2009, suggests it is doing fine so far). Lacking the depositor bases of the big four, St George relied on wholesale credit markets to fund its outstanding loan growth in the earlier years of this decade, and it’s going to be much more costly to use those markets for funding for the foreseeable future. JP Morgan’s banking analyst Brian Johnson has noted how St George has “significantly shortened the duration of its debt funding profile over the course of 2008,” perhaps in the expectation that when it needs to raise longer term funds to take the shorter debt out, it will be as higher-rated Westpac. If the deal didn’t go through, Johnson said, “the new term debt requirement for [St George] may prove problematic for a single-A rated bank.”

If shareholders do go with Kelly, then on November 24 the shares of a new banking heavyweight will begin trading. “The mandate I came in on, the explicit mandate from the board, is to drive a customer service agenda,” she says. “To take a major bank and drive that agenda, to have customers who are advocates for their bank and delighted by their bank, that’s a huge challenge. And I’m up for that challenge.”

BOX

What sort of bank will the merged Westpac and St George be?

It will have 10 million customers, which is roughly half of Australia’s entire population. Crucially, it will have Westpac’s AA rating, rather than St George’s A. At the time of the merger announcement the merged bank was envisaged as having a combined market capitalisation of A$66 billion, although a significant improvement in the St George share price since then had increased that figure at the time of writing.

The combined bank will be Australia’s leading home lender, with a 25% market share; the leading overall lender, and the leading credit card provider. It will also be the largest wealth platform provider with A$108 billion of funds under administration. It will have 1200 branches and 2700 ATMs, A$408 billion in loans and $299 billion of deposits, based on March 31 figures. According to data from the Australian Prudential Regulatory Authority, also from March, the combined bank won’t be a leader in every field though: in corporate lending it will still lag National Australia Bank and ANZ, while it will trail Commonwealth Bank of Australia in household deposits.

Looking at the bank capital, Westpac had a pro-forma tier one ratio of 7.7% in the first half of 2008, with a recent investor presentation suggesting the post-merger capital position should be “at a similar level”.

The group will have a range of brands. Apart from the Westpac and St George banking names, there will also be a South Australian group, BankSA, that was part of St George; and RAMS, a home lending brand purchased by Westpac in January this year.

Both institutions have significant wealth management businesses: in Westpac’s case BT (which was itself formed from a three-way merger involving elements of BT, Westpac and Rothschild businesses), and in St George’s case Asgard. These, in turn, involve a host of other entities: St George’s product manufacturing division, called Advance; its distribution and advice network, called Securitor; and a financial planning arm under Westpac called Magnitude. The administration platforms Asgard and BT Wrap are two of the biggest in Australia, serving the more than A$1 trillion Australian investment management industry; it is perhaps little surprise that this was the one area the ACCC asked for more information on in giving a tentative thumbs up to the deal in late July.

One of the few visible areas of combination will be on the institutional side, where the business will be combined under the Westpac name with common infrastructure.

At a management level it will look rather more like Westpac than St George, notwithstanding the fact that it will be run by someone who has been CEO of both. St George, whose shareholders will own 28.1% of the combined group, will put three of its directors onto the Westpac board, including St George chairman John Curtis who becomes the new deputy chairman.

Westpac reckons the deal will be cash earnings per share accretive for St George shareholders from the first full year of the merger, and for Westpac from the third. Merger documents allow for $700 million in integration and transition costs over two years, but ultimately expect pre-tax savings equivalent to 20-25% of the St George cost base by 2011. As discussed in the main piece, the assumption for revenue attrition – from customers walking off because they don’t like the merger – is just 5% or less.