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Cullen/Frost Bankers, Inc. (NYSE:CFR)

Q3 2012 Earnings Call

October 24, 2012 11:00 am ET

Executives

Greg Parker, Executive Vice President and Director of Investor Relations

Richard W. (DICK) Evans – Chairman & Chief Executive Officer/Director

Phillip D. Green – Group Executive Vice President & Chief Financial Officer

Analysts

Brady Gailey – Keefe, Bruyette & Woods

Steven Alexopoulos – J.P. Morgan Securities Inc.

John Pancari – Evercore Partners

Brett Rabatin – Sterne, Agee & Leach

Emlen Harmon – Jefferies & Co.

John Helfst – Schroder Investment Management

Matthew Keating - Barclays Capital, Inc.

Operator

Good morning. My name is Sara, and I will be your conference operator today. At this time, I would like to welcome everyone to the Cullen/Frost Bankers Third Quarter Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. (Operator Instructions) Thank you, Mr. Greg Parker. You may begin your conference.

Greg Parker

Thank you. This morning’s conference call will be led by Dick Evans, Chairman and CEO; and Phil Green, Group Executive Vice President and CFO. Before I turn the call over to Dick and Phil, I need to take a moment to address the Safe Harbor Provisions.

Some of the remarks made today will constitute forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995 as amended. We intend such statements to be covered by the Safe Harbor Provisions for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995 as amended. Please see the last page in the text in this morning’s earnings release for additional information about the risk factors associated with these forward-looking statements. If needed, a copy of the release is available at our website or by calling the Investor Relations department at 210-220-5632..

At this time, I’ll turn the call over to Dick.

Richard W. Evans

Thank you, Greg. Good morning, and thanks for joining us. It’s my pleasure today to review Cullen/Frost’s 2012 third quarter results. Our Chief Financial Officer, Phil Green, will then provide additional comments, after that we will be happy to answer your questions.

I’m pleased to report another solid quarter for Cullen/Frost. Highlights include a 7.6% increase in net income, a 7.5% increase in average loans, new customer relationships that drove the 13.1% increase in deposits and continued credit quality improvement. This quarter’s earnings reflect our ability to operate effectively despite ongoing economic, regulatory, and low interest rate challenges.

We are grateful to our dedicated employees and our loyal customers for another solid quarter.

Our net income for the third quarter of 2012 was $58.7 million, or 7.6% over the $54.5 million reported in the third quarter of 2011. On a per share basis, we reported $0.95 a share versus $0.89 during the third quarter last year. Third quarter returns on average assets and equity were 1.11% and 9.75% respectively.

Deposits continue to grow significantly. For the quarter ended September 30, 2012, average deposits were $17.5 billion, up $2 billion, or 13.1% over the $15.4 billion reported in the third quarter of last year. Throughout the recession, we have focused on building new relationships. Those new relationships account for much of our deposit growth and are the foundation for the future growth, especially as their economy recovers.

Net interest income for the third quarter of 2012 was $167.3 million compared to $160.6 million in the third quarter of last year. This is primarily related to an increase in average volume of interest earning assets and was partly offset by a decrease in net interest margin to 3.54%.

Non-interest income for the third quarter of 2012 was $71.2 million compared to $79.2 million a year ago. The difference was driven by two primary factors, a $6.4 million pre-tax gain on municipal securities in the third quarter of 2011 and a $4.5 million revenue decline in interchange and debit card transaction fees due to the Durbin amendment to the Dodd-Frank Law. Trust and investment fees were up $1.2 million from the third quarter of 2011, while insurance commissions and fees increased $395,000.

Non-interest expenses for the third quarter of 2012 were $144.5 million, up $7.1 million from a year earlier. Salaries and benefits accounted for the vast majority of the increase. We also saw $1.1 million year-over-year increases in occupancy expense and furniture and equipment expense.

We will continue to evaluate and adjust our financial centers and distribution points according to customer needs. Our second quarter ATM expansion agreement with Cardtronics and Valero Corner Stores enabled us to significantly increase customer access points in an efficient manner.

Turning to loan demand, the positive loan growth continues with the best quarter for new loan commitments in four years. Average loans for the third quarter were $8.6 billion, up 7.5% from $8 billion a year ago, on a period-end basis, loans were up 9% to $8.8 billion.

Year-to-date, we are seeing double-digit increases in the number of new relationships and new commitments over last year. New commitments are up 35% over last year. Loan requests are broad-based across all regions and across all categories and small to large loans.

Our disciplined calling effort focused on better teaming, preparation and collaboration are paying off significantly. Year-to-date, customers represented 87% of new loan commitments. However, last quarter we saw a decrease in loan request from customers, so our relationship managers quickly increased their calling efforts on prospects.

To summarize, year-to-date we have seen increased funding rates, decreased loan runoffs, and an increase in the volume of opportunities. More recently, as the economy started to slow, we saw reduced customer request, so we adjusted to focus more on prospects, obviously it’s a longer process to increase outstandings. This is a tough environment with economic uncertainty, poor policy decisions in Washington, and the looming fiscal cliff. Even with this volatility, Frost entered the fourth quarter with an all-time high loan pipeline. Our credit quality continues its positive trend. Most credit measurements have returned to, or surpassed their pre-recession levels.

Capital levels remain very strong. Tier 1 and total risk-based capital ratios for Cullen/Frost were 14.10% and 13.62% respectively at the end of the third quarter of 2012. The ratio of tangible common equity to tangible assets was 8.80% at the end of the third quarter of 2012. It was another good quarter for Cullen Frost, despite challenging economic headwinds.

Looking ahead, next month’s general election should provide important clarity on future policy decisions and on the role and scope of government and society, with more clarity on taxes, regulation and healthcare, we can remove much of the uncertainty that has hampered businesses and the economy. We’re fortunate that Cullen/Frost operate in a business-friendly state that consistently outperforms the national economy.

The Texas economy is expected to grow 2.4% this year compared to anemic 1.4% growth for the United States economy. The unemployment rate in Texas will continue to be lower than the national average. Despite ongoing regulatory challenges from Dodd-Frank, we move forward with confidence and our value proposition, our unique culture, and our award-winning customer service. I’m grateful to our dedicated employees who treat customers the right way and help make our success possible.

In summary, it was another solid quarter for Cullen/Frost. We grew loans in all regions across all segments. We significantly increased our customer base and deposits. Our capital levels are very strong and we have money to lend. Our credit quality is the best it’s been in years and continues to show positive trends for the future.

We operate in Texas, where the economy is stronger than the national average due to the business-friendly policies. Our outstanding customer service is recognized and validated by multiple third-party agencies. We have increased our dividend annually for 18 years and we continue to deliver consistent, steady, solid returns for our shareholders.

And with that, I’ll turn the call over to our CFO, Phil Green.

Phillip D. Green

Thank you, Dick. Let me just comment briefly about our net interest margin and our earnings outlook and then I’ll turn it back over to Dick for questions.

As Dick pointed out, our net interest margin declined seven basis points from the second quarter to 3.54%. However, this included in a 11 basis point impact from our strong deposit growth. So our core margin actually improved four basis points in the third quarter.

Last quarter I described the interplay on our core margin going forward, that would result from the competing factors of lower asset yields versus how well we are able to prudently expand the loan portfolio. And this quarter was a great example of this interplay. While the securities yield remains stable, we saw loan portfolio yields impact margin by four basis points.

But they were offset by eight basis points of improvement related to our strong loan growth. This interaction will continue to be played out over the coming quarters. Regarding our loan growth, we were pleased at the 18% annualized average growth in linked-quarter loans was broad-based. Two-thirds of the growth was from C&I lending, with the other third representing real estate loans split between commercial mortgages and construction.

On the deposit side, not only were our average balances up 13% from the previous years, but a significant portion of that growth, 42% came from new deposit customers continuing the past trend. Finally, as we look forward to the end of this year, we believe the current average of analyst estimates is reasonable.

With that, I’ll turn it back over to Dick for questions.

Richard W. Evans

Thank you, Phil. We are happy to answer your questions now.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Brady Gailey with KBW.

Brady Gailey – Keefe, Bruyette & Woods

So the last two quarters we’ve have seen end of period loan growth up 18%, up 15% annualized. When you look out into 2013 and 2014, do you think this mid-teens level of loan growth is sustainable?

Phillip D. Green

I’m having trouble looking at a quarter in this kind of environment. But as I said to you, the pipeline going into this fourth quarter is good and strong. And so, you tell me what’s going to happen in 2013 or 2014.

Brady Gailey – Keefe, Bruyette & Woods

And what about participations, were there any purchased participations in the third quarter that added to that growth?

Phillip D. Green

Well, our shared national credits were up, they increased to $175 million, or 33%, it is mainly focused in energy as has been plus we did have. So energy is a primary driver, but we did have some increase in our construction credit. It’s a company, it’s a private company that I’ve been here 41 years and handled it when I came here and it has been here a long time there.

Brady Gailey – Keefe, Bruyette & Woods

Okay. Dick, that $175 million, was that all added just in the third quarter?

Richard W. Evans

No, the growth in shared national credits in the third quarter on a linked-quarter basis was $62 million of the growth.

Brady Gailey – Keefe, Bruyette & Woods

Okay, all right. And then my last question, the reserve, year-to-date on a percentage basis, it’s down about 18 basis points from 1.38% to 1.2%. At what level do you think about keeping that percentage flat?

Phillip D. Green

Well, as we said many times, the reserves based on formula and it’s most responsive to classifieds, and so it’s going to drive that. I think there is some level that optically everyone is going to want to keep the reserve at, it’s lower than it is now, I can’t tell you what that number is, but there is some level I think at some point we reach.

Brady Gailey – Keefe, Bruyette & Woods

Okay. Thank you, guys.

Operator

Your next question comes from the line of Steven Alexopoulos with J.P. Morgan.

Steven Alexopoulos – J.P. Morgan Securities Inc.

I wanted to start and follow-up on the comments at the loan pipelines that are high and causing core NIM expansion. Banks were hearing, more broadly are talking about a pullback from businesses because of the cliff which you’ve touched on a bit. Just wondering if you could share with us what you are seeing, hearing from your customers and do you expect a pull back on loan growth here at least temporarily tied to what we are hearing around the cliff?

Richard W. Evans

Well, it’s really volatile. I mean, there is no doubt, it’s slowed down somewhat. I think the cliff that we’re faced with, I just got the October Greenwich Associates Research and it starts out that the market pessimism returned in the second quarter of 2012, leaving small and mid-sized companies asking now what. And just four bullet points in there, it said the initial optimism among middle market companies that started in 2012 is fading, positive signs at the start of 2012 were tempered by their reality of a long slow recovery. And they went on to say that elections, uncertainty on taxes, and pending fiscal cliff spurring businesses to wait and see instead of investing.

So I think, we’re going to continue to work hard and we have shown, our people have shown that we can grow the volume. We have not compromised structure. We have been more aggressive on rate, because you have to, and I think we are going to go through certainty in the next two weeks, not much is going to happen. And then probably to the beginning of next year is going to be a little bit slow. But we are going to continue to, also on the work that our people have done earlier in the year is what’s paying off to that higher pipeline that we’re going into the fourth quarter with.

Steven Alexopoulos – J.P. Morgan Securities Inc.

Okay, that’s a good color. So what was the balance of average in period-end securities in the quarter, and can you talk about where you saw investment rate this quarter for those?

Phillip D. Green

Well, see, for the quarter we average on the portfolio $8.9 billion, it yielded at 328 tax equivalent yield. As far as securities at period end, just me a second here. Securities at period end were about $9.1 billion. As far as reinvestments, we didn’t do a lot of investing during the quarter. But what we did was mainly in municipal securities, just one second. We did in the third quarter $250 million in municipal securities just under 4% tax equivalent yield for those. And there was one other small $100 million very short-term investment we made at 52 basis points is a two month deal. So that really won’t impact us very much.

So our view on the markets still continues to be that we don’t like it, don’t think anybody does, when you get to a certain level of liquidity you have to participate. I think we were up to almost $2 billion recently in the liquidity, again even after the purchases I discussed with you. And so we will be making some additional purchases over time just continue to manage that number.

Steven Alexopoulos – JPMorgan Securities Inc.

Phil, maybe just a follow-up along those lines, in your opinion, will the expiration of tag have any meaningful impact on non-interest bearing deposits on liquidity? What are you planning for there?

Phillip D. Green

We historically always plan to have strong liquidity to any depositor demand for whatever reason and that continues to be the case. But we really don’t expect any significant impact from tag. But we had tag once we dropped out of it before. We’re back in it now because we put everybody in it. We never really market FDIC. We always marketed the financial strength of the company, which really I don’t think has ever been stronger.

And so there are two views on it. If people view weaker players without tag is being a place, so they don’t want to keep their money, it’s possible, we could see some inflow from that as it relates to people moving money out, I guess it’s possible. We don’t see it right now. However, we’re extremely well positioned in liquidity if that were to happen.

Steven Alexopoulos – JPMorgan Securities Inc.

Okay. Thanks for the answers.

Operator

Your next question comes from the line of John Pancari with Evercore Partners.

John Pancari – Evercore Partners

Can you talk a little more about your outlook for the margin and just given the compression yields that you saw? And also can you talk about the loan yield compression you saw on the quarter? And then lastly, your ability to offset any incremental margin compression in coming quarters with a balance sheet growth?

Phillip D. Green

First of all, the loan portfolio yield was down about 10 basis points during the quarter. So what I mentioned there was about a four basis point hit the margins results of that. That’s what I was talking about, and that’s the result of loan yields that are paying off that you can’t replace in the current market, and also I think just more competitive pricing.

As far as the outlook for the margin, what I’ve been saying for a while, I said again today continues to be the situation. We’re going to have rate related pressure that’s going to be negative and the Fed is not doing anything to help that as we go forward. But we do have the ability and have demonstrated the ability to grow loans in this environment, and we’ve been successful in that and expect to continue to be and that’s the offset.

The other thing that can happen John is, as I’ve mentioned, we do have the tremendous amount of liquidity in our balance sheet today and occasionally we’ll take advantages of some additional securities purchases when it’s the right thing to do and when that comes out of liquidity that tends to help our margins as well.

So I continue to be looking at the margins, I’ll say on a core basis again always have to peel out the deposit growth because it’s just so strong. On a core basis, I’m looking for margin, hopefully to be pretty flat with all those factors right now assuming to impact each other, I mean offset each other.

John Pancari – Evercore Partners

Okay, all right. And then Dick, can you just talk a little bit about the overall M&A appetite and seller expectations as well? And I guess around appetite on pretty much already writing down your typical answer that you’re aggressive looker and a conservative buyer. But I’m just curious if it all that is changing giving the challenges that that you’re seeing on the right front as well as the challenges that some of the potential sellers are like we facing and you could have more looking for strategic alternatives here?

Richard W. Evans

I think the potential sellers are still in denial about where the marketplace is. They just can’t believe that it’s changed that much as they began to deal with the realities of the cost of compliance and we hadn’t really seen any effects from paying interest on accounts, on commercial accounts that support of the law because we’re the zero interest rate environments, but certainly that’s in the feature.

And so I think there are a lot of banks that just can’t see the reality that’s going to happen in the feature, now whether that’s six months or a year or two, but it’s there, unless there are some changes. Basel III on the mark-to-market of the investment portfolio is a big thing. And so I think we’re just kind of coasting all with people in denial.

John Pancari – Evercore Partners

Okay. Thank you

Operator

Your next question comes from the line of Brett Rabatin with Sterne, Agee.

Brett Rabatin – Sterne, Agee & Leach

First, I had a request. I know the Q comes out a little later today, but if at all possible I don’t know if you guys can put the consolidate average balance sheet and net interest income analysis for the quarter in the press release that would be hugely helpful, is that possible going forward?

The questions I want to ask or just around the taxable portfolio yield for the quarter, I think it was 211 last quarter, I didn’t know what it was in 3Q? And then also I was just curious it sounds like the one yield this quarter was 475, just kind of curious about the origination rates kind of where you’re seeing stuff originated today?

Phillip D. Green

The taxable rate on this quarter was 205.

Brett Rabatin – Sterne, Agee & Leach

205, okay.

Phillip D. Green

And if you are interested, the tax-exempt rate was 659. So both of those were down, but because of the mix of the two we ended up having about a little over $220 million increase in tax-exempt securities as opposed to a drop in taxable maturities we ended up with a better mix on the taxable side – in tax-exempt side. So that’s why rate actually was fairly flat. It was 327 and it actually one basis point to 328, but essentially flat in the quarter.

Brett Rabatin – Sterne, Agee & Leach

Right.

Phillip D. Green

As far as what’s going on in the loan pricing numerically, I’d say for the year on our spread to prime on new and renewed loans is running about, I’d say probably in the mid to high 90 basis points over prime. I’d say more recently. We’ve seen more competition as far as that goes and probably also since some the higher quality deals that you see, you’ll tend to get lower spreads on that and we’ve seen an awful lot of those, I think recently.

So I think our numbers are down more recently, but probably close to the 75 basis point on prime for new and renewed loans. On the LIBOR side, we’re also seeing a little more LIBOR related deals and we’ve seen and there is also be a price pressure on that, so those are the facts that we’re seeing.

Brett Rabatin – Sterne, Agee & Leach

Okay. And then if I heard you correctly, Phil you gave an outlook for kind of a flattish margin and that’s sound like that was predicated on loans continuing to grow and maybe some equity deployment, does that also assume the deposits, the pace of growth kind of slows from here, can you give us a little color on around that?

Phillip D. Green

When I talk about that, I talk about it without basically absence deposit growth.

Brett Rabatin – Sterne, Agee & Leach

Okay

Phillip D. Green

So looking at the core margin in that way, it remains to be seen whether the deposits will take a little bit of a breather this quarter or not. We keep thinking they will, but they keep proving us wrong. So we tend to just look at the number with our deposit growth.

Brett Rabatin – Sterne, Agee & Leach

Okay. Great, thanks for the color.

Operator

Your next question comes from the line of Ken Zerbe with Morgan Stanley.

Unidentified Analyst

This is Mark (inaudible) for Ken Zerbe. Actually most of my questions answered. One other thing I guess if you could elaborate a little bit on what happened on the non-accrual side in the quarter that would be helpful. Thank you.

Phillip D. Green

If you look the non-accruals were up a little bit. However, the potential problems were down significantly. If you look at potential problems as it is over 90 day’s non-performers. In the second quarter, they added up to $143.6 million and they’re down to $125.6 million. So the rats moving through the snake is we would expected to do that was a loan that move through from potential problems to non-accruals and we expect rat to continue to move on through and we’re optimistic about the outcome.

Unidentified Analyst

Thank you.

Operator

Your question comes from the line of Emlen Harmon with Jefferies.

Emlen Harmon – Jefferies & Co.

Hey, just one quick question for you on the expense side of things. The Valero ATM agreement that was signed last quarter, could you help me understand kind of any expenses that are affiliated with that rollout, I know typically kind of there is interchange paid to the card network. I was just kind of trying to understand how we should expect like that in?

Richard W. Evans

It started in August, and so you’ve got most of the full quarterly impact in the third quarter. You’re going to have a little bit when you that third month or a full quarter, you’re going to see that in the four quarter. So it will be much of an impact as relates to that going forward from what you’ve already seen in the numbers.

And it is an area where it is an additional expense, but it’s really there to basically lower a big barrier, what was a big barrier entry for potential customers by having a significant ATM network. Now we actually have a more ATMs available in the sake of Wells Fargo today. So we saw there is a real opportunity. But I think most of that impact on a quarterly basis is already end of the third, it won’t be much of an increase from third to fourth I believe.

Emlen Harmon – Jefferies & Co.

Got it. And just do you know how much that was in the third quarter?

Richard W. Evans

Well, we haven’t disclose what the amount of contract was so, but it’s in their.

Emlen Harmon – Jefferies & Co.

Okay, all right. Thank you.

Operator

(Operator Instructions) Your next question comes from the line of John Helfst with Schroder.

John Helfst – Schroder Investment Management

This maybe a tough question to answer, can you qualitatively guess how much pent-up demand there might be from borrowers regarding the uncertainty. You know that’s not reflected in the pipeline. Is there a risk to the outside for loan growth next year or downside even? Thanks.

Richard W. Evans

Nobody knows how much the pent-up demand is, we know this. We’ve led through the deleveraging part of this economy. We know that we’re fortunate to be in Texas where there is a lot of growth and lot happenings, I’m very optimistic in that regard, you got companies that are sitting on the sidelines waiting to invest and move forward and basically you got two kinds of growth. You got the money they’re spending as to keep technology up and equipment up and those sorts of things. I think there is a lot of pent-up demand about buying companies, building a new building, all the things that happen.

And we’ll have more clarity in the next 60 days. We may not like the results, but clarity will give us the ability to move forward. We’ll know more. We’ll know about the election. We will know more about what’s going to happen in the fiscal cliff. We’re going to know more about what’s going to happen to Texas. And so I think that in this economy, companies are lean and they’re mean, and they’re ready to move forward. They’re just scared to death of the insanity that it’s come out of Washington D.C.

John Helfst – Schroder Investment Management

Great, appreciate that.

Operator

Your next question comes from the line of Matthew Keating with Barclays.

Matthew Keating – Barclays Capital, Inc.

Just on the competitive environment in Texas, particularly with the big four. In the past, you talked their impact on pricing structure and if you could provide an update would be very helpful.

Phillip D. Green

It’s pretty much the same, I mean as everybody knows this is the place to be and so everybody wants their share of it and so they are very competitive. I wouldn’t say it’s less or more, I just think it’s been very competitive for some period of time.

Matthew Keating – Barclays Capital, Inc.

And just one quick follow-up question, the efficiency ratio covered around 50% for sometime, where is your longer-term outlook and where that ratio could fall over time? Thanks.

Phillip D. Green

I think our margins at real time low, so I mean hopefully if we get some sanity in the interest rates and we see the net interest income that’s really, the capacity that we’ve got for that in our balance sheet and it come to provision. We’ll see that grow and we’ll see that grow at a faster rate in expenses for growth. So the math of that will tend to take that number down. But I think that our company has done a really good job on expenses. Our people are generally very careful about that. We’re going to continue to be and need to be in this environment. But I guess I would say I would expect it to head down some as we normalize margins.

Operator

At this time, there are no further questions. Presenters, do you have any closing remarks?

Richard W. Evans

We thank everybody for their interest in Cullen/Frost and we stand adjourn.

Operator

This concludes today’s conference call. You may now disconnect.

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