Cullen/Frost Bankers, Inc. — Q3 2012 Form 10-Q
Reporting period: Quarter and nine months ended September 30, 2012. The interim financial statements are unaudited. Cullen/Frost is a Texas-based financial holding and bank holding company providing banking, wealth management, insurance and related services, primarily in Texas. Amounts below are in U.S. dollars; financial figures are rounded to millions unless stated otherwise.
Financial performance and position
| Metric | Q3 2012 / September 30, 2012 | Comparable period / change |
|---|---|---|
| Net income | $58.7 million; diluted EPS $0.95 | Q3 2011: $54.5 million; $0.89 diluted EPS |
| Net interest income | $151.5 million for Q3; $450.5 million for nine months | Q3 up 4.2%; nine months up 4.4% versus 2011 |
| Taxable-equivalent net interest margin | 3.54% for Q3; 3.63% for nine months | Q3 2011: 3.81%; nine months 2011: 3.93% |
| Non-interest income | $71.2 million for Q3; $212.9 million for nine months | Down 10.2% for Q3 and 4.2% for nine months versus 2011 |
| Non-interest expense | $144.5 million for Q3; $429.0 million for nine months | Up 5.1% for Q3 and 3.6% for nine months versus 2011 |
| Loans, gross | $8.81 billion | Up 10.2% from December 31, 2011 |
| Total deposits | $18.25 billion | Up 8.9% from December 31, 2011 |
| Total assets / shareholders’ equity | $21.85 billion / $2.42 billion | December 31, 2011: $20.32 billion / $2.28 billion |
| Cash and cash equivalents | $2.75 billion | Down from $2.91 billion at December 31, 2011 |
- Earnings drivers: Q3 net income rose 7.6% year over year, principally reflecting lower loan-loss provision and income taxes, and higher net interest income; lower non-interest income and higher expenses partly offset the gains. Nine-month net income increased 9.6% to $177.8 million, or $2.88 diluted EPS.
- Credit costs: Provision for loan losses was $2.5 million in Q3 and $6.0 million for nine months, compared with $9.0 million and $27.4 million, respectively, in 2011. Nine-month net charge-offs were $10.7 million versus $38.3 million. The allowance was $105.4 million, or 1.20% of loans, versus $110.1 million, or 1.38%, at year-end 2011.
- Cash flow: For the first nine months, operating cash flow was $269.2 million, investing cash outflow was $1.715 billion, and financing cash inflow was $1.290 billion. The resulting cash decrease was $155.4 million. Investing outflow reflected securities activity and $823.6 million of net loan growth; financing inflow included $1.488 billion of deposit growth.
- Borrowings and liquidity: Period-end federal funds purchased and repurchase agreements were $601.2 million; junior subordinated debentures were $123.7 million and other long-term borrowings were $100.0 million. Management reported $221.7 million of liquid assets at the holding-company level and stated it knew of no event likely to materially adversely affect liquidity.
- Capital: Cullen/Frost reported total risk-based capital of 15.62%, Tier 1 risk-based capital of 14.10% and leverage of 8.59%; Frost Bank reported 13.93%, 13.07% and 7.96%, respectively. Management considered both well capitalized. Dividends paid in the first nine months were $87.3 million, or $1.42 per share.
Material changes and management commentary
- Loans grew materially, led by commercial and industrial lending, which rose 14.5% from year-end and represented 50.9% of loans. Commercial real estate loans were 36.9% of loans. Purchased shared national credits totaled $712.5 million; 67.9% of that portfolio was energy-related.
- Available-for-sale securities increased to $8.72 billion from $7.79 billion at year-end 2011. Management attributed margin pressure partly to a larger share of earning assets held in lower-yielding securities and lower securities yields. The nine-month margin fell 30 basis points year over year despite higher net interest income.
- Interchange and debit-card fees fell 50.5% for the first nine months, primarily following federal limits on debit interchange fees effective October 2011. Service charges also declined. Trust and investment management fees and insurance commissions increased.
- At September 30, non-performing assets were $124.9 million, or 1.41% of loans and foreclosed assets, up from $120.9 million at year-end but below $139.3 million a year earlier. Non-accrual loans increased to $106.4 million from $94.3 million at year-end. The quarterly increase was principally associated with one $28.2 million commercial relationship.
- Management said it expected net charge-offs to continue trending down as portfolio credit quality improved. No specific earnings or revenue guidance was provided. The company expected advertising and promotional expense for the rest of 2012 to be comparable to 2011.
Outlook, risks, contingencies and unusual items
- Interest-rate exposure: Management’s 12-month model projected net interest income variances versus its base case of negative 1.0% for a 100-basis-point rate increase, negative 1.1% for a 200-basis-point increase, and negative 1.7% for a 25-basis-point decrease. The model assumed interest would begin to be paid on demand deposits in Q4 2012; actual deposit pricing could differ. Management described the balance sheet as becoming more liability-sensitive.
- Credit and concentration risk: Lending is concentrated in Texas and weighted toward commercial and real estate loans. Management identified contractors as a distressed industry and cited borrower cash flows, collateral values and economic conditions as factors affecting potential losses. A single large relationship contributed to the Q3 increase in non-accrual loans.
- Capital regulation: Proposed Basel III and standardized-approach rules could alter capital requirements and risk weights; management believed the company and bank would meet the proposals on a fully phased-in basis, but adoption and final terms were uncertain. Trust preferred securities were scheduled to be phased out of holding-company Tier 1 capital beginning in 2013.
- Unusual items: Q3 other non-interest income included $1.4 million of proceeds from a legal settlement. Nine-month other income also reflected a $765,000 reversal of a prior contingency accrual. The company recognized a $121,000 net securities loss for nine months; extensive securities purchases and sales included transactions tied to Texas franchise-tax planning. A 2011 tax under-accrual correction had increased 2011 tax expense, making the year-over-year tax comparison favorable in 2012.
- Contingencies and reporting: Management did not expect pending claims and legal actions to have a material adverse financial impact. The company disclosed no material change in previously reported risk factors. Disclosure controls were assessed as effective, and no material quarterly change in internal control over financial reporting was reported. Frost Bank converted to a Texas state charter and Federal Reserve membership in June 2012.
Important facts for investors to verify
- Whether the rise in non-accrual loans, particularly the $28.2 million relationship, develops into losses or further reserve needs.
- Whether loan growth and deposit mix can offset continued pressure on net interest margin and the sharp decline in debit interchange income.
- How securities balances, yields and securities-related accumulated other comprehensive income respond to market rates; unrealized securities gains are not the same as realized earnings.
- Whether management’s expected decline in net charge-offs materializes, and whether the allowance remains adequate as loans grow and Texas industry conditions change.
- The actual cost of any interest paid on demand deposits, the effect of proposed capital rules, and the potential phase-out of trust preferred securities from Tier 1 capital.
- The sustainability of earnings excluding the legal settlement, contingency-accrual reversal, securities-related tax planning and other period-specific items.