CFR

Business Context and Reporting Period

Cullen/Frost Bankers, Inc. (Cullen/Frost) is a Texas-based financial holding company and bank holding company headquartered in San Antonio. Its primary subsidiary, The Frost National Bank, operates over 110 financial centers across Texas. The company provides commercial and consumer banking, trust and investment management, insurance, and brokerage services. This report covers the fiscal year ended December 31, 2009.

Key Financial Metrics

Material Changes vs. Prior Period

• Net Income Decline: Net income decreased 13.6% to $179.0 million. This was primarily driven by a $27.6 million increase in the provision for possible loan losses and a $45.6 million increase in non-interest expense, partially offset by a $35.9 million decrease in income tax expense.
• Provision for Loan Losses: The provision increased significantly to $65.4 million (from $37.8 million in 2008) due to higher net charge-offs ($50.3 million vs. $19.9 million) and deteriorating economic conditions affecting land development and residential construction credits.
• Non-Interest Expense: Total non-interest expense rose to $532.2 million. A major driver was deposit insurance expense, which surged to $25.8 million (from $4.6 million) due to FDIC special assessments and rate increases.
• Asset Quality: Non-performing assets more than doubled to $180.2 million (2.14% of total loans plus foreclosed assets), reflecting the impact of the recession on commercial and real estate portfolios.
• Net Interest Margin: The net interest margin decreased 44 basis points to 4.23% due to lower market interest rates, though the average volume of earning assets increased by $1.9 billion.

Guidance, Outlook, and Risks

• Economic Outlook: Management notes that while economic conditions in Texas and the U.S. show signs of recovery, there is no assurance they will continue to improve. The company remains exposed to the general economic conditions of the State of Texas.
• Regulatory Environment: The company faces significant regulatory changes, including proposed reforms to the regulatory capital framework (Basel II/III proposals) which may require higher capital levels and changes to how trust preferred securities are treated. FDIC assessment rates have increased significantly.
• Interest Rate Risk: The company's balance sheet is currently interest-rate neutral due to hedging strategies. Simulations suggest a 100 basis point increase in rates would result in a 1.8% positive variance in net interest income.
• Dividends: The company paid quarterly dividends totaling $1.71 per share in 2009. Management is committed to continuing regular cash dividends, subject to future earnings and capital requirements.
• Key Risks: Primary risks include lending risk (specifically commercial real estate and construction), interest rate risk, and the potential insufficiency of the allowance for loan losses if economic conditions worsen further.

Investor Verification Checklist

• Asset Quality Trends: Verify the trajectory of non-performing assets and net charge-offs, particularly in the commercial real estate and construction sectors.
• Deposit Insurance Costs: Confirm the impact of ongoing FDIC assessment rate increases and special assessments on future non-interest expense.
• Capital Adequacy: Review the company's Tier 1 and Total Risk-Based Capital ratios (11.91% and 14.19% respectively) against potential new regulatory requirements.
• Fee Income Stability: Assess the sustainability of non-interest income, specifically trust fees and service charges, given market volatility and potential regulatory changes to overdraft fees.
• Dividend Sustainability: Evaluate the dividend payout ratio (57.05% in 2009) relative to earnings volatility and regulatory capital constraints.