Cullen/Frost Bankers, Inc. (NYSE: CFR) — Q3 2018 Form 10-Q
Reporting period: Quarter and nine months ended September 30, 2018. Cullen/Frost is a Texas-based financial holding company whose subsidiaries provide banking, wealth management, insurance and related services. Financial statements are unaudited.
Financial performance and position
- Revenue: Net interest income plus non-interest income was $329.3 million in Q3, up 9.5% from $300.8 million; for the first nine months it was $972.9 million, up 9.4% from $888.9 million.
- Profit: Q3 net income was $117.8 million and net income available to common shareholders was $115.8 million; diluted EPS was $1.78, versus $1.41 a year earlier. Nine-month common income was $329.6 million and diluted EPS was $5.08, versus $257.6 million and $3.98.
- Net interest and margins: GAAP net interest income was $241.7 million in Q3, up 10.2%; nine-month net interest income was $708.7 million, up 10.3%. Taxable-equivalent net interest margin was 3.66% in Q3 and 3.61% year to date, down 7 and 8 basis points, respectively, year over year as reported. Management said margin increased 25 and 24 basis points, respectively, when comparing periods using a consistent 21% tax rate.
- Credit costs: Provision for loan losses was $2.7 million in Q3 and $17.8 million for nine months, compared with $11.0 million and $27.4 million in 2017. Nine-month net charge-offs rose to $35.6 million from $26.1 million.
- Cash flow: For nine months, operating activities provided $460.2 million; investing activities used $1.404 billion and financing activities used $689.9 million. Cash and cash equivalents fell $1.634 billion to $3.419 billion. These cash flow movements reflect banking and securities activity.
- Balance sheet and liquidity: Total assets were $31.22 billion at September 30, down from $31.75 billion at December 31, 2017. Loans were $13.81 billion, up 5.1%; deposits were $26.35 billion, down 1.9%. Management reported $326.3 million of liquid assets at the holding-company level and no known event reasonably likely to materially impair liquidity.
- Debt and capital: Federal funds purchased and repurchase agreements totaled $1.084 billion; junior subordinated debentures were $136.2 million and subordinated notes were $98.7 million. Cullen/Frost’s CET1, Tier 1, total capital and leverage ratios were 12.93%, 13.63%, 15.44% and 9.19%, respectively; management said both the company and Frost Bank exceeded fully phased-in capital requirements and “well capitalized” thresholds.
Material changes and notable items
- Common income rose 27.1% in Q3 and 28.0% for nine months. Management attributed growth primarily to higher net interest income, lower loan-loss provisions and higher non-interest income, partly offset by higher operating and tax expense.
- Non-performing assets declined to $86.4 million from $157.3 million at year-end 2017; non-accrual loans fell to $82.6 million from $150.3 million. Energy loans were 11.0% of total loans, and energy-sector unfunded credit commitments were $1.1 billion.
- The allowance for loan losses declined to $137.6 million, or 1.00% of loans, from $155.4 million at year-end. Meanwhile, nine-month net charge-offs increased. Management cited improved risk grades and lower classified commercial and energy loans as factors reducing reserves.
- Unrealized securities losses drove a $230.3 million after-tax nine-month other comprehensive loss; accumulated other comprehensive income shifted from a $79.5 million gain to a $141.2 million loss. Management attributed securities impairments to market interest-rate increases, not credit quality, and said it did not intend to sell the affected securities.
- Non-interest income included $4.5 million in recovery of prior write-offs, $1.2 million from a private-equity distribution, $775,000 from an insurance settlement, and $4.2 million in gains on sales of branch and operating facilities. These items contributed to year-to-date income growth.
- A data-security incident involving unauthorized access to a third-party lockbox software program affected certain commercial customers. The company said the access was stopped, other Frost systems were not affected, and its investigation was ongoing; out-of-pocket costs were $1.9 million through September 30.
- Accounting presentation changed under revenue-recognition guidance: debit-card network costs are now netted against related fee income. This affects comparability of reported interchange fees and expenses. The adoption also reduced opening retained earnings by $2.3 million.
Outlook, risks and contingencies
- The filing provides no specific earnings or revenue guidance. Management cautioned that interim results are not necessarily indicative of full-year or future results.
- Interest-rate sensitivity modeling projected that a 100- or 200-basis-point rate increase would raise 12-month net interest income by 0.3% or 1.5% versus a flat-rate case; equivalent decreases would reduce it by 2.9% or 8.0%. Results depend on assumptions, including deposit pricing. Management characterized the balance sheet as less asset-sensitive than a year earlier.
- Key risks include economic and market conditions, interest rates, borrower performance and credit losses, Texas energy and real-estate exposures, competition, regulation, cybersecurity and technology disruptions, and the accuracy of reserve estimates. Management reported no material change in previously disclosed risk factors.
- Management did not expect pending legal claims to have a material adverse financial impact. Off-balance-sheet commitments included $8.285 billion of commitments to extend credit and $244.7 million of standby letters of credit.
- Upcoming accounting changes include lease accounting, expected to add approximately $400–$500 million of right-of-use assets and related liabilities in 2019; CECL adoption in 2020, whose impact could not yet be reasonably estimated; and callable-security premium amortization in 2019, expected to reduce retained earnings by about $11.3 million on adoption and increase 2019 amortization expense by about $5.3 million.
Important facts for investors to verify
- Whether deposit-cost increases continue to offset loan-yield gains and affect net interest margin.
- Trends in energy and commercial real-estate credit quality, charge-offs, criticized loans and reserve adequacy.
- How much earnings growth depends on nonrecurring recoveries, property-sale gains and other unusual income items.
- Further costs or consequences from the lockbox security incident and the outcome of the ongoing investigation.
- The realized balance-sheet and equity effects of securities valuation changes, lease adoption and CECL implementation.
- Deposit trends, the composition of funding, and the holding company’s reliance on dividends from Frost Bank for liquidity.