Cullen/Frost Bankers, Inc. — Q3 2016 Form 10-Q
Business context and period. Texas-based financial holding company offering commercial and consumer banking, wealth management, insurance and related services. This unaudited report covers the quarter and nine months ended September 30, 2016; balance-sheet comparisons are with December 31, 2015. Dollar amounts below are in millions unless stated otherwise.
Key financial results
| Metric | Q3 2016 | Q3 2015 | Nine months 2016 | Nine months 2015 |
|---|---|---|---|---|
| Net interest income | $194.5 | $187.0 | $574.7 | $550.5 |
| Provision for loan losses | $5.0 | $6.8 | $42.7 | $17.8 |
| Non-interest income | $82.1 | $83.4 | $256.3 | $245.6 |
| Non-interest expense | $180.5 | $175.6 | $539.1 | $520.3 |
| Net income | $80.2 | $75.9 | $220.5 | $221.1 |
| Net income available to common shareholders | $78.2 | $73.8 | $214.5 | $215.0 |
| Diluted EPS | $1.24 | $1.17 | $3.42 | $3.39 |
| Net interest margin, taxable-equivalent | 3.53% | 3.48% | 3.56% | 3.45% |
| Return on average assets | 1.07% | 1.04% | 1.01% | 1.03% |
| Return on average common equity | 10.31% | 10.73% | 9.87% | 10.47% |
Financial position, cash flow and capital
- Balance sheet: Total assets were $29.60 billion, up from $28.57 billion at year-end 2015. Loans were $11.58 billion, up 0.8%; deposits were $25.11 billion, up 3.1%. Shareholders’ equity was $3.16 billion, compared with $2.89 billion.
- Funding and liquidity: Cash and cash equivalents totaled $4.00 billion. Deposits included $10.28 billion of non-interest-bearing demand deposits (40.9% of total). Federal funds purchased and repurchase agreements were $804 million; junior subordinated debentures were $136 million and other long-term borrowings $100 million. The company reported $253 million in holding-company liquid assets, including cash and resell agreements, and said it knew of no event reasonably likely to materially harm liquidity or capital resources.
- Cash flow, nine months: Operating activities provided $335 million; investing activities used $547 million; financing activities provided $616 million. Cash and cash equivalents increased $404 million to $4.00 billion.
- Regulatory capital: Cullen/Frost’s CET1, Tier 1, total capital and leverage ratios were 12.40%, 13.24%, 14.86% and 8.18%, respectively; Frost Bank’s were 12.99%, 12.99%, 13.85% and 8.01%. Both exceeded fully phased-in Basel III minimums and “well-capitalized” thresholds.
- Shareholder returns: Common dividends were $1.61 per share for the first nine months, versus $1.57 in 2015. The company had no active repurchase plan and made no share repurchases in Q3.
Material changes and notable items
- Q3 common earnings rose 5.9%, principally on higher net interest income, lower loan-loss provision and lower income tax expense; higher operating expense and slightly lower non-interest income partly offset the gains. For nine months, common earnings declined 0.3% as higher credit costs and expenses outweighed revenue growth.
- Taxable-equivalent net interest income increased 4.5% in Q3 and 4.9% year to date. Management cited loan and tax-exempt securities volume and higher loan yields; the year-to-date comparison also benefited by about $1.5 million from an extra calendar day in leap year 2016.
- Credit costs rose sharply year to date: net charge-offs were $28.8 million versus $7.0 million, driven largely by energy loans. The allowance was $149.8 million, or 1.29% of loans, versus $135.9 million and 1.18% at year-end 2015. Non-performing assets increased to $100.9 million (0.87% of loans and foreclosed assets) from $85.7 million (0.75%).
- Energy exposure remained significant but contracted: energy loans were $1.38 billion, or 12.0% of loans, down from $1.76 billion, or 15.3%, at year-end. Energy’s weighted-average risk grade worsened to 8.13 from 6.89; classified energy loans rose to $299.6 million from $98.0 million. Management attributed deterioration to the prolonged low-oil-price environment, despite oil recovering to about $48 per barrel by September 30.
- Commercial real estate loans increased to $4.64 billion from $4.29 billion. Management cited Houston-area weakness related to energy-sector conditions, including softer construction activity, rent concessions and higher vacancies.
- Nine-month non-interest income included a $14.9 million net securities gain, versus $0.2 million in 2015. The gain included sales of municipal securities after issuer credit deterioration and other securities transactions. The company also sold $8.0 billion of Treasury securities in Q3 for Texas franchise-tax planning, recognizing a small net loss of $37,000.
- Q3 comprehensive income was $14.4 million versus $127.5 million a year earlier, mainly reflecting a quarterly decline in unrealized securities gains. Year-to-date other comprehensive income was $101.7 million.
Outlook, risks and contingencies
- No specific earnings or revenue guidance was provided. Management cautioned that interim results are not necessarily indicative of full-year or future performance.
- Interest-rate modeling at September 30 projected net interest income over the next 12 months would be 0.4% higher under a 100-basis-point rate increase, 1.5% higher under a 200-basis-point increase, and 6.5% lower under a 50-basis-point decrease, versus a flat-rate scenario. These are model estimates, dependent on assumptions including future pricing of commercial demand deposits.
- Key disclosed risks include Texas and energy-market conditions, borrower performance and credit losses, interest-rate and securities-market movements, deposit pricing, regulatory and legal developments, competition, technology and control risks, and liquidity. Management noted heightened monitoring of potential problem loans totaling $68.0 million, including energy borrowers.
- Off-balance-sheet commitments included $7.09 billion of commitments to extend credit and $252.8 million of standby letters of credit. Energy-industry unfunded commitments were $1.1 billion, with $58.7 million of energy standby letters of credit.
- The company expected to close the sale of its current headquarters building in Q4 2016, subject to contingencies, and lease it back until a replacement building is expected to be completed in 2019. Management did not expect the property transactions to have a significant aggregate operating impact. It said pending litigation was not expected to materially adversely affect the financial statements.
- Management reported effective disclosure controls and no material change in internal control over financial reporting during the quarter. It also reported no material change in the risk factors from the 2015 Form 10-K.
Important facts for investors to verify
- Track energy-credit migration, non-accruals, restructurings, charge-offs and reserve adequacy; these measures deteriorated substantially year to date.
- Assess whether loan and deposit growth, margin gains and the unusually low deposit cost can persist as rates and competitive pricing change.
- Separate recurring fee and operating performance from securities gains, tax-planning transactions and other period-specific items.
- Review exposure to Houston commercial real estate and the scale and credit quality of unfunded lending commitments, particularly in energy.
- Confirm the assumptions and sensitivities behind the interest-rate model and the timing and conditions of the headquarters property transactions.