Cullen/Frost Bankers, Inc. — Q1 2011 Form 10-Q
Business context and reporting period. Cullen/Frost is a Texas-based financial holding company offering commercial and consumer banking, trust and investment management, insurance, and related services. This unaudited filing covers the three months ended March 31, 2011; comparisons are primarily with Q1 2010 and, where relevant, Q4 2010. Management cautions that interim results are not necessarily indicative of full-year results.
Financial performance and position
- Revenue and earnings: Net interest income was $141.8 million, up 3.0% year over year; non-interest income was $72.3 million, up 1.3%. Together, these totaled $214.1 million, versus $209.0 million in Q1 2010. Net income rose 8.6% to $51.9 million; diluted EPS was $0.85 versus $0.79. Versus Q4 2010, net income declined 2.1% from $53.1 million.
- Margins: Taxable-equivalent net interest margin was 4.03%, down 16 basis points year over year but up 10 basis points from Q4 2010. Management attributed the year-over-year decline partly to a greater share of lower-yielding deposits and securities and fewer loans in the earning-asset mix. Return on average assets was 1.19%; return on average equity was 10.11%.
- Credit costs and quality: Provision for loan losses fell to $9.5 million from $13.6 million in Q1 2010. Net charge-offs were $11.4 million, or 0.57% of average loans annualized, versus $13.5 million and 0.66%. Non-performing assets were $154.7 million, 0.86% of assets, down from $171.6 million and 1.02% a year earlier. The allowance was $124.3 million, 1.55% of loans and 100.4% of non-accrual loans. Potential problem loans totaled $29.4 million.
- Expenses: Non-interest expense increased 4.1% year over year to $140.1 million, including higher compensation, benefits, technology and other costs. Management cited a $900,000 write-down of a branch facility being sold and expects advertising expense to remain significantly higher during 2011 because of a new campaign.
- Balance sheet and liquidity: Total assets were $17.94 billion; loans were $8.03 billion, down 1.1% from year-end 2010; deposits were $14.71 billion, up 1.6% from year-end and 7.1% year over year. Consolidated cash and cash equivalents were $2.70 billion. Cash from operating activities was $71.2 million, compared with $85.2 million in Q1 2010; investing activities used $479.8 million, while financing activities provided $286.3 million. The parent company reported $163.0 million of liquid assets, including $8.0 million of cash collateral.
- Debt and capital: Period-end federal funds purchased and repurchase agreements were $553.6 million; junior subordinated debentures were $123.7 million; and other long-term borrowings were $250.0 million. Cullen/Frost’s total capital ratio was 16.31%, Tier 1 risk-based ratio 14.22%, and leverage ratio 8.99%. Frost Bank’s respective ratios were 14.72%, 13.57%, and 8.58%; the filing states the bank was well capitalized. Shareholders’ equity was $2.10 billion. The quarterly dividend was $0.45 per share, up from $0.43 in Q1 2010.
Material changes, outlook, and risks
- Year-over-year earnings improvement reflected higher net interest income, lower loan-loss provision, modestly higher fee income and lower taxes, partly offset by increased expenses. Loan-loss provision also declined from Q4 2010, while non-interest expense rose 4.7% sequentially.
- Management provided no specific earnings or revenue forecast. It expects interest costs on demand deposits to increase after regulatory changes permit interest-bearing transaction accounts beginning July 21, 2011. The effect is uncertain and could make the balance sheet more liability-sensitive. Interest-rate simulations showed net interest income 0.5% and 0.6% below the base case under +100 and +200 basis-point scenarios, respectively, and 0.4% below under a 25 basis-point decrease, over the next 12 months.
- Proposed debit-card interchange rules could reduce related PIN debit and Visa check-card revenue to approximately one-fourth of current levels, based on the proposal then under consideration; the final impact was uncertain. Management also cited economic, borrower, interest-rate, regulatory, market, technology, litigation and execution risks.
- The allowance methodology was refined in Q1 2011; management said the changes did not significantly affect the quarter’s provision. Management considered the allowance adequate but noted that estimates could change with economic and portfolio conditions. Securities unrealized losses were considered temporary, with management stating it did not expect to need to sell affected securities before recovery.
- Management did not expect pending legal matters to materially adversely affect the financial statements. The filing reported no material change in previously disclosed risk factors and no material change in internal control over financial reporting.
Important facts for investors to verify
- Whether lower credit costs and improving non-performing asset trends continue, and how the $29.4 million of potential problem loans perform.
- Whether loan growth resumes and the asset mix supports net interest margin as deposit costs and market rates change.
- The final debit interchange rules and their effect on card-related fee income, as well as the actual cost of interest-bearing demand deposits.
- Whether expense growth, particularly advertising and compensation, remains elevated and how it affects operating leverage.
- Capital, liquidity and dividend capacity, including the distinction between consolidated cash and the parent company’s $163.0 million of liquid assets, and the future regulatory treatment of trust preferred securities.