Cullen/Frost Bankers, Inc. — Q3 2010 Form 10-Q
Business and period: Texas-based financial holding company providing commercial and consumer banking, trust, investment management, insurance and related services. This unaudited report covers the quarter and nine months ended September 30, 2010; comparisons are with the corresponding 2009 periods unless noted. Dollar amounts below are in millions except per-share data.
Financial performance and position
| Metric | Q3 2010 | Q3 2009 | Nine months 2010 | Nine months 2009 |
|---|---|---|---|---|
| Net interest income | $142.4 | $134.0 | $421.9 | $398.1 |
| Provision for loan losses | $10.1 | $16.9 | $32.3 | $43.1 |
| Non-interest income | $70.4 | $69.5 | $211.8 | $207.4 |
| Non-interest expense | $132.6 | $132.2 | $401.8 | $398.0 |
| Net income | $55.0 | $44.7 | $155.7 | $127.5 |
| Diluted earnings per share | $0.90 | $0.75 | $2.57 | $2.14 |
- Revenue and margins: Net interest income plus non-interest income was $212.8 million in Q3 and $633.7 million for nine months. Taxable-equivalent net interest margin was 4.04% in Q3, down from 4.12% a year earlier; nine-month margin was 4.13% versus 4.24%. Average earning assets grew, but a higher share of lower-yielding deposits and a lower share of loans pressured margin.
- Profitability: Q3 net income rose 23.0%; nine-month net income rose 22.1%. Higher net interest income and lower loan-loss provision were the main drivers. Q3 return on average assets was 1.25% and return on average equity was 10.49%.
- Credit quality: Loans were $8.05 billion at quarter-end, down 3.8% from December 31, 2009. Non-performing assets were $168.7 million, or 2.09% of loans and foreclosed assets, versus $180.2 million and 2.14% at year-end. However, non-accrual loans rose to $144.9 million from $134.5 million at June 30, 2010; potential problem loans increased to $30.3 million from $17.4 million at year-end. The allowance was $126.2 million, or 1.57% of loans. Nine-month net charge-offs were $31.5 million, up from $30.3 million.
- Cash flow and liquidity: Nine-month operating cash flow was $282.7 million, investing cash outflow $248.9 million, and financing cash inflow $1.10 billion; cash and equivalents increased $1.13 billion to $2.85 billion. Deposit growth was a major funding source. Separately, the holding company reported $139.6 million of liquid assets, including $11.2 million of cash collateral on deposit with counterparties.
- Balance sheet and funding: Total assets were $17.74 billion, up from $16.29 billion at year-end 2009. Deposits rose to $14.53 billion from $13.31 billion. Shareholders’ equity was $2.12 billion. Federal funds purchased and repurchase agreements, junior subordinated debentures, and other long-term borrowings totaled approximately $804.5 million, compared with $874.7 million at year-end. The company redeemed $12.4 million of debentures in July.
- Capital and shareholder returns: At September 30, Cullen/Frost’s total risk-based capital ratio was 15.46%, Tier 1 ratio 13.38%, and leverage ratio 8.67%; Frost Bank was reported as well capitalized. Dividends were $0.45 per share in Q3; nine-month dividends totaled $1.33 per share. No shares were repurchased under a public plan during the quarter.
Material changes and management commentary
- Net interest income increased as average interest-earning assets expanded, funded largely by deposit growth; the average cost of funds declined. At the same time, lending balances and net interest margin fell.
- Lower loan-loss provision reflected reduced provisioning from 2009 levels, though management cited continuing economic and portfolio uncertainty and said the allowance remained adequate based on its estimates.
- Deposit growth led to a larger securities and short-term deposit position. Available-for-sale securities were $5.26 billion; unrealized gains contributed to higher accumulated other comprehensive income and equity.
- Management said it expected historically low interest rates to persist for the foreseeable future, while emphasizing that rates and their effects are uncertain. Its model projected net interest income increases of 1.7% and 3.8% under +100 and +200 basis-point scenarios, respectively, and a 0.5% decrease under a 25 basis-point decline, relative to base case over 12 months.
Outlook, risks, contingencies and unusual items
- No specific earnings or revenue guidance was provided. Management cautioned that interim results are not necessarily indicative of full-year or future results.
- The Dodd-Frank Act and proposed Basel III standards may affect capital, deposit insurance costs, interchange and derivative revenues, and liquidity requirements. The filing states the ultimate financial impact was not yet determinable. Trust preferred securities are to be phased out of Tier 1 capital beginning in 2013; management said their exclusion at quarter-end would not impair compliance with current capital requirements.
- Federal Reserve rules requiring consumer opt-in for certain overdraft coverage began affecting fees in Q3. Future debit-card interchange regulation may also affect revenue; the effects were uncertain.
- Loan portfolio risks include weaker economic conditions, commercial real estate and energy exposure, and borrower deterioration. Energy represented approximately 10% of total loans; 65.5% of purchased shared national credits were energy-related. The company also disclosed Mexican borrower exposures among non-accrual loans.
- Off-balance-sheet commitments to extend credit were $4.32 billion and standby letters of credit were $290.8 million. Management did not expect pending legal matters to have a material adverse effect. The filing reported no material change in previously disclosed risk factors.
- Unusual items include a $7.3 million FDIC special assessment recorded in Q2 2009, which affects year-over-year deposit insurance comparisons; and $10.0 billion of securities sales during the first nine months of 2010 associated with tax-planning strategies, generating only a $6,000 net gain. In October 2010, after quarter-end, the FDIC adopted a revised Deposit Insurance Fund restoration plan.
Investor verification priorities
- Review subsequent credit trends, especially the Q3 increase in non-accrual loans and potential problem loans, energy and commercial real estate exposure, and adequacy of the loan-loss allowance.
- Verify whether deposit growth and reinvestment into lower-yielding assets continue to pressure net interest margin, and assess the sensitivity assumptions in the interest-rate model.
- Track implementation of Dodd-Frank, Basel III and FDIC assessment changes, including effects on capital, funding costs and fee income.
- Reconcile liquidity at the holding-company level with consolidated cash, including collateral restrictions and the availability of bank dividends to the parent.
- Assess whether securities-related gains in accumulated other comprehensive income, the large securities portfolio and the reported 2010 securities turnover affect future earnings or capital.