CFR

Cullen/Frost Bankers, Inc. - 10-Q Summary (Period Ended June 30, 2006)

Business Context and Reporting Period

Cullen/Frost Bankers, Inc. is a financial holding company headquartered in San Antonio, Texas, operating primarily through its subsidiary, Frost Bank. The company provides commercial and consumer banking, trust and investment management, investment banking, and insurance brokerage services across 12 Texas markets. This report covers the quarterly period ended June 30, 2006, and the six months ended on that date.

Key Financial Metrics

Material Changes vs. Prior Period

• Profitability Growth: Net income increased 19.3% year-over-year for the quarter and 22.0% for the six-month period. This was driven primarily by a $22.9 million increase in net interest income and a $2.5 million increase in non-interest income.
• Net Interest Income: Increased significantly due to a 28 basis point expansion in the net interest margin (to 4.70%) and a $1.4 billion increase in the average volume of earning assets. The rise in market interest rates (Prime rate reached 8.25%) benefited the company's asset-sensitive balance sheet.
• Acquisitions: The company completed acquisitions of Texas Community Bancshares, Inc. and Alamo Corporation of Texas in the first quarter of 2006, contributing to loan and deposit growth. Goodwill increased by $76.9 million related to these transactions.
• Expense Management: Non-interest expenses rose 12.0% year-over-year, largely due to increased salaries and wages (driven by merit increases, headcount growth from acquisitions, and the adoption of SFAS 123R for stock-based compensation) and higher occupancy costs.
• Loan Portfolio: Total loans grew 8.1% from the prior year-end to $6.58 billion. Commercial and industrial loans comprised 46.4% of the portfolio, while real estate loans comprised 48.3%.

Guidance, Outlook, Risks, and Unusual Items

• Subsequent Event (Merger): On July 2, 2006, the company entered into an agreement to acquire Summit Bancshares, Inc. for approximately 3.84 million shares of common stock and $143.4 million in cash. The merger is expected to close in the fourth quarter of 2006.
• Accounting Changes: The company adopted SFAS No. 123R on January 1, 2006, requiring the recognition of stock-based compensation expense based on fair value. This resulted in an additional $3.4 million in expense for the six months ended June 30, 2006, reducing EPS by $0.04.
• Asset Quality: Non-performing assets totaled $37.3 million (0.33% of total assets). The allowance for possible loan losses was $85.6 million, representing 1.30% of total loans. Net charge-offs were $6.2 million for the six-month period.
• Market Risk: The company remains asset-sensitive. Simulations indicate that a 200 basis point increase in interest rates would result in a 2.8% positive variance in net interest income, while a 200 basis point decrease would result in a 4.5% negative variance.
• Unusual Items: The prior year included non-recurring income from legal claim settlements and distributions from the sale of the PULSE EFT Association, which are not present in the current period.

Investor Verification Checklist

• Merger Integration: Verify the timeline and regulatory approval status for the proposed acquisition of Summit Bancshares, Inc.
• Stock Compensation Impact: Assess the long-term impact of SFAS 123R adoption on future earnings and cash flow, noting the $10.6 million in unrecognized stock-based compensation expense.
• Interest Rate Sensitivity: Monitor the Federal Reserve's interest rate trajectory, as the company's asset-sensitive model benefits from rising rates but faces margin compression if rates fall.
• Loan Concentration: Review the exposure to the energy industry within the purchased shared national credits (SNC) portfolio, which represented 52.0% of the SNC portfolio.
• Dividend Policy: Confirm the sustainability of the dividend payout ratio (38.9% in Q2 2006) given the capital requirements for the pending merger.