CFR

Business Context and Reporting Period

Cullen/Frost Bankers, Inc. (Cullen/Frost) 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, insurance brokerage, and investment banking services across 12 Texas markets. This report covers the quarterly period ended June 30, 2005.

Key Financial Metrics

All figures in thousands, except per share data.

Capital Ratios (June 30, 2005): Cullen/Frost maintained a Total Capital to Risk-Weighted Assets ratio of 15.82% and a Tier 1 Capital to Risk-Weighted Assets ratio of 12.84%, significantly exceeding regulatory minimums.

Material Changes vs. Prior Period

• Profitability Growth: Net income increased 19.2% ($6.6 million) for the quarter and 16.5% ($11.0 million) for the six months compared to the same periods in 2004. This was driven primarily by a 15.7% increase in net interest income.
• Net Interest Margin Expansion: The net interest margin (taxable-equivalent) increased to 4.42% for the quarter and 4.35% for the six months, up from 4.02% and 4.03% in 2004, respectively. This improvement resulted from rising market interest rates and an asset-sensitive balance sheet.
• Loan Portfolio Growth: Total loans increased 8.2% ($423.7 million) from December 31, 2004, to $5.6 billion. Commercial and industrial loans grew 9.9%, and real estate loans grew 7.8%.
• Non-Interest Income: Total non-interest income rose 2.5% for the quarter and 1.8% for the six months. A notable $2.4 million gain was recognized from the settlement of legal claims against former employees, offsetting declines in service charges on deposit accounts and insurance commissions.
• Expense Management: Non-interest expenses increased 5.0% for the quarter and 4.7% for the six months, primarily due to higher salaries, wages, and employee benefits.

Guidance, Outlook, and Risks

• Interest Rate Outlook: Management expects the upward trend in prime and federal funds rates to continue, which should positively impact net interest income given the company's asset-sensitive position.
• Acquisition Activity: On April 19, 2005, Cullen/Frost entered into a merger agreement to acquire Horizon Capital Bank. The transaction, valued at approximately 1.4 million shares of common stock and $45 million in cash, is expected to close in the fourth quarter of 2005.
• Accounting Changes: The company expects to adopt SFAS No. 123(R) regarding stock-based compensation on January 1, 2006. This is projected to increase quarterly compensation costs by approximately $1.1 million starting in the first quarter of 2006.
• Credit Quality: Non-performing assets totaled $41.3 million (0.42% of total assets) at June 30, 2005, an increase from $39.1 million at year-end 2004. Potential problem loans increased to $21.1 million, primarily related to energy, insurance, and software industry customers.
• Legal Contingencies: The company is subject to various legal actions but does not expect a material adverse impact on financial statements.

Investor Verification Checklist

• Acquisition Timeline: Verify the status of regulatory approvals and shareholder votes for the Horizon Capital Bank merger.
• Stock-Based Compensation Impact: Monitor the impact of the SFAS 123(R) adoption in 2006 on future earnings per share.
• Credit Concentration: Review the exposure to the energy industry within the purchased shared national credits (SNC) portfolio, which comprised 51.8% of that segment.
• Fee Income Trends: Assess the sustainability of non-interest income given the one-time $2.4 million legal settlement gain and declines in treasury management fees due to higher earnings credit rates.
• Capital Deployment: Track the execution of the stock repurchase plan, under which 300,000 shares were purchased in the first half of 2005.