Cullen/Frost Bankers, Inc. — Q3 2011 Form 10-Q
Reporting period: Quarter and nine months ended September 30, 2011. The interim financial statements are unaudited. Unless noted otherwise, amounts below are in U.S. dollars.
Business context and reporting period
Cullen/Frost is a Texas-based financial and bank holding company providing commercial and consumer banking, trust and investment management, insurance, and related financial services. Its primary operating segments are Banking and Frost Wealth Advisors. It acquired San Antonio-based Clark Benefit Group on May 1, 2011; the filing says the acquisition did not significantly affect the financial statements.
Financial performance and position
| Metric | Q3 2011 | Comparable period |
|---|---|---|
| Net interest income | $145.4 million | $142.4 million in Q3 2010 |
| Non-interest income | $79.2 million | $70.4 million in Q3 2010 |
| Net income | $54.5 million | $55.0 million in Q3 2010; $55.7 million in Q2 2011 |
| Diluted EPS | $0.89 | $0.90 in Q3 2010; $0.91 in Q2 2011 |
| Tax-equivalent net interest margin | 3.81% | 4.04% in Q3 2010; 3.95% in Q2 2011 |
- For the first nine months, net income was $162.1 million, or $2.64 diluted EPS, versus $155.7 million, or $2.57, in 2010. Tax-equivalent net interest income was $476.7 million versus $461.1 million.
- Nine-month non-interest income rose to $222.3 million from $211.8 million, while non-interest expense increased to $414.3 million from $401.8 million. The provision for loan losses fell to $27.4 million from $32.3 million.
- Net interest margin was 3.93% for the first nine months, down from 4.13%. Management attributed margin pressure to low market rates and a greater share of assets held in lower-yielding deposits and securities rather than loans.
- At September 30, total assets were $19.49 billion, deposits $16.06 billion, net loans $7.97 billion, and shareholders’ equity $2.25 billion. Cash and cash equivalents were $4.49 billion, compared with $2.82 billion at December 31, 2010.
- For the first nine months, operating cash flow was $259.3 million, investing cash outflow was $132.0 million, and financing cash inflow was $1.54 billion, including a $1.58 billion net increase in deposits.
- Borrowings included $658.2 million of federal funds purchased and repurchase agreements, $123.7 million of junior subordinated debentures, and $100.0 million of other long-term borrowings. The latter declined from $250.0 million at December 31, 2010.
- Regulatory capital ratios were well above the filing’s “well capitalized” thresholds: Cullen/Frost reported total risk-based capital of 16.57%, Tier 1 risk-based capital of 14.59%, and a leverage ratio of 8.82%.
Material changes versus prior periods
- Q3 net income declined 0.9% year over year, mainly because of higher income taxes and operating expenses, partly offset by stronger non-interest income, higher net interest income, and a lower loan-loss provision. Nine-month net income increased 4.1%.
- Loan balances were nearly flat year over year and down modestly from year-end 2010. Commercial and industrial loans grew during the first nine months, while real estate and consumer lending declined.
- Credit indicators improved in several respects: non-performing assets were $139.3 million, down from $165.0 million at year-end 2010, and non-accrual loans were $110.2 million versus $137.1 million. However, nine-month net charge-offs increased to $38.3 million from $31.5 million a year earlier.
- The allowance for loan losses was $115.4 million, or 1.43% of loans, compared with $126.3 million, or 1.56%, at year-end 2010. The unallocated allowance increased, reflecting higher general macroeconomic risk reserves.
- Deposits rose substantially, with non-interest-bearing demand deposits reaching $6.54 billion. The resulting growth in cash and securities helped expand liquidity, while increasing the share of lower-yielding assets pressured margins.
Outlook, commentary, risks, and unusual items
- The filing provides no specific earnings or revenue guidance. Management cautions that interim results are not necessarily indicative of full-year or future results.
- Management expected debit-card interchange revenues to be approximately one-third of pre-October 1, 2011 levels following new Federal Reserve fee limits applicable to the company. The filing notes actual impact depends on transaction mix and negotiated merchant rates.
- Interest-rate simulations projected a 0.4% increase in 12-month net interest income under a 100-basis-point rate increase, a 0.6% decline under a 200-basis-point increase, and a 1.5% decline under a 25-basis-point decrease. The model assumed the company would begin paying interest on demand deposits in Q4 2011; actual deposit pricing could change the sensitivity.
- Q3 income tax expense included $4.3 million related to correcting prior-year tax treatment of municipal-securities premium amortization, including interest and penalties, and a further $1.7 million accrual for Q1 and Q2 2011. The reported Q3 effective tax rate was 30.3%; management said the nine-month rate would have been 21.5% excluding the prior-year correction.
- Q3 non-interest income included a $6.4 million gain on sales of longer-duration municipal securities and $582,000 related to a legal judgment. Q3 other expense included a $1.4 million write-down of a limited partnership interest and other one-time charges. Management also said expanded marketing activity would make advertising expense significantly higher in 2011 than in 2010.
- Management cited continuing economic uncertainty, weakness in sectors including construction, commercial real estate, manufacturing, and healthcare, high unemployment, and low consumer spending. It identified loan-loss estimates, borrower performance, interest rates, financial-market volatility, regulation, and liquidity as risks.
- Commitments to extend credit were $4.79 billion and standby letters of credit were $235.3 million. Management did not expect the disposition of ordinary-course legal matters to have a material adverse impact. No material change in previously disclosed risk factors was reported.
Most important facts for investors to verify
- Whether interchange-fee reductions materially affect fee income after implementation, and whether other revenue offsets emerge.
- Whether loan charge-offs, past-due balances, and identified potential problem loans continue to improve; potential problem loans were $42.3 million, concentrated in a small number of borrowers.
- Whether the reduced allowance remains adequate given higher net charge-offs and management’s elevated macroeconomic-risk allocation.
- Whether deposit growth, demand-deposit pricing, and the securities-heavy asset mix further compress net interest margin or alter the interest-rate sensitivity described in the filing.
- How much reported earnings depended on securities gains and the tax correction, and whether recurring income and expense trends support future profitability.
- Capital and dividend capacity, including the effect of future regulatory treatment of trust preferred securities and the bank’s dividend restrictions.