CULLEN quarterly report, Q2 FY2011

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Cullen/Frost Bankers, Inc. (CULLEN) — Q2 2011 Form 10-Q

Reporting period: Quarter and six months ended June 30, 2011. Unaudited consolidated results. Cullen/Frost is a Texas-based financial holding company providing banking, trust, insurance, investment and related services.

Financial performance

  • Q2 revenue: $215.1 million, up 1.6% from $211.8 million a year earlier; this is net interest income plus non-interest income. Net income rose 5.3% to $55.7 million; diluted EPS was $0.91 versus $0.87.
  • First-half results: Net income was $107.6 million, up 6.8%; diluted EPS was $1.75 versus $1.66. Net interest income increased 2.4% to $286.1 million and non-interest income increased 1.3% to $143.1 million.
  • Net interest margin: Taxable-equivalent margin was 3.95% in Q2 versus 4.18% a year earlier, and 3.99% for the first half versus 4.18%. Higher average earning-asset volumes supported income, while lower yields and a greater share of funds in low-yield deposits weighed on margin.
  • Costs and credit provision: Q2 non-interest expense rose 1.6% year over year to $136.8 million; first-half expense rose 2.8% to $276.9 million. The loan-loss provision was $9.0 million for Q2 and $18.4 million for the first half, versus $8.7 million and $22.2 million, respectively, in 2010.
  • Returns and dividends: Q2 return on average assets was 1.23% and return on average equity was 10.45%. The quarterly dividend was $0.46 per share; first-half dividends totaled $0.91 per share.

Balance sheet, cash flow and capital

  • At June 30, total assets were $18.48 billion, up from $17.62 billion at year-end 2010. Deposits were $15.10 billion, including $5.82 billion in non-interest-bearing demand deposits; total loans were $8.07 billion and net loans were $7.95 billion.
  • Cash and cash equivalents were $3.42 billion. For the first half, operating cash flow was $165.7 million, investing cash flow was negative $239.5 million, financing cash flow was $673.4 million, and cash increased $599.6 million.
  • Shareholders’ equity was $2.18 billion. Borrowings included $574.1 million of federal funds purchased and repurchase agreements, $123.7 million of junior subordinated debentures and $250.0 million of other long-term borrowings.
  • At June 30, Cullen/Frost’s total risk-based capital ratio was 16.42%, Tier 1 risk-based ratio 14.37%, and leverage ratio 8.94%. Frost Bank’s corresponding ratios were 14.81%, 13.68% and 8.51%; the filing states the bank was well capitalized.

Material changes and credit quality

  • Loans declined 0.6% from December 31, 2010, while deposits increased 4.3%. Commercial and industrial loans grew; real estate and consumer loans declined.
  • Non-performing assets were $161.4 million, or 1.99% of loans and foreclosed assets, compared with $165.0 million and 2.03% at year-end. Non-accrual loans were $130.5 million, down from $137.1 million at year-end but up from $123.8 million in the prior quarter. Accruing past-due loans improved to $58.2 million from $82.0 million at year-end.
  • The allowance for loan losses was $122.7 million, or 1.52% of loans, versus $126.3 million and 1.56% at year-end. First-half net charge-offs were $22.0 million, essentially unchanged from 2010. Potential problem loans increased to $39.8 million from $33.8 million at year-end. The company reported no restructured loans at the dates shown.
  • Trust fees grew, supported by higher investment-related fees and market values of trust assets. Deposit service-charge income declined, primarily due to lower overdraft fees. First-half revenue from Visa check-card usage was $11.5 million.

Outlook, risks and notable items

  • The filing gives no specific earnings or revenue guidance. Management cautions that interim results are not necessarily indicative of full-year or future performance.
  • Management expected new debit-interchange limits effective October 1, 2011 to reduce debit-card interchange revenue to approximately half of then-current levels. The company also expected to begin paying interest on certain demand deposits following the July 21, 2011 rule change; the resulting funding costs could pressure margins. Interest-rate simulations indicated limited sensitivity under modeled scenarios, including a 0.5% negative net-interest-income variance for a 200-basis-point rate increase and 0.7% for a 25-basis-point decrease over 12 months.
  • Management cited economic uncertainty, weakness in sectors including construction, commercial real estate, manufacturing and healthcare, high unemployment and low consumer spending as credit risks. Texas Leading Index data had improved, but management maintained macroeconomic reserves amid uncertainty.
  • The company refined its general loan-reserve methodology in Q1; management said the changes did not significantly affect first-half provision expense. The allowance remains sensitive to estimates and actual credit outcomes.
  • Available-for-sale securities had $2.6 million of unrealized losses at June 30. Management attributed these mainly to interest-rate movements, considered the impairments temporary, and reported no credit-quality impairment. First-half securities sales of $5.55 billion were principally associated with Texas franchise-tax planning and generated a net gain of only $5,000.
  • Cullen/Frost acquired Clark Benefit Group on May 1; the filing says the acquisition did not significantly affect the financial statements. Management did not expect pending legal matters to have a material adverse impact. No material change to previously disclosed risk factors was reported.
  • Disclosure controls were assessed as effective, with no material quarterly change in internal control over financial reporting.

Important facts for investors to verify

  • Track deposit pricing and the realized impact of demand-deposit interest and debit-interchange limits on revenue, funding costs and net interest margin.
  • Monitor non-accrual loans, potential problem credits, charge-offs and allowance assumptions, especially commercial and real estate exposures.
  • Assess whether the shift toward securities and interest-bearing deposits, rather than loans, continues to constrain asset yields and margins.
  • Review liquidity and capital alongside the composition and cost of borrowings; the parent company depends in part on bank dividends, which are subject to regulatory limits.
  • Confirm whether stated expectations for interchange revenue, rate sensitivity, litigation and the Clark Benefit Group acquisition’s effects were borne out in subsequent filings.