Cullen/Frost Bankers, Inc. (NYSE:CFR) Q2 2023 Earnings Call Transcript

Cullen/Frost Bankers, Inc. (NYSE:CFR) Q2 2023 Earnings Call Transcript July 27, 2023

Cullen/Frost Bankers, Inc. misses on earnings expectations. Reported EPS is $1.81 EPS, expectations were $2.4.

Operator: Greetings and welcome to today’s Cullen/Frost Bankers Inc., Second Quarter Earnings Conference Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, A.B. Mendez, senior Vice President and Director of Investor Relations. Thank you. Please go ahead.

A.B. Mendez: Thanks, Donna. This afternoon’s conference call will be led by Phil Green, chairman and CEO and Jerry Salinas, Group executive Vice President and CFO. Before I turn the call over to Phil and Jerry, I need to take a moment to address the Safe Harbor provisions. Some of the remarks made today will constitute forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995 as amended. We intend such statements to be covered by the Safe Harbor provisions for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995 as amended. Please see the last page of this morning’s earnings press release for additional information about the risk factors associated with these forward-looking statements. If needed, a copy of the release is available on our website or by calling the Investor Relations Department at 210-220-5234. At this time, I’ll turn the call over to Phil.

Phil Green: Thanks, A.B. Good afternoon, everyone and thanks for joining us. We are here to review the second quarter results and our Chief Financial Officer, Jerry Salinas, is going to provide some additional comments before we open it up to your questions. And in the second quarter, Cullen/Frost earned $160.4 million, or $2.47 per share, compared with earnings of $117.4 million, or $1.81 a share reported in the same quarter last year. That represents a 36.6% increase over last year’s level. Our return on average assets and average common equity in the second quarter were 1.30% and 19.36% respectively. And that compares with a 0.92% and 13.88% for the same period last year. Once again, I’m proud of the solid performance turned in by our outstanding staff in this unusual economic environment.

The continued rate increases by the Federal Reserve and their fight against inflation have had their intended effect by slowing some segments of the market. In addition, increasing rates continue to raise the opportunity costs for businesses holding cash in liquid deposits. These impacts are to be expected through the rate cycle and will continue to play themselves out during this period and Jerry will provide some great insight into their near-term effects. As we said last time during the second quarter, Cullen/Frost did not take on any federal home loan bank advances, participate in any special liquidity facility or government borrowing, access any brokered deposits or utilize any reciprocal insurance arrangements to build insured deposit percentages.

But notwithstanding all that, we believe the most important thing for us to focus on at this time is that we are successfully executing our mission to grow and prosper building long-term relationships based on top-quality service, high ethical standards and safe sound assets. And I believe the results for this quarter show we are doing just that. And I am excited about our prospects. And let me give you a few examples. Looking at our commercial and private banking business, we had the best quarter ever for new customer relationships, which were up 33% from last year and were up 53% from the previous quarter. That was 1,145 new relationships. I think it’s also significant that almost half of those new relationships, 45% came from the largest banks we affectionately know as too big to fail.

Now, I normally wouldn’t go into this level of detail, but I’m going to read to you the unannualized linked quarter growth rates in new relationships by region. because I think it’s fascinating and tells me that it’s not an isolated occurrence in one specific market. Houston led all regions with 333 net new relationships, which was up 63% from the previous quarter. Dallas produced 262 net new relationships, which was up 32%. San Antonio produced 172 net new relationships, which was up 107%. Fort Worth produced 156 net new relationships, which was up 20%. Austin produced 117 net new relationships, which was up 102%. The Gulf Coast and Victoria regions produced 68 net new relationships, which is up by 48% and the Permian Basin produced 37 net new relationship, which was up by 28%.

Remember, these numbers are not annualized. to me, this says that we are winning competitively. Looking at our commercial lending business, we saw an increase in activity related to new opportunities, up 19% and an increase in our probability weighted pipeline by 27% from the first quarter. So, we’re seeing deal flow. In fact, we looked at 20% more deals than the first quarter. But that said, booked deals were down 8%, because we declined more, and more deals were withdrawn by the customer. We’re obviously being more careful in this environment, but I think the increases in opportunities is notable. I’ll also say that unlike the previous quarter, we saw more opportunities from our customers than prospects. Prospect opportunities were up 7% for the first quarter from the first quarter, but customers were up 34%.

Looking at our consumer business, in the second quarter, we set an all-time high for net new relationships at 8,529. This beat our previous all-time high, which was achieved in the first quarter by an unannualized 6%. Our Houston market, where we have the most mature expansion effort leads the way here with 2,600 net new relationships while Dallas and San Antonio produced about 1,500 each. Consumer loans ended the quarter at $2.6 billion, a 27% increase from the second quarter of last year and continues to be driven by consumer real estate as our home improvement and home equity products continue to provide the right product at the right time for customers with low-rate mortgages and great credit scores. Included in those numbers were over $12 million in mortgage loans as a part of our measured rollout of this product beginning in the Dallas market.

toward the end of the second quarter, we announced our upcoming expansion into the Austin region, which will build upon the momentum from our Houston and Dallas expansions. We plan to double the number of locations we have in the Austin area from 17 to 34. Austin is Texas’s third largest deposit market and we already rank fourth in deposit share. These locations will have a strong legacy to build on. our Houston expansion, including the 25 original locations plus the additional ones, which we call Houston 2.0, the most recent of which just opened in Princewood last week. Our expansion branches there are at 121% of household goals, 164% of our loan goal and 108% of our deposit goal. Expansion in Houston now represents $1.27 billion in deposits and about $850 million in loans.

for our Dallas expansion, although it’s early, we stand at 226% of new household goal, 315% of our loan goal and 377% of our deposit goal. expansion in Dallas currently represents $261 million in deposits and $217 million in loans. So all told, we have about $1.5 billion in deposits from the expansion and about $1 billion — a little over $1 billion in loans. credit quality continues to be good by historical standards. Problem loans, which we define as risk grade 10 or higher, totaled $441 million at the end of the second quarter. And that’s up from $348 million at the end of the first quarter and $429 million from this time last year. Non-performing loans totaled $68.5 million at the end of the second quarter, compared with $39.1 million at the end of the first quarter, the result of two credits.

the second quarter figure represents just 39 basis points of total loans and 14 basis points of total assets. Net charge-offs for the second quarter were $9.8 million, up from $8.8 million at the end of the first quarter and annualized net charge-offs for the second quarter represented 22 basis points of average loans and year-to-date charge-offs are 21 basis points of loans, which is below our historic average. Regarding commercial real estate, our overall portfolio remains stable with steady operating performance across asset types and acceptable debt service coverage ratios and loan to values. Within this portfolio, what we’d consider to be the major categories of investor CRE, they’re comprised, for example, of office, multi-family, retail and industrial as examples.

we totaled $3.5 billion of outstandings are about 40% of commercial real estate loans outstanding in total. Our investor commercial real estate portfolio was held up well, exhibiting an overall average loan to value of about 54% and loan to cost of about 60%, and acceptable reported debt service coverage ratios. Our interest rates have certainly led to some decline in coverage ratios, compared to original underwriting pro formas. but we’ve actually seen some improvement in coverage ratios quarter-over-quarter for the already stabilized properties in our portfolio. For example, 85% of our investor office portfolio is stabilized and average debt service coverage ratios increased from $1.38 to $1.42 this quarter. And we saw a similar trend in the stabilized portion of the multi-family portfolio.

The investor office portfolio, which is still top of mind, was relatively flat quarter-over-quarter with $927 million outstanding. It exhibited an average loan to value of 52% and an average debt service coverage ratio of 1.42 at current interest rates, starting from strong position with a cushion for potential value declines. Our comfort level with the office portfolio continues to be based on the character and experience of our borrowers and sponsors, the predominantly Class A nature of our office buildings, and the fact that 85% of the exposure is associated with stabilized, well performing projects. It also helps to be operating in Texas. We did have an $18 million office building loan that we’ve been watching migrate to non-accrual during the quarter.

But overall, the office portfolio and really entire investors CRE portfolio did not experience an identification of anything material in terms of weak, or underperforming credits or projects that we were not already watching. So to conclude, as I said earlier, I’m proud of our performance and what our bankers have been able to accomplish, as well as the competitive success we continue to exhibit in our markets. And now, I’ll turn the call over to our Chief Financial Officer, Jerry Salinas, for some additional comments.

Jerry Salinas: Thank you, Phil. I wanted to start off first by talking a little bit about our Houston 1.0 expansion results. As a reminder, the last of those branches was opened in 2021. So, these branches are still in what I call the development stage. As Phil mentioned, we’ve been very pleased with the volumes we’ve been able to achieve. Looking at the second quarter, linked quarter annualized growth in average balances for these locations was 31% for deposits and 17% for loans. And for the second quarter, Houston 1.0 contributed $0.05 to our quarterly earnings per share. Now, moving to our net interest margin. our net interest margin percentage for the second quarter was 3.45%, down 2 basis points from the 3.47% reported last quarter.

The decrease included some positives that were more than offset by some negatives. On the positive side, higher yields on loans and balances at the fed, combined with higher loan volumes were more than offset by higher cost of deposits and customer repos, and lower deposit levels at the fed compared to the first quarter. Looking at our investment portfolio, the total investment portfolio averaged $21.3 billion during the second quarter, down $466 million from the first quarter. During the quarter, we did not make any material investment purchases. During the quarter, we sold about $360 million in municipal securities as we took advantage of market dislocations, which allowed us to improve interest income going forward. we recognized a net gain of about $33,000 on those transactions.

The net unrealized loss on the available-for-sale portfolio at the end of the quarter was $1.61 billion, an increase of $207 million from the $1.4 billion reported at the end of the first quarter. The net unrealized loss on the held-to-maturity portfolio at the end of the quarter was $148 million, up $37 million from the first quarter. The taxable equivalent yield on the total investment portfolio in the second quarter was 3.24%, flat with the first quarter. The taxable portfolio, which averaged $13.8 billion, up approximately $439 million from the prior quarter, had a yield of 2.71%, up four basis points from the prior quarter. Our tax-exempt municipal portfolio averaged about $7.5 billion during the second quarter, down about $905 million from the first quarter, and had a taxable equivalent yield of 4.27%, up 4 basis points from the prior quarter.

At the end of the second quarter, approximately 72% of the municipal portfolio was pre-refunded or PSF insured. The duration of the investment portfolio at the end of the second quarter was 5.2 years, down from 5.5 years at the end of the first quarter. Looking at deposits, on a linked-quarter basis, average deposits were down $1.8 billion, or 4.1%, with about 80% of the decrease coming from non-interest-bearing deposits. I want to talk a little bit more about our non-interest-bearing deposits, which totaled $14.9 billion at the end of the quarter, with 96% of that amount being commercial demand deposits. During the individual months of the second quarter, we did see the average balance in the non-interest-bearing accounts begin to stabilize.

During last quarter’s call, we said that we expected deposits to continue to decline as this has historically been our seasonal trend that deposits peak in the fourth quarter and reach their low in the second quarter before beginning to grow in the second half of the year. I also noted that April non-interest-bearing deposits were down $492 million from March, and that we expected that April average to decline given the anticipated impact of seasonality, including tax payments. April non-interest-bearing balances decreased $587 million from March, almost $100 million more on average than at the time of our call. These average balances then decreased $441 million in May, with the average affected by tax payments in April and then decreased $108 million in June and month-to-date through yesterday, july average balances are down $202 million from the June average.

The June and July average balances have seen the pace of outflow begin to slow down and we are anticipating that slower pace of outflows to continue. But with interest rates at these levels, there continues to be uncertainty with these customer balances. Customers have attractive risk reward options in this rate cycle that didn’t necessarily present themselves in the last cycle, which provides them with multiple options for the utilization of these funds. Looking at total interest-bearing deposits, they’ve been relatively stable during the period. Average interest-bearing deposits were $25.8 billion during the quarter, down $345 million or 1.3% from the first quarter. We do continue to see a shift in the mix to higher-cost CDs from the lower-cost savings, IOC and MMA.

The cost of interest-bearing deposits in the second quarter was 1.87%, up 35 basis points from 1.52% in the first quarter. Customer repos for the second quarter averaged $3.7 billion, down $492 million from the $4.2 billion average in the first quarter as we saw some flows out of our repo product, including for tax payments during the quarter. The cost of customer repos for the quarter was 3.52%, up 32 basis points from the first quarter. Looking at non-interest income on a linked quarter basis, I just wanted to point out a couple of items, trust and investment management fees were up $3.2 million, or 9%, compared to the first quarter, driven by increases in estate fees of $1.6 million, real estate fees of $751,000 and investment fees of $463,000.

Estate fees and real estate fees can fluctuate based on the number of estates settled or properties sold respectively. Insurance commissions and fees were down $6 million, or 32% from the first quarter, driven by lower P&C contingent bonuses down $3.1 million, benefit commissions down $4.8 million and live commissions down $867,000, partly offsetting these unfavorable variances was a $3 million increase in P&C commissions when compared to the first quarter. As a reminder, the first quarter is typically our strongest quarter for insurance revenues, given we typically recognize contingent income in that quarter and are also impacted by our natural business cycle. The second quarter is typically our weakest quarter for insurance revenues again, impacted by our normal renewal business volumes.

Looking at our projection of full-year 2023 total non-interest expenses; as I mentioned last quarter, we currently expect total non-interest expense for the full-year 2023 to increase at a percentage rate in the mid-teens over our 2022 reported levels. This does not include the potential impact of the FDIC special assessment, which has not yet been finalized. The effective tax rate for the first six months of the year was 16%, or about 16.2%, excluding discrete items. Our current expectation is that our full-year effective tax rate for 2023 should approximate 16%, but that can be affected by discrete items during the rest of the year. Regarding our stock buyback, I want to mention that during the second quarter, we utilized about 28 million of our 100 million approved share repurchase plan to buy back approximately 280,000 shares at an average price of $96.02.

Regarding the estimate for full-year 2023 earnings, our current projections don’t include any additional changes to the fed funds rate through the rest of 2023. Given that rate assumption and our expectation of 2023 non-interest expense growth of mid-teens, which does not include the impact of the FDIC special assessment, we currently believe that the current mean of analyst estimates of $9.63 is a little high. With that, I’ll now turn the call back over to Phil for questions.

Phil Green: All right. Thanks, Jerry. And now, we’ll open it up for your questions.

Q&A Session

Operator: Thank you. [Operator Instructions] Today’s first question is coming from Brady Gailey of KBW. Please go ahead.

Brady Gailey: Hey, thanks. Good afternoon, guys.

PhilGreen: Hey, Brady.

Jerry Salinas: Hey, Brady.

Brady Gailey: So, your net interest margin has held in very well, especially relative to the industry, which saw NIM slippage by a decent amount this quarter for most of your peers. Do you expect the net interest margin to continue to hold in relatively well, or do you think that at some point, you will see some real downside there.

PhilGreen: What I’d say, Brady, I thought that last quarter, I said it was going to be relatively stable. I think I’d stick with that, except that I would say that there’s a downward bias. When I talked about the two basis-point decrease that we had between the first and the second quarter, all those positive and negatives are still kind of affecting us going forward. So, I’d say kind of stable. but again, with probably more towards a little bit negative bias. But I don’t see it changing significantly, not based on anything I’m seeing.

Brady Gailey: Okay. And then I know in the past, you guys have talked about some of the financial impacts of expanding into a new market like Austin. I don’t think they’ve moved the numbers a ton. But any guess on the financial impact of the Austin expansion over the next year or two?

Jerry Salinas: Brady, we’ll talk about that in January. We really would give some guidance and obviously, it’s going to be primarily expense based at the beginning as you know. as we start putting those locations together, I don’t expect for 2023 that they’ll have a significant impact. So any impact, we’ll start feeling next year and we’ll kind of give some color at the beginning of the year.

PhilGreen: Yes. I just might add, Brady, just that the scope of it’s a little bit smaller just by its nature than Dallas or Houston. The expansions that we’ve had there. So, pound for pound, it’ll be about the same, but the scope of it just a little small.

Brady Gailey: Okay. And then finally, for me, NPAs are up. They’re still at a very low level. But I think I heard you mention two credits move into the NPA bucket. One was an $18 million office loan. What was the other NPA that went into that bucket this quarter?

PhilGreen: Yes. it was in the pre-owned auto sale dealership, and the higher interest rates really impacted its carry costs and also the performance of some of the paper that it carries. And so we thought it was appropriate to recognize that. So, it wasn’t real estate related, but it was in the automobiles area.

Brady Gailey: Okay. All right, great. Thank you, guys.

PhilGreen: Thank you.

Jerry Salinas: Thank you.

Operator: Thank you. The next question is coming from Steven Alexopoulos of JPMorgan. Please go ahead.

Steven Alexopoulos: Hi, everybody.

PhilGreen: Hey, Steven.

Jerry Salinas: Hey, Steven.

Steven Alexopoulos: I want to start. So, the non-interest-bearing deposits last quarter, you guys thought would come down in 2Q and then stabilize, and we’re seeing continued outflows. I’m just curious what’s taking customers so long to just reach that amount of operating cash that they need? I find it hard to believe with every move, they’re, like, digging deeper and deeper. I would have thought it would pretty much be done by now.

PhilGreen: I think, Steven, it’s — as I’ve said in my comments, I think the rate environment that we’re in is so unique and so different, there’s a lot more opportunities for them to invest that money. It’s really impressive rates. So, even though I said that in my mind, a couple of hundred million is certainly better than the 500 million and 600 million decreases that we were seeing. But I do think that there continues to be volatility there. I think there’s just too many options for them to utilize those funds, whether it’s to pay off any debt that they might have or decide to invest it and investment could certainly be. And we’ve seen some dollars obviously flow into our off-balance sheet, either trust areas or treasury areas.

So, I think, now I’m with you. I kind of thought most of it was gone, but I think in the environment, we’re going to continue to see some pressure there. I think the upside for us is, as Phil mentioned, we really feel very positive about all the new relationships that we’re bringing in. We see some pretty impressive deposit wins. and in some cases, those commercial wins take a little bit longer to get on the books and get them closed. But I think in the rate environment, we’re just going to continue to be cautious. I think everybody’s going to have to make the decision on how they want to invest those funds. And all we can really do is to continue to focus on growing the business and adding new customers.

Steven Alexopoulos: Okay. And then on the balance sheets, you guys had good loan growth in the quarter, more or less funded with securities. If you just look at the movements on the asset side. as we think about the back half, jerry is maybe these non-interest-bearing outflows subside a bit, do you think we’ll see net balance sheet growth in the second half or will you just continue to fund loan growth with other assets that run off?

Jerry Salinas: I think that we’re projecting some small growth on the funding side at this point. Nothing really material. Again, given the uncertainty that we’ve got on the commercial side, our projections really do have some growth, but it’s not anything that I would say is significant.

Steven Alexopoulos: Okay, thanks. And then final one. So Phil, I appreciate all of the line items that you ran through by market, in terms of customers that you guys are picking up, I’m curious. So, your service is consistently good, peers are consistently not as good. What is it about this environment that you’re seeing in so many customers move banks? Thanks.

PhilGreen: Yes. Mr. Steven, I think it’s a couple of things primarily. when you look at our movement in terms of growth and new relationships, the expansion no doubt has a really big effect on that. and I think it’s really paying off in terms of growing those relationships overall. we’ve also been spending more and focused more on marketing. I think we’re doing a better job on marketing. and then reputationally and just to be honest, we’ve got a great reputation and reputation for great service. So, it’s been pretty exciting as we’ve moved into some of these markets. In some cases, I was thinking about one we opened up and I think it’s Dallas just recently. I think the closest Frost bank was 15 miles away and the growth has just been tremendous.

So, I think it’s really simple. I think we are investing in our business. We’re growing our distribution in fantastic markets. We’ve got a great value proposition for service, and we’re marketing and investing in marketing and technology. I think it’s just all working together to win. And I apologize for giving so much granularity on that, but it just shows that that’s really what we’re focused on is new relationships. It’s a part of our mission statement that’s called out. And we’re going to go through rate cycles up and down, and we’re going to see movements of non-interest-bearing deposits out and all that stuff. That’s going to happen. But if we just focus on growing the business, growing the relationships in great markets, we’re going to do fine.

Steven Alexopoulos: Okay, thanks. And I appreciate all the detail for what it’s worth. Thanks for taking my questions.

PhilGreen: All right, thank you.

Operator: Thank you. The next question is coming from Dave Rochester of Compass Point. Please go ahead.

Dave Rochester: Hey. good afternoon, guys.

PhilGreen: Hey, Dave.

Dave Rochester: Just going back to your EPS outlook comment for ‘23, I know you mentioned the stable NIM with a downward bias, so that was helpful to hear. I was just wondering, how are you expecting that to translate into NII trends for the back half of the year at this point? Are you thinking stable-ish NIM and stable funding what you just mentioned would get you to stable-ish NII, or how are you thinking about that at this point as you look at your EPS outlook?

PhilGreen: Yes. I guess, the thing that I would focus on is kind of where we ended the quarter on the deposit side. I mentioned to Steven that we’re not projecting a whole lot of growth from there for the rest of the year. And so that obviously will have some impact on net interest income. So, I think that’s really where the pressure is.

Dave Rochester: Okay. And then regarding deposit trends, you said earlier, it sounded like you’re baking in marginal deposit growth or marginal funding growth, I guess, in the back half. Are you assuming that DDA continues to decline through that period as well? I know you mentioned that the runoff had subsided a bit, but is that the general expectation now you continue to have mixed shift through the end of the year?

PhilGreen: Yes. and again, we’re projecting growth. but I think that on an annualized basis, I think we’re at 2% or something like that, that we’re projecting. What’s interesting is 1% of that is our legacy bank and 1% is coming from our expansion. So obviously, they’re having an impact on our growth. But that aside, I think that gives you some perspective on the size of the deposit side that we’re projecting. And I think the mix, I would expect that it probably will not change a whole lot. But if there is a movement, I would expect that the pressure continues to be more on the non-interest-bearing side than on the interest-bearing side. And on the interest-bearing side, I think we’re starting to see some settlement there on rates. but with this rate hike, we’ll actually obviously react to that. But I think you’ll still see some movement of mix, but it appears everything’s stabilizing, certainly a lot more than we saw just a quarter ago.

Dave Rochester: Yes. Okay. And then just given where we are in the rate cycle, have you guys been reducing asset sensitivity at all in the past quarter, or do you have any plans to do that in the back half of the year, just with swaps or anything else?

PhilGreen: I think right now, we’re really kind of sitting tight. We’re obviously looking at a lot of opportunities and things that we can do. but at this point, I wouldn’t envision that we’re doing anything very drastic obviously, asset sensitivity is diminishing as the balances that we’re holding at the fed are diminishing as we’re seeing the decreases in non-interest-bearing deposits. but other than that, not doing anything actively.

Dave Rochester: Okay. And maybe, just one last one on expenses. I appreciated the reiterated guide there. It seems like just given where we are in the first half, you’re looking for a pretty deep ramp up in the second half. Is that kind of what you guys are looking at, at this point? Is that likely to see that kind of a ramp up?

PhilGreen: Yes. that’s kind of what we’re saying. We obviously review our projections monthly and talking to our lines of business, and everything that we’re seeing certainly is pointing us in that direction.

Dave Rochester: Okay. Thanks, guys.

Operator: Thank you. The next question is coming from Manan Gosalia of Morgan Stanley. Please go ahead.

Manan Gosalia: Hey, good afternoon. I wanted to ask about the liquidity and the cash balance in the quarter. I know the average was about $7 billion, which was, I think, sort of in line with where you had indicated balances were back in April. So, is it fair to say that you didn’t utilize any of that through the quarter? And now that the environment has stabilized, do you plan to continue, or would you use cash to support loan growth and deposit outflow? Or just given where fed rates are, does it sort of make sense to keep cash at 5% and continue to let securities level come down?

PhilGreen: Yes. that’s really where we are right now. I think that’s the sort of guidance we gave last quarter. And you heard me say we didn’t make any investment purchases. I think at this point, any decrease that we’ve seen in the cash balances at the fed and I think we were at the end of the quarter, we were down to $6.3 billion, little under 16% of our deposit balances. So at this point, I think we’re pretty comfortable with that. As you said, looking at the 540 that we’re earning now, we’re not looking to make any active moves on the investment portfolio at this point.

Manan Gosalia: So can you remind us how much the securities portfolio, how much of that should mature every quarter for the next year or so?

PhilGreen: I think for the rest of the year, I think we’re at 720 million — say 715, with really 250 million, a third of it, say a little bit more than a third on the last day of the month. So, the last part of ‘23, the second half of ‘23 is what I’d call a normal amount. As we look at ‘24, we’re probably talking something in the neighborhood of $3 billion for the year.

Manan Gosalia: Got it. Thank you.

PhilGreen: Sure.

Operator: Thank you. The next question is coming from Peter Winter of D.A. Davidson. Please go ahead.

Peter Winter: Thanks. I was curious, what’s the outlook for the deposit beta? I think the original forecast was 32%. And then secondly, do you think that there’ll be pressure on this deposit beta next year as we’re in kind of a higher for longer rate environment and your interest rates on deposits are a little bit lower than peers?

PhilGreen: Our cumulative beta through — on interest bearing deposits through the second quarter was 37%, up from 33% in the first quarter. On total deposits, that translates to 23% at the end of the second quarter versus 20%. I would expect that we would go up to somewhere by the end of the year, say in the 39% given this last rate hike that we’re dealing with. I think that’s comparable to what we’ve looked at, what we’ve done historically, say the average of the last two cycles. but looking at 2024, not really in this environment, not expecting, Peter, that we’d have to do much. again, it’ll be interesting to see where we’re at come January and what our expectations are. But I don’t envision we’ve kept up with deposit pricing and tried to be fair and obviously have gone out early to provide our customers with a fair deal.

So, I don’t expect that once if the fed has stopped hiking, I don’t expect that we’re going to have to do a lot of continuing to increase our betas, if you will, or increase our deposit rates after the hikes stop. So now, I don’t really expect much change. We’ll have to see obviously. we’re going to want to make sure that we continue to be competitive with our peers. That’s the one thing that we want to make sure. But at this point, if I had a crystal ball, I’m not seeing a lot of pressure there at this point.

Peter Winter: Okay. And then I just want to ask a big picture, I’m just a little bit surprised that maybe, the deposit outlook is not a little bit stronger. I mean, I realized what the environment is like. but every quarter, you guys keep having this record new account growth both on the commercial bank, the consumer bank, the success with the branch build out expansion, and that’s starting to take hold. I’m just wondering why the deposit outlook is just not a little bit stronger with all this growth.

Jerry Salinas: Well, I think one thing, Peter is that we need to consider as we answer the question. and I’d say, from a broad perspective, I can’t say exactly why. but one thing I can say is that we tend to have a lot more operational transactional accounts, demand deposit accounts, checking accounts than peers. And I think those are more susceptible to opportunities that Jerry’s talked about. So, I think we’ve got to work our way through that. And then I think once we touch bottom, you’ll get to see movement up. I’m confident that we’re going to see a traction from these new relationships. One thing we saw early in the Houston expansion was that when we looked at our performance versus goal on deposits, we were better on relationships, but we were under our goal in commercial deposits as far as balance.

And one thing that we learned was getting the relationship is one. but they’ve got to — and this is on the commercial side, you’ve got to go through getting your customers to send their payments to a different place. There’s just a lot of operational things that have to happen before you as a business see the full effect of being the primary checking account take place. And so I think that’s part of it. But what we’ve seen is, as we’ve grown and relationships historically, we’ll see more and more of that company’s business go through there, and I’m confident we’re going to see that.

Peter Winter: Got it.

Jerry Salinas: Remember, we don’t count a relationship unless we get the primary checking account. We’ll do business with people. We get different aspects of their business, but you don’t get to count it as a relationship unless you get the primary checking account.

Peter Winter: Got it. Thank you.

Operator: Thank you. The next question is coming from Brandon King of Truist securities. Please go ahead.

Brandon King: Hey, good afternoon. Thanks for taking my questions.

PhilGreen: Hey, Brandon.

Brandon King: So, I wanted to talk about the $80 million office loan. Could you please provide us with some details as far as what potentially makes that loan or property different from the rest of your office CRE portfolio?

Jerry Salinas: Okay. well, in the case of this one particular asset, it’s one that lost a major tenant and it was one that is a newer relationship for us. and that it came on right before COVID, it came over, I think it was in January of 2020. And so there’s not that same type of history. A good reputational group, but not the same kind of history thus. And as they lost that tenant and then their debt service coverage numbers suffered as a result, we felt like they needed to right-size it to a certain extent, they didn’t agree with it. And they were willing to do a smaller amount. So, it’s been restructured and it’ll perform for the next year, but not to the level that we think it should. And so we’ve got that on a non-accrual and it was basically you just had a disagreement between the parties on what they should do as far as right-sizing the project.

in terms of the asset itself, it is an office building loan, but we booked it at the amount of the underlying real estate. And it is a tremendous piece of real estate in a very dynamic area of Houston. And so I’m not concerned about valuation losses of any significance, but because of where we are and because it does cash flow to the place that we feel it needs to be, we put it on non-accrual. And as far as what’s different, I mean, look, rates are higher and we’ve got a tremendous amount of projects and they’re not all going to be perfect. And you could end up, I think we talked before, maybe as I recall, you could have a property that is an industrial property with a Fortune 500 credit tenant, long-term lease and underwritten before COVID or the current increases in rates.

That looks great, right. But at the present value of that lease stream today is less. And so equity suffers in the project, those types of things. And they’ve got to get worked out and we’ll just see how they work out. Do we think there’ll be significant impact on loss? No. but we’re watching credits that look like that. You might have a senior housing property that is kind of a different deal. I mean again, this is a lending business. There are all kinds of things that happen. It’s a risk business, but there are lots of properties that are being impacted. And the main thing that we’re doing is we’re relying on the underwriting that we did going in and the people that are backing it up, the vast majority of which have been long-term customers.

So, we’re going to see some dislocation here and there. Sure, we are. but do things look good today on a historical basis? And are we happy with the underwriting that we’ve done over time? I am. And we’ll just see how it goes out over the cycle.

Brandon King: Got it. Very helpful. My follow-up question is on the share repurchases in the quarter. Just kind of what led to that decision and kind of what kind of appetite do you have for the rest of the year?

Jerry Salinas: We really just — at the price, like I said, we were at $96, and we just thought it was a deal that we really couldn’t pass up. Obviously, we didn’t spend all of it. We just thought, given where the price was, we thought it was a great value for us and we took advantage of that. At this point, we’ll be opportunistic if something like that happens. Again, we may take advantage, but at this point, nothing planned.

PhilGreen: Jerry’s a great example of those people using those demand deposit balance.

Brandon King: Thanks for taking my questions.

PhilGreen: Yes, Brandon.

Operator: Thank you. The next question is coming from Broderick Preston of UBS. Please go ahead.

Broderick Preston: Hey. good afternoon, everyone.

PhilGreen: Hey, Brody.

Broderick Preston: I was hoping to follow up just on the securities question. I just wanted to confirm what you said, that it was $750 million was that through the rest of the year with the large chunk on 1231? And then 3 billion next year. Am I hearing that correctly?

Jerry Salinas: Yes, sir. You got it exactly.

Broderick Preston: All right, great. Do you happen to know what the yield on the securities that’s rolling off is?

PhilGreen: I can tell you something right off the top of my head. We bought $1 billion we’ve talked about this. We bought $1 billion in treasury securities two years ago, I guess, a year and a half now when there was conversation about Russia invading Ukraine, and we made that purchase as a defensive posture, obviously I wouldn’t have made it today. We did that at 1%. So, that first $250 million comes off at the end of the year and it’s at 1%, 102, I think is. And then the next 750 of those proceeds come in within the first few weeks of January, again, at that same 102%.

Broderick Preston: Got it. Okay. And I think you said earlier that you weren’t being too aggressive on new purchases, but in terms of adding to the size of the book. But is it safe to assume that you would look to replace that $3.75 billion over the next 18 months? Would you just look to kind of replace that, or are you trying to move the size of the securities portfolio lower?

PhilGreen: Yes. I think all things being equal. and by that, again, we’re talking about deposits a lot today, and assuming that we’ve reached some sort of stabilization and start to grow, I think the quick response would be, yes, we would look to replace it. But I think until we get to that point in time, we’ll have to see what else is going on, on the balance sheet and make our decision at that point. But obviously, that could be a great positive or will be a great positive impact to NIM and to net interest income in ‘24 just even if we kept it at the fed.

Broderick Preston: Got it. Is there any bias towards any type of security? I know you have a lot of the community bonds in Texas. I just didn’t know if you would look to kind of replace treasury with treasury, if it was anything more complex than that.

PhilGreen: Yes. I think we would really evaluate at that point with our investment committee what made, what we saw the most value. So, we don’t have anything that we’d say, oh, we’re necessarily going to replace a treasury with a treasury. We’re going to see where we think there’s most value in the market.

Broderick Preston: Okay, got it. That’s all I have for questions. Thank you very much.

PhilGreen: Thank you.

Operator: [Operator Instructions] The next question is coming from Jon Arfstrom of RBC Capital Markets. Please go ahead.

Jon Arfstrom: Thanks. Good afternoon.

PhilGreen: Hey, Jon.

Jon Arfstrom: Hey, just a few random ones here. on the credit question, Phil or Jerry, what should we expect on non-performers? I know these two kind of feel like random and very different credit, but what do you guys see in terms of stress in the portfolio? And maybe, it’s obvious, but do we just expect it to continue to rise?

PhilGreen: Jon, I think realistically, it will. Some of these — we’re watching a lot of credits and we’ve got good eyes on everything. If rates stay up and higher for longer, I think we’ll see some more non-performers and in real estate. But do I think there’s much loss there? No, I don’t. And we might get lucky and avoid some of them. But there are just some properties that are under stress, and I’m a Frost Banker. and so I’m going to take a conservative view. And I think non-performers will increase, but they’re so low right now. it’s really hard for us to expect them to be at the same level going through a cycle like this indefinitely. So, I mean, I’m not trying to paint a bleak picture, I’m just trying to be realistic. And we’re going to have to be patient as we work with these customers, the main thing you want to see is people doing the right thing that you’ve banked and working with you on restructuring deals, doing their part to contribute to make it right.

And we’ve got some deals that we’re seeing that they’re going to need that and we’re having conversations with that and I’m expecting everyone to perform the way they should. and I think it’ll be fine. But realistically, not everyone is going to do what you want them to do. And I don’t have any specific expectations there except I’ve just been in this business a long time and some of that’s going to happen. That to me, is not the big worry right now. Look, and I don’t want you to think we don’t have all eyes on credit we do I mean. But to me, that’s going to work its way out. I’ve got faith in the underwriting and the relationships that we’ve been doing for the last few years. Again, it doesn’t matter what you do today. Really, what matters is what you’ve done over the last few years.

And I’ve got a lot of faith in that. The thing that I want to see us continuing to do is win competitively. We are winning competitively. And I’m really excited about the opportunity in Austin. I think it’s got every chance to be as good as we’ve seen in other places and we’ll see. But that’s what we’re focused on is growing the business and winning competitively. Will we see some non-performers increase? I bet we will.

Jon Arfstrom: Okay. Yes. It kind of reminds me of energy seven years or eight years ago in some ways. Jerry, for you, the Houston 1.0, you talked about $0.05 EPS impact. So, call it 2% of EPS, maybe, crude math, but 4% of footings, how long does it take Houston 1.0 to reach, like corporate wide profitability and returns?

Jerry Salinas: Let me see if I can grab my — put my hands on some of that information. What was interesting is that Phil and I really haven’t talked about this. but for the quarter, it was interesting that how well Houston paid that, now at this point, they’re starting to pay for more of the expansion. It’s kind of what we had been talking about when all this started was the plan was to make 1.0 profitable. So that it could start paying for some of those. And I’d say what we said was it takes about 27 months to break even is kind of what we kind of project. So at this point, I think that Houston 2.0 is probably a couple of years away just from the standpoint that remember early on, it’s all expense loaded. And so at this point, it’s still going to be a couple of years before Houston 2.0 is contributing, okay. It’s not the size of 1.0, but we’ve got some of that same expense front loading.

Jon Arfstrom: Okay. And just on 1.0 for it to reach call it, similar returns and profitability profile of the rest of the company. Is that a year away?

Jerry Salinas: Yes. I think that’s probably right. We’d kind of have to take a little bit closer look at it, sharpen our pencil. but I don’t think it’s too far from that. Again, I don’t have in front of me what their projections are for the rest of the year. but like we said, they had a 30% linked-quarter growth on deposits. With that sort of a growth horizon, that we wouldn’t be too far. But I have to be honest, I don’t have that sort of a projection in front of me and happy to be able to talk about it at some future point when we get together.

PhilGreen: Jon, it’s an interesting question. Just kind of overall, as we look at these branches and we perform it out, we tend to use, when we began all this, a five-year horizon for the branch to kind of reach maturity. and that was I guess that would be similar profitability to what we were overall. But honestly, it’s also true. We don’t talk a lot about it, but it’s also true that in years six through 10, I think we’ve seen really more growth than we see in that first five years. As those things mature, we see some really significant growth. So, I think ultimately, these locations end up with better profitability than the total profitability of the company, just because they’re more efficient and more focused on a book of business in a defined market, in a defined structure.

So, I think that we’re not at five years for all of them and it’ll take a little bit even for 1.0 to get there. and then certainly 2.0 is going to take some time before all of those are five year mature, but don’t count out continued growth in those markets from the expansion year six through 10. Historically, as we looked at those 40 branches that we had done before we started the expansion, some of the growth in year six through 10 was really significant.

Jerry Salinas: Yes. that’s really where the power is.

Jon Arfstrom: Yes. Okay. So, we’re just kind of just getting there.

PhilGreen: I think so.

Jon Arfstrom: Okay. All right. I could go on and on with questions, but I’ll just leave it there. I appreciate it, guys.

PhilGreen: Thanks, Jon.

Jerry Salinas: Thanks, Jon.

Operator: Thank you. At this time, I’d like to turn the floor back over to Mr. Green for closing comments.

Phil Green: All right. as always, we appreciate all of your interest and we thank you for your questions. And we’ll now be adjourned.

Operator: Ladies and gentlemen, thank you for your participation. This concludes today’s event. You may disconnect your lines at this time and enjoy the rest of your day.