Cullen/Frost Bankers, Inc. (NYSE:CFR) Q3 2023 Earnings Call Transcript

Cullen/Frost Bankers, Inc. (NYSE:CFR) Q3 2023 Earnings Call Transcript October 26, 2023

Cullen/Frost Bankers, Inc. beats earnings expectations. Reported EPS is $2.38, expectations were $2.14.

Operator: Greetings. Welcome to Cullen/Frost Bankers Incorporated Third Quarter Earnings Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. [Operator Instructions] Please note this conference is being recorded. I will now turn the conference over to A.B. Mendez, Senior Vice President, Director of Investor Relations. Thank you. You may begin.

A.B. Mendez: Thanks, Jerry. 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 text in this morning’s earnings 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.

Phillip Green: Thanks, A.B. Good afternoon, everyone, and thanks for joining us. Today, I’ll review the third quarter results for Cullen/Frost, Jerry is going to make some additional comments, and then we’re going to open it up for your questions. In the third quarter, Cullen/Frost earned $154 million or $2.38 per share compared with earnings of $168.1 million or $2.59 per share reported in the same quarter last year. Our return on average assets and average common equity in the third quarter were 1.25% and 18.93%, respectively, and that compares with 1.27% and 20.13% for the same period last year. This solid performance can be attributed to the execution of our sustainable organic growth strategy and the commitment to our culture that develops deep customer relationships and provides world-class customer service.

And all this happens, because of the hard work and dedication of our Frost Bank staff. As in the past, our balance sheet and our liquidity levels remain strong. As an example, at quarter-end, our cash liquidity at the Fed equals 17% of our deposit base. Also during the quarter, Cullen/Frost did not take on any Federal Home Loan Bank advances, participating in any special liquidity facility or government borrowing, access any broker deposits or utilize any reciprocal deposit arrangements to build insured deposit percentages. Let me also say our available-for-sale portfolio represents 82% of our portfolio at quarter end. So, in short, basically with our balance sheet, what you see is what you get. Our average deposits were stable in the third quarter at $40.8 billion, less than a percent change from the previous quarter.

Average loans grew to $18 billion in the third quarter compared to $17.7 billion in the second quarter and annualized growth rate of 6.8%. As I mentioned, we’re laser focused on our efforts to achieve organic growth and I’m very pleased with our results. For example, to update you on our physical expansion efforts for our combined Houston expansions, we stand at 107% of deposit goal, 162% of loan goal, and 127% of our new household goal. As of quarter end, expansion loans represented 22% and deposits represented 18% of our total Houston market presence. For the Dallas market, we stand at 292% of deposit goal, 273% of loan goal, and 216% of our new household goal. While still relatively early in this effort, expansion loans and deposits represent approximately 9% respectively of Dallas market totals.

And we’re excited about our new Austin expansion effort which has opened the first of 17 planned locations to double our presence in that market. But beyond these overall numbers, I wanted to take you a little deeper into the character of the expansion business. For example, in Houston, we stand at $1.4 billion in deposits and $1 billion dollars in loans. Our deposit mix is 53% commercial and 47% consumer, essentially mirroring our company profile. Two-thirds of the deposit relationships are under $1 million and only four are over $10 million. Loans are 73% commercial, 27% consumer, and only 8 customers have over $10 million. Similarly, in Dallas, of our $325 million in deposits, 53% are consumer versus 47% commercial. And 72% of those deposits were under $1 million, no relationships over 10 million.

Our $258 million in loans are 62% consumer and 38% commercial, which I think is remarkable. The reason I labored through that detail is to show you that the kind of business we’ve been successful generating in our expansion is core, stable, grassroots business, which I believe will generate tremendous value over an extended period of time. I’m very pleased with the results of these efforts, and I believe that this strategy is both scalable and durable, and I’m convinced we’ll be doing this for a long time. Looking at our consumer banking business, we continue to see outstanding organic growth. We added 6,220 net new-checking households in the quarter, bringing the year-to-date totaled to 22,800, a 12% improvement on 2022 year-to-date results.

To give a perspective of the power and durability of our organic growth, let me point out that in the past 36 months, we’ve added 80,000 net new consumer-checking households. This means we grew our core customer base by 23% in just 3 years. We believe these are industry-leading numbers and represent tangible evidence that the customer experience we offer and the reputation we’ve built set us up to be successfully competitive. As we look at these new households, we see that the quality of the growth is also high. A high percentage of the accounts are active, the balances are healthy and the growth is balanced across all the segments we serve. These factors are evidence that the growth is sustainable and beneficial. Consumer loan balances outstanding were $2.8 billion at the end of the quarter growing 26% year-over-year.

In the third quarter alone, balances increased to $181 million or 7% from the second quarter. This robust growth was driven by our home equity products. In a market where it’s becoming increasingly expensive to buy, many families are deciding to stay and fix up their home. And we’ve got the right products and services and relationships to help at this time. We have a long history of credit quality in the consumer banks similar to what you’re used to hearing about on the commercial side. And the weighted average credit score on the portfolio is 754. Delinquencies are low and stable at about 80 basis points. Charge-offs are also low and stable at 19 basis points for the year. Also, as we’ve noted, we’re excited about the prospects for our new mortgage product, which is in its very early stages, but just recently opened up to all our markets in the state.

Now, looking at our commercial business, I think it’s an interesting story. Our new opportunities for the quarter were strong, but they were down 17% from the second quarter. However, that was because our second quarter new opportunities were at all-time high after the dislocations brought on by the SVB situation. And as you’d expect, our declines for deals were also high, and we’re almost 2.5 times our quarterly average. Now, looking at the third quarter and focusing on our weighted pipeline, that weighted pipeline is up 22% from last quarter, and it’s our highest of all time at $1.918 billion. Our previous high was during the second quarter of 2022 at $1.832 billion. The increase comes from all categories, both customers of 18% and prospects of 25% both core, which we define as relationships under $10 million in large, core up 26%, large up 20%, and both C&I up 23% and CRE up 24%.

Credit quality continues to be good by historical standards with classified and non-accrual assets flat and net charge-offs down quarter-over-quarter. Non-accrual loans totaled $67 million at the end of the third quarter compared with $68 million at the end of the second quarter essentially flat for the quarter. The third quarter figure represents just 37 basis points of total loans and 14 basis points of total assets. Problem loans, which we define as risk-grade 10 or higher, totaled $513 million at the end of the third quarter that’s up from $441 million at the end of the second quarter and $387 million this time last year. Virtually all the linked quarter growth was in the OAEM risk category or grade 10. Net charge-offs for the third quarter were $5 million.

They were down from $9.8 million in the second quarter. Annualized net charge-offs for the third quarter represented 11 basis points of average loans and year-to-date annualized net charge-offs are 18 basis points of average loans, which is below historic averages. Regarding commercial real estate, our overall portfolio remains stable, with steady operating performance across all 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, that is office, multifamily, retail, and industrial, as example, totaled $3.5 billion or 40% of CRE loans outstanding in our flat quarter-over-quarter. Our investor CRE portfolio has held up well with the average performance metrics remaining essentially unchanged quarter-over-quarter and exhibiting an overall loan-to-value of about 54% loan-to-cost of about 60% and acceptable reported debt service coverage ratios.

Higher interest rates continue to be a challenge for our CRE borrowers and have impacted performance of some project as compared to original performance. However, on average, we’re comfortable with the quality of the portfolio. As an example, the investor office portfolio, which has been top of mind since the pandemic, had a balance of $950 million at quarter end and it exhibited an average loan-to-value of 52% and an average debt service coverage ratio of 1.46, up slightly from last quarter. 83% of this portfolio is stabilized with healthy coverage levels and less than 5% of the portfolio is considered spec with even these few projects being in strong sub-markets with good leasing dynamics in strong experienced developers. Our comfort level with our office portfolio continues to be based on the character and experience of our borrowers and sponsors, and the predominantly Class A nature of our office building projects and, again, we’re glad to be operating in Texas.

So, in closing, we remain optimistic for what lies ahead. We’re capitalizing on opportunities and I’m proud of all our bankers as they accomplish all of this across all our communities. 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 – more about our Houston 1.0 expansion results. As Phil mentioned, we’ve been very pleased with the volumes we’ve been able to achieve. Looking at the third quarter, linked quarter annualized growth in average balances for these locations was 46% for deposits that’s $170 million growth linked quarter and on loans of 52% annualized growth or $133 million quarter-over-quarter for loans. [I’m sorry, the 46% was for deposits.] [ph] And for the third quarter, Houston 1.0 contributed $0.06 to our quarterly EPS. Now, moving to our net interest margin, our net interest margin percentage for the third quarter was 3.4% down only 1 basis point from the 3.45% reported last quarter.

Some positives for the quarter included higher yields on loans and balances at the Fed combined with higher loan volumes. These positives were primarily offset by higher cost of deposits and customer repos compared to the second quarter. Looking at our investment portfolio, the investment portfolio averaged $20.6 billion during the third quarter, down $721 million from the second quarter. During the quarter, we did not make any material investment purchases and sold about $361 million in municipal securities at a small net gain as we took advantage of market dislocations, which allowed us to improve interest income going forward. The net unrealized loss on the available for sale portfolio at the end of the quarter was $2.2 billion, an increase of $600 million from the $1.6 billion reported at the end of the second quarter.

The taxable equivalent yield on the total investment portfolio in the third quarter was 3.24% flat with the second quarter. The taxable portfolio which averaged $13.6 billion, down approximately $216 million from the prior quarter had a yield of 2.76%, up 5 basis points from the prior quarter. Our tax exempt municipal portfolio averaged about $7 billion during the third quarter, down $505 million from the second quarter and had a taxable equivalent yield of 4.26%, down 1 basis point from the prior quarter. At the end of the third quarter approximately 71% of the municipal portfolio was pre-refunded or PSF insured. The duration of the investment portfolio at the end of the third quarter was 5.7 years, up from 5.2 years at the end of the second quarter impacted by duration, extension, and both our municipal and MBS agency portfolios.

Looking at deposits, on a linked quarter basis, average deposits of $40.8 billion were basically flat with the previous quarter as they were only down $179 million or 0.4%. We did continue to see a mixed shift during the quarter as noninterest bearing demand deposits decreased $408 million or 2.7%, while interest bearing deposits increased $229 million or 0.9% when compared to the previous quarter. Based on third quarter average balances, noninterest bearing deposits as a percentage of total deposits were 36.3% compared to 37.1% in the second quarter. Noninterest bearing deposits totaled $14.8 billion at the end of the quarter, with 96% of that amount being commercial demand deposits. During the individual months of the third quarter, we did see the average balances in the noninterest bearing accounts begin to stabilize.

During last quarter’s call, I noted that July’s average balance was down $202 million from the June average. The full month-to-date average for July was $14.84 billion, down only $173 million from the June average. Our August average was flat with July, and the September average was down only $60 million to $14.78 billion. For October month-to-date through yesterday, the average non-interest bearing deposit balance is $14.52 billion, down $259 million from the September average. Looking at total interest bearing deposits, they’ve been relatively stable during the period. Average interest bearing deposits were $26.0 billion during the quarter, up $229 million or 0.9% from the second quarter. For October month-to-date average, the balance in interest bearing deposits through yesterday was $26.3 billion, up $102 million from our September average.

We do continue to see a shift in the mix in interest bearing deposits to higher-cost CDs from lower-cost savings, IOC and MMA. The cost of interest bearing deposits in the third quarter was 2.12%, up 25 basis points from 1.87% in the second quarter. Customer repos for the third quarter averaged $3.5 billion, down $183 million from the $3.7 billion averaged in the second quarter. The cost of customer repos for the quarter was 3.67%, up 15 basis points from the second quarter. Looking at our noninterest income on a linked quarter basis, I just wanted to point out a couple of items. Trust and investment management fees were down $1.8 million or 4.5% compared to the second quarter, driven by a decreases in estate fees of $1.1 million, real estate fees of $673,000, and tax fees of $413,000, partly offset by an increase in investment fees of $750,000.

Estate fees and real estate fees can fluctuate based on the number of estates settled or properties sold respectively, while tax fees, by their nature, are typically higher in the second quarter. Other charges, commissions, and fees were up $1.0 million or 8.6% compared to the second quarter, impacted by increases in various accounts, including money market income up $282,000, letter of credit fees up $155,000, and annuity income up $121,000. Other income was up $3.0 million or 29% when compared to the second quarter, impacted by higher public finance underwriting fees up $1.6 million, and higher combined derivative and foreign exchange income up $1.8 million. Looking at our projection of full year 2023 total noninterest expenses, we continue to expect total noninterest 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 SBIC special assessment, which has not yet been finalized. The effective tax rate for the first 9 months of the year was 16.3%. Our current expectation is that our full year effective tax rate for 2023 should approximate 16.5% to 17%. But that can be affected by discrete items during this fourth quarter. Regarding the estimates for full year 2023 earnings, our current projections don’t include any additional changes to the Fed funds rate through the rest of the year, through the rest of 2023. Given that rate assumption and our expectation of 2023 noninterest expense growth of mid-teens, which does not include the impact of the SBIC special assessment, and given our strong performance this quarter, we believe that the current need of analysts’ estimates of $9.22 is too low.

With that, I’ll turn the call back over to Phil for questions.

Phillip Green: Thanks, Jerry. And we’ll open it up for questions now.

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Q&A Session

Operator: Thank you. [Operator Instructions] Our first question is from Steven Alexopoulos with JPMorgan. Please proceed.

Steven Alexopoulos: Hi, everyone.

Phillip Green: Hi, Steve.

Jerry Salinas: Hi, Steve.

Steven Alexopoulos: I want to start, so on the deposit side, Jerry, to follow-up, where you just left off with the noninterest bearing, that $14.9 billion – $14.8 billion. It’s pretty stable. In the fourth quarter, we typically see some window dressing from companies that it picks up a bit. Can we safely say that we’re now at a bottom for the noninterest bearing deposits?

Jerry Salinas: Steven, I think that certainly when I look at it, I feel today versus 3 months ago feel a lot more comfortable with where they’re at. Obviously, you’ve seen, and I kind of tried to give that sort of color in my commentary. We are seeing little downward ticks, but it’s really been stable. In my mind, those small $100 million, $200 million decreases have been relatively stable as you’ve said, and we’ve seen historically the fourth quarter is the best quarter, right, as companies try to do some window dressing. So, I don’t know that I can confidently say that we’re at the bottom, but I certainly feel a whole lot better today than I did a quarter ago.

Steven Alexopoulos: Got it. Okay. And then on the loan side, I didn’t – I mean, it will be pieced together all the color you gave on consumer and commercial, but there’s no doubt loan growth picked up this quarter. Can you give us – drill down why is it just these new markets coming online when you look at the growth? And it sounds like you’re pretty optimistic. You think it’s sustainable, this improvement you’re seeing.

Phillip Green: No, Steven, with all of that, it’s still, I think, high-single-digits number. And that’s kind of what our sustainable target has been for a while. So I would hope that it is. It would be our goal that it is. We’ve looked hard at where it’s coming from, like I said, with that really big spike in the second quarter. We talked about where it came from and it was by and large a lot of good credits. It just didn’t meet our structure that what we wanted to do, maybe we were full in a category and didn’t want to reach out in one particular area. And, I think in just talking to our people, a lot of banks have just put their pencils down. And we have liquidity, people know that we’re not always the place where people like to go to get the leggiest structure on a deal.

But we’re consistent through the good times and bad times, I think people realize that. And I think that we got a lot of phone calls and a lot of opportunities to do stuff. And I mentioned how many we declined, because I didn’t want people thinking that, oh, well. Look, Cullen/Frost got some loan growth, they must be just taking other people’s problems. That’s not what’s happening. And we’re just seeing a lot of good opportunity. I think part of it is – what’s a lot of things. It’s our reputation for strength and stability in times like these. But now, our people are great at sales and calling in developing relationships. They’re held accountable to it. They’ve been doing a good job. When you have a balance sheet like ours, it puts you in a good place to take advantage of opportunities.

And I think that’s what we’ve been seeing. It’s hard to pin down on any one particular thing, because I think it’s been pretty consistent. I might speak a little bit more about it, because I just had a recent conversation about the expansion growth. I tried to give you some feel for – it’s pretty granular in terms of what’s coming on. But I had a conversation about what kind of deals are we seeing. And a lot of it is its owner businesses, right? They have a business to consumer model. They’re not really sexy [ph] businesses. But in a sense, but they’re just good stable long-term businesses that are a result of hiring community bankers in these communities we’ve gone in. And so it is very diverse. The commercial real estate that we see there is mainly because someone wants to not pay rent anymore.

They want to own their own building for their business. That’s slowdown some, because rates are so high, but that’s still going to be the arc, I think, of the kind of business we’re doing. When I hear that, it makes me feel really good about just how core and how stable it is, because that’s really our wheelhouse.

Steven Alexopoulos: So if I could ask, but final one, so as we’re probably, I don’t know, two-thirds through earning season, what we’re hearing from the industry, particularly the larger regionals, because most of them are on this RWA Ozempic diet, right? They’re just shrinking assets. They’re almost all tightening on expenses, right? A lot of them are guiding to flattish expenses for 2024. And to be quite frank, I don’t know how to think about Cullen/Frost for 2024. And I’m not looking for a number, but I want to know how you’re thinking about it because in many ways, this is going to be a great market for you to take bankers, right? I mean, as everybody’s sort of on the sidelines, which you mentioned. So I don’t know, I think number’s 14% year-over-year.

Are you thinking about, “Hey, this is a year that we’re going to continue to expand and maybe expense growth stays at that rate? Or are you share some of your other CEOs like, no, we need to tighten also just because the environment’s a little more challenging.” How do you think about that?

Phillip Green: Well, what we’re thinking is that we’ve got a great opportunity to expand. And we have plans in place. We started the process of doubling Austin, in the middle of tripling Dallas. We think these are great opportunities. And we are getting good applicant flow and put it that way. And in these markets, so it’s not like we’re going, “Oh, we need to hire more bankers, because we’ve got an opportunity for this or that.” I mean, we are hiring tons of bankers as a part of this expansion. And there’s plenty of work to go around there. So we are hiring, but it’s a part of our strategy that we’ve put in place already, we’re having good success there. We are not backing off and saying, “Oh, look, we need to cut expenses now, because I don’t know because for whatever.” We’re winning competitively, I’ll just say it.

And now is the time for us to keep moving forward. Now, Jerry and I talked with the folks about what they’re spending and what the trend is. And we want it to be lower next year, just because there’s a limit to what you can do over time. And we want to be prudent about all this stuff. But, no, we’re not in a retrenchment mode at all. Jerry, do you want to talk something about expenses?

Jerry Salinas: No, I mean, I think Phil said it. And we’ve been very focused, as he said. And, Steven, as our focus on expenses continues, certainly, when you look at the percentage, you might – someone may roll their eyes. But, obviously, we’ve talked about the things that we’re doing to grow the business, grow our product selection, and expand our marketing. I think those have all been in improve our technology, those have all been smart things that we’re doing. And as he said, our guidance for our team has really been that, we’ve kind of given guidance to this mid-teen sort of growth this year. But certainly would expect that, when we talk in January that’s not the sort of growth we’ll be giving from a target standpoint.