Cullen/Frost Bankers Inc (CFR) 2002 Q4 法說會逐字稿

Good day. All sides are now on the conference line in a listen-only mode. I'd like to turn the program over to the Senior VP and Director of Investor Relations of Cullen/Frost, Mr. Greg Parker. Go ahead, please, sir.

Thank you. This morning's conference call will be led by Dick Evans, Chairman and CEO; and Phil Green, Group Executive Vice President and CFO. Before I turn the call over to Dick and Phil, I need to take a moment to address the Safe Harbor provision. 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 the 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 at our website or by calling the Investor Relations department at 210-220-5632. And at this time, I'd like to turn the call over to Dick Evans.

Thank you, Greg. As always, we're pleasure to report a record year. And, in fact, it was a year that was better than we expected it could be at the start. Our net income for 2002 was a record $117m2 or $2.24 diluted common share; 140 return on assets and an 18 percent return on equity. And from continuing operations, there was $122.4m or $2.34 diluted common share.

In the 135 years of operation, this is the best ever year. I continue to be extremely proud of our staff. The 2002 performance is an excellent example, as it was the year where the economy was weak and interest rates were not favorable to Frost. We planned 2002 to be a tough environment, and we took the following steps before the year began. We reduced the '02 salary run rate by $16m due to staff reduction and salary freeze for most of the year, and we reduced the volatility for future pension expense by freezing our defind benefit plans, and we added a preferred profit sharing plans. With later economic uncertainty, we also put in the plan that we would provide so the provision level would be significantly in excess of charge-offs during the year.

While looking back at 2002, it was a record year in the tougher economic environment. The federal reserves cut interest rates to the lowest levels in 40 years. Net interest income was down only $1.7m. I say the "only" because as you know, we're an asset-sensitive organization and we experience margin squeeze. Loans were flat, really because we did exit as you know, the mortgage business and indirect and we sold a block of our student loans. We have adjusting our share of national credits. When we take all that away our core loan growth actually increased 4.2 percent. Also helping the margin was a higher deposits, which resulted in higher earning assets and helped soften this squeeze. Our non-interest income was up 9.4 percent. Important factors were the commercial service charges and our interest commissions.

Our non-interest expense were well managed throughout the company, in fact, they were down 8 percent and we build the loan loss reserve to 1.83 percent at year end. As we look forward to 2003, the truth it's hard to know what to say. We find supporting information for both a bullish and a bearish economy. I can tell you that customers feel the uncertainty and our cautious about the future. It seems to have created a perception of a down mood. The reality is really closer to a positive environment. With Texas the recession has been mild and is showing signs of dissipating. We have had a less job loss in this current recession than before, however, it’s been prolonged and I think this adds to the down mood. I seem to be hearing the same remarks that I have heard for the last two years, that projections call for a weak economy for the next six months with the last half of the economy is likely to pick up. Well, I hope it does pick up in the second half.

At onetime we do feel strong about that looking long term Texas has the factors for the Texas economy to continue to outperform the nation. As we look closer at Cullen/Frost for 2003 on the short term there is no question that the -- there is a great deal of uncertainty in the economy. What I am certain about is the fundamentals of Cullen/Frost are sound and improving. We have an outstanding staff. We have a better sales culture. We have better processes and discipline throughout the company. And we have better knowledge of our customers are using our data warehouse. We know, we will meet competition head-on and win new business because we are aggressive about going after accounts.

We do expect the economy to have slow growth; however, we expect core loans to continue to grow modestly, and deposit growth trends will continue in line with 2002. We expect a low rate environment. In fact, our plan calls for flat rates for the entire year of 2003. Margin pressure will continue. We will have some expense pressure, as we stopped our salary freeze in October of 2002; and like all companies, our benefit costs are increasing, particularly, in healthcare. Measuring asset quality for 2003, I believe the levels will continue to be manageable. Orderly identification of credit weakness has long been a focus of Frost resulting in more favorable resolution and fewer charge-offs. This year marks our 135th year doing business in Texas, and we will continue to grow building long-term customer relationships and create shareholder value. Now, I'd like to ask Phil Green, our Chief Financial Officer, to make a few statements. Phil.

Thanks, Dick. I think Dick’s done a good job of going over our overall performance and outlining that. So I just want to make a few comments about our fourth quarter results and discuss our earnings guidance for 2003 and then open it up for questions. Before I start, I want to tell you that much of the financial information that I'll be referring to can be found in the earnings press release on pages six and following at the tables. The reported results in that release of 58 cents a share were pretty much in line with market expectations and represented, I think, a good ending to the record year Dick discussed. Our earnings for the fourth quarter of 2002 exceeded last year's by over 130 percent while it was aided by $20m reduction in restructuring charges that we took in the fourth quarter, as we reduced head count in preparation for the uncertain year. More importantly, I think, it shows we were able to increase revenues and holding operating expenses flat to slightly down. As we've been talking about, it wasn't an easy operating environment. The Fed did cut interest rates again by 0.5 percent in early November.

That put additional pressure on our margin, given our asset sensitivity. Our net interest margin was down 14 basis points from the third quarter to 4.41; but there was some good news. When you compare the last year's fourth quarter, we were actually up about 2.5 percent in terms of net interest income dollars. It was almost $2m increase. That's the first time that's happened in a long time. I think, in the third quarter, we were pretty much flat with the year previous to that. This was an absolute increase in revenue from margin, and it was brought about in spite of the drop in spread by the growth in earning assets. Our earning assets were up by about 7 percent from last year, and we're able to achieve that because of strong deposit growth. Our total deposits were up about 6 percent, and demand deposits really were the fuel that drove that. DDAs were up by 18 percent year-over-year on an average basis. As I've said that those funds didn't go into the loan portfolio since loans had been flat for us. Where they did go was split about half and half between fed funds, which increased our liquidity, which has continued to be very strong. And little bit more than half went into the investment security portfolio, about $270m. Those investments were largely in mortgage back securities, those being agency securities. And what that's done for us is we've taken what the market's given us in terms of helping our net interest margin by going out the yield curve somewhat, but we are still maintaining our duration in a range that frankly was less than it was a year ago, when you look at the end of the year, our portfolio duration to that 2.9 years.

That compares to a little over three years at the end of last year. And what that tells you is we've had a tremendous amount of liquidity and cash flow come in from the investment portfolio over this year's time. This portfolio -- prepayments of these have really picked up, particularly in the third quarter of this year. So what we've got to do is, we got to undergo a fair amount of investment just to stay even. In fact we were able to increase the dollar amount in our investment portfolio somewhat and as we said, help soften that impact of lower rates that we find ourselves in.

As we look forward or look on, look at non-interest income for a second, that's where other major source of revenue -- that was up by 7 percent from last year. And we mentioned in the release some of the big factors. Service charges on deposits were up 14 percent. That is basically all commercial business. Some of that is by increased volumes and billable services. But in addition to that lower interest rates, which gives less credit for the balances our customers maintain causes an awful lot of that increase, because people holding the same amount of balances have to pay more fees when interest rates were lower and those balances are worth less.

The insurance line was up 27 percent. In the past quarters we usually had to adjust our acquisition numbers. This is in pure numbers and apples-to-apples increase. No acquisitions in there, it's up 27 percent. Obviously, the premiums the people have paid on their policies are going up as the insurance market has hardened significantly from what it has been in the past. But we also are being successful in selling this product. We continue to have over 60 percent success rate on proposals that we make on qualified referrals with bank customers. So again we are happy with the rate of growth in that business and what's going on there. Cost was up and that wouldn't be a big thing, except when you consider the S&P was down about 19 percent over -- year over year. We were, I think, pleased to have some growth there. We did have a slight decline in investment fees, they were down about 270,000 but we a little bit more than made up toward in estate fees and also securities lending revenue, which taken together, caused the slight increase that we had year over year. If you look at managed assets, I think it's interesting to look at what's happened there. They're about flat year over year, but the managed -- the value of the stocks that we managed was down about 13.8 percent.

The value of the fixed income instruments that we managed was up about 22 percent. So, by having a good mix of fixed income and equity assets that we did manage, it does tend to have somewhat of an offset. We're hoping to get a little help from the market next year. If you look at non-interest expenses, I think things say there, it was good control. Obviously, we didn't have the restructuring cost of almost $20 million than what we had in the fourth quarter last year. But even excluding that, we were basically flat on expenses. The only categories that really showed an increase was medical, which was up a couple of percent, and that shows up in the benefits line, and that is just a tough item to manage. We've just seen growth in medical. I think all businesses have. We're trying lots of things to try and manage that number, but its -- it is a hard one. And finally, other expenses were up, they were up about 12 percent.

There was some unusual activity in there which helps explain the increase. We did have a write off on an OREO property, the first one of those we’ve had in a while. About $700,000 related to a write-down on a Houston property that was writing it down to net realizable value. We also had some OREO related operating expenses that were than the fourth quarter of last year, which was worth around $300,000 on a comparative basis. We did also see some increases related to attorneys and accountants expense. Some of that is timing but as you are probably, aware the Sarbanes-Oxley activity that is really, I think, on everybody’s mind - with the change in laws causing expenses there. In addition to the FAS 70 wrong reviews and a lot of more -- lot more work to [indiscernible] our accountants to do. And it's just an example of some of the increasing other expenses. Provisions were up from the year ago. They were $4.5m up from $4m in the fourth quarter of 2001. We did have a coverage on our charge-offs of about 1.3 times. So, we continue to build our reserve. We increased it from the 178 in the third quarter to 1.83 percent in the fourth quarter. And Dick has already mentioned, it was up a lot from the 1.61 percent last year. So the reserve has been built. It was our objective to, as we say, get ahead of the game and really provide in excess of charge offs, and we've been able to do that. Charge offs for the quarter were, I should mention $3.4m for the fourth quarter this year. Now in light of the assumption that Dick has already provided, as we look forward, and especially in light of the assumption of flat rates for the entire year, our guidance for earnings is going to be somewhat below the current range of estimates for 2003 that's out there. Having said that, we would also say that given a modest increase in rates, we would be more comfortable with the range of current estimatesalthough at the lower end of the range. With that I'll turn it back over to Dick.

Thank you, Phillip. We now encourage your questions and discussion.

Very good. If you like to ask a question at this time, please press "*" "1" now on your touchtone telephone. To withdraw yourself from the queue, you may press "#." Once again at this time, if you would like to ask a question, press "*" "1" now on your touchtone phone. We'll take our first question from Jennifer Demba of Robinson Humphrey. Go ahead please.

Good morning. Could you repeat the earnings guidance that you just gave a moment ago? And secondly, could you give us an update on the Shared National Credit portfolio?

Let Phillip takes the earnings guidance first.

We're assuming the flat rates that was currently in our plan now that our guidance and our guidance would be somewhat below the range of estimates that are currently out there. But given the modest increase in rates, we would be more comfortable with the range that's currently there, but we would be on the lower end of that range.

With regard to the Shared National Credits, as you know, we have talked about a mile [ph] yearlong and had a tremendous amount of activity. The end result is they are really pretty much flat with where we started. We started at $237m in '01, and we ended the year with $239m. As you know, we have been running about 40 percent of that portfolio in energy production loans. And as I have said, throughout last year, we would hope that some of those started advancing and that's what happened a little bit, I think, in the last quarter. I think the most important thing while we don't go into the specifics. I'll tell you that the quality from the grade standpoint has improved all year long and today we have a higher grade in quality than we had at the beginning of the year. And we have only one credit that is classified in that group and that has been one that has lingered from the year before last and it continues to pay down. So all that's decided (inaubdible) are flat, and we believe the quality is better.

Thank you.

We'll take our next question from the site of Scott Alanis of Stevens. Go ahead please.

Good morning, gentlemen.

Good morning.

One quick question please, could you talk a little bit about what you are seeing in terms of loan demand and also asset quality in Houston?

Let me talk to you maybe first if it's all right about the whole strike as we look at it from that standpoint. Then we can make a few comments. I'd say in general from Houston, we have been pleased with the quality and what's happen there -- or just to give you a flavor before what's happened with loans. As you know and as I have said, our core loans grew 4.2 percent. We're really pleased that that's in the commercial and industrial loans. It's got good diversification in that regard. Grew about 4 percent last year. In the last quarter, if you look at length quarters and in fact it was slower than that and it was in the 2.5 percent range, and overall loans length quarters were down and primarily from real estate loans paying off. I hate to lose the loan volume, but I'd a lot rather have what happened with real estate loans, and that is they moved into the permanent loans. We had about $50m that the construction was complete and moved into permanent loans. And that's what you want to happen.

Right.

That's what happened and we got a problem, and we don't have problems in that regard. So overall I'd say, as you look at asset quality and you've got all the statistics in the release on page seven, we really had a 0.30 percent charge-off. I'm pleased -- never pleased to loss any money, but if you look at the trends I think in this environment that's a very reasonable. You look at a strong reserve at 183. You'll have a reported -- in the K, we've started talking about potential problem loans. You remember we talked about that at the last quarter and they were about $19m and we talked...

Right.

...about one specific credit representing 77 percent of that. I remember the percentage write-in and it is -- I will tell you that credit is still in the total number but hadn't gotten any worse. In fact, if you put it on a scale, it's probably a little better but it is still appropriate that it stay there. Again, I'll remind you and all of you what the name of this is it's potential. And -- but we'd like to identify things and we work with it early. That number you will see has grown from $19m to $25 m. It's still very comfortable with the management of those loans. And there is no new loan over 5 million. So there's diversification in that regard. So, if you really -- for Houston coming back to the problem loans are really low. When you compare to the past dues are about 0.51 percent and our OREO and other measures that we look at are very much under control. So despite all the stuff you hear about Houston, I'm happy to report to you that our experience is positive.

Terrific.

I'd say with regard to just the loan volume question that you asked, on a period end basis, certainly last year Houston's loan growth was probably about 5 percent. It's been weaker, as Dick mentioned, on a period end basis down about 4 percent, from a period end from the third quarter of this year.

I'd just add one last line in regard to the potential problem loans. There are none in Houston.

Okay. Very good. Thank you very much.

Our next question comes from Charlie Ernst of Putnam Lovell NBF. Go ahead please.

Hey, guys.

Hi, Charlie.

Hi, Charlie.

I wanted to start out with the margin to begin with. Could you just go through and give a couple of statistics about where the loan yield stood on average for the fourth quarter in addition where the securities yield stood? And just walk through kind of the leveraging that you all did during the quarter?

Okay. Let me talk about the leveraging first and the securities we bought, and I'll get the loan yield and securities yield from there. Two things. One, just so you have a little bit better feel on the investments that we have made, in the quarter we bought about $600m worth of investments that we've made. In the quarter we bought about $600m worth of investments. They are broken down to about $150m and what's called Fanny May 5 year ”no call 3s”but they had a yield about 3.5 percent.

We bought $350m of Fanny May 15 years. They yield about 490 and then we actually bought, for the first time in a while, some 30-year Jenny Mays, $100 m of them to yield 566. The leveraging part that you may see from the release, if you look at period and earning assets, you see that those spiked up. And this didn't have a big effect on the margins, Charlie, for this quarter because it happened more near the end of the quarter. But it will have an impact on budget because I can talk about it as far as going forward.

As we actually undertook some dollar rolls transactions particularly with those Fanny May 15 years. Those securities turned to be very highly valued in the marketplace. And I am not a big one for leverage, but it was such a good opportunity we had to take advantage of it. We ended up the year with $400m worth of dollar roles and if you are not familiar with those, those are basically; it's not what it is but I think of it in terms of the repo. I mean basically you are selling out the security and you are buying it back in typically 30-day period, and it ends up being basically a borrowing. And it's on our balance sheet to that effect. But the average cost of those dollar rolls are about 5 basis points in terms of the borrowing rate on it because of the higher demand of the securities. And that one will always be there but I think it's an example of where we are able to take our investment portfolio since we’ve got good liquidity and we can buy high quality securities at good times.

It just -- you know these are some that were very highly valued and they were going to shorten the marketplace and the banks and dealers needed them, and we were able to take advantage of them. So we'll probably continue to do that as long as those continue to be in favor for a while. That transaction, $400 million or those or so of those would probably cost us about 15 basis points on the margin. So it had a little bit of an impact in the margin drop of this quarter - I would only about four basis points or so. Probably net of the first quarter, if we kept the same level to be around 15 basis point drop. Now that's just cosmetic. When you have the opportunities to borrow at 5 basis points, then you can invest even the Fed funds of 125, I think it's something that you got to do, if it's a low-risk transaction, your balance sheet can stand it, and ourscertainly can.

And with regard to loan yields, I'd say that the gross loan yields are running around 5.5 percent. Securities yields are a little over five.

And that was for on average for the quarter?

That's actually a number that's -- that I happen to have handy here. It happens to December. So I'm giving you a more current number than that.

Okay. And, Phil, how about the interest-bearing liabilities cost?

Our interest-bearing liability costs would be about - not much. It's around 1.2.

1.2. And that was up for December or was it up for the first quarter?

Then, I think, for December.

Okay. And then did you all shift earnings assets away from the short-term investment portfolio during the quarter, and what was that level on average for the quarter?

Well, we were actually up on average for the quarter on our investment portfolio. It's a short-term...

Yes. Then

...asset sales.

Then, I guess, it's Fed funds primarily.

Okay. Our Fed funds and repos were actually up from the preceding quarter. Is that what you're talking about?

Yes.

This quarter.

Yes. And, last quarter, I've got it at 316.

Okay. I have them being up on the Fed funds and repos. That's about 125 million on average from the previous quarter.

Should that cost you guys probably 5 basis points or so? Maybe, maybe not.

I think if you look at it in a vaccuum, then, yes. I haven't done the math on it. But you're expanding the balance sheet. Even if we funded that with BDA, and that's -- that would have 125 spread, a 125 margin, and our margin's been running 4.40 or something. So, yes, that would tend to dilute it. Is that what you're saying?

And, lastly, on capital, 7.26 leverage ratio -- does that impair your ability to go out and maybe do some insurance deals or even a small bank transaction? And what's kind of your target there?

It doesn't impair that.

Where are you guys comfortable? To be about just north of 7 percent or...

You aretalking about the leverage?

Yes, on the leverage ratio. And if it's not the leverage ratio, do you really -- is your bucket really [indiscernible] than what is?

No. Our leverage is the one that we -- from a practical standpoint – manage with, given the regulatory environment. You know, we really haven't said what it is. I mean, if you look historically, we've been, I'd say, between 6 and 7 in some years. We have been running over seven, we sort of built it somewhat. I think we are really comfortable at some level over seven, but we generate a lot of capital. And so we got a lot of flexibility there I think. I don't really see particularly in the insurance deals, you know, the prices that we paid there, and the capital we have used, is not been inordinate and we got a lot of cash at holding company as well. So I don't think that's going to hurt us on any insurance acquisition, that I am aware of right now.

I’d just add, the other thing is, there is in the past going back, you can take the capital down below 7 percent as Phil said. As fast as we’re generating it, then if you come back to it in a relatively short period of time,then we're comfortable with it dipping and ranging down, then coming back up. Just looking at what we are generating but I think bottom line, do we see that as limitation to expand and being able to make acquisition? The answer is no.

Thanks a lot, you guys.

Once again if you’d like to ask a question please press "*" and "1" now on your touchtone phone. Our next question comes from the site of Robert Lacoursiere of Lehman Brothers.

Good morning. Asking a question on Robert’s behalf. Just a couple of balance sheet items, you know, I saw an improvement in the asset quality. But what's the pipeline looking like and what was the 90 days, plus 90 days for the quarter?

Well, I'm sure I understand the question. You're asking loan growth or you're asking?

Just the balance sheet, oh sorry the item for plus 90 days?

Plus 90 days [indiscernible]

Correct.

They are excellent in fact past dues overall are at 0.88 ended and have been running under 1 percent all year long. And we feel very comfortable with where they are. There is only one loan that is over 90 days that is greater than $500,000.

Okay. I'm just looking at -- the balance I had for last quarter was $7.3m. Is that right?

I don't have last quarter here, I got -- is that...

I was just trying to get a comparative figure. I think it may have come from the queue. So, maybe we'll have to wait for it.

Yes, I would say that past dues are in excellent shape and have been really all year long. All last year, they were under 1 percent and again, they set at 0.88. And as far as over the 90 days, there's only one loan. If you compare, we had a $7 million figure last year, and that compares to -- I mean in last quarter, and that compares to this quarter at $9 million.

Okay, thank you.

Thank you.

We'll take a follow up question from Charlie Ernst, Putnam Lovell NBF. Go ahead.

Hey Charlie.

Can you guys just go through the credit numbers a little bit more there, give some color behind the drop in non-performing loans, and also the increase in OREO? Is that related to the property that you charged off, and what kind of property specifically is that? Thanks.

Quite frankly Charlie, I see that as a positive. This is a property that Phil went through with you. It is a property -- a development that we have been financing in Houston area for a number of years - -- well over five and probably closer to 10 years. The individual had a partner in the Orient,] and he died. And so his capital source went away. I'd say the good news is that it didn't go into -- he'd lost his -- obviously his partner and his cash, and also his liquidity. So, it started having some problems, and we were able to foreclose on it. That is really what drove up the foreclosure to the 8 million. We did write it down to a price value. We are currently negotiating with five purchasers, and so there is good activity. And I'd say the good news is, if it had gone into bankruptcy, you just sit there and it drags on. I'm optimistic that we can do something with it relatively quick.

[indiscernible]

I'm sorry I didn't hear you.

We lost Mr. Ernst. But if you'd like to ask another question, please press "*" "1" on your touchtone phone. Once again, if you'd like to ask a question, please press "*" "1" on your touchtone phone. We'll take a question from Caleb Piper of Morgan Stanley. Go ahead.

Hi guys. Could you quickly walk through the loan portfolio, just breaking down the different categories, how it sort of has developed, I guess? I just want to get a feel quarter over quarter and year over year. Thanks.

You're asking me the loan portfolio breakdown?

Yes, please.

Are you looking for the period or the average numbers? Can we talk the period with you?

Just for the period end, and if you could breakdown commercial and the breakdownsthat you usually give?

Okay. Just to be consistent with what we have inside the queue. If you look at the portfolio fourth quarter 2002, the numbers you're looking at are period end numbers. Excuse me, I'm sorry. Commercial and industrial loans are $2.155b. If you look at total land loans, this can to be looked at real estate, total lands is $166m (indiscernible). Construction loans, which includes commercial and consumer, are $360m. Commercial real estate mortgages will be $1.50b. One to four family residential is $179m, and just other consumer real estate is $276m. So, our total real estate loans would be $2.33b. And then just doing some other dogs and cats; indirect, what's left of that is $25m; student loans are $43m; other consumer loans are $246m. So, total consumer, that's not real estate, is $314m. And then, throw in other loans of 23; unearned discount is negative 7. So, total loans, $4.519 b.

Great, thanks.

Once again, if you would like to ask a question, please press "*" "1" now on your touchtone telephone. We have a follow up from Mr. Robert Lacoursiere of Lehman Brothers. Go ahead.

Good morning, guys. One more item, if you could just discuss borrowed funds. How those tracked over the quarter, I guess, on an average basis and period end, please? Thanks.

Okay. Let’s see on an average basis, and I guess what I'll take where [ph] your question Robert is, fed fund's purchase is more funds would have been up for the [indiscernible] quarter about $106m; and for the same quarter last year it would be up around $195m. That's on an average basis. On a period end basis, I think I've got that, I don't have it handy - but I think the most important thing about the period end borrowed funds is, although it can be volatile , to remember it had $400m of these dollar rolls that I'm talking about, which would be when you see it come out on the segments it's going to be included in the repo [ph] numbers. That affect on purchase and securities, actually though, but it's only by giving what it helped you in balance sheet here in our -- in the period fed fund purchased and securities, again which includes the $400 million of dollar rolls would be $811 million. So take out the $400 million dollar rolls and you'll be looking at about a $411mperiod end basis, that would compare to, say, last year of $305m period end basis.

Great. Thank you.

Okay.

Once again, "*" "1" if you would like to ask a question at this time. It appears that we have no questions at this time. I'll turn the program over to our host for any concluding remarks.

Well again let me just say thank you for the support of our shareholders, and we look forward in this -- even though it is an uncertain time, to continue to build this company and grow and look forward to a good year. Thank you for your support.

This does conclude our conference call for today. You may now disconnect your lines and thank you for participating.

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