Cullen/Frost Bankers Inc (CFR) 2006 Q2 法說會逐字稿

Good morning. I would like to welcome everyone to the Cullen/Frost Bankers quarter two conference call.

[OPERATOR INSTRUCTIONS]

Thank you, Mr. Parker, you may begin your conference.

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 Investor Relations at (210)220-5632.

At this time I'll turn the call over to Dick Evans.

Thank you, Greg.

I'm pleased to report second quarter 2006 net income of $48.6 million, a 19.3% increase versus last year. On a diluted common share basis it's 11.7% increase, to $0.86. The return on assets was a 1.70%, a new high for Cullen/Frost. Return on equity of 19%.

As always I am grateful to our staff's continued dedication and commitment to our values making these results possible. The staff continues to execute our sales strategy across business lines backed by an outstanding support staff.

Additionally they have done an excellent job successfully integrating our recent acquisitions. A summary of the major components of '06 versus '05 on second quarter's, interest income is up 40%, interest expense is up 98%, net interest income is up 24%, and our margin increased to 4.70%.

Loan loss provision was $5.1 million, and the reserve stands at a 1.30%. Non-interest income is up 4%, non-interest expense is up 12%, and bottom line the net income increased 19.3%.

I am particularly pleased that the $1 billion increase in loans was funded with a $1 billion increase in deposits and 3/4 of the net interest increase gain was a result of increased volumes, and as you would expect, 1/4 was the result of rising interest rates on our company's asset sensitive balance sheet.

The Company continues to have good core loan and deposit growth without acquisitions. For example, looking at second quarter's '06 versus '05, loans with acquisitions grew 19.3%, without acquisitions, 11.2%. Deposits with acquisitions grew 15.2%, without acquisitions, 9.1%.

As you know just three weeks ago we announced a merger agreement with Ft. Worth based Summit Bancshares which has assets of $1.1 billion. This is an outstanding bank and in an outstanding market we have served since 1998. Their philosophy and relationship driven based business focus parallels our own and we look forward to bringing their staff and customers into the Frost family and in the fourth quarter of this year.

On the Texas economy I continue to feel very positive about the markets we serve. It's easy to understand why our state is so competitive when you look at our strong population growth, demographics, low cost of living and business friendly environment. Texas economy is diversified.

Our job growth is above the nation and is expected to grow slightly over 1% better than the U.S. All indications are that all cylinders are working. In fact, its even hard to find some weakness.

Housing continues to expand even the more speculative condo projects are working so far. Energy prices are higher at the pump in Texas just like anywhere in the nation. But net energy overall is a help to the Texas economy.

Looking at our sales activity, first the consumer, the state continues to be very competitive across the board in consumer activity. Net growth in consumer checking accounts without acquisition is in the mid single digits. Remember, our model focuses on higher retention rates and we have been successful because of our high level of customer service.

Home equity loans and lines activity is slightly weaker. Moving to the financial management group which includes trust and brokerage, continues to grow with trust fees up 8.3% to $15.7 million compared to the second quarter last year. The market value trust assets also topped $20 billion this quarter, a new high for us. With managed accounts at 8.4 billion and non-managed at 12 billion.

On the business side we have improved our conversion of prospects to customers. year to date, we have made 11% more calls on prospects than we did last year. This has resulted in an 8% increase in new pipeline opportunities from prospects and this increase has been well diversified as it has come in the under 10 million size segment.

Year to date, our new commitments booked from prospects is 38% higher than last year, and again, it's from the smaller size segments. In addition, we tracked a number of new relationships that are in process of moving to Frost and YTD we have moved 48% more relationships than last year.

The Texas market continues to be very competitive but we are working to maintain our pricing and structure disciplines. Through the first half of the year we lost about $725 million of opportunities to other financial institutions because they offered transactions that did not meet our standards in pricing or structure. This is about 18% more than the first half of last year.

We are also seeing a shift in the competition towards more right competition than structure. Last year the split was about 50/50, 50% pricing and 50% structure, and this year, the shift is about 60% pricing and 40% structure.

In summary, Texas expansion appears to have its legs and for now this robust economy should go on for some time. Our strong sales disciplines continue to give us the ability to meet the strong competitive challenges. It was a good quarter both on an annual basis and linked quarters.

Now I will ask Phil Green, our CFO, to make some comments.

Thanks, Dick, I will make a few comments about our margin, a few other comments about some operating components, I will address our outlook for the year and then open it up for questions.

As Dick said the second quarter was a strong quarter for us. It was an all time high for us and particular happy that return on assets broke the 170 mark, 1.70% for the quarter which was another record for us.

We continue to increase our operating leverage. We improved it by increasing revenue by 17% from last year while non-interest expense increased by 12% from a year ago. As an example, then, the efficiency ratio improved from 58.2% last year to 55.8% this quarter.

Obviously net interest income growth is what drove revenue was up by 24% as we mentioned, but even with the flat service charges because of the higher earnings credit rates our non-interest income was up about 4.4% versus a year ago. We are asset sensitive and higher rates have helped us but as we mentioned 3/4 of our net interest income growth was from higher volumes, 1/4 was due to increased rates. And we did match the increases in our loan portfolio with increases in core deposits on an annual basis.

Our margin was up by four basis points from a first quarter of the year to 4.7%. Most of that resulted from the two fed increases during the quarter. I thought it was interesting what Dick said about the changes in interest income and interest expense versus last year.

Just to recap, interest expense is up 100% in dollar terms from a year ago while interest income is up by 40% from a year ago in dollar terms. But our net interest income is up by 24% in dollar terms versus a year ago and I think that shows the core nature of our funding base, in particular our 36% demand deposits percentage of total deposits.

That is obviously a high level of interest free deposits, and what it does, it allows us to compete more effectively on the deposits that are more rate sensitive like the money market deposit accounts and CDs. I really feel better than I ever have about the competitive position of our time accounts and the value proposition to our deposit customers. In fact not just rate but also in account design.

Earnings have definitely been good but at the same time we've been leveraging that profitability to protect our competitive position and reward our customers. I mentioned the 4.4% increase in non-interest income, however, if you adjust for the $2.4 million net gain on the legal settlement we had last year, non-interest income was up almost 9% versus a year ago, and to me the highlights are trust fees which were up over 8% driven by investment fees and oil and gas fees, and then other service charges which were up by 45% which were driven by strong corporate advisory fees and our investment banking unit.

On the expense side it was up 12% 3/4 of that increase was from salaries and benefits. And to break that down just a little bit further about 1/3 of the salary increases came from higher head count. Remember we added three acquisitions and I think we mentioned before that we brought our mainframe IT data processing services in-house from a third party provider the beginning of this year so that added significantly in terms of our IT costs in terms of head count but on a net basis was a benefit to us by over $1 million for bringing that in-house.

About 1/3 of the increases in salaries were from merit increases and of the remaining the biggest piece of it was expensing stock options which we didn't have to do last year but we did this year which costs us about $1.8 million for the quarter. Provisions were $5.1 million and we built reserves by $1.4 million during the quarter which left the reserve at a 1.30% coverage at the end of the quarter.

Finally, regarding our outlook for the rest of the year, we are expecting flat rates from this point out, and assuming current trends continue we'd expect to be somewhere in the top half of the current range of analyst estimates for the year.

With that I will turn it back over to Dick for questions.

We are now happy to entertain any questions you may have.

[OPERATOR INSTRUCTIONS] Your first question comes from Charlie Ernst from Sandler O'Neill Asset Management.

Good morning.

Good morning, Charlie.

Just had a couple of numbers questions first. Can you go through and give the average balance for the bond portfolio? And also what the rate was for the overall portfolio?

Charlie, for the quarter, the portfolio averaged $2.947 billion. And the average yield on it was a 4.97.

And then, Phil, can you also just talk about the reserving methodology? I think overall the MPA ratio was slightly down in the quarter yet your reserve to loans went up. So can you just add a little color there?

Charlie, this is Dick, let me take a stab and give you a few numbers and then I will let Phil make any comments he wants to. You're right, the non-performance are down from 41 million to 37 million. And over 90 days they are pretty much flat and potential problems are pretty much flat.

The methodology as you know, I will tell you that we're consistent. It has a range and we are within the same methodology that we've always had and we feel the appropriate position is the 130 position. It really hasn't changed that much. It was a 129.

Charge-offs were a little bit higher this quarter than in the past. They are still running at 23 basis points. You know our company for a long history of time and that's pretty much, 23 basis points, where it historically has been. At the same time it would be misleading to come to any conclusions that it's going to stay at that level or go back to more in the mid-teens where it's been.

So I think it's very appropriate of looking at all the numbers and it's a good reserve. While the economy is, as you heard my comments I think you would interpret that I feel very positive about where the economy is. There's a lot going on and I feel comfortable with where our reserve is.

Charlie, I think that basically the reserve methodology is in like most other peoples. It's driven primarily by historical loss ratios on your portfolio based upon risk rates and that's fairly empirical and then there's another component of it, that has--I think they used to call them BC201kind of factors that are more general in nature and deal with more over arching factors in your portfolio.

And I think that it's probably those over arching factors that are driving the reserve percentage than the specific right now, because I think things look pretty good on a specific empirical basis but as Dick said we think 130 is a good reserve. We built it a little bit. We've had good loan growth. And so overall we feel good about it.

Charlie, I'd just add the non-performers are just one component in adding to the comments Phil made on methodology. Remember that it also includes external events such as competition. And I probably--I don't know how many times I used that word in my opening remarks.

It also includes the regulatory environment. And then we've got to remember that we take into consider the acquisitions that we have recently made. And all of those are factors in coming up to the final answer.

In looking at net charge-offs is there any lumpiness this quarter, one or two charge-offs that are majority of that or is it pretty well spread out over a number of charge-offs?

I would say there's a little lumpiness in it and I would not draw any trend conclusions one way or the other.

Is there any one charge-off that was particularly big?

No.

Okay. And then you kind of refer to merger expenses in the quarter but can you add a little color there?

I'm sorry, what did you say?

You refer to some integration expenses related to the mergers. Is there any color that you can add to that, as to whether there were expenses in the quarter?

Charlie, let me think. Give me just a minute.

You talked about $1 million or so year-over-year in acquisition related conversion expenses.

Yeah, I think that's right. As far as what they are, basically we had three conversions. They are in different cities.

We have a lot of people that we have to move around to do that. At times we bring in consultants for the data processing conversions. We brought in additional resources for that. So it's just that type of thing that you'd see.

Great, thanks a lot, you guys, nice quarter.

Your next question comes from Beth Messmore from Merrill Lynch.

Good morning. Can you please flesh out your comments, Phil, about your value proposition on the deposit front? I thought you said something about mechanics?

I think that our value proposition on our accounts overall, I said the structure as well as rate. I just feel our people have done a good job differentiating their various product offerings so that we've got a good product offering that's no matter what level you want to use for the account we can provide you with an account that's structured right for your needs and I feel better about that than I ever have.

And most of my comments related to how good a job I think we are doing on the interest bearing deposit side relative to the competition in terms of being very competitive with our rates. And yet still being able to increase our margin while we are doing that and that relates to the good core deposit mix and low cost deposit structure that we've got that allows us to be more aggressive on the part of the portfolio deposits that is more rate sensitive.

Beth, the only thing I would add to that is the--it was a number of years ago that we simplified our accounts so our sales people could communicate clearer about the advantages of each account. And this is particularly true in acquisitions.

After we came through the 90's of 15, 18 acquisitions, we had at one time 34 different types of checking accounts and savings and today we have less than ten and we continue to keep that simplified so that there is a clear communication. And as Phil has described to you we can bring that value proposition on an individual basis of what is in their best interests.

When the (inaudible) tightening cycle comes to an end do you expect the net interest margin to stabilize or should it continue to expand with solid bond volume trends?

I think if rates, in a flat rate environment, Beth, the margin should continue to expand somewhat if we continue to see loan growth the way it has been.

There are really mainly two factors that have historically driven the net interest margin for us and one has been the direction of interest rates which have been both good and bad since we are asset sensitive and the other one has been that loan to deposit ratio and what we see there.

So we've seen it creeping up to the extent it does creep up and we are investing investment securities into loans we will see a continued expansion of the margin but maybe not to the extent of a debt increase in rates every quarter.

I would just add to that, what Phil said, and I said is 3/4 of our net interest margin increase gain was a result of volumes. And we are certainly focused on that. At the same time there's no question that an increased rising interest rate environment on our company's asset to balance sheet is a positive.

Perfect. Thanks. On the pending Summit transaction, can you please comment on their loan to deposit ratio? To what extent does Summit change your funding mix?

Summit's loan to deposit ratio is in the 90 percentile range, but our funding mix really stays fairly consistent. I think their demand deposit percentage was a little bit less than ours. I think they ran about 30% in round numbers to our 36% and I think whenever we combine them together we will still be about 36%.

So I really don't see that changing as far as the loan portfolio, we have I think about 45% of our loans are CNI today and they will be 44% when we bring Summit in. So we have very similar business mix, that shouldn't change. As I am looking now at some numbers 36% were non-interest bearing after the acquisition we expect to still be 36%. So.

Thank you so much.

Your next question comes from John Pancari from JP Morgan.

Good morning, guys. Forgive me if you've already commented on this, I missed the first part of the call but I just want to see if you can give some incremental detail just around any type of hedging you're putting on still, any type of core contracts and if you've been adding them in any way throughout the quarter?

We did not add any additional core contracts in the quarter. We have the one contract that we talked about before. I think we put it on at the end of last year.

One thing that we did do is we did eliminate some interest rate swaps that we did have in place. We eliminated--I can't recall the number but I can find it probably in just a second. But it was over $150 million, I believe, in interest rate swaps that were eliminated. About that amount.

And we did that because we really took the loans that had been made into LIBOR floaters through the derivative and put them back to their fixed rate status. The reason we did it was just to provide some additional protection against lower rates, it's not a big number, about $150 million, but we still have the prepayment penalties in place with the loans, so we've got the protection for falling rates on the asset side, but we took that off on the hedging side.

One of the things it did do is also, we have not really bought any bonds because we have really not liked the market that much, although it's getting better, I think we are getting closer to being willing to participate. But removing a hedge that caused a fix rate loan to be a floating rate loan is sort of a non-cash way of participating in the market, but in a way that does not use up your liquidity so that you can utilize it when you do like the cash markets better.

Okay. And are you looking at or adding more core contracts at all in incoming quarters or are you comfortable with where you stand right now in terms of your hedging?

I'd say it's something that we consider as we look at the market. You might remember the last time we talked about it we put a hedge in place that was--we limited by the amount of loan pools that we had which would give us extremely effective hedging.

And so we wanted to leave ourselves some room there so we didn't run a foul of the hedging rules. I guess it's possible with Summit coming into provide some additional floating rate loans we might consider to do that with.

We could also consider maybe extending the contract that we've got today. So there are a lot of things that we are looking at, it's going to depend on just how we see the market and what we can do at the time.

Do you have more opportunity for on balance sheet repositioning at all?

I think we do. I think because of the fact that we have basically stayed out of the bond market for six months now we've got liquidity that's building up, depending upon what happens with deposits and loans that's going to give us some opportunities I think to move out into the cash markets, particularly if we begin to see some movement up in the yield curve.

Hopefully we will. At some point we will be back in the market. That's I would say the main thing at this point that we would look at it would be the cash markets.

Okay. Great. Thank you. Good quarter.

Thank you.

Your next question comes from Charlie Ernst from Sandler O'Neill Asset Management.

Hey, guys, one follow up on the loan growth. The period numbers were a little bit slower than kind of what we've been seeing recently. Is there any color you can add to that? Do you feel like that's indicative of the environment or is that just a period end number and it's hard to go off of that?

Charlie, I wouldn't comment to any big conclusions on it. I would say that there is no question that the market is very competitive. And so that's--that's a factor. But as I look at all the markets, market by market, they are all performing pretty well.

We continue to, as I shared with you, fight this, keeping this pricing and structure discipline up and you know us well enough that we will stay in that posture and the competition as I said we lost $725 million or thereabouts in loans to other financial organizations because we wouldn't bend to either the structure or the pricing.

But I--we are still real optimistic as I shared with you about how we are able to execute new prospects so we are building business and we are taking care of customers and you are going to go through some--some swings, but I think it's too early to come to any final conclusion.

Charlie, this is Phil and I would just make a couple other comments, to add a little more, additional color on to what Dick said. The period end numbers do swing around and the average are the better indicator I think. As Dick said if you look at it on a market by market basis we had the largest period end growth, was in Fort Worth, which is up--I am going to give you annualized numbers now, 16%--this is on a linked quarter basis, San Antonio was up by 14% on a linked quarter annualized basis. Corpus Christi was up by 8% and Austin was up by 7%.

And we had some offsets on those, namely Houston was down by 4% annualized and Dallas was down by 7% annualized, and if you follow us--I know you've followed us a long time you know that Dallas has historically been a particularly high growth market for us. That just shows you some of the volatility that you see in the numbers side. I wouldn't get too obsessed about those.

I would say also, that on a period end number, on a linked quarter basis, the drop was really in real estate loans which were down almost 5% on an annualized basis linked quarter period end. But the CNI component of the business was up almost 13% so that was--which I think is okay. Again, it just shows that you you are going to have pay offs and pay downs and you are going to have some volatility.

I think the last thing Phil said is very important because we do have a commitment to build our CNI. Certainly we have--we are very comfortable with our real estate portfolio and when you bring Summit in, it looks really just the same with little change and--but we are going to emphasize CNI and continue to build real estate but not build the bank, just real estate.

Thanks a lot.

[OPERATOR INSTRUCTIONS]

Your next question comes from Justin Maurer from Lord Abbett.

Good morning, guys. Phil, just on the margins just to clarify that, you said you expect kind of the 470ish run rate for the balance of the year, is that right?

What we said was we thought that interest rates would be flat for the remainder of the year, so that means whatever improvement in margin we have is going to be driven by loan volumes.

Okay. Any thought though relative to what your comments were regarding the securities portfolio that made you tow back in a little bit there? Did that have any implication just on a pure margin basis, obviously it's favorable for income, but does that pull you down marginally?

Given the fact it comes out of fed funds it's probably not going to have much difference to the margin. If you look at Fannie Mae 15 years for example, which is what we bought the last time we were in the market, they are running--they're moving between 575 and 6%, I think fed funds are 5 1/4 or something, so we are really not picking up a whole lot more but we would be picking up some duration against future declines in interest rates, so that's really kind of what we are thinking about these days.

Just on the four basis plan expansion linked quarter what was the asset yield improvement relative to the liability pressure? Was it about the same?

Actually we ended up with a slight reduction in our net interest spread if you're familiar with that ratio. It's not used a lot these days but, yeah, our margin was up by four basis points, our net interest spread was down by 11. And what you've had there is we've just been more aggressive on our liability pricing.

Again we've been able to afford it and we want to protect it so that's one of the things that we've been doing. But given the fact that our interest income runs, it's 3.5 times our level of interest expense, we can do that and still make money and in fact prosper.

So what's the Delta there in the spread versus the margin, obviously tax equivalent, right, but is that just a mix of securities that have run off versus what's remaining?

Well, I guess to address your question specifically the earning asset yield for the first quarter was a 647 and the earning asset yield for the second quarter was a 674. So that's a 27 basis point increase, and on the liability side we went from a 264 in the first quarter to a 298 in the second quarter, which is a 34 basis point increase.

And again that's just a liability side. I don't think it's so much of a mix issue. It is a little bit in that we do have a tremendous money market, a high yield money market deposit account that we are getting a lot of interest in from our customers and it's--it carries a rate that's about double what the more traditional money market deposit account is.

Yes.

You are getting a little bit of a mix effect there but overall we've just been more aggressive on our deposits relative to competition and as I kind of referred to before we do have good earnings but we are trying to be realistic as we make those good earnings and make sure that we are taking care of our franchise and taking care of our customers.

Yeah. And within the deposits, I mean holding your own on the demand side and then interest bearing moving up a little bit again linked quarter are you seeing like you said the movement more towards the money market type of product and/or what are you seeing in the CD book relative to just traditional time deposits?

We are seeing more--I would say definitely we are seeing--well we are seeing growth in both of them but I will just give you the numbers. The money market deposit account, this includes both of them, both the traditional and then the high yield went from $2.884 billion in the first quarter to $2.946 billion.

So we had good growth there on the time accounts, which is the CD portfolio, went from $1.34 billion to $1.102 billion. So you can see they are both growing.

Thanks, guys.

Your next question comes from Brent Christ.

Can you provide a little bit more color around the investment banking, in this quarter? I know it's a bit lumpy and maybe talk about what kind of the run rate you've seen over the past year or so on a quarterly basis has been?

I think the--most of it was related to a single transaction that we'd been working on for some time. I always said that I'd be really happy when I had to start talking about investment banking fees in the conference call because they caused some lumpiness and I'm excited to be talking about that today.

It's--I don't know there's much more we can say about it. We have about six professionals in our investment banking operation. And we tend to work on a number of deals through the pipeline and they come to fruition occasionally. It's really hard to predict when they will come through but we do have a good pipeline of transactions that we are working on.

I think that's the most important thing. This is not just a meteor falling out of the sky. It is a part of a plan and a business model that they are undertaking. I think they are doing a good job at it and the main thing I think the pipeline is still there. But I can't really say when you will see it but I do think that we will continue to see investment banking fees.

How much did that single transaction account for and how much expense offset was there?

Well, the business runs, as far as expense offset, the business typically runs about a 25% pre-tax profit margin. That's what we expect to have over long-term.

Okay. All right, thanks a lot.

There are no questions at this time.

Okay. Thank you very much for your interest and support of Cullen/Frost Bankers, Inc. and this concludes our conference call.

This concludes today's teleconference. You may now disconnect.