Cullen/Frost Bankers Inc (CFR) 2006 Q3 法說會逐字稿

Good morning. My name is Brian and I will be your conference operator today. At this time, I would like to welcome everyone to the Cullen/Frost Bankers, Inc. third quarter earnings conference call.

[Operator Instructions]

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 provisions. Some of the remarks made today will be constitute forward-looking statements as defined in the Private Securities Litigation Reform Act 1995, as amended. We intend such statements to be covered by the Safe Harbor provisions by 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.

At this time, I will turn the call over to Dick Evans.

Thank you, Greg. I'm pleased to report record earnings for the third quarter of $50 million, a 17.8% increase over the same period in 2005. On a diluted common share basis, it's 11.4% increase to $0.88. The return on assets, 1.72%, another new high for our company. Return on equity, 18.56%. As always, I am grateful to our outstanding staff for their dedication and support and serving the needs of our customers.

Our net interest income was up 19.6% to $121 million versus last year's same quarter on a taxable equivalent basis. Average loans increased 17.4% to $6.6 billion. Without acquisitions, the increase was 6.4%. Average deposits were up 14% to $9.1 billion. Without accusations, it's a 5.3% growth.

Non-interest income was up 3.2% to almost $60 million. The largest factor was trust fees that increased 10.4% to $16 million. It was mainly because of increased investment fees, but also oil and gas was up $344,000. Other non-interest income was up 10%. The primary reason was increase in Visa check card income. As expected, the increasing rate environment, service charges on deposits decreased.

Non-interest expenses were up 11.9% to $103 million. It's primarily a result of adding acquisitions as seen in the salary category where we added approximately 250 people. Also impacting the increase was a $900,000 write-down on other real estate owned.

Asset quality continues to be manageable. The reserve is at 1.31%, 285% coverage of non-performing loans. Charge-offs for the quarter of 10 basis points. It doesn't get much better.

Non-performers decreased to $35 million from 37.3 million last quarter. The 90 days in over past dues were flat. Potential problems increased to $34 million or a $23 million increase. It's primarily made up of one customer who has two student loan housing facility projects in two different markets. The customer has a history of successfully managing and owning student housing projects. They have a good equity position. This is a unique situation and does not indicate a weakness in real estate trends.

A few comments about the Texas economy. Texas job growth is strong, better than two times the U.S., and we would expect it to grow around 3%, like last year.

We have a very tight labor market. Some examples, on a high end, engineers are in short supply. On the lower end, truck drivers are hard to find and hard to qualify. Bank officers are also in strong demand. However, there are more positives than negatives.

Affordability is strong in Texas. Energy is obviously a positive and also we benefit from strong port districts. The Laredo port is the fourth largest in the United States and Houston the fifth.

Looking closer at linked quarters, the most important focus is on loans. Second quarter to third quarter average loans were flat. Period end loans, however, from the second quarter to the third quarter were down $61 million.

In the commercial real estate mortgages that moved into permanent loans, they were down 61 million, a $34 million increase in our shared national credit lines; a $9 million decrease in home equity loans and lines; and a $6 million decrease in land loans, both commercial and consumer.

On the positive side, we had a $45 million increase in commercial construction loans, and our sweet spot and where we focus, we had a $38 million increase in commercial and industrial loans without shared national credits.

What does this tell us? When you have a flat quarter, you will have some carryover in the following quarters. It's hard to say how much, because we certainly believe long-term we will continue to grow loan volumes in this strong Texas economy. But the market is very competitive, and we will hold to our structure standards and pricing at profitable levels.

I believe one of the best ways to demonstrate competition is through loss commitment. Year-to-date, we have lost $957 million due to pricing and structure. That's 20% more than last year. 55% is pricing and 45% structure. Also in the third quarter was the largest quarter for withdrawals by customers in dollar volume, 25% higher than in the second quarter. This is largely driven in real estate loans. And I'm not sure exactly why. It could be that they chose not to do the projects because of the economy, interest rates, or it was just an abnormal quarter.

I am pleased with our efforts on new prospects. Year-to-date, our new prospect calls were up 8%. Our pipeline is up 6%. Our new loans are up 28%. I believe this reflects our efforts to better qualify and focus on our prospecting efforts.

What do we need to improve? In a strong economy, but also a strong competition and sometimes irrational competition, I believe we must have a strong, quality calling effort. Ours is good, but it can be better.

Year-to-date, looking at all of our calls to customers and prospects, we're down 2%. Why? Mergers do take a few months for new officers to adjust to new systems. Officer turnover, while ours are low, it does cause some loss of momentum. However, I have been pleased that our officers who have left the company have been -- the loans made by new officers have made up for this loss.

One exception is in our Dallas market where we lost officers whose focus was on larger transactions and an officer who handled one-time close products. We chose not to pursue these types of transactions which were not full relationships. Bottom line, I feel good about the high quality of our staff and their ability to execute a quality growth strategy.

Overall, our company continues to have strong fundamentals. The financial management group which includes trusts is having an excellent year and is strengthened by the addition of our of our wealth management group.

Consumer deposits and the number of new accounts continue to grow with and without accusations. Branch locations statewide for our company will be over 100 by year end with the acquisition of Summit. Additionally, our new branch or de novo strategy is much improved, with detailed analysis of our trade areas that include statistics of both business and individuals residing in the area.

Texas is a great market. Frost is an outstanding brand. And Texas has a large market for our relationship style banking. We will continue to meet the competitive challenges.

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

Thanks Dick. I'm going to make a few comments about our operations, a few additional comments address some of the outlook issues for the remainder of the year and then we will open it up for questions.

As Dick said, we did have, I think, what was a strong quarter. Our quarterly results were good. They represented another record level of earnings for us, and I believe it's the first time that we achieved net income over the 50 million dollar mark for our quarter. So we are pleased with that.

Once again, we did improve our operating leverage versus a year ago. Our revenues were up almost 14%. Our expenses were up by just under 12%. And our revenue growth was, as has been the case recently, driven by net interest income, 90% of our growth and revenue was from net interest income, 10% was fee income.

When you look at the net income growth, 80% of the growth there was volume related; 20% was related to rates; and of course the acquisitions have helped us some there, as Dick pointed out, in the growth of loans and deposits. So we're pleased that those are working out for us.

We did also see our efficiency ratio improve for the quarter. It went from 57.7% a year ago to 56.9% this year. Our return on assets which had reached a new high in the second quarter at 170, continued to increase above that slightly now to 1.72%. So just I think a really tremendous level of profitability for our company.

When you look at last year, our loans were up in dollar amount about a billion dollars. On the other side of the balance sheet, core deposits were up by $1.1 billion. So I feel really good that we're funding the growth and the loans that we're having over the last year by additions and core deposits; and that's really important to our business model. As you know, we have a very enviable funding base with high levels of demand deposits, good levels of core deposits, and that's been important. It's been a focus of ours and we have been able to continue to increase that in a competitive environment.

If you're looking at the $1.1 billion increase in deposit levels, about a third of that growth was from demand deposits and about two thirds of that growth was with time. So we did well in both categories.

Dick talked about fee income, up a little over 3%. I think the highlight of that area continues to be the trust area, which is up 10.4% versus a year ago. Investment fees is the largest share of the growth there. It's the largest part of the fees. But also oil and gas was a good growth compared to last year. And also real estate fees, where we're managing real estate, selling real estate, getting paid fees for that showed good growth year-over-year. Our trust assets are almost $23 billion now, 9 million in managed assets, $14 million in custody assets. So our asset growth continues to be on the increase.

On the expense side, we were up $11 million year-over-year on expenses. About two-thirds of that growth was in the salary component. To break that down a little bit, of that increase about a third of it was from increasing head count; and most of that is driven by the acquisitions of the three banks that we put on.

As we've said before, we did move our mainframe IT processing in-house at the beginning of this year and that added some additional people as well. And it also adds some cost on furniture, equipment, that type of thing, software, etc. But it reduces the amount of expense that we paid for that service. It was coming out of other expenses. It wasn't net positive on an annual basis -- an ongoing basis.

I said about a third was related to headcount of that salary increase. About a third was related to merit increases. And about a fourth was related to expensing of stock options this year. So those are the main components of the increases in salaries, and benefits, of course, pretty much follow the headcount.

Regarding credit cost, Dick said that the numbers looked good and I think they do. We did have the increase and potential problem loan that he mentioned, and we did have a sale -- or actually got a contract on an old piece of Aurea, which will call for the $900,000 write down. But charge-off's only 10 basis points, improvements in non-performers, increasing the reserve slightly to 131. All of those numbers, I think, are very strong. Having coming out of Texas banking from the '80's, we will all know knock on wood.

Looking forward, we are seeing somewhat of a slowness recently in the loan portfolio, as Dick pointed out. We do have somewhat of a flattening loan growth. He talked about the slight decline we had in the third quarter, and he talked about the reasons for it.

Looking forward so far through October, we have a slight decline from the period end third quarter numbers in loans. We're down to about $40 million. So while we expect volumes to pick up some as we go through this quarter, I think on average, I don't think we'll get a lot of relief in the fourth quarter in terms of the loan volumes. So there will be some pressure there on net interest income related to the loan portfolio.

Also keep in mind that we are closing the Summit acquisition in December. As we noted when we announced that acquisition, there will be a one time cost associated with the closing of it. Most of those are capitalized, but about 2 million of those are going to be expense. So we are going to have that level of nonrecurring expenses in the fourth quarter related to that acquisition. And then as look forward on rates, as we said last time, we expect rates to be flat, not only flat in terms of direction, but I think the curb we expect to continue to be flat.

And in light of these factors, we now expect that the end of year we'll be at or near the low of the current range of analyst estimates for 2006. So with that we'll open it up for questions. I'll turn it back over to you, Dick.

Yes. Thank you, Phil. Let me just make one correction. When I was going through the decreases of period end loans, I think I said shared national credits increased. They actually decreased. Outstandings were down $34 million. The commitments were up about 10 million. But that's a decrease.

Well, we will be happy to entertain your questions.

[Operator Instructions] Your first question is from the line of Andrew Collins with Piper Jaffray.

This is Andy Collins. Just wanted to know what counted for the quarter-to-quarter drop in net charge-offs?

Good asset quality.

Good asset quality. And what's your watch list look like at this point?

We continued to see it's just a real good time in the environment. I'm always scared to say that because about the time you say it something will turn. But 10 basis points charge-offs and the trends are all positive. The only only negative trend was what I mentioned about the potential problem. But again, I also went through the details of that. But we feel good. I think it's a good time for asset quality. A good economy always makes it look good.

Okay. What about competition for deposits? What's that like and how does it compare to the past quarter? Because we're seeing a lot of pressure at some of your competitors.

I think that it continues to be aggressive. We have, however, I think met the challenge on the rate side. Our rates continue to be very good compared to the major competition. One of the reasons, as we talked last quarter, that we have been table to do that is, if you look at our funding base and you look at demand deposits being about 36%, and if you put in interest on checking accounts, which are fairly low rate and pretty rate insensitive, we'ew almost half of our deposit base or right at half of our deposit base is basically interest free. And so that part that we are paying interest on we have made the decision to be more aggressive on, and I think it has worked well for us.

We are seeing, as you expect, sort of a migration in our portfolio of deposits more towards growth in CDs for the first time, not a lot of growth but some growth in CDs, as customers are taking advantage of the rate level of those, and I think also maybe preparing for declines in rates in the future. And then our money market index product, which is our highest rate product both for businesses and consumers, we're seeing movement out of our traditional money market account product into that. So we're seeing some migration from that into that higher rate NMA.

I will say the higher rate NMA is a relationship product and requires another account relationship to have it. So we're pleased to have that situation. I think for me it is very competitive, but I feel very good about so far our ability to compete and add to the growth level in our deposits.

Everything Phil said, obviously, is correct. Let me just add to his and reemphasize his first comments, and that is our commitment to demand accounts and built-in value. That is key to our profitable model. It is where we make decisions that we will in some markets, such as in Dallas, give up some loan growth if we don't see that we're building the total relationship, because long-term that is certainly how we make the profits that we make is in the total relationship and not being a transaction organization.

Okay. And then finally, just an unrelated question on commercial construction loans, those were up about 45 million during the quarter, I think. And I was just wondering how the yields on that portfolio compared to the overall portfolio.

It's very competitive, like all rates in this environment. But remember, this is still a very good market. It's still growing strong in jobs, about twice, as I said, the U.S. And from that standpoint, we will continue to find those quality products in construction, and we will continue to make those loans because it's a good market. And we will get the best yeild that we can.

I don't see a lot of compression, to answer your question, from one quarter to the other. They continue to be -- there's compression everywhere on pricing as I've already said. But there's nothing unique about commercial construction.

Great. Thank you very much.

Your next question is from the line of John Pancari

I just want to see if I can get some additional color on your expectations for loan growth. I know you indicated that some of the trends you're seeing in October and that's kind of pointing to another modest quarter, another flatish quarter for the fourth quarter. I just want to get a little more color on that. What are you seeing that you actually, this early on, expect that type of modest growth this quarter? We're all hearing that the demand is certainly there in Texas, and pipelines are solid, and how come we're not going to see evidence of that really in the fourth quarter, and does that really push over your expectations for '07, a pickup on the early part of the year there?

We haven't put our '07 budget together. But let's just talk a little bit about quarter end, which I talked about being down $61 million. It's interesting that $55 million in payments came in the last week of the quarter. And in fact, 25 million of that came in the last day. And so there's no doubt that we had some strong payments.

In regard to the $61 million in commercial real estate loans moving into permanent, it's bad news they paid it off, but it's good news that they could go into the permanent market. It speaks of the quality of the loans, and it also speaks of the business decision that that real estate developer is making to go out in this flat yield curve and put his loans to bed.

So, I think it speaks to quality. How much of that is hard to manage. I can't really know how many will do that. But I hope that we continue to have that quality of customers. If you look, shared national credits were down $34 million. The commitments are actually up 10 million. They're going to move up and down. Energy still represents about 50%. As you well know, the energy customers are very flush with cash. So they're actually paying down their credits.

So there's no question that we're starting off. And being 25 days into the fourth quarter there is pressure. You come off of a flat quarter and go in with that kind of pay-downs, it's hard to ride your bicycle fast enough to catch all of that up.

But again, as I said, we're going to stay with making the loans at a profit. And we're going to stay with our structure. At the same time, we still have seen that we're able to grow in this kind of environment. It's a different kind of environment.

As you know, it is a strong economy. But it's strong competitiveness and some of it is irrational. And we're not going to fall into that irrational side of it.

Okay. All right. Then could you just give us an idea of some of the breakout in loan demand in certain markets and where you are seeing some very solid growth, and if you have any markets that are ordinarily weaker than others?

Well, since we're talking about period end loans, it might be a good place just to stay. If you look, as I've said, C&I loans, without shared national credits, we're up $38 million. Our Fort Worth market was very strong. They were up $73 million in that category. San Antonio was up $78 million. Dallas, which I have already talked about, was down $15 million. Austin was up almost $16 million in that category. Corpus was down 5 million. And Houston was down -- it was up $22 million.

Now, you've got to take into consideration Houston, this is period end quarters. Those numbers I'm giving you was third quarter '06 versus '05. I apologize. That was year-over-year. Let's look at linked quarters and go back to those same quarters as C&I. Forth Worth continues to be a very strong quarter, with 47 million.

San Antonio in C&I loans was down about $8 million, although its commercial real estate portfolio was up almost 14 million. Houston was weak in both the C&I and commercial real estate. Dallas was down in both, as you would expect. And Austin was down $2 million dollars in the C&I at the end of the quarter versus the second quarter, and commercial real estate were up 6 million. Does that give you a little bit of a feel?

Yes. That's helpful. Great. Thank you.

Your next question is from the line of Charlie Ernst with Sandler O'Neill Asset Management.

Good afternoon. A couple of quick questions. The short-term earning asset level, the average for the quarter, Phil, do you have that?

Yes, I do. On [Inaudible] funds sold and resale agreements average for the quarter 755 million, and that was versus 600.9 million in the second quarter.

Can you talk about service charges? I know that rates going up, that's mathematically impacted service charges. I'm assuming rates are going to flatten out here for a while, and I think you guys are too. So do you think that we might see service charges level off or even pick up over the next couple of quarters?

I think that's possible. That has been a factor with increasing interest rates. Even in the third quarter compared to the second, there was an increase in the earnings credit rate, even though rates didn't change in the quarter because they did change in the second. So they were up 33 basis points quarter to quarter. I think when we see that earnings credit rate flatten out we should see some growth, particularly in the commercial side.

On a year-over-year basis, our billables were up by 5% year-over-year. Now, they were down slightly in the third quarter on a linked quarter basis, but I think we've been doing a pretty good job of selling those services. And so when rates flatten out, we should hopefully begin to see some growth there. And then we'll just have to keep an eye on what happens with overdraft fees and then asset fees and that type of thing both on the commercial and the retail side, because that can affect the numbers some. But the biggest piece of what we do there, as you know, is corporate related and then service charges.

And then, Phil, the other expenses, even if you back out -- I'm assuming Aureas and other expenses, even if you back that out, it still looks like there's a pretty good increase linked quarter. Is there anything else in that loan that is sort of one time oriented?

Well, we are having some acquisition related expenses in terms of conversion related because that process goes all on -- and one thing I didn't mention but I want to make sure I highlight, we are going to convert all of the systems for Summit all on the closing date, which is in fairly early December.

So we're working hard right now and doing all of those conversions. There's a lot of mailing and that type of thing and other work. So I'd say that is probably the biggest thing. It could be argued it's somewhat one time and probably is, but you know how it is, something else will come up and take its place. I think that should be the main things.

Thanks a lot.

Your next question is from the line of Brent Christ with Fox-Pitt.

Good morning, guys. A couple of quick questions. First, in terms of the improvement and charge-offs this quarter, was that driven by an increase in recoveries or was that just lower gross charge-offs?

It's mainly lower charge-offs. If you look at the last few quarters, the first quarter we were at 16 basis points, the second quarter 23 basis points, and 10 basis points the third quarter. It's pretty much been in line. We knew that we mentioned last quarter there were what we thought were some one time things in that regard. I think we're about 16 basis points year-to-date, which is really very good.

Then it sounds like, given your loan gross loans expectations over the near term, that we'll probably see deposit growth in excess of loan growth. Is the plan to continue to use those incremental deposits and invest them into short term earning assets? And how is that going to play into your outlook for the margin?

I think the answer to the first question is, yes, I think for this quarter we expect -- or for the remainder of the year to see the deposit growth probably outpace loan growth, given the fact that we are where we are in October. As far as the use of the proceeds, I think that we are going to begin using some of the liquidity in the investment portfolio. In this quarter, we have recently made some purchases. We hadn't bought anything in like 12 months pretty much -- not quite 12 months. I'd say 10 months. We've seen debt funds sold get up above the billion dollar level during this month.

So we really needed to take advantage of some of what the market offered on the investment side. So I believe we made the commitment for $300 million worth of purchases in this quarter. And we we'll mix it up with probably average of about a 6% yield, just under 6%, let's say, on those investments.

So that could help other things equal a little bit. But I think, as far as looking at the margin going forward, you might recall last quarter I got a question with what is the margin going to do? Can it continue to go up? I think the answer is -- well, even if rates are not going up -- the answer was that yes, it could, but loan growth has to continue to increase. And I think with the moderation of loan growth we have seen recently, our margin pretty much flat quarter to quarter.

I think we're going to still need to look to that loan growth to be in the absence of higher interest rates that driver of expansion in net interest margin.

Last question. You mentioned the time frame for the Summit integration. Could you refresh my memory in terms of your thought on a cost savings and how quickly those are going to fall into place?

I think we said we'd have roughly 30% cost savings. And we get about 80% of that the first year.

You obviously can't '06, the first year because we're just going to have a couple of weeks there, but 2007, we should get 80% of cost savings.

Okay. Great. Thanks a lot.

Your next question is from the line of Andrea Jao with Lehman Brothers.

Good morning, gentleman. Hoping to find out what happened with average securities this quarter? Do you have the number, the average for the quarter?

Securities in total for the quarter were 2,000,000,856, with an average --

How about borrowing?

Our debt funds purchased and repos were 765 million for the quarter.

And then insurance commissions, which had a nice spot this quarter, does that pull back again next quarter? What went into the increase this quarter?

The third quarter has historically been a high quarter for us. There's a lot of school activity, for one thing. I know, historically, that we have had good position in the market, which does a lot of their business at this time. And so the fourth quarter typically seasonally drops off some in insurance.

Got you. Now, with respect to the margin, given that average loans would at best be flat, is five bits of compression in the fourth quarter reasonable?

It's going to just depend on some other things. What happens DDA. There will be some benefit with regard to these investments I talked about. I won't say it's unreasonable. But I think that the general tone is -- again it goes back to what we were saying last time. If rates aren't going up and loans are going to be increasing, we're going to, other things equal, sort of have a flat margin or somewhere around that, modulating around that.

So I'm not going to say what the margin percentage will be, because I don't know. But you're saying will there be some potential compression with flat loans? Potentially, yes. And there may be some other things that could offset it.

Last but not least, the current range of first call estimates as of this morning goes from 344 to 354 for '06, an average of 348. Just to clarify, you're comfortable with the 344, 345 in that area?

I'd say we would be at or near the low point of the range. That's the same numbers I'm looking at.

Okay. Same numbers. Perfect. Thank you very much.

[Operator Instructions]

There appears to be no further questions at this time.

Thank you for your time and we appreciate your interest in our company. And this concludes our call.

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