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Operator
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. fourth quarter and annual earnings conference call. [OPERATOR INSTRUCTIONS]
It is now my pleasure to turn the call over to Mr. Greg Parker, Executive Vice President and director of investor relations. Sir?
- EVP & Director - Investor Relations
Thank you Brian. 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 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 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.
At this time, I'll turn the call over to Dick.
- Chairman & CEO
Thank you, Greg. I'm pleased to report another record year for Cullen/Frost Bankers Inc.. Our annual earnings for 2006 was $193.6 million, $3.42 per diluted common share, an increase of 17% over 2005. That's a return on assets of 1.67%, a return of equity of 18.03%. Our net income for the fourth quarter of 2006 was $48.4 million or $0.84 per diluted common share. Included in these results were $2 million in conversion expenses related to the December acquisition of Summit Bank Shares Inc.. Exceptional staff makes strong performance possible. I'm extremely proud of our people for their dedication and support in serving the needs of our customers.
Some highlights of the year. We completed three acquisitions that added an outstanding group of employees and customers to Frost. They were the Texas Community Bank Shares Inc. in Dallas, the Alamo Corporation of Texas in the Rio Grande Valley, and Summit Bank Shares Inc. in Fort Worth. We expanded to over 100 branches located statewide. Our net interest margin was 4.67%, highest level since 2001. Our year-end loans were $7.4 billion, an all-time high. Year-end deposits were $10.4 billion, an all-time high. And our non-interest income, $240.7 million, also an all-time high.
As you can see from all the hi -- all-time highs, 2006 was a big year for Cullen/Frost to grow and expand our Company, while hitting a new high in profitability. Our staff was challenged by the additional work brought on by the acquisitions, and the challenge was met with superb performance. All system conversions were completed for all three acquisitions. And the staff did all this while staying true to their core values, relationship banking and a commitment to accomplishing the Company's goals. Texas continues to have an increasingly challenging competitive environment. At the same time there's a large market exists for Frost to build its long-term customer relationships. And our focus on executing our sales disciplines will assure our continued profitable growth. Overall our Company continues to have strong if fundamentals to build shareholder value.
Taking a closer look at some of the major parts of the Company, let's first start with deposits. Deposits continue to have good growth, with and without acquisitions. I want to talk a little bit about without acquisitions. If you look at the average deposit growth year-to-date '05 versus '06 without the acquisitions, the growth was 5.2%. On a linked-quarter basis we grew 6.5% annualized. Looking at more detail for the linked quarter, the demand deposit grew 4% on an annualized basis without acquisitions. Having the primary account for both businesses and individuals is fundamental to our relationship strategy. Time deposits for the same period were up 8% on an annualized basis without acquisitions, adding to our short-term liquidity and was a primary reason for the net interest margin contracting seven basis points from the 4.69% previously reported. The numbers of new accounts growth was in the lower single-digit in '06.
And as we look at '07, and in order to continue to grow our new accounts, we are repositioning the value proposition of our checking accounts. Not something new for our Company, as we have been doing this through the years and had a major positioning five years ago when we took 35 different checking accounts down to less than five. We also know that in this new environment free checking no longer attracts the customers that it once did. And also direct mail cannot just be mailing out lots of mail; it must have a strong analytical engine. Bit we will reposition to make sure that we're giving good value to our customers as we have done for over 100 years. Also supporting this growth will be new financial centers in San Antonio, Austin and Brownsville. Plus, as a result of the acquisitions, we have significantly expanded our distribution system in Fort Worth and the Rio Grande Valley.
Now let's take a look at loans. They grew faster in the first six months of '06, as we discussed last quarter, and they began to flatten out from the second to the third quarter. We also told you that we expected this trend to continue through part of the fourth quarter and it did. However, the loan growth at year-end was up. Management has given a great deal of attention to this flatter growth without acquisitions, again, without acquisitions. I think it's important to examine recent activity trends and competition, and take a look deeper at some of the details. First let's look at activity trends. Fourth quarter volume of new commitments was a record high and 30% higher than the third quarter. Linked quarters, quarter three '06 versus quarter four '06 at period end balances, that is the loans were up $33 million without acquisitions. Prospect calls were up 6% and the dollar volume of new loans coming from prospects increased 10%.
I'm also pleased with the good diversity in the size of the loans that we see in our pipeline. They're about a third over $10 million, they're about a third $3 million to $10 million and about a third of them are under $3 million. At year-end our commercial and industrial loans without acquisitions grew 10% versus the total loan growth without acquisitions over the year at 3%. Again, this growth in commercial and industrial loans added to the diverse group of loans to small, medium and large businesses, which is important to our relationship strategy.
Finally, a word about the competitive landscape in Texas. Last year in '06 we lost a $1.2 billion due to pricing and structure. $700 million was pricing, and that increased 19% versus last year -- that being '05 -- and $500 million was from structure, up 3%. So you can see that the pricing competition continues to increase. Obviously the competition is strong, but Texas market has plenty of opportunity and the economy is growing faster than the nation as a whole. We will continue to keep our priority on well-structured loans. On the pricing side, we will focus on team selling of our diversified financial service products and look to the total relationship to maintain profitability.
Moving to asset quality, our non-performers increase to $57.7 million, primarily related to two commercial real estate loans totaling $23.2 million that moved from potential problems to non-accrual. At the same time our potential problems decreased $21.3 million to $12.7 million. You will recall our discussion last quarter related to the $23.2 million. It is one customer, it is two student housing projects, and two different college markets, which the college markets are smaller college markets than you would expect. Currently this customer is negotiating the sale of these projects and also a leasing arrangement with one of the universities. Our net charge-offs were $3.3 million, 20 basis points for the quarter and 17 basis points for the year. Our reserve at year end was 1.30%, with a fourth quarter provision of $3.4 million.
Moving to non-interest income, which is an important part of our Company, in 2006 our income increased $10.4 million, 4.5%, to $240.7 million. Trust represented almost half of this increase. It was a $5.1 million increase or almost 9%. Deposit service charges were down $1.6 million, as we experienced higher interest rate environment. Our insurance business increased $0.5 million, investment banking increased $2.8 million and check card fees were up $2.7 million. As we look at the job growth in Texas, we know that '06 our growth was stronger than the nation, and we think we can expect more of the same as we move through '07, growing at a one -- about 1% greater than the U.S. as a whole. Energy and housing affordability are significant positive factors to our state. All the major MSA's in the state experienced good growth, and quite frankly were in a tight range, growing at about 2.9% to 3.8%. In summary, the state had a broad base of positive trends.
In closing, I am pleased to report another record year for Cullen/Frost and most pleased about the quality of these earnings, which are built around long-term relationships. Now I'll ask Phil Green, our CFO, is make some comments.
- CFO
Thanks Dick. I think Dick's had a really good comprehensive recap of '06 in the fourth quarter, so I'm just going to make a few additional comments, and then we will open up for questions. We talked last time that we saw loans flattening in the third quarter and that we anticipated seeing that continue through the fourth quarter, with hopefully growth increases as we reached the end of the quarter and that's, in fact, what exactly happened.
We were up on a period-end basis for loans, as Dick pointed out, about $32 million from the third quarter. But if you go inside the quarter and look at the period ends for the various months in the quarter, I think it tells even a little bit better story than that. We reached a low point in the loans in October at $6.470 billion and they were pretty much flat with that in November. But in December we did see $79 million increase from that low point in October, loans reaching $6.549 billion at the end of the year. And then if you go a little farther and look in January through the 22nd, loans were up an additional $55 million to $6.604 billion, so I think we're seeing that momentum that we hoped we'd see by the end of the quarter. Obviously the important thing is we keep our sales disciplines in place today to continue to capitalize on that momentum in what's a very competitive environment today.
We said in the release -- and Dick talked about the net interest margin a little bit -- it was down seven basis points on a linked-quarter basis. But, again, I think it's important to consider the cause of it. We did have -- six basis points of that drop was because of the increase in liquidity that we had built up in the balance sheet in the fed funds area. Fed funds increased $183 million in the month. This is not including Summit, by the way. It was funded by our higher-yield time deposits. Our most popular time deposit is our high-yield money market account.
We also had some decent growth in jumbo CDs, which is a little bit of an anomaly for us. After seeing those decline over a -- for a long period of time, we've seen growth there as well. But we had about $160 million growth in the categories. And while we've got a positive spread when you put those in fed funds, it's not a very high spread and certainly doesn't compare to our net interest margin, which is in the 460+ range. So that results in some compression until we can take that liquidity and see those utilized in the loan portfolio and hopefully we will be able to see that happen as we capitalize on this momentum that we've had. As I've said in the past, really the key to our margin stability and even some improvement in a flat or inverted yield curve is for us to utilize the liquid assets that we have, not so much in the investment portfolio but in the loan portfolio, which is the place that we've got the best opportunity to enhance our yields.
Another thing that happened on the margin that I think it's important to be aware of is, Dick talked about the non-performer that came on -- those two commercial real estate loans -- one part of that process is that we did reverse accrued interest of over $0.5 million associated with those loans in the quarter. And that cost us about two basis points on our margin, and I think that's somewhat of a non-recurring item there on the margin, as well. If you look at non-interest income, we were up by 3% year over year, as Dick pointed out. We were down $2 million on a linked-quarter basis, and I want to talk for just a second about some of the trends in the quarter that brought about that decline. On insurance and other service charges, both those were down about $1.3 million in round numbers. On the insurance side, remember the third quarter's always seasonally a large quarter for us on revenues, because we have a big business on the school districts, and they let those contracts in those quarters, so that's a -- that's really a seasonal factor. If you look versus the previous year fourth quarter we were up 6.6%, so I feel pretty good that we've got the growth in those revenues back on track.
The other service charges line item is really all Frost securities in terms of the volatility we see there, and that, again, was just a situation where we had a particularly good quarter. In the third quarter, we had $1.3 million worth of fees there. And as we've said many times, the fees in this area are going to be somewhat lumpy. But the important thing is the deal pipeline that we have continues to be good and feel good about that, and so we hope to see some good performance there as we move through the next 12 months. On the service charges on deposits, those continue to decline, but again, that is really more than anything else the result of the higher earnings credit rates we're seeing. For the quarter the earnings credit rate was up about 23 basis points. And so while we saw an increase in the -- in the treasury management sales effort, we did see -- we're not seeing that in these fees. We're seeing that really more through the net interest margin as we're giving credit for those higher balances --higher rates to our customers.
The trust side I think is an interesting line item. It was basically flat for the quarter. It was up a little bit. but I think if you look inside it, it's a more interesting story. Investment fees were up an annualized 10% for the quarter, and as you're aware that's the lions share of these fees. But we did have two categories that were down, because, again, we had some strong performance in the previous quarters. One of those is real estate fees, where we manage properties, and let's say we may sell a ranch and we take a fee for that. We had $245,000 in lower fees in the fourth quarter than we did in the third quarter for that category of fees. Again, you can see how sales of real estate properties could be, again, somewhat lumpy there.
And then also oil and gas fees were down by $190,000 in the fourth quarter. That was not price related. That was more the result of fewer bonuses that were paid for leasing and then for properties being drilled. And, you know, the outlook for that area continues to be strong. I think it's really more of a factor where we saw a pause in some of the good bonus activity that we've been experiencing. So, still feel real good about the oil and gas area. One thing I'll point out is that oil and gas fees area, most of that revenue base on the royalty side is in gas, and so it's not subject to -- most of it's not subject to as much volatility as you're seeing in the oil piece. If just those two areas of real estate fees and oil and gas fees had just been flat from the third quarter, trust fees would have been up an annualized 12.5% over the third quarter, so we still feel very good about the trust business and how it's going.
On the expenses we were up 11%, as Dick pointed out. In addition to the operating expenses that we're experiencing from the three acquisitions that we converted this year, I think the two -- a couple of things to keep in mind there. One is the $2 million in conversion expenses that we incurred, and that's the bad news. But the good news is that, even though the conversions were difficult to do that fast and it takes a lot of work and certainly a lot of patience on both sides, that the cost saves are now in place and we're moving forward and we're very pleased with the acquisition. So that's not something that has to divert at this point going into 2007. Also in the expense base is we reached an agreement in principle to settle a long standing patent infringement dispute that -- where we accrued a little over $600,000 for the past use of that patent over time and will incur a similar amount over the next few years, as we license that patent use for the future. But feel good about getting that out of the way. That was somewhat of an unusual item for us, and glad to have that behind us.
On provisions, we did exceed charge-offs slightly. They were up from previous quarter, but charge-offs were just 20 basis points, which still is very good for us, really; us historically and good, certainly, compared to our peer groups. So I think we feel very good about the quality of our earnings, and that they were pretty solid for the quarter. One other item that I think I'll mention is that you might have seen in the press release that we did disclose that we will be redeeming a trust-preferred security issuance on February 21st. That's $100 million trust preferred that we did ten years ago. It it carries around an 8.5% rate all in, and it's callable now. It's got a premium on the call, so we mentioned that there would be $5.3 million worth of estimated expenses when we call that. Most of it's the call premium. Some of it's unamortized cost of issuance. So we'll see that in the second quarter, which is certainly an unusual item for us, but we believe will be a positive item for our net interest margin impact.
So looking forward, our outlook continues to be for flat rates in -- in the -- in 2007, and we're currently comfortable with the Street's consensus estimate for us for 2007. I should say that's notwithstanding the impact of calling the trust preferred in the -- in the first quarter and the requisite expenses that we're going to recognize at that point. So with that I'll open up for questions, so give it back over to Dick.
- Chairman & CEO
Thank you, Phil. We are -- we would be happy to entertain any questions you might have.
Operator
[OPERATOR INSTRUCTIONS] Your first question comes from the line of Andrea Jao of Lehman Brothers.
- Analyst
Morning gentlemen.
- Chairman & CEO
Good morning.
- Analyst
The $2 million in conversion cost, where should I net that out of? What line item is it -- or line items is it in right now.
- CFO
Most of it's in other expenses, I think $1.7 million, if I recall right is in other expenses, and the rest of it will be scattered out in other categories.
- Analyst
Got you. Then, with respect to your outlook on deposits for the first quarter, is there seas -- is first quarter typically seasonally weak and should that -- should we expect that to weigh in the margin the first quarter, and will liquid assets in your balance sheet remain elevated still in the first quarter?
- CFO
That's an excellent point. Certainly deposits are seasonal in the first quarter. We see a build up in the last part of the year, typically, then a drop-off as business activity slows in the first quarter. That's one reason that our first quarter is predictably the weakest quarter of the year. You know, I think some people in other industries have a hard time understanding that, but that's the way that works out. But then we typically see those build back up as we move through the year and towards a high point at the end of the year, so you're right, Andrea.
- Analyst
About how long the liquid assets on your balance sheet will kind of stay there?
- CFO
Well, I'm not sure we have a good answer to that question. I mean, it's all going to depend upon two things. One is we hope -- it depends on continued momentum in the loan area, and we're feeling pretty good about what we've been able to do recently there. Also, it'll depend on what the yield curve does, if we begin to see any positive slope. Maybe I'm giving up hope for that. I'd much rather see the loans pick up, bit we could invest some of that liquidity if we see opportunities in the bond portfolio.
- Analyst
And your outlook on the yield curve is asset based, right? No cut in the fed funds target?
- CFO
That's correct.
- Analyst
Okay, perfect. Thank you very much.
Operator
Your next question comes from the line of Charlie Ernst of Sandler, O'Neill Asset Management.
- Analyst
Good morning.
- Chairman & CEO
Good morning, Charlie.
- Analyst
Can you guys first talk about the [trup]? There's obviously another side of the balance sheet. Are you planning on just shrinking the balance sheet a little bit, maybe that short-term earning asset position, or what are your thoughts there?
- CFO
Charlie, one -- attorney's have told me that, based upon securities laws, I can't make any comment about the other side of that. I can just tell you what I'm going to do on the redemption side. But I think just common sense will tell you that we're doing it because we think we can improve our margin.
- Analyst
Okay. And Phil, can you confirm what the average short-term asset earning position was in the quarter?
- CFO
Yes, I think I can if you give me just a second.
- Analyst
Okay.
- CFO
Average fed funds sold and reposed would be $939 million, and that would include any impact from Summit.
- Analyst
Okay.
- CFO
That's a period -- excuse me, that's an average number.
- Analyst
Okay. Then on the real estate loans, is there any other color you can add? You didn't really give much sense as to whether you're comfortable about your collateral positions, maybe you can say what the loan to values are on them?
- Chairman & CEO
Are you talking about the $23 million?
- Analyst
That's right.
- Chairman & CEO
The non-accrual?
- Analyst
Yes.
- Chairman & CEO
I think I mentioned last time that we felt very good about the -- there was good equity in those going in and, Charlie, really we obviously had hoped that would've been worked out before now. But those student loan housing projects across the country have been very successful, and I see no reason why this one shouldn't be successful also. It's just -- as I mentioned before, they really just overbuilt in a smaller market. But again you've got good equity and they're negotiating the sale of them, and one of the universities is working to lease it up, which makes a difference. That particular university is short on housing and they've got to redo their housing, so they may buy the project or lease it up while they're building. So there's a lot of it activity in that regard.
It's not -- I think the other important thing, don't come to any conclusion about this as a weakness in real estate, because this is a very unique situation. We have done many of these projects before. They've all been successful. Obviously these two are having some problems, but again, good equity going in. These are experienced people and there's lots of interest in different solutions to solving this problem. It always takes longer than you think it would.
- Analyst
Right. And in terms of Summit, it looked to me like the loan numbers were a little bit lighter than their end of third quarter and the deposit numbers were a lot higher. Is there any color you can give to their fourth quarter performance, and does their performance have any impact on your expectations for the financial performance of the deal?
- CFO
I'll say that the -- just in general, Charlie, we feel good about what they're doing. You know, there's always going to be -- any time you do an acquisition and you do that kind of conversion activity and all that goes into it, there could -- it takes people's time. So it's not surprising to me that you may have seen a little bit of weakening there, but certainly on the deposit side they've got a great franchise and expect them to do well. So I think getting the deals convert and getting the cost saves done right away is a big positive for us. I'd say that we feel a little bit -- even better about the deal now than we did before.
- Chairman & CEO
Charlie, I'd just add we see no significant business loss as we've gone through the transaction.
- Analyst
And when did the conversion actually happen?
- CFO
On December 8th.
- Analyst
December 8th. Okay. So we'll see -- in the first quarter we'll see kind of a full run rate on cost savings?
- CFO
Yes, you should see that.
- Analyst
Okay, great. All right, thanks a lot you guys.
Operator
[OPERATOR INSTRUCTIONS] Your next question comes from the line of John Pancari of JPMorgan.
- Analyst
Good morning.
- CFO
Good morning John.
- Analyst
Just wanted to see if we can get some more color on your outlook for loan growth, just given the pickup that you're seeing, or that you saw toward the end of the quarter and you indicated January the pickup there. So I just want to see if you're comfortable with more like a return to a high single-digit range, or if you think it could be north or south of that number? Just wanted to get an idea of your feel there.
- Chairman & CEO
John, that's a tough question, but let me -- that's one reason I spent a little bit of time looking at some of the detail. You know, I'm very pleased with the commitments at a record high in the fourth quarter, and that was 30% higher than the third quarter. You know, I talked about prospect calls. We're also working hard to be sure we continue to build our relationship-type banking. I've said that over and over. Commercial and industrial loans growing 10% for the year I think is very significant, because that's where you get your strongest relationships and building good deposit accounts and other type business with that. So it's -- it's a tough call to see how it is. The fundamentals look good going into the year, which I'm pleased with, and obviously there's a big focus in our Company of growing it. And so, to be precise other than those numbers would be very difficult, but it continues to look good and we close the loan -- closed the year up $32 million.
- Analyst
Are you seeing pay downs on the -- on real estate or other credits continuing to abate somewhat from the previously-elevated levels or are they still remaining somewhat high?
- Chairman & CEO
You know, real estate pay downs -- in fact I looked at it -- if you look it at the details we were down $100 million in real estate loans without the acquisitions last year. You know, you can look at pay downs in real estate loans and you can get unhappy or you should get very happy. Real estate loans are supposed to pay. The kind of construction loans you want them to move into long-term. At the same time our job is to continue to get the next project and start advancing on it it. So you're going to have those kinds of activities. I'm pleased with -- I'm pleased when real estate loans work like they're supposed to and ours did, and certainly we went through a period of time where we thought there was a little bit more of that than others. But we -- we still see a good market and we'll continue to build those.
- Analyst
And then on the -- and t at kind of just points me to the front end production then. In terms of the competitive side of that, are you seeing some of the larger players there in Texas or the larger out-of-state banks, possibly either moving upstream or anything changing on the competitive front, or is it just as competitive from the larger participants in the markets?
- Chairman & CEO
They're all competitive and certainly they've been very aggressive, as I try to quantify this number with you each quarter and I just gave you the year. Pricing is more competitive than it was, structure's probably about the same and -- but, as I mentioned, we're not going to give on our structure. We still want to make good quality loans and we're going to stay with that. At the same time on loan pricing, we have the ability, because we have a nice financial service Company, to be sure that we're selling other products and look at the overall profitability of the total relationship and not just the price of the loan. And that's the way we look at it and I think we can continue to grow this business, working together in the total Company of team selling is what I refer to it, and maintain our profitability. But it's a challenge.
- Analyst
Okay. Good, thank you.
Operator
And gentlemen, I'm showing that there are no further questions. I would like to turn the call over now to management for closing remarks.
- Chairman & CEO
Well, thank you. I understand we have one more question, maybe.
Operator
Yes, sir, from Andrew Collins with Piper Jaffrey.
- Chairman & CEO
Okay, Andrew.
- Analyst
Hi, this is [Peter Felk] for Andy Collins. Most of our questions have been asked and answered, but just a question on earnings credit rate. You mentioned it was up, I think, 23 basis points sequentially. Given that the fed hasn't moved since June I was wondering when do you think the earnings credit rates are going to be topping off for you guys? Just trying to get a feel of when that could lead to resumption of some of the service charge income growth.
- CFO
I think it's going to depend on what treasuries do. Yes, the fed didn't really change, but it's based on -- one of the most important ones is based on what the treasury rate is, and so I guess we could look at the yield curve and see what the implied dates would be for that. But if the fed begins to move down, you'd expect those to respond as well.
- Analyst
Okay. And then finally, I know you were talking a little bit about your new branches for '07 in San Antonio, Austin and Brownsville, just wondering how much of that's already been expensed? In other words, have the construction costs already passed and do you just have staffing as an incremental expense at this point?
- CFO
No, they're in progress now, and so what will happen is once they get completed they'll begin an amortization of the cost of the facilities and the improvements, as well as the staffing expense. So you really don't see much, other than I would say interest lost on the money you're spending to build the thing, up until the point that you open it it up and then you begin amortizing all that.
- Chairman & CEO
I would -- I'd just add that is exactly right. On the other side --on the revenue side, in our model we have been working hard as we're building to also build revenue and deposit relationships. It certainly doesn't offset all that, but we try to get ahead of the curve in building the income stream while we're building the branch.
- Analyst
All right, thanks.
- CFO
You will see those as new expenses as they begin to open up during the year.
- Analyst
Okay, thank you.
- Chairman & CEO
Okay.
Operator
And again, gentlemen, there are no further questions at this time, if you would like to make your closing remarks.
- Chairman & CEO
Well, thank you very much for your support and we will continue to work hard for our shareholders. We stand adjourned.
Operator
And this does conclude today's Cullen/Frost Bankers Inc. fourth quarter and annual earnings conference call. You may now disconnect.