Cullen/Frost Bankers Inc (CFR) 2008 Q2 法說會逐字稿

Good morning. My name is Morris, and I will be your conference operator today. At this time, I would like to welcome everyone to the Cullen/Frost Bankers second quarter earnings conference call. (OPERATOR INSTRUCTIONS) Thank you. At this time I would like to turn the call over to Mr. Greg Parker, Executive Vice President, Director of Investor Relations. Sir, you may now 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 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. At this time, I'll turn the call over to Dick.

Thank you, Greg. I'm pleased to report another quarter of solid results for our company. In fact, I would say that our results were remarkably steady when considering the overall economic environment in which we're operating. I would attribute this primarily to two factors. First, our approach to business is one that has succeeded for 140 years in good and bad times. And during those tough times Frost's reputation as a disciplined, reliable financial institution makes us a safe haven for customers and investors seeking shelter in a storm. That's a result of strategic decisions we have made to enter some businesses and to exit others as we saw in the residential mortgage business. It's always attributable to our employees who are dedicated to providing customers with outstanding service. I'm very proud of their commitment.

The second factor in our success this quarter is that Texas economy in which we operate is compared to the conditions nationally doing very well. Texas is not immune to the changes occurring elsewhere in the nation, but we are certainly stronger than most. The lone star state might be the lone bright spot in the economy today and we're seeing that in our results. Together these two factors have allowed us to continue producing quality results consistently and this quarter is no exception. As usual, Phil Green, our CFO, will provide depth behind the numbers we are reporting today, but I would like to start with a brief overview and then will be happy to answer your questions.

Results of the second quarter of 2008 were steady, although we did encounter some pressure from the current environment with net income of 52.5 million for the second quarter of '08 versus 53.6 million reported for the second quarter of '07. On a per share basis, however, earnings remain at $0.89 per diluted common share, the same as reported a year earlier. In brief, the primary reason for the relatively slight decline in income is approximately $700,000 in after tax expense related to the settlement of a lawsuit which Phil will discuss in a bit more detail. While the markets in Texas continue to be competitive, we saw good increases in business volumes during the second quarter as our average loans increased 9.8% from last year to $8.2 billion and average deposits increased 3.2% to 10.4 billion. Our net interest margin was 4.68% for the second quarter compared to 4.67% for the first quarter and 4.72% for the second quarter a year ago.

Net interest income on a taxable equivalent basis rose 2.4% to 136 million compared to 133 million reported for the second quarter '07. Non-interest income 70.6 million, up 10.2% for the second quarter -- from the second quarter of last year. As you look at these comparisons, I think you will see like I saw that they are consistent in growth in all the categories. Trust fees increased 7.6% to $19 million, largely due to our oil and gas management fees and investment fees. Service charges on deposits were 21.6 million, up 7.4%. Impacting this was a $2 million increase in service charges on commercial accounts resulting from higher treasury management fees due to the drop in earnings credit rate. Insurance commissions and fees were up 7.2% to $7 million compared to a year ago. Other service charges and fees were $9.5 million compared to 7 million for the second quarter '07, investment fees of 1.4 million were recognized in the second quarter of '08. Other income increased 6.3% to $13.5 million.

On the expense side, non-interest expenses for the quarter were up 6 .6%. Without the litigation settlement we would have been up 5.7% versus the second quarter of last year and continue to be well managed with a growing company.

Now let's take a look at credit quality. I am pleased that our credit quality continues to be favorable and consistent with prior reporting periods. Charge offs before recoveries was 6.5 million versus 6.7 million in the first quarter. No single loan or industry represented a significant portion of the charge off total. Loan delinquencies 30 days or more are down to $68.6 million versus $71.5 million for the first quarter. Similar to the charge off expense, no one borrower type or industry represents a disproportionate share of the past due total. Non-performing assets did increase to 49.6 million versus 36.6 million in the first quarter, but slightly less than 12 months ago where we sat at 49.7 million.

One loan, an insurance company of approximately $7 million, was the primary addition to nonperforming assets this quarter. That loan was first identified in 2005 and now has a 50% reserve. Allowance for possible loan losses at the end of the second quarter of '08 stood at 94.5 million or 1.13% of loans and covered non-accruals by 233.5%. I would also note that the provision exceeded net charge offs by almost $2 million for the quarter.

As you know, we exited the mortgage business seven years ago, a decision that continues to benefit us. Given the level of scrutiny that mortgages and homebuilders have been subject to, I would like to take a couple minutes to discuss our home builder portfolio. We continue to reduce our exposure to the homebuilders. In the second quarter we had loan commitments of 443 million, down from 480 million in the first quarter. Outstandings for the same period were down from 255 million to 252 million, and almost a third of these loans outstanding are to individuals constructing their own homes where obviously you have a broad diversification. Frost home builder portfolio is only in Texas, no national builders, the average experience of our builders is 20 plus years, our committed dollars are only 10% to starter home market. We are not taking on any new homebuilders and we are supporting our current home builder clients who continue to perform and communicate with us on a regular basis.

While we're feeling some pressure on the housing front, Texas has been somewhat insulated from the housing crunch felt across the nation, partly because the economy continues to grow here, partly because Texas builders have been through harder times than this, and we both know how to adjust. Moving to the consumer banking front. Our consumer banking business remains strong as our business model of relationship banking, extraordinary customer service and fair pricing pays off. We are seeing solid organic customer growth as we see continued improvement in our industry leading retention rate. Once we get a customer, they don't leave us. We're seeing positive consumer balance growth. Consumer loan growth is good at 12.5% growth rate from the second quarter last year along with good credit quality.

Now let's move to the business side of our company and first take a look at loan growth. We are comfortable that our current loan growth is meeting our strategic goals. We continue to execute a disciplined growth strategy. We're quick to determine which business prospects we target and the potential from those prospects. This strategy lead us to booking more than a billion dollars in new commitments in the quarter. We again had a loss of volumes of 726 million related to pricing and structure for the first half of the year, a 27% increase over last year. However, we held to our standards and we still achieved good growth this quarter. More importantly, we believe the most sophisticated models cannot replace personal experience to form an opinion about character.

Let's talk a minute about the deposit growth on the business side. We continue to see substantial opportunity in the current environment based on depositor only prospects. We need to remember that 75% of businesses do not require consistent borrowings and many have no borrowing needs at all. With loan growth meeting our expectation, our focus will be increasing new business relationships with solid deposit characteristics. We focus on targeting businesses that have similar attributes to the existing Frost customers and which align with our philosophy of high quality service and safe, sound assets. This helps our sales associates identify the best prospect clients. As a result, we are more efficient and targeting producing better results faster.

A comment about fees on the business side, we have observed an opportunity to increase business fees. The current market conditions are providing fee and rate increase possibilities even in this competitive Texas environment. Our management is focused on programs aimed at revenue growth.

To close, let me reiterate how pleased I am with this quarter's results. Our approach to doing business, our discipline, our strategic decisions have positioned Cullen/Frost to succeed in difficult economic conditions providing solutions to customers and investors alike searching for a safe haven during tough times. As a result, we are producing steady earnings where others are in trouble, and we're going to keep the pressure on. We recently announced the availability to the general public of a family of mutual funds. In the coming week we are introducing a first of its kind online account and we believe this will gain great acceptance. At the same time, we're continuing to expand our bricks and mortar as we expect to open five new offices by the end of 2008. We're excited about the opportunities to grow our business. You know, they say you should never dig a well when you're thirsty. That's why we're ready right now. And now let me turn it over to Phil.

Thanks, Dick. I'm just going to make a few additional comments about our operations as you mentioned and provide an update for the rest of the year as far as our outlook, then open it up for questions. It was a good quarter, but in many ways it was an fairly uneventful quarter for us with the most unusual item being a $1.1 charge for the settlement of the patent lawsuit that Dick mentioned. We also increased provision slightly to exceed charge offs and build reserve by about $2 million. Outside of that, we saw decent revenue growth and fairly controlled expenses. I feel like the 2.5 % growth we had in net interest income versus last year was really especially gratifying when you consider that interest rates were down by 325 basis points from a year ago. That $1.2 billion interest rate swap that we talked about before really helped us offset the impact of lower rates and allowed us to continue the growth we had in deposits and loans to be reflected in our net interest income growth. As we said before, the swap really just helps us offset the volatility of our net interest income due to changes in interest rates and instead allows us to build revenue through the deposits and loans in the new relationships that we build every day.

On the net interest margin, excuse me, while down slightly from last year, it actually increased one basis point to 4.68% in the second quarter even with 100 basis point drop in rates that occurred in March and April. During the quarter I should point out that the swap attributed $7.4 million of positive cash flow to offset rate declines and that was up $4 million from the first quarter. Our fee income was up by over 10% from the previous year with really no real unusual items in various categories. What might be a little unusual is the fact that we were able to show nice revenue gains in both trust income and insurance commissions with both of those up over 7% in what could be considered tough markets for both those areas. The 7.5% growth in trust fees was aided by oil and gas revenues, securities lending fees and investment fees. The growth in investment fees was as a result of above market performance as well as good account growth. The 7.2% increase in insurance revenues was as a result of several factors. As most people know, property and casualty fees have been under pressure. They dropped 7% due to the soft market in this area. However, we offset that decline with a 17% organic increase in our benefits business and the impact of some smaller benefits agency acquisitions which we made during the year which added $1.2 million in revenue.

I also want to comment on the small securities loss of approximately $50,000 for the quarter. Because of the strong loan growth we have been able to achieve, we sold approximately $190 million of mortgage-backed securities choosing to build liquidities to support that growth and we mixed gains and losses to about a break even. We could have continued to leverage the investments; however given the environment and our outlook for the yield curve going forward we chose to undertake the sales.

Regarding expenses, I feel that the growth of 5.7% adjusted for the lawsuit settlement represents good control of expenses for a company which continues in the growth mode. A number of the expense categories were impacted by our growth in branches, both three new branches as well as four branch relocations during the year. Our expense growth also included cost associated with significant upgrades of our customer service systems that we talked about before.

Regarding the lawsuit settlement, it involved check imaging patents, it involved over 50 banks across the country, it's been fairly well publicized. We settled our portion and obtained a use of the license for the use of the patents going forward. It resulted in a $1.1 million current quarter charge as well as future payments for the license we received; however, the future payments are not material to the operating trends our company would otherwise experience.

Taking a quick look at deposits, they were up by 3.2% versus last year. But growth slowed somewhat in the first quarter with annualized increase of about 1% due to various factors. Some of the slow down was seasonal such as demand deposits which had an annualized growth of about 1.5% and public fund transaction accounts which were down at 25% annualized clip. Another area of decline was in CDs, which although really not a large source of funding for us saw an annualized decline around 16% as we saw maturities of higher yielding CDs, including some promotional rates we offered a few months earlier. However, we did see growth in the areas of consumer checking, savings and all money market accounts. Together these grew at an annualized rate at over 7%.

I will say that we have seen a continuation of the extremely high penalty rates being paid by larger organizations as they struggle to add liquidity amid their problems. And while our rates are strong by historical standards, we are in some cases well behind some of these troubled competitors, yet to this point we have continued to see deposit growth as depositors have chosen our value proposition of fair rate combined with security and stability. However, as we said before, we will continue to monitor the situation.

In closing, regarding our outlook, I will say we expect continued flat rates through year-end, although rate changes impact us much less than in the past. And given our current outlook for the environment, we continue to see our performance somewhere more towards the middle section of the range of estimates for our company. With that I'll turn it back over to Dick now for questions.

Thank you, Phil. I will now open the call for any questions anyone should have.

(OPERATOR INSTRUCTIONS) Your first question will come from the line of Brent Christ.

Morning.

Good morning.

I apologize if you covered this before, I had a little trouble getting into the call. Could you talk a little bit more about the drivers behind the strong loan growth this quarter and then maybe touch on kind of where the pipeline stood at the end of the quarter?

The drivers were very across the board. The good news is they were driven by energy, owner occupied real estate, public finance, contractors and medical, which is pretty much the areas that we continue to focus on in the past. So -- plus consumer, as I mentioned earlier, did have good growth and we're continuing to see that have a good broad based growth. You remember, I'll remind you in consumer that that, remember Texas is kind of the old antiquated state where you can't loan more than 80% of the liens added together. So we're seeing really some good quality and good growth at the same time.

I might just elaborate a little bit on Dick's comments as far as the categories that you will see in our public filings. Of the growth on quarter basis of about $340 million, about half of that was in C & I type lending and about half of that was in real estate type lending. Dick's talked about some of the components of C & I. When you look at real estate, about 60% of that was commercial real estate mortgages most of which are owner occupied. Then of the remaining 40%, it was 20% would have been consumer related real estate like home equity, home equity lines of credit and other consumer real estate. And then construction would be that other 20% mainly commercial construction with increase there.

Your question about pipeline, obviously we had a really strong first quarter and the pipeline's down a little bit going into the third quarter primarily because you -- I don't like to run these cycles, but you have a little bit of cycles when you have real strong, then you go into closing lots of loans and you get a little bit behind in your pipeline. When I say a little bit, it is a little bit less than 10% lower than it was going into the first quarter.

Yes, that's helpful. How about from a geographic perspective in terms of the growth.

It was spread out really pretty much every area had growth. Some of them had some of the I'll say smaller markets, although none of them are real small, had some fairly high percentage growth because they got smaller bases, I'll just run through it. On an annualized basis our growth in the valley was about 2%, San Antonio was 12, Houston was 12%, Fort Worth was 13%, Austin was 20%, our Dallas market had 44% growth, and our Corpus Christi market which had some unusual public finance activity was 56%. So we had good growth really in all the markets. It was not concentrated really in one particular.

I just remind you just to fill in on those numbers, if you look at Fort Worth, Houston and San Antonio where about 80% of the company is, they're all running around 12% growth.

Got you, okay. One other question. I know you guys have syndicated shared national credit portfolio with a fair amount of energy exposure in there, there was a larger company in Oklahoma that filed for bankruptcy yesterday, I believe. Just curious if you can comment on if there was any exposure to that specific credit and if there was if it would have been reflected in this quarter's results.

No exposure. In fact, I never had heard of it, which is the good news and I've been scrambling to find out what it was about.

All right, thanks a lot.

You're welcome.

Your next question will come from the line of John Pancari of J.P. Morgan.

Good morning.

Good morning.

Can you give us your view here on any weakness that you may be seeing evolve in the commercial portfolios as we work through this credit cycle here. Obviously you have commented on some of the pressure you're seeing in home building and the real estate side. But in terms of C & I and in terms of commercial real estate, income producing type property, I just want to get an idea of the trends you're seeing there, if you're seeing mounting weakness there you're worried about.

I really can't find a trend, John. We have looked. The only common thread which goes through good and bad times is really relates to management. We're having, we will have a problem here and there in different kinds of industries, but when you get down to it, it's really created by poor management. And definitely we have searched, as I think all of us are like you, is there a trend. We talked a lot about commercial real estate and others, but it's really, they're up a little bit, the problems as I just said, the non-performers are up. You get a slower economy you're going to be up a little bit. Even in this great state of Texas, we grew last year very strong at over 3%, and I think we will have job growth coming in at about 1.5%.

I think the other thing that we have to watch for, back to your question on problems, is that I'm one that believes this inflation is pretty serious. And you've got to watch those companies where the cost of fuel costs, obviously trucking companies and anybody that is heavy in transportation, we're asking a lot of questions related to those and how they're dealing with it. I've been surprised that this nation has dealt as well as it has with increasing fuel costs. But also in restaurants food cost is up really relates a lot to corn prices being up and no use in us getting in a long discussion about ethanol, but that has driven costs across the board. So I think what we have got to do, to answer your question I cannot see a trend outside of home building and it mainly relates to management. And then, third, we have got to look carefully at where the inflated costs are affecting companies and watch for that.

Okay. And I know I'm sorry if you may have already addressed this, but can you talk a little bit about how you may see some opportunities to pick up share here as some of the larger banks are pulling back and licking their wounds a bit, and as the conduits have pulled back it seems to be particularly in the state like you're in with a bank of your size that you're probably one of the better ones to compete and pick up share in this type of situation where you've got the big players hurting a little bit.

Well, John, that certainly is logical and one of the things that surprised me, the big players seem to think that Texas is the golden place and everything's perfect here. And they haven't pulled back as much as I thought they would, although we're starting to see it. We're also starting to see, which I'm pleased about on the deposit side, both businesses and individuals start to get some understanding of why they should be in a place that's safe for their money. Obviously, FDIC insurance and all that kind of stuff and different ways you can structure, but at the end of the day when you go out to get on an airplane if you think it's going to crash, I don't think you ought to get on it.

If you see all the crashes that we're seeing in the banking business today, more people are starting to understand that and they want to be at a place they don't have to worry about it and certainly Frost is a safe haven and a good place for those customers, and we're hearing more and more stories of people, and particularly businesses, that are moving over because they can be comfortable here. And we did have good loan growth, as you saw in the first quarter, and that's really a result of staying with our disciplines and continue to build, going after prospects, as I mentioned in the call, that have the same attributes that customers that currently bank with us and appreciate good safe sound assets, high quality service, so we're seeing more response to that.

Okay. Then a last question here, do you see any potential opportunities here as we could see some Fed intervention of some local Texas players, smaller ones that is, and any opportunities to pick up branches in select markets or anything in terms of acquisition opportunities as these guys are running into trouble?

Well, fortunately we are in a position that people think of us. We're not going to vary from our value system and our standards and our strategic plans and that is, number one, stay in Texas, number two, to stay in the markets in which we're currently serving, stay with quality. But as the larger organizations sell bricks and mortar that could be attractive to us, certainly we would be interested. And as they spin-off different types of their businesses that are in Texas that possibly could be attractive to us. So we're very open to it. We have got a strong capital position, we have a strong liquidity position, and we don't take it for granted. We want to keep this organization and we will keep it going in the right direction, a good solid organization.

Okay, thank you.

(OPERATOR INSTRUCTIONS) Your next question will come from the line of Andrea Jao of Lehman brothers.

Morning everyone.

Good morning, Andrea.

Well, last quarter you mentioned that the investment banking pipeline was good and so we saw a ramp up in income this quarter. I was wondering if you have any color as you look at the back half of the year for investment banking.

We still got some good things in the pipeline. It's a small organization, so it's not one that you should expect to see a tremendous amount of scale in terms of ramp up in fees Andrea, but the top line continues to be good and it's, and we expect to have a good year.

Okay. Then with respect to tax rate, that came down the second quarter. I was wondering what the good run rate would be for the back half of the year.

Andrea, the reason it's been coming down is because of the opportunities we have been seeing in municipal investments, tax free investments. And I would say that I wouldn't expect to see a lot of change, there may be some. We add a few of these investments opportunistically, but given what we're seeing with loan volumes I really expect our investment activity to be somewhat less in the second half than the first. So I think the opportunities for taking that down are probably not as great as they were in the first half.

Okay. Great, thank you so much.

You're welcome.

(OPERATOR INSTRUCTIONS) And you do have a followup question from the line of Andrea Jao.

Thanks. Hello again. Sorry about that.

That's all right.

Do you think provisioning should come back down more to the $4 million area, which is kind of the run rate in 4Q and 1Q versus the elevated $6 million in the second quarter?

I think one of the things that you got to think about is we're coming off of times where charge offs were running 15 basis points and 14 last year and very low rates. We seem to be getting back into, if you look over a longer period of time more normalized kind of where in the low 20s which is still quite frankly I believe is excellent. I think it's a time that it's prudent to keep the loan loss allowance strong. We're at 113. We were at 115 last time. We're having good loan growth. So those are, the economy is slowing, those are tough decisions that you have got to look for the right answer. But all in all I feel very good about where our asset quality is and sure it's up a little bit, but that would be expected in a slower economy.

Yes. Okay. Great. And then was hoping to get some numbers, specifically securities and borrowings. Average numbers.

Average numbers? Okay. Hold on just one second. Are you talking about for the quarter compared to the previous quarter?

Yes, please.

Quarter basis. You will see that our securities portfolio averaged 3 billion 380, which is down a little bit from the previous quarter of 3 billion 414. Our Fed funds sold position averaged $144 million which was down a little bit from $266 million that we averaged the previous quarter. And then you saw in the release the growth in loans which went from an average of 7 [billion] 917 in the third to 8 billion 187 in the first. So you can see that we were sort of taking the securities portfolio somewhat and certainly the liquidity portfolio somewhat to support the good loan growth that we have been able to achieve in this time.

Great, thank you so much.

You're welcome.

And you do have a followup question from the line of Brent Christ of Fox-Pitt.

Good morning. Just a couple quick follow-ups. First on the reserve question that Andrea just asked. How are you guys kind of thinking about the reserve coverage given it has come down a little bit over the past couple quarters even though it's been providing more than the charge offs just because of the growth? Is there a floor that you would not like to see that fall below?

It's not mathematical from our thinking, it's really looking at what's happening with the economy and the loan growth and a lot of factors considered.

I think as we said before at this point classifides grow more than we anticipate we will provide more than we anticipate because it's pretty responsive to it. And I think other things equal we tend to err toward maintenance or building but that will depend on what loan growth does, then what we see in classifieds. As we said before new loans don't really, under the formula approach we use today new loans don't really have a big bearing on your reserve levels, not like they used to. You used to say well, let's keep a 1% reserve all the time, loans grow, we will keep that 1%. The reserve really is there more to go against risk that have been identified, particularly classifications as I say. So I think that's the thing you would see the most responsive to. Having said that, we're cognizant that we are compared to a number of others and we have a lot of different audiences that look at that number as far as just the overall reserve level. But I tend to think that the formula tends to work all that out over the long run and I don't really see us getting into a position where we're some kind of gross anomaly in terms of our reserve coverage versus the market.

Okay. So any real build in that ratio that would have to be driven by some adverse risk rating migration within the loan portfolio then?

That's correct.

Okay. And then just a question on the margin now with the Fed seemingly on hold here and how you guys kind of thinking about the margin over the near to intermediate term?

I think we are expecting it to be fairly consistent, honestly. And I say the swap really that's in place models out to where we don't really have much impact to higher rates and small impact to lower rates just because of negative complexity of the investment portfolio. What we have seen in the past is that if loan levels grow these are the other assets in the balance sheet, since they typically have a higher yield you will see a margin increase because of loan growth. I will tell you that because we did sell some fairly good yielding securities, as I mentioned earlier, to support some of the loan growth we have had, any time you get in the position where you're selling securities to fund those loans that doesn't really afford you, because those security yields are so good, it doesn't really allow you the opportunity to build margin through growing loans because the yields are pretty comparable. I'll say if deposit growth continues and picks up, we're putting in loans, seeing a little bit of increase in loan deposit ratio, you could see pickup in margin related to that. But I tend to, my outlook is it's fairly consistent would be my expectation over the next six months.

Got you. Then my last question is just on the securities you sold, did you say it was 109 million?

190.

190. And what was the yield on it?

They were about a 560.

560. Was that early in the quarter or at the end?

It was right at the end of the quarter. Fairly near the end.

Okay. And are there other securities that you're kind of contemplating potentially selling some more over the next quarter or two to fund some of the loan growth?

No.

Okay. Great, thanks a lot guys.

There are no further questions at this time. Do you have any closing remarks?

We appreciate the interest in Cullen/Frost Bankers and this concludes our call. Thank you very much.

And this does conclude today's conference call. You may now disconnect.