Cullen/Frost Bankers, Inc. (NYSE:CFR) Q4 2022 Earnings Call Transcript

Cullen/Frost Bankers, Inc. (NYSE:CFR) Q4 2022 Earnings Call Transcript January 26, 2023

Operator: Greetings, ladies and gentlemen, and welcome to the Cullen/Frost Bankers Inc. Fourth Quarter Earnings Conference Call. At this time, all participants are on a listen-only mode. A brief question-and-answer session will follow the formal presentation. . As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Mr. A.B. Mendez, Senior Vice President and Director of Investor Relations. Thank you. Please go ahead.

A.B. Mendez: Thanks, Donna. This morning’s conference call will be led by Phil Green, Chairman and CEO and Jerry Salinas, Group Executive Vice President and CFO. Before I turn the call over to Phil and Jerry, 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 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 on our website or by calling the Investor Relations department at 210-220-5234. At this time, I’ll turn the call over to Phil.

Phil Green: Thanks, A.B., and good afternoon, everybody. Thanks for joining us. Today, I’ll review the fourth quarter results for Cullen/Frost and our Chief Financial Officer, Jerry Salinas, will provide additional comments before we open it up for your questions. Well, in the fourth quarter, Cullen/Frost earned $189.5 million or $2.91 a share compared with earnings of $99.4 million or $1.54 a share reported in the same quarter of last year. That represented an increase of 90%. You don’t get to say that very often. Our return on average assets and average common equity in the fourth quarter were 1.44% and 27.16%, respectively, that compares with 0.81% and 9.26% for the same period last year. These are very strong results and along with our strategy of sustainable organic growth, they position us well heading into 2023.

Now taking a closer look at the quarter, loan growth was solid and above our long-term expectation of high single-digit annual growth, average loans, excluding PPP in the fourth quarter were just over $17 billion compared with average loans of $15.4 billion in the fourth quarter of 2021, an increase of 10.6%. For the full year 2022 average total loans, excluding PPP were up 11.3%. Our growth in loan balances for the fourth quarter versus the third quarter represented approximately 2/3rds C&I growth and 1/3rd consumer. CRE balances were basically flat. We booked $2.2 billion in new commercial commitments in the fourth quarter, and this is up by a non-annualized 9% from the third quarter and demonstrated our staff success from our calling and prospecting efforts earlier in the year.

That said, I believe it’s clear that the Fed’s program of interest rate increases is having an impact on economic activity, especially in the commercial real estate sector as more borrowers evaluate the impact of the current environment on their projects. For example, I think it’s interesting to look at our weighted 90-day pipeline at year-end. It’s down 14% from the previous quarter. However, the prospect component of that pipeline is up 19%, while the customer segment of that pipeline is down 32%. So as we continue to see potential deals come in from prospects as our strong available liquidity and our consistent underwriting shine through, our current customer base reflects the overall softening of the commercial real estate market. Average deposits in the fourth quarter were $44.8 billion, an increase of more than 9% compared with the $41 billion in the fourth quarter of last year.

And for the full year 2022, average total deposits were $44.6 billion, up 15.9% over 2021, and Jerry will talk more about recent deposit trends in his comments. We continue to see great growth in our consumer banking business. Average consumer loans were $2.3 billion in the fourth quarter, up by 22.6% over the fourth quarter last year. This is primarily from our consumer real estate products of HELOC, home equity and home improvement. The outlook for these loans continues to be good and credit strong. In fact, the consumer loan growth in 2022 was 283% of our previous best year. The sharp increase in mortgage rates created the perfect environment for our secured consumer real estate loans, such as home improvement, home equity and HELOC. Credit quality is outstanding in this portfolio, and our average credit score is 754.

I’m also pleased that we recently began funding loans in our mortgage program. Our team has created a new mortgage loan process from the ground up to originate and service mortgage loans and keeping with the Frost philosophy, and we’ve created a great digital and mobile experience around it. Once we complete this pilot program, we’ll roll out mortgage lending to customers on a or limited basis with the goal of opening it up to everyone later this year. Growth in new households continues. For the year, we added almost 26,000 new households, about 6.6% higher than the number of customers we had at the end of last year. While we believe this represents best-in-class organic growth, it was down slightly from last year’s all-time high of almost 27,000 customers, and that’s related to the lower net number of branches that we opened in 2021.

Given the increase in opening since then, we expect to achieve all-time high number of new customers in 2023. In addition, our across wealth advisers has seen a record amount of new business. Regarding our branch expansion efforts, the original 25 Houston expansion branches have surpassed $1 billion of deposits, and they continue to exceed pro formas. Loans totaled $727 million at year-end, including the additional branches we’ve opened in what we call Houston Expansion 2.0. At year-end, we stood at 114% of our household goal 170% of our loan goal and 104% of our deposit goals, and we’ll continue to add new locations in strong areas around the region. In Dallas, we are very encouraged by the early results of the new sites, which are doing even better than what Houston had achieved in the same time frame, 229% of the new household goal, 275% of loan goal and 372% of our deposit goal.

We added new financial centers at a rapid pace in the fourth quarter and soon, we’ll be up to 13 locations under the program. Overall, credit quality remains good. Problem loans, which we define as risk grade 10 and higher, totaled $322 million at the end of the fourth quarter compared with $387 million at the end of the previous quarter and $691 million a year ago. We reported a $3 million of credit loss expense in the fourth quarter. Net charge-offs for the fourth quarter were $3.8 million compared with $2.8 million in the fourth quarter of 2021. Annualized net charge-offs for the fourth quarter were 9 basis points of period-end loans. Non-accrual loans were $37.8 million at the end of the fourth quarter, an increase from the $29.9 million at the end of the third, which was the result of 2 small credits.

With regard to the current economic environment, there are potential risks on the horizon that could result from higher interest rates, continuing high inflation and pockets of supply chain disruption. Overall, investor commercial real estate loan metrics remain stable and indicative of above-average project operating performance across all portfolio asset types. While acceptable debt service coverage ratios are still reported for office, multifamily, office warehouse and retail asset types, a year-over-year decline is observed at fourth quarter ’22, primarily due to the impact of rising interest rates, higher operating expenses for multifamily and the inclusion of now completed construction projects that remain in lease-up. Regarding specifically the office portfolio, our optimism around this asset class stems from, one, the character and experience of the sponsors; two, the predominantly Class A nature of most portfolio office projects; three, tenant quality and lease duration; and four, strong existing office portfolio metrics, including low loan-to-value at an average number of 56% and weighted average debt service coverage ratio of 1.59x for the current stabilized office assets.

Office buildings outstanding at year-end were $1.8 billion, and of this amount, half was owner-occupied and half represented investor projects. Our energy loan portfolio concentrations remains in the single digits at 5.4% of loans excluding PPP at the end of the fourth quarter. Our energy borrowers as a whole have advanced rates and leverage ratios that are the lowest, we’ve experienced in many years, as borrowers have continued a program of deleveraging and returning more to shareholders. The current oil and gas price environment continues to be favorable for them, and our borrowers generally have a bullish outlook for prices for the near and intermediate term. Frost will continue to offer energy lending with prudent structures including appropriate advance rates and hedging structures to minimize risk.

We’ve done a great job with closing out the PPP forgiveness process. So I want to say I remain proud of our team to work so hard and the relationships that we’ve built and strengthened with customers when they need to help most. We say this often that we’ve got a lot going on for us. We’re expanding into new areas with beautiful new financial centers. We’re enhancing our consumer offerings with all new mortgage loans. We’re strengthening our communities and growing our brand awareness with exciting new sponsorship opportunities that will pay dividends for many years. And best of all, we are continuing with our strategy of sustainable organic growth. It’s kept our company strong positioned us well for whatever the future holds. Day in and day out, our employees do all this while adhering to our core values of integrity, carrying and excellence and by providing industry-leading customer service.

At Frost, we truly work hard to be a force for good in people’s everyday lives. Now I’ll turn the call over to our Chief Financial Officer, Jerry Salinas, for some additional comments.

Jerry Salinas: Thank you, Phil. Looking first at our net interest margin. Our net interest margin percentage for the fourth quarter was 3.31%, up 30 basis points from the 3.01% reported last quarter. Higher yields on both balances held at the Fed and loans had the largest positive impact on our net interest margin percentage. The increase was also positively impacted to a much lesser extent by a higher yield on investment securities and by higher volumes of both investment securities and loans. These positive impacts were partially offset by higher costs on deposits and both higher volumes and cost of repurchase agreements. Looking at our investment portfolio. The total investment portfolio averaged $20.1 billion during the fourth quarter, up $727 million from the third quarter average as we continue to deploy some of our excess liquidity during the quarter.

We made investment purchases during the quarter of approximately $1.2 billion, which included $735 million in Agency MBS securities with a yield of 5.43% and $470 million in municipal securities with a taxable equivalent yield of about 5.38%. For 2023, our current expectation is that we would invest an additional $4 billion of our excess liquidity into investment purchases during the year or about $2.2 billion net of projected inflows during the year. The taxable equivalent yield on the total investment portfolio in the fourth quarter was 3.09% up 15 basis points from the third quarter. The taxable portfolio, which averaged $12 billion, up approximately $534 million from the prior quarter had a yield of 2.41% up 21 basis points from the prior quarter, impacted by the higher yields on recently purchased Agency MBS securities.

Our tax-exempt municipal portfolio averages about $8.1 billion during the fourth quarter, up about $193 million from the third quarter and had a taxable equivalent yield of 4.17%, up 8 basis points from the prior quarter. At the end of the fourth quarter, approximately 76% of the municipal portfolio was pre-refunded or PSF insured. The duration of the investment portfolio at the end of the fourth quarter was 5.8 years, up from 5.3 years at the end of the third quarter impacted by the extended duration of our Agency MBS securities in this higher rate environment. Looking at deposits. On a linked-quarter basis, average deposits were down $1 billion or 2.3% with about half of the decrease coming from demand deposits and half coming from interest-bearing deposits.

Customer repos for the fourth quarter averaged $3.6 billion, up $1.6 billion from the $2 billion average in the third quarter. We have seen some deposit flows into our repo product during the quarter. Total combined deposits and customer repos in the fourth quarter averaged $48.3 billion, up $571 million from the prior quarter. The cost of interest-bearing deposits for the quarter was 1.16%, up 54 basis points from the third quarter. Regarding credit loss expense, during the fourth quarter, we booked a credit loss expense of $3 million, which represents the first quarter we booked a credit loss expense this year. The credit loss expense was driven by growth in unfunded commitments. Unfunded commitments grew $698 million during the quarter, ending at $12.5 billion at the end of the year.

Looking at non-interest income on a linked quarter basis. Trust and investment management fees were up $1.1 billion or 3% as increases in estate fees of $1.6 million, investment fees of $860,000 and real estate fees of $529,000 were partly offset by a decrease in oil and gas fees, down $2 million due to lower commodity prices. Service charges on deposit accounts were down $639,000 or 2.8% primarily as a result of lower commercial service charges, down $1.5 million, largely resulting from a higher earnings credit rate on annualized balances. Partially offsetting this decrease was a $756,000 increase in combined consumer and commercial overdraft charges. Insurance commissions and fees were down $1.5 million or 11.2% from the third quarter as a result of lower life insurance commissions, which were down $706,000 and also impacted by our normal business cycle.

Other income was up $7.1 million, primarily due to a $5.1 million distribution received from an SBIC investment. Regarding total non-interest expenses, total non-interest expense was up $23.4 million or 9.1% compared to the third quarter. The primary drivers were salaries and wages up $9.5 million or 7.5% and other expenses up $13.3 million or 29.2% compared to the third quarter. The increase in salary and wages was impacted by a $6.4 million increase in stock compensation as those stock awards are made in October of every year and some by their nature, are expensed immediately. Additionally, accrued incentives were up $1 million from the prior quarter. The increase in other non-interest expense of $13.3 million was impacted by higher fraud-related losses up $4.7 million, $4 million related to a licensing negotiation and marketing and advertising up $2.7 million, which is typically higher in the fourth quarter.

Looking at our projection of full year 2023 total noninterest expenses, we expect total non-interest expense for the full year 2023 to increase at a percentage rate in the mid-teens over our 2022 reported level. Our continued expansion in Houston and Dallas and the introduction of our mortgage product accounts for about 2.5% of that projected growth. Also impacting the projected growth rate is significant investments that we will be making in information technology for both people and infrastructure. Investments in marketing in both advertising and people as we focus on expanding the communication of our value proposition and expense growth is also impacted by costs associated with continued support of our staff. The effective tax rate for the fourth quarter was 13% or about 13.8%, excluding discrete items.

Our current expectation is that our full year effective tax rate for 2023 should be in the range of about 14.5% to 15.5%, but that can be affected by discrete items during the year. Regarding the estimates for full year 2023 earnings, our current projections include a 25 basis point Fed rate increase in February, followed by a 25 basis point decrease in July. Given those rate assumptions and the 2023 non-interest expense growth of mid-teens, we currently believe that the current mean of analyst estimates of $10.89 is reasonable. With that, I’ll now turn the call back over to Phil for questions.

Phil Green: Hi Jerry, we’ll open it up for questions now.

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Q&A Session

Operator: . The first question today is coming from Ebrahim Poonawala of Bank of America. Please go ahead.

Ebrahim Poonawala: First wanted to follow up on remarks, Phil, around commercial real estate. So you noted 2 things. One, you mentioned the impact from rate hikes was having an impact on the pipeline cooling off. But at the same time, we talked about the strength of your book. But give us — like how do you see this playing out if interest rates don’t get cut. one, and maybe this may not play out at Frost, but do you see credit pain in the sector across your markets to manifest themselves over the next 12 months across multifamily office. And how do you think that translates to impacting cash flows for your customers? Maybe it has a pressure on rent rolls as we look out? Would love some color around that? And just your thought process around both the risk for the market and how it may come back and translate in terms of risk to Frost? Thank you.

Phil Green: Okay. Thanks, Ebrahim. Well, we are seeing some tightening on debt service coverage ratios, as I mentioned. But we don’t expect, let’s say, multifamily, for example, to be underwater on those the word that I got from our credit people was, I’ll quote, so we feel pretty good about it. If you look at — I think I gave you what our loan-to-value on offices was about 56%. If you look at our loan to value on multifamily, it’s 58%. About half of our deals will be completed in ’23, the other half in ’24. So I don’t think there’s a lot of pressure today as it relates to our portfolio. I also hear from our people that rents are keeping up for now. So that’s helping things, but costs are also increasing. I think in this market, if you have issues, it’s been kind of what everyone’s been hearing.

It’s going to be the lower-class office buildings where you’re losing tenants and you’ve got some risk around that. But I don’t want to give the feeling that we’ve got problems. I just want to make sure I’m being honest, if things are tightening up. If you took a look at our portfolio, I was asking about, I guess, the office portfolio, I think we have $44 million of what might be problem credits on what is the portfolio. It’s probably over $1 billion. So you don’t really have much that are issues and they’re kind of specific. So again, I don’t want to give the impression things are too negative, but I do want to give the impression things are not as good as they were. I would also say that property tax is a big problem around here, and they’ve seen a big increase.

So when you combine that with interest rates and then also operating costs on apartments, multifamily. It’s going to create some pressure, but at this point, not so much. Again, offices are probably the biggest concern, I’d say, generally in the market because I don’t think anybody has figured out what’s going to happen with offices over the next couple of years, we’re still trying to figure it out as a business. So I’m sorry I don’t have any better clarity than that but that’s what we’re seeing Ebrahim.

Ebrahim Poonawala: No. That’s helpful, Phil. One, Jerry, you mentioned about the earnings outlook for the year. Give us a sense of what you expect in terms of net interest income growth for the year? And how you see that trending, do you expect NII continues to grow given just what you expect in terms of loan and deposit growth? Or do you see some trajectory where NII declines quarterly at some point in ’23?

Jerry Salinas: Yes, sure. I think that I said last quarter, we got a little bit into 2023, and we were talking about the NIM percentage. I think that we’re currently, I don’t expect that the fourth quarter was our peak. I still think that, obviously, we had a nice increase between the third and fourth quarter, 30 basis points, I don’t see that sort of a growth coming into the first quarter. But certainly, we do expect some improvement. And in my mind, I think given our assumptions that we’ll see a rate increase in February and then a decrease in July. I would expect that our NIM is probably given our assumptions, probably peaks in the third quarter. As far as we’re not going to give specific percentage growth on net interest income. But it’s year-over-year, I think we grew between ’21 and ’22, say, 30%. I don’t think we’ll be there based on kind of what I’m seeing. But I think we’re going to have strong growth this year compared to last.

Ebrahim Poonawala: Got it. Thank you.

Operator: Thank you. The next question is coming from Steven Alexopoulos of JPMorgan. Please go ahead.

Steven Alexopoulos: I wanted to start on the deposit side. So the outflows of non-interest-bearing were fairly sharp a bit more than we were looking for. And I know you mentioned repos, but could you give a little bit more color what you saw in the quarter, what you might still see at risk moving out of non-interest bearing. And where do you see that mix stabilizing?

Jerry Salinas: Yes, non-interest-bearing. I think what I said on the non-interest-bearing is that’s really been kind of the area that I’ve been concerned about that we had some exposure there. And I continue to think that’s really the area where we have the most exposure. With rates where they’re at today, and we all know there’s some pretty nice rates out there. I think that it really is compelling a lot of treasurers and CFOs to make sure that they’re managing their liquidity well and looking for alternatives. I think that certainly, we can be competitive in a lot of situations, but there’s probably going to be cases where we’re going to see some deposit outflow, especially on some of the larger balances, especially, I think that’s where most of the risk is.

I don’t think it’s anywhere unique to anybody. I think that from a deposit rate standpoint, our rates, I think, are competitive with banks. I think the challenge becomes trying to compete with some alternative sources. But I do expect that the commercial side on the commercial DDA is probably the most at risk in my mind.

Steven Alexopoulos: Got it. Okay. And then, Jerry, in terms of the loan-to-deposit ratio, moved up slightly through 2022. I hear what you’re saying I’m putting liquidity to work in the securities book. But should we expect a similar trend through 2023, just basically funding loan growth with deposit growth?