Good morning, welcome to the Cullen/Frost Bank second quarter earnings conference call. My name is Amy, I will be facilitating the audio portion of today's interactive broadcast. All lines have been placed on mute to prevent any background noise. For those of you on the stream, please take note of the options available in your event console. At this time, I would like to turn the show over to Mr. A.B. Mendez, Senior Vice President and Director of Investor Relations. Mr. Mendez, you may begin.
Thank you, Amy. 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 for 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.
Thanks, A.B., welcome to the investor relations team. I'd also like to thank Greg Parker, who's been managing investor relations for Frost for about the past 20 years. Greg's done an outstanding job for us. Greg, thank you, and congratulations on your new role in operational risk. Good morning, everyone. Thanks for joining us. Today, I'll review second quarter results for Cullen/Frost, our chief financial officer, Jerry Salinas, will also provide additional comments before we open it up to your questions. In the second quarter, Cullen/Frost earned $109.3 million, or $1.68 per diluted common share, which represents a 30% increase compared with the same quarter last year. Our solid second quarter earnings are the result of Frost bankers executing the strategy that we discussed over the past several quarters, focusing on sustainable, above-average organic growth.
Along with the excellent earnings, our return on average assets reached 1.43% in the second quarter, the highest quarterly total in nine years. I'd like to offer some details about the elements that go into this growth. We continue to build our loan portfolio while maintaining our quality standards. During the second quarter, average loans were $13.5 billion. This represents an increase of more than $1.2 billion, or just over 10%, versus the second quarter last year. C&I loans grew 10%, commercial real estate loans grew 11%. Our provision for loan losses was $8.3 million in the second quarter, that compared to $6.9 million in the first, and $8.4 million in the second quarter of 2017. Non-performing assets totaled $122.8 million in the second quarter. This was down 10% from the $136.6 million in the first quarter.
Potential problem loans totaled $50 million at the end of the second quarter. That's our lowest level in more than three years, and it matches levels prior to the energy downturn. Net charge-offs in the second quarter of 2018 were $7.9 million, compared with $12.4 million in the first quarter and $11.9 million in the second quarter of last year. The lower total represents continued improvement in credit quality and maintaining high loan standards. As expected, second quarter annualized net charge-offs dropped to a level of 23 basis points over average loans. Overall delinquencies for accruing loans at the end of the second quarter were $67 million, or 49 basis points of period end loans. That's a number well within our standards and comparable to what we've experienced in the past two and a half years.
Total problem loans, which we define as risk grade 10 and higher, decreased by more than 6% compared to the first quarter, we're down about 25% from a year ago. Outstanding energy loans at the end of the second quarter represented just over 11% of total loans. The energy industry activity is increasing in markets where we do business, the percentage of energy loans in our portfolio remains well below our peak of more than 16% in 2015. Other industries in Texas continue to do well. In general, our customers tell us they're optimistic about their prospects for future growth, Frost is well-positioned to serve them with a competitive product mix and strong value proposition. Average total deposits in the second quarter were $26.1 billion, compared with $25.7 billion in the second quarter of last year.
In consumer banking, our value proposition and award-winning service continue to attract customers. On a linked quarter basis, same-store sales growth for new account origination is up 4.5% unannualized in the second quarter. Almost nine percent of our account openings came from our online channel, which includes our Frost Bank mobile app. That's nearly 65% higher than last year. The consumer loan portfolio averaged $1.62 billion in the second quarter, increasing by 8.3%, or $125 million compared to the second quarter of 2017. This was impacted by new energy opportunities, which were down 27% from a year ago, and public finance opportunities, which were down 26%. Regular commercial new opportunities were up by 7%, while commercial real estate opportunities increased 4%.
Looking now at new loan commitments booked in the second quarter, overall, they declined from a year ago by 6%. The regular C&I component was up by 7%. Both energy and commercial real estate new commitments were down 17%. As we mentioned last quarter, early 2017 was an extremely strong period for commercial real estate. On a linked quarter comparison of new loan commitments booked, shows solid growth from the first quarter with all portfolio segments increasing. Remember that the first quarter is typically seasonally weaker. With regard to the current active loan pipeline, I'm glad to see the second quarter was up from the previous year by 7%. Our strategy of building our core loan portfolio, which we define as loan relationships under $10 million in size, continues to help provide steady, sustainable organic growth.
For the second quarter, new commitments under $10 million accounted for 50% of commitments booked, up from 44% in the second quarter last year. Let me say that I'm extremely pleased with what our people at Frost were able to achieve this year, and this quarter particularly. It's not often you're able to report a 30% increase in earnings. They do it by taking care of our customers and by offering them top quality service and excellence at a fair price. They provide a safe, sound place to do business, and most of all, they provide great customer experiences and make people's lives better. We've been doing that for 150 years now, and that experience has shown us the value of having a positive, optimistic attitude towards growth.
Our hardworking Frost bankers build long-term relationships with our customers that benefit everyone in good times and bad, and I want to thank them for that. I'll turn the call over to our Chief Financial Officer, Jerry Salinas, for some additional comments.
Thank you, Phil. I'll make a few general comments about the Texas economy before I provide some additional information about our financial performance for the quarter and close with our guidance for full year 2018. The Texas economy continues to expand amid a tight labor market and historically low unemployment. According to the Federal Reserve's Dallas branch, Texas employment has expanded 3.6% year to date. The Texas unemployment rate in June decreased to 4%. That's near a four-decade low and the same as the U.S. national average. Tight labor markets are challenging Texas businesses to find qualified workers. The Dallas Fed projects 2018 Texas job growth at 3%. Based on that forecast, Texas should add more than 370,000 new jobs in 2018. Looking at individual markets, Houston's economy expanded 6.1% in June, the fastest among the major metro areas. Year to date, Houston employment is up 4.8%.
The biggest gains are in professional services and manufacturing. Energy jobs are also increasing. Houston's unemployment rate fell to 4.4% in June, the lowest in more than three years. According to the Dallas Fed, employment in the Dallas-Fort Worth metroplex grew 3.2% annualized year to date. Growth through the first six months is 3.6% in Dallas and 2.4% in Fort Worth. Job expansion is widespread across all sectors. Payrolls in the goods producing sector, that's manufacturing, construction, and mining, were up an annualized 9.3% this year in Dallas. June unemployment was 3.5% in Dallas and 3.6% in Fort Worth. The Austin labor force is up 3.8% annualized this year. Growth is mixed across industries. Leisure and hospitality grew 14% from March to May, while healthcare and professional business services had the largest declines. Austin's unemployment rate in June was 3%. The San Antonio economy is steady with low unemployment.
Goods producing industries are growing at a robust pace. Energy sector and manufacturing jobs expanded briskly in the previous three months, although leisure and hospitality jobs continued to decline. San Antonio's June unemployment rate fell to 3.3%. The Permian Basin economy is growing rapidly, with surging employment and record low unemployment. Midland-Odessa employment has added jobs at an annualized rate above 10% for four consecutive months. Employment in the Permian Basin is now higher than during its pre-bust peak. Midland-Odessa's unemployment rate fell to a new low of 2.5% in June, the lowest in the state. For Texas as a whole, the Dallas Fed projects 3% job growth in 2018. Now moving to our financial performance. Our net interest margin percentage for the second quarter was 3.64%, up 12 basis points from the 3.52% reported last quarter.
Driving the increase was the favorable effect of higher yields on earning assets, primarily loans and balances at the Fed, and higher loan volumes. In addition, a lower proportion of earning assets invested in balances at the Fed during the second quarter had a positive effect on the net interest margin percentage. These favorable variances were partly offset by higher deposit costs during the second quarter. The taxable equivalent loan yield for the second quarter was 4.90%, up 25 basis points from the 4.65% reported in the first quarter, driven by the higher rate environment. Looking at our investment portfolio, the total investment portfolio averaged $11.9 billion during the second quarter, up about $90 million from the first quarter average of $11.8. The taxable equivalent yields on the investment portfolio was 3.36% in the second quarter, flat with the first quarter.
Our municipal bond portfolio averaged about $7.7 billion during the second quarter, up about $59 million from the first quarter. During the second quarter, we purchased about $230 million in municipal securities with a taxable equivalent yield of about 4%. The municipal portfolio had a taxable equivalent yield for the second quarter of 4.1%, down two basis points from the previous quarter. At the end of the second quarter, about 68% of the municipal portfolio was pre-refunded or PSF insured. Regarding income taxes, our effective tax rate for the quarter was 11.1%, up from the 9.5% reported last quarter, impacted by higher net income and a lower benefit from stock option settlements during the second quarter as compared to the first. On a year-to-date basis, our effective tax rate was 10.3%.
Regarding the outlook for 2018, regarding the estimates for full year 2018 earnings, we currently believe that the mean of analyst estimates for the year of $6.74 is reasonable given our current assumption of another rate hike in September. With that, I'll now turn the call back over to Phil for questions.
Thank you, Jerry. With that, we'll open the call up for questions.
Ladies and gentlemen, at this time, if you would like to ask a question, please press star, then the number one on your telephone keypad. We'll pause for just a moment to compile the Q&A roster. Our first question today comes from the line of Ebrahim Poonawala of Bank of America Merrill Lynch. Your line is open.
Good morning, guys.
Good morning.
I guess if you can first just wanted to touch upon in terms of deposits, we saw a pretty sharp decline on a period end basis. Average balances were a little bit better. If Phil or Jerry, you can talk about the dynamics on the deposit front, whether you expect those to grow in the back half of the year and the change that you're seeing in the cost of deposits quarter-over-quarter.
Sure. The one thing, Ebrahim, to look at a period end is really kind of tough because those balances fluctuate so much period end to period end from one day to the next. We certainly tend to focus more on the averages. I guess if I look at year-over-year average, for example, we're showing a 1.6% quarter-over-quarter growth compared to the second quarter last year. What we saw was really our demand deposits, which for us were about $10.7 billion or about 40% of our deposits. They were actually down about 0.6%. That's really where we're seeing the decrease is in those commercial balances. Our interest bearing accounts were actually up 3.2% compared to the second quarter last year.
Really what we're seeing is that with the alternatives available to customers, we are seeing some dollars moving into some sweep accounts, for example, and customers are using their balances to grow the business. There is going to be pressure in deposits as we look through the rest of the year. For us, we really see a pickup typically seasonally starting in the third and fourth quarter. Right now that's really what our projections show is that we're assuming that we'll have that same sort of trend going up for the latter part of the year.
Understood. If you could provide the change in the cost of interest bearing deposits for the quarter.
Sure. Total cost for the first quarter was 16 basis points going up to 27.
Understood. Just moving to sort of the outlook when we think about the margin in 364 based on sort of the expectations on the deposit front. If we don't get a rate hike, what's your expectation for the margin? It should continue to trend higher without the hike and with the hike, what's that adding to the margin?
What I'd say is again on the net interest margin as we discussed, some of that's going to be dependent on what happens with deposits. Our projections right now assume that those will continue to trend up. The net interest margin will trend up through this latter part of the year really either way with or without the September increase because again the impact of the June increase isn't completely in our numbers but obviously better if we get the rate hike in September. Percentage wise it'll be dependent on those deposit volumes.
Got it. Just last question moving to expenses. We are running like sub 2% year-over-year in terms of expense growth. Do we still expect expenses to end the year in that 4% range or is 2% the right way to think about expense growth for 2018?
No, what I would say, I think, the guidance I've given is what I'm still comfortable with. What we've said, and I think we need to be careful with last year, because remember, the network costs are in last year's expenses, and this year they're netted against the income. If you adjust out the 2017 expenses, they're like at $747 million. If you adjust out the $12 million in network cost. The guidance I've given is that we projected we'd be up about 4.5% from that, and that's still a good number.
Got it. Thank you for taking my questions.
Yes, sure.
Your next question comes from the line of Jennifer Demba of SunTrust. Your line is open.
I was just wondering if you could talk about the loan competition dynamics you saw during the quarter, where the most opportunities were, and where you were seeing maybe the most pricing or structure competition. Thanks.
Jennifer, on the competition side, it continues to be tough. It's been that way for a long, long time. Shows no signs of abating. I think that it's my sense that probably the biggest level of competition you see on price side is probably fixed rate loans on the smaller side, because I think you get a lot of community banks in that area which tend to price particularly aggressively. That's where I would see that. As far as where our growth is coming from, it's been really well-balanced. The biggest part of the growth that we've seen has been in C&I loans, and that's good because that's really our wheelhouse. We do great with consumer, CRE, obviously, we're a good energy lender.
The part of the portfolio that's been growing the most has been C&I, and I think that's partly because focus, and that's partly because of our focus on core loans, and those tend to be more in the C&I area. You've heard us talk about final authority, where we give some authority to execute transactions on an expedited basis to our people, and I think those tend to be C&I as well. Whether or not C&I think they tend to be owner-occupied CRE for the most part.
Thank you.
Thanks.
Your next question comes from the line of David Rochester of Deutsche Bank. Your line is open.
Hey, good morning, guys.
Morning.
Morning, Dave.
I was just curious, next year for 2019, how much in the way of expense savings are you expecting to get from the roll-off of the FDIC surcharge?
Dave, we're projecting that number in the eight to nine million range. Pre-tax, obviously. Yeah.
The data security expense that was in this quarter, are you expecting that to drop out as we head into the back half of the year?
There was a lot of communication that happened early, as it relates to that part of it, yeah, I would think that that would lighten up some.
Yeah.
Like any time you get into these data intrusion issues, it's a process, where there's regulatory, legal, whatever, and so there'll be some ancillary costs, I'm sure, that we'll see as we go through that process. The biggest amount of activity was in that previous quarter.
Yeah. Okay. Just switching back to the NIM, I know you guys had raised rates on deposits a few times this quarter. I was just curious if you've noted that those increases have had a positive impact already on flows. Then if you could just talk about maybe where average deposits have trended so far this quarter, just to give an early look on that trend, since it sounds like you're positive on that this quarter.
I'll just make a couple comments, and Jerry can fill in. Yeah, I think definitely the rate changes have had a positive impact. I think year-over-year, Jerry said we were up like around 3.5% or so in time deposit growth, and I really believe that would've been a negative number had we not taken the action we did on increasing interest rates.
Then on the average balances so far this quarter, are you seeing that growth there so far?
Let me grab some information here, Dave, real quick. What I'd say is that, we are seeing, basically right now, I will tell you that we're probably about flat, maybe up a little bit on average.
Okay.
All right?
Okay, great. Just one last one. You guys had some great loan growth this quarter, and I was just curious how the pipeline heading into 3Q looks versus the pipeline heading into 2Q. It sounded like you were saying it was up from a year ago, was just curious quarter-over-quarter how that looks.
If you looked at the pipeline, current active pipeline on a linked quarter basis, it was up by, on a growth basis, up by 5%. That's quarter-over-quarter.
Okay.
On a weighted basis, three. To me, the pipeline still looks good, and I think our outlook for loans still looks good. It hasn't changed from what we've been seeing over the last few quarters and expecting for this year.
Just one last one back on the NIM. It sounded like you were saying that you think the NIM can still expand next quarter, whether you get another rate hike or not in September, I guess expand through the end of this year, whether you get that September rate hike or not. Is that just because, as you were saying, you did not benefit the full amount from the June rate hike? I guess you had some of the impact in the second quarter, and even though you're going to see the rest of it in Q3, you think that's enough to have the NIM expanding through the end of this year?
Yeah. All I said really, Dave, was that it's trending up. I think that obviously if we get the September rate hike, things look better. With the June rate hike, it was so late in June that its effect really isn't in all the numbers.
Yep. That incorporates all the increases that you've made on the cost deposit side, obviously. Yep. Okay, great. Thanks, guys.
Again, ladies and gentlemen, if you would like to ask a question, please press star, then the number one on your telephone keypad. Your next question comes from the line of Alex Hoffman of JPMorgan. Your line is open.
Good morning, guys. This is Alex on for Steve. Just wanted to touch on the question from before on deposit costs. You mentioned 16-27 basis points. That's on the total cost of deposits, right?
Right. From 16 to 27, yes. Mm-hmm.
Got it. Okay. That helps. Then just touching on expenses, were there any one-timers in the quarter? Can you just touch on that for a bit?
Yeah, I think that we tried to identify in the quarter kind of the things that were unique. We did have like $900,000 related to the IT incident that I mentioned. We had another $900,000 in settlements during the quarter, settlement costs. We had a $500,000 contribution to our charitable foundation. They were kind of unique.
Got it. That's on a year-over-year basis?
Yes.
Okay. Got it.
They would be unique, if you will, but the comparison numbers are, yes, against the-- actually, those are distinct numbers in the second quarter. Regardless of the comparison, they're distinct numbers, discrete numbers.
Mm-hmm. Okay. Got it.
Does that make sense?
Yeah. Helpful. Just given what some of the banks have been saying about the commercial real estate market getting more competitive and even irrational, can you touch on what you're seeing in the CRE space?
Well, like I said, competition's always strong. The thing to focus on and remember about us is we're not banking things, we're not doing transactions, we're banking people. We've got some great relationships as it relates to commercial real estate. Again, competition's strong, but we see strong equity in projects. The economy is good. We're being careful, but we've got plenty of opportunity, and we're continuing to see that. As I said, we were down a little bit from last year because that was such a strong period last year, but I still think the pipeline's good, and we've got opportunity to really support great customers as they see good projects. Obviously, you got to be careful in what you're doing, and things are changing. Retail is changing in terms of how we see that underwritten and what good developers are looking for.
Even we're being careful with multifamily, although there are some good opportunities that are out there for some great customers. The industrial side, I think, continues to be very strong in Texas, and residential as well. Got to be careful, but to describe it as irrational, from our point of view, I don't think would be accurate, particularly as you relate to the work we do with great customers.
Great. Thanks for taking my question.
Your next question comes from the line of Brady Gailey of the, sorry, KBW. Your line is open.
Yeah, thank you. Good morning, guys.
Hey, Brady.
Hey, Brady.
Just another question on deposit costs. You look at the total cost of deposits, they were up 11 basis points linked quarter. That's more of an increase than you all have seen in the past, which totally makes sense that that's where everybody is headed. Just looking forward, I just wanted to get your take on where you think deposit betas will be. You look at the 11 basis points, that's about a 45% deposit beta. We're seeing some of your peers closer to 80%-90% deposit beta. Do you think that Frost will get up to that level over time?
We were a lot higher than that earlier if you go back to July of last year. I think one reason that we're not at those levels is because we did our heavy lifting a year ago, which is why we've been able to show some growth. I think we've got some flexibility, frankly, Brady, in terms of the betas that we bring to the table for future increases.
Got it.
We'll see. We're just keeping an eye on the market, taking a look at deposit flows. With that, I'll let Jerry, Steve, any comments you have on this?
No, I think I agree with you 100%. Yeah. I think that's the way we're looking at it, is if we do have more flexibility and be able to move accordingly.
All right.
I'm sorry, Brady, as Phil said, I don't think we feel the same amount of pressure today as some of the peers because as he said, we did a lot of the heavy lifting a year ago, we're not in the same place as they are.
Yeah. I mean, deposit balances were down a little bit this quarter, it sounds like from commercial demand deposits. I know you never like to see down deposits, at the same time, your loan to deposit ratio is only 53%. Would you be fine seeing a little more deposit shrinkage if that helped keep deposit costs at bay?
Honestly, no. We're really trying to grow organically and make sure our value proposition is working, I think it is. I think what we're seeing, as Jerry mentioned, is if you're a commercial business and you have opportunities now, the opportunity cost of leaving that in cash is just higher. Plus, the activity here in Texas is strong, we're seeing people use money. That's really the area that I think is going to be most interesting to see. Consumer checking accounts are up. Any interest-bearing account categories are up. We've done, as we said, the lifting to keep that value proposition strong. I think if it's a funding source that's low cost and somewhat transactional, and it's in the commercial area, that's the thing that's going to be interesting to see.
If you look at the growth we've had in commercial, over 100% of the growth we've had in the commercial sector has been from new customers. You've seen diminishment from our current customer base. That's different than in the consumer side. It's roughly 50/50 new customer growth and augmentation on the consumer side. It really revolves around this commercial funding base and what we're going to see as rates go up. I think we'll reach some kind of dynamic equilibrium at some point go from there. While we're seeing some diminishment in customer balances, I am really happy with the work that our people have done in growing new relationships, again, which account for really all the growth in the commercial area. That's really the job that we have had and will continue to have.
We've just got to continue to grow long-term relationships, and we're pretty good at it, but we've got to stay good at it.
Finally from me, just the duration of the bond book. Last quarter, it was 4.8 years. It sounds like that didn't change much in 2Q.
Yeah, I think that's right. I think that it was maybe down to 4.7, but that's really why I didn't say anything. Yeah.
Great. Thanks, guys.
Sure.
Your next question comes from the line of Jon Arfstrom of RBC Capital Markets. Your line is open.
Thanks. Morning, guys.
Morning, Jon.
Hey, just a few follow-ups on some of the numbers that seemed a little bit outsized. Phil, I think you said on consumer, you talked about new account origination up 4.5% unannualized. Did I hear that correctly?
That's same-store sales, right? Stores that have been open for a year or more.
Can you talk a little bit about that? It seems like that's a strong number if it's unannualized.
Yeah, it is a strong number. Probably we got some seasonality in that because I wouldn't be surprised if the first quarter is a little bit weak. If you were to look at year-over-year growth, which really isn't the best one to use this quarter because the Rio Grande Valley was down a lot, that was largely because Capital One got out of that market. We had a really big increase as they exited. If you took the Rio Grande Valley out and you looked at year-over-year growth in same-store sales, it would've been 6.8%. It's not like annualizing the first quarter, but that's still really good same-store sales growth. If you look at major markets we were in, Dallas was up 14.8%, Permian Basin was up over 15%, Tarrant County was up over 15%, Houston was up over 5%.
Those are just some examples of where I think our value proposition's good, and we're working hard on that.
Okay. Good, that helps. Two other things there. One other number that seemed outsized, you talked about new energy opportunities down 27% from the year-ago quarter. Is that your risk tolerance or is there something else happening that you'd want to call out on that number?
I think it's mainly us pruning the portfolio, just making sure that the things that we're doing are ones that we really want to do. Really I think they're good opportunities for us. It's really our call. We could do a lot more if we wanted to in that line of business.
Okay. Last question I have, you talked about the, I think you call it the core loan portfolio of under $10 million, and that's 50% of your commitments. Would you have any idea what your market share would be where you have geographic presence in that under $10 million market?
I've seen numbers that we've come up with. Let me just give you a general feel for it. If you look at companies with sales size of, say, under $100 million, and we kind of look at it sometimes under $10 million, then we look at under $100, so it's just a little bit under $100. Our market share is not that far off from the big three to dig the sale. Chase is over and 100 and under for us. The sale side, we're probably twice our size, but Chase is 100 times our size or more as a company. You're looking at the other two of the big three, we're sort of not that far off from the share that they have in that segment. Of course, they're a lot bigger than we are in the really big companies in Texas.
We don't really play in that area. That's the numbers that I've seen for us. I think we've been doing a good job frankly taking some share there.
Okay. All right. Thank you.
There are no further questions in queue at this time. I turn the call back to Mr. Green for any closing remarks.
Well, we thank you for your support, and that is the end of our call. We appreciate you joining us today.
This concludes today's conference call. You may now disconnect.