Earnings Call: Q2 2018

Jul 26, 2018

Good morning, and welcome to the Collins BOSS Bank Second Quarter Earnings Conference Call. My name is Amy, and I will be facilitating the audio portion of today's interactive 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 that 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, and welcome to the Investor Relations team. And I'd also like to thank Greg Parker, who's been managing Investor Relations for Frost for about the past 20 years. Greg has done an outstanding job for us. So Greg, thank you and congratulations on your new role in operational risk. Well, good morning, everyone. Thanks for joining us. Today, I'll review second quarter results for Cullen Frost and our Chief Financial Officer, Jerry Salinas, will also provide additional comments before we open it up to your questions. In the Q2, CullenFrost earned $109,300,000 or $1.68 or 1.68 dollars 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 point 4 3% in the 2nd quarter, the highest quarterly total in 9 years. Now 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 Q2, average loans were $13,500,000,000 This represents an increase of more than $1,200,000,000 or just over 10 percent versus the Q2 last year. C and I loans grew 10% and commercial real estate loans grew 11%. Our provision for loan losses was $8,300,000 in the 2nd quarter and that compared to $6,900,000 in the first and $8,400,000 in the Q2 of 2017. Non performing assets totaled $122,800,000 in the 2nd quarter. This was down 10% from the 136 $600,000 in the Q1. Potential problem loans totaled $50,000,000 at the end of the second quarter. That's our lowest level in more than 3 years and it matches levels prior to the energy downturn. Net charge offs in the Q2 of 2018 were $7,900,000 compared with $12,400,000 in the first quarter and $11,900,000 in the Q2 of last year. The lower total represents continued improvement in credit quality and maintaining high loan standards. As expected, 2nd quarter annualized net charge offs dropped to a level of 23 basis points of our average loans. Overall delinquencies for accruing loans at the end of the second quarter were $67,000,000 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 Q1 and were 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, but 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 and Frost is well positioned to serve them with a competitive product mix and strong value proposition. Average total deposits in the Q2 were $26,100,000,000 compared with $25,700,000,000 in the Q2 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% on annualized in the 2nd quarter. Almost 9% 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 $1,620,000,000 in the second quarter, increasing by 8.3 percent or $125,000,000 compared to the Q2 of 2017. On the commercial side, new loan opportunities are up by 2% year to date compared with last year. However, this was impacted by new energy opportunities, which were down 27% from a year ago and public finance opportunities, which were down 26 percent. However, regular commercial new opportunities were up by 7%, while commercial real estate opportunities increased 4%. Looking now at new loan commitments booked in the 2nd quarter, overall they declined from a year ago by 6%. However, the regular C and 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. However, on a linked quarter comparison of new loan commitments booked, shows solid growth for the 1st quarter from the 1st quarter with all portfolio segments increasing. Remember that the Q1 is typically seasonally weaker. With regard to the current active loan pipeline, I'm glad to see the 2nd quarter was up from the previous year by 7%. Finally, our strategy of building our core loan portfolio, which we define as loan relationships under $10,000,000 in size, continues to help provide steady sustainable organic growth. For the 2nd quarter, new commitments under $10,000,000 accounted for 50% of commitments booked, up from 44% in the Q2 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 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 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 4 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 3 years. According to the Dallas Fed, employment in the Dallas Fort Worth Metroplex grew 3.2% annualized year to date. Growth through the 1st 6 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% 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%. 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 3 months, although leisure and hospitality jobs continue 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. Middle and Odessa employment has added jobs at an annualized rate above 10% for 4 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 2nd quarter was 3.64%, up 12 basis points from the 3.52% reported last quarter. Driving the increase was a 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 Q2 had a positive effect on the net interest margin percentage. These favorable variances were partly offset by higher deposit costs during the Q2. The taxable equivalent loan yield for the 2nd quarter was 4.90%, up 25 basis points from the 4.65% reported in the Q1 driven by the higher rate environment. Looking at our investment portfolio, the total investment portfolio averaged $11,900,000,000 during the 2nd quarter, up about $90,000,000 from the 1st quarter average of $11,800,000 The taxable equivalent yield on the investment portfolio was 3.36% in the 2nd quarter, flat with the Q1. Our municipal bond portfolio averaged about $7,700,000,000 during the Q2, up about $59,000,000 from the Q1. During the Q2, we purchased about 230,000,000 dollars in municipal securities with a taxable equivalent yield of about 4%. The municipal portfolio had a taxable equivalent yield for the Q2 of 4.1%, down 2 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 percent, up from the 9.5% reported last quarter impacted by higher net income and a lower benefit from stock option settlements during the Q2 as compared to the first. On a year to date basis, our effective tax rate was 10.3%. Regarding the outlook for 2018, estimates for the full year 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. And with that, we'll open the call up for questions. 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. So I guess, if you can first just wanted to touch upon in terms of deposits, I mean, 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, where the growth whether you expect those to grow in the back half of the year and the change that you've seen in the cost of deposits quarter over quarter? Sure. The one thing, yes, Abraham, we to look at a period end is really kind of tough, right, because those balances fluctuate so much period end to period end from one day to the So we certainly tend to focus more on the averages. So if you're looking 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 Q2 last year. And what we saw was really our demand deposits, which for us were about $10,700,000,000 or about 40 percent of our deposits, they were actually down about 0.6%. So 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 Q2 last year. And 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. But there is going to be pressure in that in the in deposits as we look through the rest of the year. For us, we really see a pickup typically seasonally starting in the 3rd Q4. And 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. And if you could provide the change in the cost of interest bearing deposits for the quarter? Sure. So the cost of total cost went from for the Q1 was 16 basis points going up to 27. Understood. And just moving to sort of the outlook when we think about the margin in 3 64 based on sort of the expectations on the deposit front. If we don't get a rate hike, like 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. But percentage wise, it will be dependent on the deposit volume. Got it. And just last question moving to expenses, we are running like sub-two percent 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. So if you adjust out 2017 expenses, they're like at $747,000,000 if you adjust out the 12,000,000 dollars in network costs. And the guidance I've given is that we project that we'd be up about 4.5% from that and that's still a good number. Got it. Thank you for taking my questions. 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 the 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. So 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 and I loans and that's good because that's really our wheelhouse. I mean we do great with consumer, CRE, obviously we're good energy lender. But the part of the portfolio if it's been growing the most has been C and I And that's 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 and I area. And then our you've heard us talk about final authority, where we give some authority to execute transactions on an expedited basis to our people. I think those tend to be C and I as well. So and whether or not C and I, I think they tend to be owner occupied CRE for the most part. Thank you. Thanks. Your next question comes from the line of Dave Rochester of Deutsche Bank. Your line is open. Hey, good morning guys. Good morning, Dave. I was just curious, next year for 2019, how much in the way of expense savings you're expecting to get from the roll off of the FDIC surcharge? Yes, we're projecting that number in the $8,000,000 to $9,000,000 range. Pre tax, obviously, yes. Great. And then, 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. So I mean as it relates to that part of it, yes, I would think that that would lighten up some. But like anytime you get into these data intrusion issues, there's a a it's a process, there's whether it'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. But the biggest amount of activity was in that previous quarter. Yes. Okay. And 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. And 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? Obviously, a couple of comments and Jerry can fill in. Yes, I think definitely they've had a 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 have been a negative number had we not taken the action we did on increasing interest rates. And then on the average balances so far this quarter, are you seeing that growth there so far? Let me grab some information here, David, real quick. What I'd say is that we are seeing basically right now, I would tell you that we're probably about flat, maybe up a little bit on average. Okay. All right. Okay, great. And then just one last one. You guys had some great loan growth this quarter. I was just curious how the pipeline heading into 3Q looks versus the pipeline heading into 2Q. It sounded like you're saying it was up from a year ago, but was just curious quarter over quarter how that looks? Yes. If you look at the pipeline, your current active pipeline on a linked quarter basis, it was up by on a gross basis up by 5%. So that's quarter over quarter. On a weighted basis, 3%. So I mean to me, it's 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. And then just one last one back on the NIM. It sounded like you were saying that you think the NIM can still expand the 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? And is that just because, as you were saying, you did not benefit the full amount from the June rate hike or you're not expecting to 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 3Q, you think that's enough to have the NIM expanding through the end of this year? Yes. 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. But with the June rate hike, it's just it was so late in June that it's really the effect really in all the numbers. Yes. And that incorporates all the increases that you've made on the cost of deposit side, obviously. Yes. Okay, great. Thanks, guys. Your next question comes from the line of Steven Alex Fosseman 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 to 27 basis points. That's on the total cost of deposits, right? Right, from 16 to 27, yes. Got it, okay. That helps. And then just touching on expenses, were there any one timers in the quarter and you just touch on that for a bit? Yes, I think that we tried to identify in the quarter kind of the things that were unique, but we did have like 900,000 related to the IT incident that I mentioned. Then we had another 9 $100,000 in settlements during the quarter, settlement costs. And then we've had a $500,000 contribution to our charitable foundation. It was kind of unique. Got it. And that's on a year over year basis? Yes. Okay. They would be unique, if you will, but the comparison numbers are yes against the actually those are distinct numbers in the Q2. So regardless of the comparison, they're distinct numbers, discrete numbers. Okay. I got it. Yes. Helpful. And then 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 is 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. And we've got some great relationships as it relates to commercial real estate. And it's again competition strong, but we see strong equity in projects. The economy is good. So 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 is 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. But even we're being careful with multifamily, although there are some good opportunities that are out there for some great customers. And the industrial side, I think it continues to be very strong in Texas, so and residential as well. So, got to be careful, but to describe it as irrational, from our point 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 KBW. Your line is open. Yes. Thank you. Good morning, guys. Hey, Brady. Hey, Brady. So just another question on deposit costs. I mean, 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. But just looking forward, I just wanted to get your take on where you think deposit betas will be. I mean, you look at the 11 basis points, that's about a 45% deposit beta. We're seeing some of your peers closer to 80% to 90% deposit beta. I mean, 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 last year, I think one reason that we're not those levels 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. And we'll see, we're just keeping out on the market, looking at deposit flows. And with that, I'll let Jerry see any comments you have on this. No, I think I agree with you 100%. Yes, I think that's the way we're looking at it is that we do have more flexibility and be able to move accordingly. All right. And then As Phil said, I'm sorry, Brady, but 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 heavy lifting a year ago. So we're not in the same place as they are. Yes. And then, so 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, but at the same time, your loan to deposit ratio is only 53%. So I mean, would you be fine seeing a little more deposit shrinkage if that helped keep deposit costs at bay? Honestly, no. I mean, we're really trying to grow organically and make sure our value proposition is working. And 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 to believe that in cash is just higher. And plus the activity here in Texas is strong. So we're seeing people use money. And so 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 and we've done as we said the lifting to keep that value proposition strong. And so I think if it's a deposit, not a deposit, 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. So you've seen diminishment from our current customer base. That's different than in the consumer side. It's roughly fifty-fifty new customer growth and augmentation on the consumer side. So it really revolves around this commercial funding base and what we're going to see as rates go up. And then I think we'll reach some kind of dynamic equilibrium at some point and then go from there. But 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. And that's really the job that we have had and we'll 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. And then finally for me, just the duration of the bond book last quarter, it was 4.8 years. So that it sounds like that didn't change much in 2Q. Yes, I think that's right. I think that it was maybe down to 4.7%, so that's really why I didn't say anything yet. Great. Thanks, guys. Sure. Your next question comes from the line of Jon Arfstrom of RBC Capital Markets. Your line is open. Thanks. Good morning, guys. Good morning, Joe. 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% on annualized. Is that 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 it's a that's a strong number, if it's on annualized? Yes, it is a strong number. Probably we got some seasonality in that because I wouldn't surprise that your Q1 is a little bit weak, but if you were to look at, let's say you looked 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 and that was because largely because Capital One got out of that market. And so we had a really big increase as they exited. So if you look at you took the Rio Grande Valley out and you looked at year over year growth in same store sales, it would have been 6.8%. And so, I mean, it's not like annualized in the Q1, but that's still really good same store sales growth. And 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%. So those are just some examples of where I think our value proposition is good and we're working hard on that. Okay. Okay. Good. That helps. 2 other things here. 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 we're the things that we're doing are ones that we really want to do, really a good opportunity for us. So 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 10,000,000 dollars 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 $10,000,000 market? Seen numbers that we've come up with and what I let me just give you a general feel for it. If you look at companies with sales size of say under $100,000,000 and we kind of look at it sometimes under 10, maybe look at under 100, so it's just a little bit under 100. I mean, our market share is not that far off from the big three, too big to fail. Chase is over 100 and 100 for us, the sales side, we're probably twice our size, but Chase is 100 times our size or more as a company. And you're looking at the other 2 of the big three, I mean, we're sort of not that far off from the share that they have in that segment. Of course, they're a huge a lot bigger than we are in the really big companies in Texas. We don't really play in that area. But that's the numbers that I've seen for us. And I think we've been doing a good job frankly taking some share there. Okay. All right. Thank you. And 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. Appreciate you joining us today.