Blue Chip Cullen/Frost Could Make You Bank (Lots Of Money) (NYSE:CFR)

This article was coproduced with Williams Equity Research.


Prior to Austin’s emergence as a major job hub, the Frost Bank tower was the city’s tallest building. But then came the Austonian and Independent, along with a plethora of other significantly sized structures.

The once proud Frost Bank tower is now invisible from a cityscape view. Though that’s not necessarily a bad thing for its namesake.


Every single Texas city with more than 100,000 residents has grown in the past decade, especially San Antonio and Austin. They’re usually ranked as the fastest-growing large cities in the nation.

In the midst of that, we find San Antonio-based Cullen/Frost Bankers (CFR) – one of the most solid regional banks covered by Williams Equity Research (WER). A pure play on the great state of Texas, it’s expanding too.

It’s currently No. 1 in deposit market-share in San Antonio and No. 5 statewide, despite the largest U.S. banks all having major networks in the state.

(Source: Yahoo Finance and WER)

WER has followed Cullen/Frost for a few years while waiting patiently for its valuation to come down and its loan statistics to improve. The valuation was highly attractive in March, but we had better risk-adjusted opportunities at that time. And so we focused on those.

But that was then. This is now.

Trading for less than 20% off its March lows, the true value of this banking stock has definitely gone up in our estimation.

A Historical Analysis of Cullen/Frost

Cullen/Frost, which began in 1868, is now one of the 50 largest banks in the U.S. despite being Texas bound. It received trust powers from the Federal Reserve Board in 1919 and managed to survive the Great Depression despite over 5,000 other banks closing permanently.

(Source. Frost bank’s lobby and tellers’ window in 1892.)

Texas experienced another depression-like collapse in the 1980s, this time due to the savings and loan crisis combined with a historic collapse in commodity prices. Texas was approximately twice as sensitive economically to the energy sector back then compared to today, and it showed.

At the time, Texas accounted for more than half the failed S&L institutions. Per the Federal Reserve Board’s website, the FSLIC insurance fund backing the institutions decided it was cheaper to burn unfinished condos than sell them.

Yet Cullen/Frost survived anyway – the only top 10 bank there to do so without federal assistance or mergers. It also declined TARP bailout funds.

So, today, as this bank deals with non-performing loans and CECL reserve losses, it’s worth remembering that this isn’t its first rodeo.

And it almost assuredly won’t be its last either.

And a Regional Evaluation Too

More recently, Cullen/Frost acquired the privately held Western National Bank, or WNB, for $220 million. The financial had $1.4 billion in assets, $656 million in loans, and $1.2 billion in deposits. And it has a large presence in the Midland and Odessa regions of Texas.

It’s hard not to approve of that addition. Then again, it’s hard not to approve of much of what management does.

It consistently offers better loan and investment rates than national banks, for one thing – no doubt part of its appeal considering how many national banks have inferior rates with much higher minimums.

In other areas, the bank is admittedly less competitive and losing business, as with structured products. But Cullen/Frost now has one of the highest-rated online banking systems of its peers. That’s proven immensely valuable given over half of all new account applications are now done online.

With more than 140 locations and nearly $40 billion in assets, Cullen/Frost has just enough scale to sufficiently diversify its business and compete with larger banks. Global marketing and information services firm J.D. Power ranked it the No. 1 retail bank in Texas in 2019.

In fact, this bank has earned that every year since the award’s inception 11 years ago.

This brings up an important consideration…

As a Texas-only company, it’s important to evaluate its economic environment too. Using 2018 GDP, the state ranks slightly below Brazil but above Canada, Russia, South Korea, and Australia.

It contains four of the 11 most populous cities in the U.S. And its 6.6% estimated population growth from 2020 through 2025 is twice the national average!

2018 wage growth of 4.5% was also materially higher than the nationwide average of 3.8%.

Dividends Are Just One of Its Perks

(Source: Cullen/Frost 6/30/2020 Report)

Cullen/Frost has increased its dividend for 27 consecutive years, taking it from $0.04 per share in 1993 to $2.80 in 2019. Meanwhile, the stock price rose from about $7 to a high of around $119 in mid-2018.

(Source: Cullen/Frost 6/30/2020 Report. Data from S&P Global Market Intelligence and as of 6/30/2020.)

Over both the long and short term, Cullen/Frost has completely outclassed the SNL mid-cap U.S. bank index. So its pullback since mid-2018 has created a rare opportunity we want to explore further.

This entails gauging the stock’s fair value.

Net interest income in Q1 2020 was $268.5 million, a 1% decrease compared to 2019. Its net interest margin, a metric we’ll mention a few times, was 3.56% compared to Q4-19’s 3.62%. And, going back a full year, it fell by 0.23%.

Non-interest income, however, was $212.9 million – more than double Q1-19’s $96.8 million. This was primarily due to its sale of $500 million in Treasury securities, purchased a few months prior as a hedge against falling interest rates.

Excluding that gain, non-interest income still rose 7.4% over Q1-19.

Trust and investment management fees are a small portion of earnings, but they also demonstrated strong 8.8% growth. In fact – outside of an immaterial $1.9 million decline in insurance commissions and fees – every major business area showed meaningful growth.

Banks can be accurately interpreted as both very complex and simple businesses. After smoothing over interest and non-interest income for any non-recurring items, expenses alone determine profitability.

In Cullen/Frost’s case, non-interest expenses were $224.2 million for Q1, up 11.1% year-over-year. Its move to a new corporate headquarters in San Antonio represents the bulk of that, with its Houston expansion another major driver.

The timing of both, admittedly, could have been better given most employees now work from home.

More on Cullen/Frost’s Financials

As you might know, the January 2020 adoption of the Current Expected Credit Loss standard resulted in an after-tax reduction to retained earnings of $29.3 million for BDCs and banks. Excluding that, Cullen/Frost still experienced a $134.3 million build in its allowance for credit losses in Q1.

Obviously then – for that reason and so many other possibilities – it’s critical to evaluate several quarters of financials before coming to definitive conclusions. So, for Q2, credit loss expense and net charge-offs (i.e., realized losses rather than accounting items) declined significantly year-over-year compared to Q1.

Meanwhile, net interest income declined 2.9%, with margins falling to 3.13% from Q1’s 3.56%. To be sure, net interest margins are among Cullen/Frost’s biggest challenges right now.

And earnings were lighter as well. Q2 saw $1.47 in earnings per share compared to $1.72 in Q2 of 2019.

Greater expenses in recent quarters have exacerbated margin concerns. But we don’t see anything that warrants the stock’s year-and-a-half decline. So let’s move to the balance sheet.

Balance Sheet and PPP Loans

For starters, Cullen/Frost is A3/stable at Moody’s and A-/negative at S&P. Taking the time to understand its loan portfolio helps to reveal why.

In today’s climate, that means looking at:

  1. Sector exposures
  2. Deferral requests.

(Source: Cullen/Frost 6/30/2020 Report)

With Cullen/Frost’s Texas focus and acquisition of WNB, we will say we expected a higher percentage to energy than 9.6%. Our major worry here is a significant rise in energy-related loans over time or growing non-performing loans and charge-offs.

(Source: Cullen/Frost 6/30/2020 Report)

Yet, so far, the opposite has occurred. Energy loans have declined at a 4.5% compound annual growth rate since their peak in Q1-15, while non-energy loans have grown by 7% annually over the same period.

(Source: Cullen/Frost 6/30/2020 Report)

The other sector exposures are in line with expectations other than “Religion,” which accounts for 2.2% of the loan pool. Religious service attendance has declined meaningfully nationwide as a result of the coronavirus.

(Source: Cullen/Frost 6/30/2020 Report)

The firm has done well managing risk in retail, hotels/lodging, and aviation though. And even restaurants and entertainment are doing OK, relatively speaking.

Overall, we estimate there are $1 billion in loans that could go south, with an 85%-95% recovery rate.

When it comes to lockdown-specific risk, if movies and restaurants continue to open, losses should be contained relative to what Cullen/Frost had on the books at the end of Q2, when the picture was considerably bleaker.

And here’s a look at the risk associated with energy and non-performing loans:

(Source: Cullen/Frost 6/30/2020 Report)

Cullen/Frost maintains approximately $1.15 billion in loans to exploration and production (E&P) companies – which are generally considered higher-risk energy plays. On one hand, Frost/Cullen isn’t a newcomer to the lending game in general or commodities lending in particular.

More on Balance Sheet and PPP Loans

Energy-related allowance for loan losses as a percentage of total energy loans was 2.86% as of June 30. This makes problematic energy loans 0.28% of the entire loan portfolio.

Though CEO Phil Green stated that total non-performing assets were 0.22% per the conference call.

(Source: Cullen/Frost 6/30/2020 Report)

A key differentiator between now and the 2016-2018 period is that the loan pool is less risky, while the stock is much cheaper. That’s a combination we pay attention to.

(Source: Cullen/Frost 6/30/2020 Report)

Non-performing loans peaked in 2017 as energy loans from 2015 and 2016 were dealt with. Despite the coronavirus, they were the lowest percentage wise in Q2-20 of any period since 2012.

The bank also maintains healthy 3.1x non-accrual reserve coverage.

Now, there’s an area of weakness hidden in this chart.

(Source: Cullen/Frost 6/30/2020 Report)

Net charge-offs (NCOs), or the portion of loans actually written off, have spiked since early 2019 compared to peers. This is attributable to troubled energy loans from 2015 and 2016 that were finally put to rest.

(Source: Cullen/Frost 6/30/2020 Report)

Another common way to evaluate bank risk is through capital ratios. Cullen/Frost maintains lower leverage and higher common equity tier 1 and tier 1 capital ratios than its peer average, with a larger cushion than mandated.

Total deposits grew by 20.5% in Q2 year-over-year – its greatest increase ever. That’s a testament to its customers’ confidence in it.

The firm’s municipal bond portfolio is 93% AAA rated and 100% backed by political subdivisions or agencies. We don’t see notable risk there given the state’s relatively strong financial standing.

Cullen/Frost was unusually active in PPP loans, issuing more than $3.2 billion in total volume. As such, it was No. 1 in many Texas metro areas, helping more customers in its San Antonio headquarters than Bank of America (NYSE:BAC), Chase, and Wells Fargo (NYSE:WFC) combined.

The amount of smaller loans also was much higher than peer averages, setting it up well from a marketing and public relations perspective. The $104 million in fees generated from the loans doesn’t hurt either.

(Almost) Last but (Definitely) Not Least

Of course, a lengthy and impressive track record is great. But a nearly 50% drop in the stock price warrants concern regardless.

We’ve already discussed the energy loan exposure and related increase in NCOs. Though there must be more to it than that.


To answer that question, let’s look at return on average assets and common equity. Both have suffered since 2018, with the stock price almost mirroring their movements.

(Source: Cullen/Frost 6/30/2020 Report)

Cullen/Frost underwrote its entire energy portfolio at:

  • $9/barrel crude oil in Q1 for all of 2020
  • $26 for the second half of 2020.

That caused a major spike in losses on paper – most of which won’t be realized, given where oil trades.

The firm granted $2.2 billion in 90-day deferrals, or approximately 5% of total assets. As of July 31, only $72 million (6.5%) of the $1.1 billion of deferrals that expired requested a second deferral.

Factors such as record low interest rates have driven these two key metrics to 20-year lows. Fortunately for the bank and investors, year-to-date loan spreads have finally recovered. They’re 2.45% and 0.81% versus LIBOR and prime, respectively.

Those are the largest spreads in the past five years.

The firm’s concentrated PPP loan activity caused new relationships to grow by 28% in Q2 – which should open new business opportunities in the coming quarters. Improving margins and the final burial of troubled energy loans bodes well for Cullen/Frost’s 2020-and-beyond outlook.

In Conclusion…

The stock currently yields 4.4% based on Q3’s $0.71 distribution.

(Source: Macrotrends)

This is the highest yield in the last 20 years, despite Treasury bonds trading near all-time lows. From a risk-adjusted perspective, Cullen/Frost is providing investors the best spread over government bonds in at least 25 years.

(Source: Macrotrends)

The stock consistently bottoms around 10x trailing 12-month earnings and stalls at 14x-17x on the upside. And the current multiple is 11.5x based on Monday’s close of $64.18.

We consider $55.50-$60.50 the optimal window to acquire shares. And we’re targeting a total return of over 50% in the next two years.

Shares remain highly attractive up to $66.

(Source: FAST Graphs)

Author’s note: Brad Thomas is a Wall Street writer, which means he’s not always right with his predictions or recommendations. Since that also applies to his grammar, please excuse any typos you may find. Also, this article is free: Written and distributed only to assist in research while providing a forum for second-level thinking.

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Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in CFR over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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