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Morningstar | Solid 3Q Results for Cullen/Frost as the Bank Plans a New Expansion Into Houston

Cullen/Frost reported decent third-quarter 2018 results, with return on average assets improving to 1.49% and the return on average common equity improving to 14.4%. Both again were some of the best results we have seen since the global financial crisis. After making some minor adjustments to our model, we are decreasing our fair value estimate to $102 from $107. This is 2.6 times tangible book value as of September 2018.

Net interest income steadily increased 1.8% over last quarter, and fee income was up a strong 3%. Loan growth also remained good for Cullen/Frost, with average balances up roughly 1% quarter over quarter and 9% year over year. Credit quality was pristine, as the provision for loan losses was almost nonexistent, at under $3 million for the quarter. While net charge-offs did increase, these charges were expected and had already been provisioned for. Nonperforming assets actually decreased during the quarter, while delinquencies remained range-bound. Management again sounded upbeat on its economic prospects in Texas, stating they are generally seeing optimism among customers. One of the more interesting stats is the traction the bank is getting with retail customers, where net new customer growth was up by 60% compared with last year, with almost a fourth of these new customers opening accounts digitally. For a bank that is already strong on the commercial side of the business, improving the consumer side would improve the overall value of an already strong banking franchise.

The bank also announced a planned expansion into the Houston area. While the initial expansion will result in negative net income on average for the new financial centers, management believes that the average center will begin to be profitable over a three- to five-year period. We like that the bank is choosing to expand organically, rather than paying a premium for an existing branch network. If the bank can gain traction with new clients, as it has been through its new digital consumer efforts, this expansion will add real value to the franchise. But however strategically sound the move is, the execution of this in an already competitive Texas market will be the tough part. Another interesting point is that Cullen/Frost has typically been a keen underwriter, so in the event of any downturn, the bank may be better positioned to invest in organic growth compared with any peers who get hit on the credit side of the income statement. We will keep a close eye on how this plays out over the next several years.