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CFR > SEC Filings for CFR > Form 10-Q on 24-Oct-2012All Recent SEC Filings

Show all filings for CULLEN/FROST BANKERS, INC.

Form 10-Q for CULLEN/FROST BANKERS, INC.


24-Oct-2012

Quarterly Report


Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

Financial Review

Cullen/Frost Bankers, Inc.

The following discussion should be read in conjunction with the Corporation's consolidated financial statements, and notes thereto, for the year ended December 31, 2011, included in the 2011 Form 10-K. Operating results for the three and nine months ended September 30, 2012 are not necessarily indicative of the results for the year ending December 31, 2012 or any future period.

Dollar amounts in tables are stated in thousands, except for per share amounts.

Forward-Looking Statements and Factors that Could Affect Future Results

Certain statements contained in this Quarterly Report on Form 10-Q that are not statements of historical fact constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 (the "Act"), notwithstanding that such statements are not specifically identified as such. In addition, certain statements may be contained in the Corporation's future filings with the SEC, in press releases, and in oral and written statements made by or with the approval of the Corporation that are not statements of historical fact and constitute forward-looking statements within the meaning of the Act. Examples of forward-looking statements include, but are not limited to:
(i) projections of revenues, expenses, income or loss, earnings or loss per share, the payment or nonpayment of dividends, capital structure and other financial items; (ii) statements of plans, objectives and expectations of Cullen/Frost or its management or Board of Directors, including those relating to products or services; (iii) statements of future economic performance; and
(iv) statements of assumptions underlying such statements. Words such as "believes", "anticipates", "expects", "intends", "targeted", "continue", "remain", "will", "should", "may" and other similar expressions are intended to identify forward-looking statements but are not the exclusive means of identifying such statements.

Forward-looking statements involve risks and uncertainties that may cause actual results to differ materially from those in such statements. Factors that could cause actual results to differ from those discussed in the forward-looking statements include, but are not limited to:

Local, regional, national and international economic conditions and the impact they may have on the Corporation and its customers and the Corporation's assessment of that impact.

Volatility and disruption in national and international financial markets.

Government intervention in the U.S. financial system.

Changes in the mix of loan geographies, sectors and types or the level of non-performing assets and charge-offs.

Changes in estimates of future reserve requirements based upon the periodic review thereof under relevant regulatory and accounting requirements.

The effects of and changes in trade and monetary and fiscal policies and laws, including the interest rate policies of the Federal Reserve Board.

Inflation, interest rate, securities market and monetary fluctuations.

The effect of changes in laws and regulations (including laws and regulations concerning taxes, banking, securities and insurance) with which the Corporation and its subsidiaries must comply.

The soundness of other financial institutions.

Political instability.

Impairment of the Corporation's goodwill or other intangible assets.

Acts of God or of war or terrorism.

The timely development and acceptance of new products and services and perceived overall value of these products and services by users.

Changes in consumer spending, borrowings and savings habits.

Changes in the financial performance and/or condition of the Corporation's borrowers.

Technological changes.

Acquisitions and integration of acquired businesses.

The ability to increase market share and control expenses.

The Corporation's ability to attract and retain qualified employees.

Changes in the competitive environment in the Corporation's markets and among banking organizations and other financial service providers.

The effect of changes in accounting policies and practices, as may be adopted by the regulatory agencies, as well as the Public Company Accounting Oversight Board, the Financial Accounting Standards Board and other accounting standard setters.

Changes in the reliability of the Corporation's vendors, internal control systems or information systems.


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Changes in the Corporation's liquidity position.

Changes in the Corporation's organization, compensation and benefit plans.

The costs and effects of legal and regulatory developments including the resolution of legal proceedings or regulatory or other governmental inquiries and the results of regulatory examinations or reviews.

Greater than expected costs or difficulties related to the integration of new products and lines of business.

The Corporation's success at managing the risks involved in the foregoing items.

Forward-looking statements speak only as of the date on which such statements are made. The Corporation undertakes no obligation to update any forward-looking statement to reflect events or circumstances after the date on which such statement is made, or to reflect the occurrence of unanticipated events.

Application of Critical Accounting Policies and Accounting Estimates

The accounting and reporting policies followed by the Corporation conform, in all material respects, to accounting principles generally accepted in the United States and to general practices within the financial services industry. The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. While the Corporation bases estimates on historical experience, current information and other factors deemed to be relevant, actual results could differ from those estimates.

The Corporation considers accounting estimates to be critical to reported financial results if (i) the accounting estimate requires management to make assumptions about matters that are highly uncertain and (ii) different estimates that management reasonably could have used for the accounting estimate in the current period, or changes in the accounting estimate that are reasonably likely to occur from period to period, could have a material impact on the Corporation's financial statements. Accounting policies related to the allowance for loan losses are considered to be critical, as these policies involve considerable subjective judgment and estimation by management.

For additional information regarding critical accounting policies, refer to Note 1 - Summary of Significant Accounting Policies in the notes to consolidated financial statements and the sections captioned "Application of Critical Accounting Policies" and "Allowance for Loan Losses" in Management's Discussion and Analysis of Financial Condition and Results of Operations included in the 2011 Form 10-K. There have been no significant changes in the Corporation's application of critical accounting policies related to the allowance for loan losses since December 31, 2011.

Overview

A discussion of the Corporation's results of operations is presented below. Certain reclassifications have been made to make prior periods comparable. Taxable-equivalent adjustments are the result of increasing income from tax-free loans and securities by an amount equal to the taxes that would be paid if the income were fully taxable based on a 35% federal income tax rate, thus making tax-exempt asset yields comparable to taxable asset yields.


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Results of Operations

Net income totaled $58.7 million, or $0.95 diluted per share, for the three months ended September 30, 2012 compared to $54.5 million, or $0.89 diluted per share, for the three months ended September 30, 2011 and $58.1 million, or $0.94 diluted per common share, for the three months ended June 30, 2012. Net income totaled $177.8 million, or $2.88 diluted per share, for the nine months ended September 30, 2012 compared to $162.1 million, or $2.64 diluted per share, for the nine months ended September 30, 2011.

Selected income statement data and other selected data for the comparable periods was as follows:

                                                         Three Months Ended                                   Nine Months Ended
                                         September 30,        June 30,         September 30,         September 30,         September 30,
                                             2012               2012               2011                  2012                  2011
Taxable-equivalent net interest
income                                  $       167,341       $ 163,972       $       160,579       $       496,020       $       476,725
Taxable-equivalent adjustment                    15,809          14,755                15,218                45,564                45,272

Net interest income                             151,532         149,217               145,361               450,456               431,453
Provision for loan losses                         2,500           2,355                 9,010                 5,955                27,445

Net interest income after provision
for loan losses                                 149,032         146,862               136,351               444,501               404,008
Non-interest income                              71,158          69,763                79,217               212,900               222,342
Non-interest expense                            144,450         142,536               137,407               429,026               414,265

Income before income taxes                       75,740          74,089                78,161               228,375               212,085
Income taxes                                     17,071          16,027                23,654                50,611                49,964

Net income                              $        58,669       $  58,062       $        54,507       $       177,764       $       162,121

Earnings per common share - basic       $          0.95       $    0.94       $          0.89       $          2.89       $          2.64
Earnings per common share - diluted                0.95            0.94                  0.89                  2.88                  2.64
Dividends per common share                         0.48            0.48                  0.46                  1.42                  1.37
Return on average assets                           1.11 %          1.14 %                1.15 %                1.16 %                1.19 %
Return on average equity                           9.75            9.95                  9.79                 10.09                 10.11
Average shareholders' equity to
average total assets                              11.39           11.51                 11.73                 11.51                 11.76

Net income increased $4.2 million, or 7.6%, for the three months ended September 30, 2012 and increased $15.6 million, or 9.6%, for the nine months ended September 30, 2012 compared to the same periods in 2011. The increase during the three months ended September 30, 2012 was primarily the result of a $6.5 million decrease in the provision for loan losses, a $6.6 million decrease in income tax expense and a $6.2 million increase in net interest income partly offset by an $8.1 million decrease in non-interest income and a $7.0 million increase in non-interest expense. The increase during the nine months ended September 30, 2012 was primarily the result of a $21.5 million decrease in the provision for loan losses and a $19.0 million increase in net interest income partly offset by a $14.8 million increase in non-interest expense, a $9.4 million decrease in non-interest income and a $647 thousand increase in income tax expense.

Net income for the third quarter of 2012 increased $607 thousand, or 1.0 %, from the second quarter of 2012. The increase was primarily the result of a $2.3 million increase in net interest income and a $1.4 million increase in non-interest income partly offset by a $1.9 million increase in non-interest expense, a $1.0 million increase in income tax expense and a $145 thousand increase in the provision for loan losses.

Details of the changes in the various components of net income are further discussed below.

Net Interest Income

Net interest income is the difference between interest income on earning assets, such as loans and securities, and interest expense on liabilities, such as deposits and borrowings, which are used to fund those assets. Net interest income is the Corporation's largest source of revenue, representing 67.9% of total revenue during the first nine months of 2012. Net interest margin is the ratio of taxable-equivalent net interest income to average earning assets for the period. The level of interest rates and the volume and mix of earning assets and interest-bearing liabilities impact net interest income and net interest margin.

The Federal Reserve influences the general market rates of interest, including the deposit and loan rates offered by many financial institutions. The Corporation's loan portfolio is significantly affected by changes in the prime interest rate. The


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prime interest rate, which is the rate offered on loans to borrowers with strong credit, remained at 3.25% for the entire year in 2011 and through the third quarter of 2012. The Corporation's loan portfolio is also impacted, to a lesser extent, by changes in the London Interbank Offered Rate (LIBOR). At September 30, 2012, the one-month and three-month U.S. dollar LIBOR rates were 0.21% and 0.36%, respectively, while at September 30, 2011, the one-month and three-month U.S. dollar LIBOR rates were 0.24% and 0.37%, respectively. The intended federal funds rate, which is the cost of immediately available overnight funds, remained at zero to 0.25% for the entire year in 2011 and through the third quarter of 2012.

The Corporation's balance sheet has historically been asset sensitive, meaning that earning assets generally reprice more quickly than interest-bearing liabilities. Therefore, the Corporation's net interest margin was likely to increase in sustained periods of rising interest rates and decrease in sustained periods of declining interest rates. During the fourth quarter of 2007, in an effort to make the Corporation's balance sheet less sensitive to changes in interest rates, the Corporation entered into various interest rate swaps which effectively converted certain variable-rate loans into fixed-rate instruments for a period of time. During the fourth quarter of 2008, the Corporation also entered into an interest rate swap which effectively converted variable-rate debt into fixed-rate debt for a period of time. As a result of these actions, the Corporation's balance sheet was more interest-rate neutral and changes in interest rates had a less significant impact on the Corporation's net interest margin than would have otherwise been the case. During the fourth quarter of 2009, a portion of the interest rate swaps on variable-rate loans were terminated, while the remaining interest rate swaps on variable-rate loans were terminated during the fourth quarter of 2010. These actions increased the asset sensitivity of the Corporation's balance sheet. The deferred accumulated gain applicable to the settled interest rate contracts included in accumulated other comprehensive income totaled $77.3 million ($50.3 million on an after-tax basis) at September 30, 2012. The deferred gain will be recognized ratably in earnings through October 2014. See Note 8 -Derivative Financial Instruments in the accompanying notes to consolidated financial statements included elsewhere in this report for additional information related to these interest rate swaps.

The Corporation is primarily funded by core deposits, with non-interest-bearing demand deposits historically being a significant source of funds. This lower-cost funding base is expected to have a positive impact on the Corporation's net interest income and net interest margin in a rising interest rate environment. As discussed in the section captioned "Supervision and Regulation" included in Item 1. Business, of the 2011 Form 10-K, the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act") repealed the federal prohibitions on the payment of interest on demand deposits, thereby permitting depository institutions to pay interest on business transaction and other accounts beginning July 21, 2011. Although the ultimate impact of this legislation on the Corporation has not yet been determined, the Corporation may begin to incur interest costs associated with demand deposits in the future as market conditions warrant. See Item 3. Quantitative and Qualitative Disclosures About Market Risk elsewhere in this report for information about the expected impact of this legislation on the Corporation's sensitivity to interest rates. Further analysis of the components of the Corporation's net interest margin is presented below.

The following table presents the changes in taxable-equivalent net interest income and identifies the changes due to differences in the average volume of earning assets and interest-bearing liabilities and the changes due to changes in the average interest rate on those assets and liabilities. The changes in net interest income due to changes in both average volume and average interest rate have been allocated to the average volume change or the average interest rate change in proportion to the absolute amounts of the change in each. The comparisons between the quarters include an additional change factor that shows the effect of the difference in the number of days in each period, as further discussed below.

                                     Third Quarter            Third Quarter            First Nine Months
                                       2012 vs.                 2012 vs.                   2012 vs.
                                     Third Quarter           Second Quarter            First Nine Months
                                         2011                     2012                       2011
Due to changes in average
volumes                             $        18,575          $         4,960          $            26,059
Due to changes in average
interest rates                              (11,813 )                 (3,410 )                     (8,574 )
Due to difference in the
number days in each of the
comparable periods                               -                     1,819                        1,810

Total change                        $         6,762          $         3,369          $            19,295

Taxable-equivalent net interest income for the three months ended September 30, 2012 increased $6.8 million, or 4.2%, while taxable-equivalent net interest income for the nine months ended September 30, 2012 increased $19.3 million, or 4.0%, compared to the same periods in 2011, respectively. The increase during the three months ended September 30, 2012 was primarily related to an increase in the average volume of interest-earning assets partly offset by a decrease in the net interest margin. Taxable-equivalent net interest income for the first nine months of 2012 included an additional day compared to the first nine months of 2011 as a result of leap year. The additional day added approximately $1.8 million to taxable-equivalent net interest income during the first nine months of 2012. Excluding the impact of the additional day during 2012 results in an effective increase in taxable-equivalent net interest income of approximately $17.5 million during the first nine months of 2012, which was primarily related to an increase in the average volume of interest-earning assets partly offset by a decrease


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in the net interest margin. The average volume of interest-earning assets for the three and nine months ended September 30, 2012 increased $2.2 billion during each respective period compared to the same periods in 2011. The net interest margin decreased 27 basis points from 3.81% during the three months ended September 30, 2011 to 3.54% during the three months ended September 30, 2012 and decreased 30 basis points from 3.93% during the nine months ended September 30, 2011 to 3.63% during the nine months ended September 30, 2012. The decrease in the net interest margin during the comparable periods was partly due to an increase in the relative proportion of average interest-earning assets invested in lower-yielding, taxable securities during 2012 compared to 2011 while the relative proportion of average interest-earning assets invested in higher-yielding loans decreased. The impact of this shift was partly mitigated by a decrease in the relative proportion of average interest-earning assets invested in lower-yielding interest-bearing deposits. The net interest margin was also negatively impacted by a decrease in the average yield on securities, as further discussed below. The average yield on interest-earning assets decreased 42 basis points from 4.20% in the first nine months of 2011 to 3.78% in the first nine months of 2012 while the average cost of funds decreased 18 basis points from 0.43% in the first nine months of 2011 to 0.25% in the first nine months of 2012. The average yield on interest-earning assets is primarily impacted by changes in market interest rates as well as changes in the volume and relative mix of interest-earning assets. As stated above, market interest rates have remained at historically low levels during the reported periods. The effect of lower average market interest rates during the reported periods on the average yield on average interest-earning assets was partly limited by the aforementioned interest rate swaps on variable-rate loans.

Taxable-equivalent net interest income for the third quarter of 2012 increased $3.4 million, or 2.1%, from the second quarter of 2012. Taxable-equivalent net interest income for the third quarter of 2012 included an additional day compared to the second quarter of 2012. The additional day added approximately $1.8 million to taxable-equivalent net interest income during the third quarter of 2012. Excluding the impact of the additional day results in an effective increase in taxable-equivalent net interest income of approximately $1.6 million during the third quarter of 2012, which was primarily related to an increase in the average volume of interest-earning assets partly offset by a decrease in the net interest margin. The average volume of interest-earning assets for the third quarter of 2012 increased $613.2 million compared to the second quarter of 2012. The average volume of funds invested in interest-bearing deposits increased $274.9 million from $1.4 billion during the second quarter of 2012 to $1.7 billion during third quarter of 2012. The average volume of funds invested in securities did not significantly fluctuate during the third quarter of 2012 compared to the second quarter of 2012, though a larger proportion of such funds were invested in higher-yielding tax-exempt securities during the third quarter of 2012, while the average volume of funds invested in loans increased $367.5 million. The net interest margin decreased 7 basis points from 3.61% in the second quarter of 2012 to 3.54% in the third quarter of 2012. The average yield on interest-earning assets decreased 7 basis points from 3.75% in the second quarter of 2012 to 3.68% in the third quarter of 2012 primarily due to decreases in the average yields on tax-exempt securities (down 25 basis points) and loans (down 10 basis points). The impact of the declines in average yields on these categories of assets on the overall average yield on interest-earning assets was partly mitigated by growth in the average volumes of these higher-yielding assets. Average tax-exempt securities increased $223.4 million while, as stated previously, average loans increased $367.5 million in the third quarter of 2012 compared to the second quarter of 2012. The decrease in the net interest margin primarily resulted as the decrease in the overall yield on interest-earning assets was not matched by a corresponding decrease in the average cost of funds. The average cost of funds remained unchanged at 0.24% during both the second and third quarters of 2012.

The average volume of loans during the first nine months of 2012 increased $253.0 million compared to the same period in 2011. Loans made up approximately 44.6% of average interest-earning assets during the first nine months of 2012 compared to 49.1% during the first nine months of 2011. The average yield on loans was 4.85% during the first nine months of 2012 compared to 5.01% during the first nine months of 2011. Loans generally have significantly higher yields compared to securities, interest-bearing deposits and federal funds sold and resell agreements and, as such, have a more positive effect on the net interest margin.

The average volume of securities increased $3.1 billion during the first nine months of 2012 compared to the same period in 2011. Securities made up approximately 47.8% of average interest-earning assets during the first nine months of 2012 compared to 35.6% during the first nine months of 2011. The average yield on securities was 3.31% in the first nine months of 2012 compared to 4.80% in the first nine months of 2011. The decrease in the average yield on securities was partly due to a decrease in the yield on taxable securities as proceeds from principal repayments and excess liquidity were reinvested at lower market rates. Furthermore, a large portion of the growth in taxable securities was in lower-yielding U.S. Treasury securities. The decrease in the average yield on securities was also partly related to a decrease in the relative proportion of higher-yielding, tax-exempt municipal securities in the first nine months of 2012 compared to the same period in 2011. The relative proportion of higher-yielding, tax-exempt municipal securities totaled 25.9% of average securities during the first nine months of 2012 compared to 37.2% during the first nine months of 2011. The average yield on taxable securities was 2.13% in the first nine months of 2012 compared to 3.50% in first nine months of 2011, while the average taxable-equivalent yield on tax-exempt securities was 6.85% in the first nine months of 2012 compared to 6.98% in first nine months of 2011.

Average federal funds sold, resell agreements and interest-bearing deposits during the first nine months of 2012 decreased $1.1 billion compared to the same period in 2011. Federal funds sold, resell agreements and interest-bearing deposits made


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up approximately 7.5% of average interest-earning assets during the first nine months of 2012 compared to 15.3% during the first nine months of 2011. The combined average yield on federal funds sold, resell agreements and interest-bearing deposits was 0.29% during the first nine months of 2012 compared to 0.24% during the first nine months of 2011. The decrease in average federal funds sold, resell agreements and interest-bearing deposits the first nine months of 2012 compared to the same period in 2011 was due to the reinvestment of funds into higher-yielding securities and loans.

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