Cullen/Frost: Texas, 22% Cash, Insider Buying

Purpose

On price weakness, in March I accumulated shares in Cullen/Frost Bankers, Inc. (CFR) in my buy-and-hold bank portfolio. I also added to a position in CFR's Preferred B (CFR.PB) when yields exceeded 6%.

The purpose of this post is three-fold:

• Share my current thoughts on Cullen/Frost Bankers Inc.
• Identify key watch items for the bank's April 26 Q1 earnings release.
• Get investor feedback that challenges my current thinking.

CFR Key Statistics at a Glance

Source: YCharts, Seeking Alpha, Bankregdata.com, FDIC

• March 31 closing price: $105.34.
• Market Cap: $6.78 billion.
• Headquarters: San Antonio, TX.
• Share count: 64.36 million.
• One month price: -20%.
• YTD price: -21%.
• One year price: -24%.
• YTD price range: $97.86 - $137.09.
• Analyst one-year price target $140.30. (17 analysts: 3 Buy, 4 Outperform, 9 Hold, 1 Underperform, Consensus 2.52, Price Targets: $107 - $170).
• P/E: 11.96x.
• Forward P/E: 10.0x vs. 15.4x YE 2022.
• Frost Bank Loan/Asset Ratio: 32% (lowest among peer banks).
• Holding Co. Return on Equity 2022: 17.25%.
• Holding Co. ROA: 1.11%.
• Frost Bank Cost of Funds Q4: 76 basis points Q4 vs. 33 bp 2022.
• Frost Bank Net Interest Margin Q4: 247 basis points, +29 bp Y/Y, +18 bp Q/Q.
• Frost Bank Efficiency Ratio Q4: 57.6 (down/favorable 319 bp Y/Y).
• Dividend yield: 3.30%.
• Payout Ratio: 37%.
• Beta (3-year): .73.

What I Like About CFR

Conservative Risk Culture Stemming from Near-Death Experience

Since getting into banking in 1980, I have accumulated a wonderful library of books about the industry. (Goes well with my baseball card collection).

One of my favorite banking books is the woeful tale of Texas banking during the Great Texas Depression of 1986-1990. "The Great Texas Banking Crash" by Joseph M. Grant (1996, University of Texas Press) is must-read for serious bank investors.

More than 1,000 Texas banks failed during this time. Only one of the state's largest banks survived: Cullen/Frost.

Grant makes this observation:

"What happened to the ninth-largest banking company, Cullen/Frost Bankers of San Antonio? Were they smarter than everyone else? Not necessarily. Cullen/Frost had been a relatively large oil lender and had suffered from severe loan problems beginning in 1983... As a consequence, during 1983-1985, Cullen/Frost was preoccupied cleaning up oil lending problems... Thus, while the other major Texas banks were actively booking real estate loans in 1983-1985, Cullen/Frost was on the sidelines."

Whether Cullen/Frost was lucky (Grant's view) or good (my view), either way, the bank survived when almost every other bank in Texas failed.

The near-death experience has not been lost on the bank's management and directors. To this day, Cullen/Frost remains one of the most conservative banks in the world.

Tangible Evidence of Conservative Risk Profile

• Low loan-to-deposit and low loan-to-asset ratios: 38%/32%
• History of holding a lot of Cash on balance sheet: At YE 2022, of the bank's $53 billion in assets, nearly $12 billion (22%+) was Cash compared to its one hundred bank peer median of 2.81%. CFR held more Cash as percentage of assets than any bank in peer group. Cash on the balance sheet is the ultimate Liquidity risk mitigator.
• Strong Credit Loss History: Besides having a low loan-to-asset ratio, the bank has long maintained a conservative credit risk appetite. The bank's rolling four-quarter net credit losses is 28 basis points dating back to 2003. Losses peaked in 2010 at 70 basis points.

Other Evidence of Conservative Risk Profile

• I worked in Texas banking from 1989-1996 when my bank acquired the two largest failed banks in Texas. I witnessed first-hand how Texas banking lurched overnight from go-go to go-slow. Trust me, there is nothing like a Great Depression to tamper banker zeal. Memories are long.
• Frost Bank has provided great leadership to the 110-year-old Risk Management Association, banking's leading risk organization.
• Frost Bank's risk executives are highly respected throughout the industry. Perhaps because they know how important it is to have competitors who operate soundly, Frost Bank is an active leader in industry risk training and regulatory relations.

One of Only 31 Banks to Grow Dividend during Great Financial Panic

My 2016 book about bank investing includes a chapter highlighting 31 banks of the nation's 800 publicly traded banks that succeeded to raise dividends during the Great Financial Panic years of 2008-2010.

Cullen/Frost is one of those banks and it remains a Dividend Champion bank having continued its streak of dividend raises through 2022.

Pure Texas Play

Frost Bank has stuck to its knitting and remains focused exclusively on the Texas economy.

This is a good thing because Texas has the most robust economy of any state in the country. U.S. Bureau of Economic Analysis shows Texas's 3Q 2022 GDP to be 7.0%, the best by far in the nation. CFR is a pure play on the nation's best state economy.

GDP growth is the lifeblood of banks. When GDP grows >4%, banks thrive. When GDP stalls out to <1%, look out.

Insider Buying

Frost insiders run the bank like they own it, which they kind of do because of the Frost family connection. One of my better long-term bank buys occurred in February 2016 when I followed the lead of CFR's chairman who bought $1 million in CFR shares when oil prices fell precipitously. I still own those shares.

The table below is from www.openinsider.com. It shows impressive CFR insider buys in March, including a $1 million buy by the bank's chairman/CEO. It is also worth noting that the bank's Chief Risk Officer bought 1,500 shares during the month.

Watch Items

I am not prepared to announce an "all clear" signal for bank stocks.

There is too much uncertainty in light of the Fed's push to raise interest rates which has resulted in the unintended consequence of exposing banks to liquidity and even solvency risks. Given my profound concerns that systemic risk remains elevated, I am maintaining a low tolerance for risk assets, and I am even more cautious about US banks.

I expect bank stock prices to bounce around recent lows until we hear from CEOs during April earnings calls. I would not be surprised if bank stock prices remain moribund through September, the month historically when bank stock prices find a bottom.

What I Want to Know When CFR Reports Q1 Earnings April 28

• Deposits, Funding Costs, Net Interest Margin. I want to hear management talk about deposit and funding trends and the outlook for the remainder of 2023. As noted above, Frost Bank's funding costs hit 76 basis points in Q4. I expect funding costs to eclipse 100 bp in Q1. If true, this is not the end of the world as funding costs are still low compared to history. The key question, however, is whether the jump in funding costs outpaced the improvement in earning asset yields? We could be in for a year of NIM compression in some banks. Also, I am very curious to hear management talk about their big depositors' behavior in the month of March. Do large corporate depositors appreciate the strength and conservative risk profile of CFR? Or are they moving money to the nation's megabanks?
• Liquidity: I expect CFR to maintain a conservative balance sheet with a strong cash position. The bank at YE 2022 maintained a classic barbell shaped liquidity position: Cash + <1-year Securities = ~25% of assets (~$12.5 b.) against ~$8.4 billion in Securities maturing >6 years. The bank has another almost $4 billion in Securities maturing 1-3 years as of YE 2022. I am not worried about the bank's paper losses in the AFS portfolio (-$1.7 b.) nor in its HTM portfolio (-$.17 b.) as I think we will learn that as of March 31, some of those paper losses will have reversed in light of interest rate movement since March 8.
• Credit Trends: I am very confident credit metrics will be strong at quarter-end. Investors know from the Federal Reserve's Senior Loan Officer Survey that banks began paring back on risk appetite in January. There is zero doubt in my mind that the April Survey will show further retrenchment. I am looking forward to hearing CFR as well as other banks talk about their attitude and appetite for loans. The liquidity pressures clearly are enormous on some banks that I have called the "Have Nots." On the other hand, a "Have" bank like CFR is now in a preferred position to use its liquidity advantages to attract strong commercial borrowers at earning yields favorable to what banks earned in 2022.

Closing Thoughts

The banks' loss -- cheap funds -- is my gain of now having access to CD rates yielding ~5%. I covered this theme in my March 9 article on CD rates.

It is difficult to pass up on risk-free 5% CD rates (3 to 24 mos.) in favor of bank equities. For that reason, I have been a big buyer of CDs in 2023. (And for those of you who want to remind me that Treasuries are not taxed by states, please be advised that I live in a state that does not tax income).

Systemic industry risk is high because of Fed actions. Had the current Fed a better track record, I would be more bullish on bank stocks. My confidence in Powell et al is low as described in this recent article.

That said, CFR is attractive to me today. I like management, insider buying, liquidity, Texas, and a decent dividend with a strong probability of future increases. The non-cumulative preferred is attractive a 6%; I view it as annuity-like when held in a non-taxable account. And unlike a traditional insurance annuity which I struggle to calibrate risk, I have a sense of confidence that I can measure CFR risk in addition to my appreciation for the Preferreds liquidity (trades 10,000 shares a day).

Caveat

The foregoing is my opinion. I share my investment thoughts for the purpose of getting feedback and questions that challenge my ideas and assumptions.

Every investor needs to do his/her own due diligence before investing as well as determine their risk profile. I am risk-averse, preferring to invest in the nation's best banks, which historically earn returns exceeding cost of capital.