March 09, 2020 - 9:17pm EST by
2020 2021
Price: 54.72 EPS 6.8 6.5
Shares Out. (in M): 63 P/E 8 8.5
Market Cap (in $M): 3,400 P/FCF 0 0
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 2,900 TEV/EBIT 0 0

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I believe Cullen Frost to be one of the most underappreciated banks in the US, which has become very cheap due to the large selloff in the past week. I had not been planning on writing up CFR, as it hasn’t been particularly cheap for the past year. However, the recent 40+% decline makes it very attractive. I did not have a writeup prepared, so this will be short and to the point. 


Why do I think Cullen Frost is a phenomenal bank and largely underappreciated? Few points:

- CFR is one of the best banks at gathering deposits. Its deposits per branch are over $200mm, which far exceeds most peers.

- CFR has very low funding costs.

- CFR is very conservative in its lending.

- CFR has nowhere near the scale of the largest banks, with only ~140 branches, but is still able to be as efficient, if not more efficient, despite its size.   

Gathering Deposits - 

The attractiveness of pushing deposits per branch is rather self explanatory. The higher the deposits per branch, the more scale advantage you have against competitors as you’re going to have lower operating expenses per earnings assets. The default bank that comes to mind when thinking about ability to gather deposits is Wells Fargo. To compare the 2, Wells Fargo has about $180mm deposits per branch while Frost has about $200mm. Each of these numbers are much higher than other large, traditional banks (for example, US Bancorp has $130mm deposits per branch, PNC has $125mm deposits per branch).  So what does this translate to? In the most recent FY, non-interest expenses over earning assets was 2.6% which is very impressive. In comparison, the top 3 banks in the US average around 2.9%. Despite being around 50x smaller than the largest banks in the US, it is able to have a cost advantage because of its scale per branch. However, this wasn’t always the case. Back in the 90s, Frost’s occupancy costs and non-interest expense were much higher. As Frost has been able to push deposits per branch much higher than the industry as a whole over the past 25 years, these scale advantages have grown. Back in 1996, Frost’s occupancy costs over earning assets was .5% and non-interest expenses over earning assets was 4.78%. Since then, Frost has increased same branch deposits by nearly 5% annually, which is fairly incredible. Because of this organic growth and massive increase in scale, occupancy cost/EA has decreased to .29% and non-interest expenses/EA has decreased to 2.6%. This deposit growth has moved Frost from being a relatively inefficient bank, to now one of the most efficient banks in the US. If this deposit per branch growth is able to persist into the future, it’s reasonable to assume that these numbers will only continue to get better.     


Low Funding Costs -

This is CFR’s real advantage, and probably the most important point listed. CFR’s portion of deposits that are non-interest bearing is much higher than any other bank I’m aware of. For CFR, that number is upwards of 40% of their deposits. For comparison, most other banks are around 25-30%. On top of this, another 25% of their deposits are “nearly free” savings and interest checking accounts, averaging only .08% interest. This means that about 65% of CFR’s deposits are free or nearly free. That is incredibly high and has 2 consequences - it makes funding costs lower than basically anyone in the business and it makes CFR especially sensitive to interest rates. To put their advantage here in perspective, CFR’s average current cost on total deposits is .27%, while most other banks currently pay upwards of .5-.6% on total deposits. 


Sensitivity to Interest Rates - 

No, this is not decidedly a positive, but it deserves its own section to explain this. Frost is not a normal bank. The US banking system overall gets about half of its funding from deposits. Other sources clearly bear more expense as well as risk - debt, preferred stock, etc.. Frost does not use these sources. About 93% of Frost’s liabilities are customer deposits, the majority of which are non-interest bearing. Hence, when interest rates move, Frost’s income moves with it but its expenses largely do not. You can see this clearly in Frost’s ROE over the years. Pre-interest rate collapse in 2007, Frost’s ROE was routinely over 15%. Once we entered our current low interest rate environment post-2009, Frost’s ROE has typically been closer to 11%. In Frost’s most recent annual report, they model that 100 and 200 basis point increase in interest rates would result in .3% and 1.5% respective increases in net interest income. On the other hand, they model 100 and 200 basis point decreases in interest rates would result in 2.7% and 7.5% respective decreases in net interest income. Given the current economic climate, this would appear to be a definite negative, or risk, in the short term. However, with a long term outlook, a return to a normal interest rate environment would obviously provide huge upside in terms of Frost’s earnings. 


Conservative Lending/Balance Sheet - 

Frost is relatively different than other banks when it comes to its balance sheet. Over 40% of Frost’s earning assets are made up from its securities portfolio. The reason being, Frost has averaged 9% annual growth in deposits for the past decade. Deposits went from $11B in 2008 to over $27B in the most recent quarter. Due to their conservative nature, they have more deposits than they can lend, hence the large portion of securities. This securities portfolio is made up mostly of Texas municipal bonds, with a minority allocated to US Treasury bonds and mortgage back securities. The main risk here is an increase in interest rates, which seems unlikely at this point (and would ultimately be a net positive clearly). 


As mentioned earlier, Frost is unique in that 93% of its liabilities are customer deposits. This is obviously more stable and provides lower funding costs than any other bank.


Onto Frost’s loan book, which has become increasingly relevant in the past day. What I have neglected up until this point is that Frost operates exclusively in Texas, which obviously entails some sort of reliance on the oil industry. In the 1980s, oil went through a major boom/bust cycle. Obviously all banks that were big lenders to the energy industry were hit with loan losses. During this time, Frost was unprofitable as it had many problem loans, just as all other Texas based banks did. As Texas emerged from its recession in the early 90s, Frost once again turned profitable in 1993. However, that wasn’t the story of most banks during this time. Of the top 10 largest Texas based banks in the 80s, only Frost remains. All other banks either merged with a larger bank, or failed along with 100s of other banks during this oil boom/bust cycle. I think the reason why Frost survived is rather self explanatory. The company always carries far fewer loans relative to deposits than other banks - the rest carried in mostly cash equivalents or municipal bonds. That is just as true now as it was in the past. Liquidity and leverage are never an issue for Frost. Further, Post-1992, Frost’s loan losses have been extremely low in any environment. The US banking industry as a whole has seen an average of .85% of total loans charged off annually since 1993. Frost, on the other hand, has seen an average of .23% of total loans charged off annually over this period. 


Of the loans/securities on the balance sheet, Frost approaches each with a very conservative mentality. 

For the security portfolio:

  • Frost only buys securities with very high credit qualities

  • 64% municipal bonds. 93% are AAA rated. 99.7% of the portfolio is issued by political subdivisions or agencies within Texas. 69% of the Texas issued municipal securities are guaranteed by the Texas Permanent School Fund, which has a AAA insurer financial strength rating or are pre-refunded. The muni bond portfolio carries limited exposure to geographies with energy intensive economies.

  • 15% US Treasury bonds

  • 21% residential mortgage-backed securities. These have no subprime exposure, even before the GFC.

For the loan portfolio:

  • Frost has reduced energy concentration to only 11% of portfolio.

  • As mentioned, net charge-offs over the past 25 years have been significantly lower than the overall banking industry. 

  • NPAs/Assets is significantly below peer average at .32%. 

On oil specifically, I think there are a few mitigating factors that reduce Frost’s vulnerability to the volatility in price recently. 

  • Frost has been operating in Texas since 1868. It has navigated the worst when it comes to oil boom/bust cycles and come out the other side. If there is any bank with a core competency in lending to the energy sector, it is Frost.

  • Energy loans have declined from 16% of total loans in 1Q15 to 11% currently.

  • To get a better idea of the current situation, we can look back to the oil price collapse in 2015. Back then, Frost had 16% of their portfolio in energy and performed a stress test of the following scenario: oil prices to stay at $37 per barrel for 2015 and to remain below $50 through 2018. Now that isn’t quite what happened, but regardless, that stress test is a fairly good approximation of the current situation. In that stress test, Frost found that only 7% of its energy loans were potentially exposed to those conditions. However, when they considered each borrower’s liquidity and other assets beyond actual production, the potential exposure was actually less than 1%. 


So to summarize, for every loan Frost makes, it has a .62% advantage in terms of charge offs vs the industry. In terms of funding, Frost has at least a .25% advantage in terms of funding costs vs the industry. In terms of efficiency, Frost’s operating costs, or non-interest expenses/EA, are on par with banks that are over 50x its size. Liquidity and leverage are not a risk to Frost, with 93% of its liabilities being customer deposits. Frost boasts extremely high customer retention, upwards of 90%, versus the industry standard in the 80s. Meanwhile, while the yield may not be the highest, Frost’s securities portfolio and loan portfolio are very conservative.   


Valuation, Why Does This Opportunity Exist - 

At today’s close, Frost trades at 8x last years earnings, .86x BV, and 1.05x TBV. I don’t know what it’s worth, but I’d say considerably more than that for a bank of its caliber. Since 1996, Frost has grown earnings from $54mm ($1.01 per share) to $435mm ($6.84 per share), nearly a 7x. Frost has paid out $2.1B in dividends, or $35.40 per share. Frost has grown earning assets from $3.8B to $31.7B, or over 8x. Frost has grown deposits from $4.2B to $27.7B, or 6.5x. In those 2 decades being a shareholder, you watched your earnings go up almost 7x and were paid out almost 3x your cost basis in dividends - all through one of the largest financial crises in global history and multiple periods of extreme volatility in oil price. I think that serves as a testament to the quality of Frost’s management and its durability as a bank. 


There are 2 assumptions for the coming year driving the share price down. First - the assumption that interest rates are headed lower, which may very well be the case. Second - prolonged low oil prices will cause losses in their loan portfolio. We can judge the first fairly easily. Assuming a 100 basis point decrease in interest rates for the following year, Frost models a 2.7% decline in net interest income. That would put Frost at 8.5x forward year earnings. I don’t think the oil risk can be accurately predicted. What we do know, however, is that the Frost stress test in 2015 predicted a MAX potential exposure of 7% of its energy loans (and estimated the actual number would be less than 1%). Considering energy loans make up only 11% of its total loan portfolio currently, a  7% exposure to its energy loans equates to a potential exposure to .77% of its loan portfolio. It would take an extreme scenario for the current situation to have any meaningful impact on the bank. Charge-offs to even 30% of the energy portfolio would only cause a total charge-off rate of 3.3%. This is even less of a concern when you consider that Frost’s loan portfolio only makes up 46% of its earning assets. 


Are falling interest rates a risk and a concern? Yes. Are prolonged low oil prices a risk and a concern? Yes. But I think you’re adequately compensated for both even in the most draconian of scenarios. On top of that, Frost is an extremely conservative bank in which a liquidity crisis is nearly impossible. I don’t think Frost is the type of bank that should ever trade for below tangible book. 


On the upside, if you take a long-term investment horizon - if we see a normalized interest rate environment at any point within the next 10 years, we could see Frost’s earnings power easily double from here assuming zero growth in the business. In the meantime, you’re getting paid a 5.2% dividend yield to wait.



- Further interest rate decreases

- Prolonged depressed oil prices

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.


- Clarity into potential oil charge-offs

- Return to normalized rate environment 

- Patience as you collect a 5.2% dividend yield that isn't going anywhere

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