Reducing Our Fair Value Estimate for Cullen/Frost on Higher Funding Costs, Shares Still Undervalued

Strategist

Eric Compton

Cullen/Frost is one of the smaller regional U.S. banks we cover, and it focuses exclusively on the Texas market. The bank is the largest Texas-based bank and prides itself on knowing the Texas market better than anyone else. It has implemented a relationship-based approach to banking that has garnered strong loyalty in its customer base. The bank's sweet spot is small to medium sized Texas based commercial clients. We think that the relationships Cullen/Frost has built up, often times over generations, along with the bank’s consistent approach to conservative underwriting will continue to serve it well in the years to come. 

The great strength of Cullen/Frost's approach is the strict adherence to its long-term strategy to attract high-quality borrowers and retain them with uniquely personal service. The bank often says that it doesn’t bank industries or businesses, it banks people. Tight relationships provide the bank with insight into the Texas environment that it can leverage to advise all clients and deepen its business relationships. The bank also has a history of surviving when other banks have failed, such as during the S&L and energy crises of the 1980s that led to the demise, through bankruptcy or acquisition, of every other top-10 Texas bank during that period. In addition, Frost exited retail mortgage lending in 2000. As a result, it was one of the first banks in the U.S. to turn down Troubled Asset Relief Program funds during the financial crisis. The bank has also navigated energy downturns in 2016 and again during the pandemic, despite having 100% Texas exposure and one of the higher energy exposures under our coverage.

The story of Cullen/Frost is nothing if not of consistency. We like the bank's current organic expansion efforts, first in Houston and more recently in Dallas, and we believe these efforts will add value over time, both through higher growth and, eventually, profitability. The bank's valuation will depend on how much growth these efforts produce and particularly around how expenses develop over the next several years. Interest rates also remain a key influencer of revenue growth for the bank.

Business Strategy & Outlook

We assign Cullen/Frost has a narrow Morningstar economic moat rating as it possesses maintainable cost advantages and switching costs that are consistent with our bank moat framework. While Cullen/Frost’s business model does have heavy interest rate exposure, as the majority of the bank’s loans are floating rate loans, the bank has proven that even within a low interest rate environment it can earn excess returns on tangible equity, and in more constructive rate environments, returns only get better. We believe the bank’s superior deposit costs, business relationships, pristine underwriting quality, and above average operating efficiency on a tax equivalent basis all support a strong narrow moat for the firm, and we are confident that returns will exceed the bank’s 9% cost of equity. 

We argue that bank moats are derived primarily from two sources: cost advantages and switching costs. We see cost advantages as stemming from three primary factors: a low-cost deposit base, excellent operating efficiency, and conservative underwriting, with regulatory costs being a final factor that must also be considered. Cullen/Frost has a unique business model as it primarily focuses on commercial banking, and the bank is a Texas bank through and through, with all its business coming from the state. The focus on deep relationship commercial banking, along with a decent number of non-interest-bearing retail deposits means that the bank has one of the highest proportions of non-interest-bearing deposits under our coverage. While earnings credit rates, or ECRs, can offset some of this benefit, the combination of ECRs, which are lower than comparable interest costs on interest-bearing deposits, along with a significant proportion of non-interest-bearing retail deposits, gives the bank a funding advantage. We also believe the ability to determine deposit pricing within the context of a complete business relationship leads to further cost advantages. While deep relationships can help from a deposit cost standpoint, it also helps the bank to develop more profitable relationships with clients who use more of the bank’s services, and we believe Cullen/Frost does a good job of this as well. The bank remains focused on its core, middle market to small business client base, with loans sized at less than $10 million. Relationships with these smaller companies, which have often been built up over decades, lead to more profitability and maintainable switching costs. Cullen/Frost is perhaps one of the best examples under our coverage of a “relationship” based bank, and we believe the cultural focus on this pervades the entire organization.

Along with deposit cost advantages. The bank has one of the more impressive underwriting histories we have seen, leading to credit cost advantages over time as well. The bank has survived in environments where other banks have failed, including the Great Depression, the banking and energy crises of the 1980s, and most recently the financial crisis. The bank consistently has better credit metrics than peers and spends less of its interest income on provisioning. We believe the culture, institutional knowledge base, and overall relationships that lead to these credit cost advantages are fully ingrained throughout Cullen/Frost and are likely to continue.

Cullen/Frost also operates a fairly efficient operation, and after adjusting interest yields to a tax equivalent basis (the bank has a sizable municipal bond portfolio), the bank has fairly consistently operated in the sub-60s for the past decade in spite of different periods of low interest rates environment. While the early stages of organic expansion efforts tend to be front loaded with expenses and then produce revenue over time, with rates set to rise again, we see the bank easily clearing the 60% efficiency ratio hurdle over time and remaining a solid operator from an efficiency standpoint. 

From a systemic standpoint, we believe the U.S. offers a fair but improving banking environment. Regulation has become considerably stronger in the past several years, and capital levels have never been higher, although the country still uses a complex and somewhat archaic system of regulation. Furthermore, the U.S. banking market is quite fragmented; Cullen/Frost must compete with a variety of regional and community banks as well as large money center institutions. Our outlook is relatively positive from a macroeconomic and political standpoint. The U.S. is still the world's leading democracy, has increased GDP at a steady pace for years, and maintains the world's reserve currency, all of which contribute to banking stability.

Cullen/Frost is not large enough to be considered a global systemically important bank and therefore avoids some of the more onerous regulatory capital requirements. The bank is also small enough to avoid the Federal Reserve's annual CCAR and DFAST exams, and the bank is also not subject to any of the LCR or modified LCR requirements.

Narrow

Economic Moat

Cullen/Frost Bankers

Cullen/Frost Bankers, Inc. operates as a bank holding company of Frost Bank, which engages in the provision of commercial and consumer banking services. It operates through the following segments: Banking and Frost Wealth Advisors. The Banking operating segment includes both commercial and consumer banking services and Frost Insurance Agency. Commercial banking services are provided to corporations and other business clients and include a wide array of lending and cash management products. Consumer banking services include direct lending and depository services. Frost Insurance Agency provides insurance brokerage services to individuals and businesses covering corporate and personal property and casualty products, as well as group health and life insurance products and human resources consulting services. The Frost Wealth Advisors segment includes fee-based services within private trust, retirement services, and financial management services. The company was founded by Thomas Claiborne Frost in 1868 and is headquartered in San Antonio, TX.

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Cullen/Frost Bankers, Inc. is a financial holding company, which engages in the provision of commercial and consumer banking services. It operates through the Banking and Frost Wealth Advisors segments. The Banking segment operates commercial and consumer banking services. The Frost Wealth Advisors segment includes fee-based services within private trust, retirement services, and financial management services. The company was founded by Thomas Clayborne Frost in 1868 and is headquartered in San Antonio, TX.

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