CMA - Cullen/Frost Looks Unexpectedly Interesting

Summary

• Cullen/Frost surpassed analyst expectations with net interest income and pre-provision operating income growth that was roughly double that of its peers.
• Loan growth may be underwhelming in 2023 and management is guiding for higher opex spending, but rate tailwinds should still drive above-average pre-provision growth across 2022-2025.
• Cullen/Frost shares aren't the most undervalued in the sector, but on a risk/quality-adjusted basis, it's definitely an opportunity to consider.

You know that movie cliché that goes, “it’s quiet … too quiet”? I feel similarly about Cullen/Frost ( CFR ), as the valuation looks curiously attractive for this high-quality bank. I realize that the market didn’t like the aggressive operating expense growth guidance for FY’23, and I can understand concerns about subpar loan growth, more limited rate leverage, and rising credit costs, but all in all I find the risk/reward to be more appealing than I expected.

Cullen/Frost shares have lagged a bit since my last update – when I thought the valuation and the relative positioning of the bank wasn’t quite so appealing. With the prospect of high single-digit pre-provision growth across the next three years (and maybe double-digit growth), though, and a reasonable valuation, I’m finding a lot more here than I expected to when I began refreshing my model.

Not A Perfect Quarter, But A Strong One

Cullen/Frost’s fourth quarter was a good end to the year and I don’t have many concerns coming out of the report.

Revenue rose 42% year over year and more than 10% quarter over quarter, beating expectations by about 5% (or $0.33/share). Net interest income rose almost 61% yoy and 12% qoq, roughly doubling the sequential growth of its peer group (though what the right group of peers for Cullen/Frost should be is certainly up for debate), and beating by around $0.24/share. Net interest income was driven by further growth in earning yields, driving net interest margin up 100bp yoy and 30bp qoq to 3.31%, while earning assets declined slightly.

Fee-based income fell 3% yoy and rose 6% qoq, with trust fees up modestly over both period comparisons.

Operating expenses rose 18% yoy and 9% qoq, missing Street expectations by around $0.19/share as management continues to invest in growth (and pay higher compensation in light of the stronger revenue growth). On an efficiency ratio basis, Cullen/Frost missed slightly (20bp), and the 53.1% efficiency ratio is only a little worse than average for its peer group.

Pre-provision profits rose 85% yoy and 12% qoq, beating by $0.14/share and roughly doubling the growth rate of its peer group. Provisioning and tax expense also came in lower than expected, driving most of the remaining gap between the $0.14/share pre-provision beat and the $0.19/share bottom-line core beat.

Entering 2023 With Some Growth Questions

I do think a more moderate near-term loan growth profile could perhaps explain some of the performance with the shares. Between a slowing economy and a level of conservatism from management, Cullen/Frost may well only see mid-single-digit loan growth in 2023, and that would be below the peer group by a noticeable amount. Charge-offs are almost certain to tick up as well, with provisioning taking a bigger bite out of earnings.

Even so, there’s still a lot of lagging rate leverage left in the model. Unlike most banks, Cullen/Frost likely won’t see its net interest margin peak until the second half of 2023, and I expect meaningful year-over-year leverage in net interest margin as a result (75bp to 80bp), about double what I expect from other banks. With that, I expect net interest income growth well into the 20%’s, likely double the growth of its peer group.

I do think that management’s expense guidance was a major hit to sentiment. The Street was looking for around 10% year-over-year growth, and management’s mid-teens growth guidance was a surprise. Even so, I think reinvesting in the long-term growth of the business is exactly what the bank should be doing – adding personnel and infrastructure and further investing in IT to facilitate growth (including ongoing expansion in Dallas and Houston) and improve efficiency over the longer term.

Here’s part of what I think the Street is missing – while expenses will be higher in 2023, I still think there will be positive operating leverage, and the pre-provision growth next year is likely to be well ahead of its peer group. Likewise, I believe Cullen/Frost has a good chance of posting a 3-year 10% CAGR in pre-provision profits from 2022-2025 and there aren’t too many comparable banks that I believe can do that.

Okay, so I keep talking about pre-provision profits, but what about the impact of provisioning? I expect a significant increase in provisioning next year (as well as 2024), but I believe that will likely only bring the bank’s charge-offs up to average. I do expect operating income to decline in 2024 (which will be worse than average), but I still expect three-year operating income growth to be above its peer group average.

Healthy Balance Sheet Trends Continue

Loans grew just 1% sequentially, and that was weaker than its peer group. C&I lending was about in line (up 2.6%), but Cullen/Frost saw little growth in CRE lending and saw construction decline 5% qoq. At this point in the cycle, I’m fine with taking the foot off the throttle in these two categories. The 1% growth in energy lending is interesting to me given the strength of the sector today ( BOK Financial ( BOKF ) had similar performance), and I wonder if there will be stronger demand in 2023 (assuming Cullen/Frost would want to increase its exposure).

Cullen/Frost continues to reap the benefits of its rate leverage, with loan yields up almost two points year over year and almost a point sequentially. The cumulative loan beta isn’t quite as high as those for BOK or Comerica ( CMA ), but is still quite strong.

Deposits declined almost 6% sequentially, with non-interest-bearing deposits down about 5%. Cullen/Frost is doing better than average holding onto its deposits (no surprise), and strong customer service is part of the reason why. Even though the bank arguably doesn’t need to raise rates (they could do fine with elevated deposit run-off), management is doing so because they believe it’s the right thing to do. I think that is a part of management’s service-oriented culture and why Cullen/Frost enjoys such a strong Net Promoter Score.

Deposit costs rose 65bp yoy and 32bp qoq to 0.69%, with interest-bearing deposit costs up 109bp yoy and 54bp qoq to 1.16%. Non-interest-bearing deposits are still 40% of total deposits, and the loan/deposit ratio is an exceptionally low 40% - meaning that Cullen/Frost could do a lot more lending if they chose to, but can also deploy surplus cash into low-risk earning assets like securities. The cumulative deposit beta of 18% is quite good now, and while it will almost certainly head higher, I expect Cullen/Frost to be an outperformer here through the cycle.

The Outlook

I have no real concerns about Cullen/Frost where credit or capital are concerned. Charge-offs are going to pick up, and non-performing loans jumped 27% qoq (but to just 0.22% of loans), but the bank is well-reserved (over 600% of NPLs) and well-capitalized (a CET1 ratio of 12.9%). If management wanted to, they could return meaningful capital to shareholders and/or pursue M&A (the latter seems unlikely).

I’m looking for above-average pre-provision profit growth across the next three years and strong core operating earnings growth over the longer term. I’m looking for long-term growth of around 7% against a trailing adjusted tangible book value per share growth rate of around 8%.

Between discounted core earnings, ROTCE-driven P/TBV, and P/E, I believe these shares are undervalued. Discounted core earnings suggests a fair value around $140, while a 12.5x multiple on my 2023 EPS gives me a $136 fair value. Although 12.5x is high relative to where peer banks trade, it’s in line with the historical premium Cullen/Frost has enjoyed.

The Bottom Line

Cullen/Frost isn’t ridiculously undervalued, and investors can find bank stocks that are 20% or more undervalued if they care to look around a bit. Still, relative to the quality of the franchise, for Cullen/Frost to trade at much of any discount is unusual and of interest to me. I can understand why some investors may be underwhelmed by the company’s aggressive near-term spending plans, but I think there is a pretty good opportunity to own the shares today at a price that will likely look good further down the road.

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