Cullen/Frost Bankers, Inc.

Moat: 2.5/5

Understandability: 2/5

Balance Sheet Health: 4/5

Cullen/Frost Bankers, Inc. is a Texas-based financial holding company that operates a commercial banking network primarily in Texas, providing banking, insurance, and investment services to businesses and individuals.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

Business Overview

Cullen/Frost Bankers, Inc. (CFR), a Texas-based financial institution, operates primarily through its subsidiary, Frost Bank. The company offers a broad range of financial services, including commercial and retail banking, wealth management, investment, insurance, and other financial products. CFR’s operational strategy is focused primarily on Texas.

  • Revenues: CFR generates revenue through two primary sources: net interest income and non-interest income. Net interest income is derived from the difference between the interest earned on loans and investments and the interest paid on deposits and borrowings. Non-interest income comes from service fees, commissions, trading activity, and investment management. The trend within the industry is seeing a gradual shift toward more non-interest income generating avenues. * Net Interest Income: The difference between revenue earned from assets and the expenses paid out on liabilities. This includes interest made on loans as well as the payments for the various borrowing and deposit products provided by the company. * Non-Interest Income: All other revenues from things like fees, brokerage, and commission etc. These are typically not related to the assets or liabilities of a bank and are not interest based revenues.
  • Customer Base: CFR focuses on serving commercial clients, primarily in Texas, offering tailored solutions such as loans, checking accounts, and treasury management services. CFR’s customer base also includes individual investors and consumers, with a mix of products.
  • Geographic Focus: The company’s operations are concentrated primarily in Texas, which allows it to develop a deep and localized understanding of customer needs and market dynamics.

CFR operates in a sector marked by a dynamic economic landscape and increasing regulation. The banking industry’s performance is tightly correlated with interest rates, which have seen substantial increases in recent periods. Higher interest rates, while beneficial for net interest margins (NIM), can impact loan demand and increase credit risk, which leads to higher loan loss provisions. Increased regulatory compliance also leads to higher expenses.

  • Regulatory environment: Banks face increasing regulations and compliance demands in areas such as capital adequacy, cybersecurity, consumer protection, and anti-money laundering. * Interest Rates: Banks thrive on interest rates; with increased interest rates, banks have higher margins but the fear of loan defaults increases. Lower interest rates also lead to reduced margins, as well as lower revenues from fees that are a product of a company having higher volumes. * Technology: Banks, especially in the retail part of their business, are investing heavily in newer technology to make banking faster, smoother, and more integrated. This trend will lead to a huge change in the business model of banks, and will probably reduce operating and fixed costs.
  • Competition: Banks face ever-increasing competition due to newer FinTech players as well as non-bank lenders. FinTech and non-bank lenders have less compliance and red tape that traditional banks have, enabling them to serve the niche markets.

Competitive Landscape and Moat Analysis

CFR operates in a fiercely competitive landscape, battling both large national banks and smaller, more agile community banks. While some banks focus on national reach, CFR has a strong regional focus, which allows for deeper customer relations.

The core problem faced by any investor in the bank is that banks are all essentially the same, and so finding differences is essential to getting any advantage. CFR’s potential moats are:

  • Brand Loyalty in Texas: The bank has a long history in Texas and a strong local brand name that provides it with a loyal customer base.
  • Local Relationships: CFR has deep relationships with its client base that leads to stable deposits and loan customers. In addition, having local managers and banking presence that is not too far flung is an added moat, making clients more comfortable doing business with the company.
  • Scale and Efficiencies: CFR has economies of scale that will allow it to operate more efficiently than smaller players. Given these potential moats, I am giving a 2.5/5 moat rating to the company. While the moats do exist, they are not strong enough to maintain high returns on invested capital for a long term.

Risks

The biggest threat faced by the company is from the rapidly changing macro environment. High interest rates, inflation, reduced spending power of customers, recession, and other factors create very challenging times for banks.

  • Macroeconomic Factors: A slowdown in the Texas economy could decrease loan demand and increase credit risk, potentially hurting CFR’s earnings. Additionally, the interest rate environment plays a major role in its success.
  • Credit Risk: A downturn in the business cycle might increase the probability of loan defaults, creating a surge in credit losses and negatively impacting profitability. This can be mitigated by good lending standards and a close watch on loan-to-value ratios, and by the quality of the underlying lending profile.
  • Competition: Both national players and smaller banks aggressively compete in the region, increasing pressure on loan rates and fees.
  • Technological Disruption: FinTech companies and non-bank lenders may disrupt the traditional banking business model, impacting profitability.

Financial Deep Dive

Analyzing the company’s financials is essential to understanding its sustainability and future performance.

  • Revenue: CFR’s revenue has experienced slow growth in recent quarters. Overall, non-interest income appears to be a stable revenue stream. The biggest chunk of revenue comes from the net interest income. The rising interest rates are aiding the net interest margins, but they are starting to stabilize as well, so further growth of net interest income is limited. The revenues from interest expense, however, will likely grow due to rising rates. We will have to keep a close eye on the revenue growth in the coming few years.
  • Margins: The company had a net interest margin of 3.21 percent in 2023. The company’s operating margin was roughly 25 percent. These are pretty good for a bank, but are not high, given the overall return profile of banks. We should analyze margins relative to its peers to determine if it has an economic advantage.
  • Asset Quality: CFR has maintained a good asset quality, meaning that the loan portfolio is well balanced and has lower loan default ratios than industry averages, despite the current macroeconomic headwinds. This is very crucial for a bank to survive and thrive.
    • Return on Assets (ROA): Return on assets has been relatively flat over the last few years, indicating a lack of pricing power that has stagnated ROA. We will need to track this further.
    • Return on Equity (ROE): The return on equity has remained relatively stable at just under 10% for a long period of time. However, the rising interest rates in the recent past seem to have had some positive effect in boosting ROE.
    • Capitalization: Cullen/Frost has a decent financial health, with a Tier 1 capital ratio hovering around 11% and a leverage ratio between 7 and 8% . This is fairly good for a bank, which signals that it is fairly well capitalized and can withstand economic pressures.
    • Cash and Equivalents: Cash and cash equivalents also play a significant role in the health of the company. The higher the cash reserves, the better the chances that a bank can survive downturns. Currently, CFR has sufficient cash and assets to meet any liquidity crunch that it may face.

Recent Concerns and Management Outlook

  • Economic Uncertainty: Management has acknowledged the ongoing economic uncertainty and is monitoring its potential impact on the bank’s business. They are positioning themselves to maintain credit quality during the current slowdown. There are fears of recession, inflation, as well as rising interest rates, so management has remained cautious on the path forward.
    • Cost Management: The management is focused on carefully managing its expense structure to balance both growth and profitability. They are also making investments in technology to reduce costs and provide better customer services.

Understandability and Balance Sheet Health Ratings

  • Understandability: I’m rating the company’s business a 2/5 in understandability. While the banking sector is fairly well understood and well known, the interrelation between various segments of the business are complex and makes it difficult to understand its true financial performance. Moreover, the terminology and business specific jargon that is used by management can often prove complex for a normal reader.
  • Balance Sheet Health: I’m rating the company’s balance sheet as a 4/5. While some risks do exist, the company is fairly well managed and has decent financial ratios. Having a well-managed loan portfolio is also a huge positive for this rating.

Conclusion

Cullen/Frost Bankers Inc. (CFR) is a company that operates a strong regional banking network within Texas, providing a variety of banking services to both commercial and retail customers. The company faces a fair share of the risks as many do in the banking sector, but is positioned well to navigate these challenges given its strong management, local relationships and scale. However, as long as the risks of the sector remain the primary factors, the moat of this company cannot be above average. A diversified portfolio that combines low risk and a few stocks with relatively high rewards is a prudent path forward.