Cullen/Frost Bankers, Inc. (CFR) Q3 2018 Earnings Report, Transcript and Summary

Good morning. My name is Heidi, and I will be your conference operator today. At this time, I would like to welcome everyone to the Cullen/Frost Third Quarter Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session [Operator Instructions]. Thank you. A.B. Mendez, Senior Vice President and Director of Investor Relations, you may begin your conference.

Thank you, Heidi. This morning's conference call will be led by Phil Green, Chairman and CEO and Jerry Salinas, Group Executive Vice President and CFO. Before I turn the call over to Phil and Jerry, I need to take a moment to address the Safe Harbor provisions. Some of the remarks made today will constitute forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995, as amended. We intend that such statements should be covered by the Safe Harbor provisions for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995, as amended. Please see the last page of the text in this morning's earnings release for additional information about the risk factors associated with these forward-looking statements. If needed, a copy of the release is available on our Web site or by calling the Investor Relations department at 210-220-5234. At this time, I'll turn the call over to Phil.

Thanks, A.B. Good morning, everyone and thanks for joining us. Today, I'll review third quarter results for Cullen/Frost and our Chief Financial Officer, Jerry Salinas, will also provide additional comments before we open it up to your questions. But before we begin, I would like to take a minute and acknowledge that in August, we Tom Frost, our Chairman at Emeritus. Those of you who followed us over the years understand the impact Tom had had on our company and most of us can recite the mission statement. And we will grow and prosper building long-term relationships based on top quality service, high ethical standards and safe sound assets. The reason we have those words to guide us today is because of Tom Frost. And our adherence to those principles is the basis for our success, both in the quarter we will discuss in over the long-term. In the third quarter, Cullen Frost earned $115.8 million or $78 per diluted common share, which represents 27% increase compared with $1.41 per diluted common share reported in the same quarter last year. Our solid third quarter earnings results from Frost bankers executing the strategy that we discussed over the past several quarters, focusing on sustained above-average organic growth. Our return on assets reached 1.49% in the third quarter, the highest quarterly total in nine years. Now, I would like to offer some details about the elements that go into this growth. We have continued to grow our loan portfolio, while maintaining our quality standards. During the third quarter, average loans were $13.7 billion. This represents an increase of more than $1.1 billion or almost 9% versus the third quarter last year. Growth was broad-based across all categories. Our provision for loan losses was $2.7 million for the quarter compared with $8.3 million in the second quarter and $11 million in the third quarter of 2017. Non-performing assets totaled $86.4 million in the third quarter. This was down 30% from the $122.8 million in the second quarter. Potential problem loans totaled $59.1 million, which matches levels before the energy downturn. Net charge-offs in the third quarter of 2018 were $15.3 million compared with $7.9 million in the second quarter and $6.2 million in the third quarter of last year. Of the third quarter net charge-offs total, approximately 75% was related to four credits, all of which have been noted as problems and had allowance dollars allocated to them in previous quarters. Third quarter annualized net charge-offs were 44 basis points of average loans. Overall delinquencies for accruing loans at the end of the third quarter were $81.8 million and 69 basis points for the period in loans that's a number well within our standards and comparable to what we've experienced in the last three years. Total problem loans, which we define as risk grade 10 and higher, decreased $122 million or 19.5% compared to the second quarter and were down about 28% from a year ago. Problem energy loans were down about 46% from a year ago. Outstanding energy loans at the end of the second quarter represented 11% of total loans, energy industry activity has been a source of growth in markets where we do business, but the percentage of energy loans in our portfolio remains well below our peak of more than 16% in 2015. When we visit our customers across Texas, they tell us they are optimistic about opportunities ahead of them. And because we're well positioned to serve them with competitive product mix and strong value proposition, we are looking forward to our own opportunities. Average total deposits in the third quarter were $26.2 billion compared with $25.8 billion in third quarter last year, and growth was primarily in interest-bearing accounts. In consumer banking, our value proposition and award winning service continued to attract customers. Net new customer growth is up by 60% compared with a year ago. I’m going to say that again, because I like the way it sounds. Net new customer growth is up by 60% compared with a year ago. About 22% of our account openings came from our online channel, which includes Frost bank mobile app, that's nearly 26% higher than last year. The consumer loan portfolio averaged $1.66 billion in the third quarter, increasing by 8.2% or $125 million compared to the third quarter of 2017. On the commercial side, new loan opportunities are up by 8% year-to-date compared with last year. Core loan opportunities are up by 12% and large loan opportunities are up by 5%. Our strategy of building our core loan portfolio, which we define as loan relationships under $10 million in size, continues to help provide steady sustainable organic growth. For the third quarter, new commitments under $10 million accounted for 48% of commitments booked up from 47% last year. Looking at new loan commitments booked in the third quarter. Overall, they declined from a year ago by 8% due to lower CRE commitments and energy commitments. However, the volume of non-energy C&I was up by 17% compared to the third quarter of last year. Pay-off activity was high during the quarter. In fact, the level of pay-offs was 62% above the quarterly average for the last year. With regard to our current active loan pipeline, the third quarter was up 25% from the previous year. Finally, as we move through the last quarter of the year when you look back on an eventful 2018, all year long, we celebrate our 150th anniversary with a series of good deeds and charitable efforts across the state. We launched an optimism initiative, which will continue into 2019. We raised the Frost logo on the new headquarters building in downtown San Antonio, which will be completed next year. We expanded our strategic marketing partnership with the San Antonio Spurs and signed one with the Houston Rockets of the MBA, to increase our name recognition in key markets. And as you saw in the press release this morning, we plan to significantly expand our presence in the Houston region by building 25 new financial centers in growing market areas over the next 25 months. We've operated in Houston since 1977 and we have slightly more financial centers there than any of our other regions. But the area is so big and growth has been so substantial that we've really under-invested there. Our expansion plans will help us increase our deposit market share, which is currently just slightly below 2% and extend our value proposition to a greater number of customers. Let me say that I'm extremely pleased with what our people at Frost were able to achieve this quarter and so far this year. It's not often you are able to report a 27% increase in earnings. We can do this because Frost bankers take care of our customers by offering them top quality service and excellence at a fair price. They provide a safe sound place to do business and most of all, they provide great customer service experiences that make peoples' lives better. We've been doing that for 150 years and that experience is shown us the value of having a positive, optimistic attitude for opportunities along. The long term relationships that our Frost bankers have built with customers and doing through all kinds of up and down, and I would like to thank them for that. And now, I will turn the call over to our Chief Financial Officer, Jerry Salinas for additional comments.

Thank you, Phil. I will make a few general comments about the Texas economy before I provide some additional information about financial performance for the quarter and close with our guidance for full year 2018. Regarding the economy, the Texas economy remains strong in the third quarter and unemployment continue to decrease to record lows. According to the Federal Reserve, Dallas branch, Taxes employment has expanded 2.9% year-to-date and September marks the 27th month of consecutive growth. The Texas unemployment rates fell to 3.8% in September, hitting at historical low over the past four decades. The Dallas fed revised its 2018 Texas job growth estimate to 2.7%. Based on the forecast, Texas should add more than 336,000 new jobs in 2018. Looking at individual markets, since the last quarter, the Dallas-Fort Worth economy had seen a consistent uptick in growth. According to the Dallas Fit, Metroplex year-to-date employment growth of 2.6% is on par with last year's pace. Office unemployment hit near historical lows at 3.4%, below both the state and U.S. rates. Houston's economy expanded 6.4% in August, the fastest among the major metro areas, despite a slowdown in its core energy-related sectors. Year-to-date, Houston employment is up 3.6% and all of the major sectors have increased year-over-year. Houston's unemployment rate fell slightly to 4.2% in August, below its evenly adjusted unemployment rate since February 2008. The Austin economy grew at an accelerated pace in September. Austin's economy expanded 7.5% in September, above the long-run average of 6%. Third quarter growth was mixed across industries with the search in construction and mining activities, professional and business services, while the financial and manufacturing sectors showed declines. Year-to-date, Austin's unemployment growth is at 3.2% and the unemployment rate held steady at 2.9% in September. The San Antonio economy expanded at a steady but subdued pace in September. San Antonio's economy expanded at 2.2% annualized rate in September below long-term average of 2.9%. San Antonio's unemployment rate was stable in September at 3.3% below the state and U.S. averages. The Permian basin economy remains robust employment growth has moderated in recent months, but the unemployment rate remained at historical lows. The unemployment rate in the Permian basin stayed flat at 2.4%, which is the lowest in the state. Month-over-month growth and oil production has slowed, but production is still 34% higher year-over-year. Now, moving to our financial performance. Looking at our net interest margin. Our net interest margin percentage for the third quarter was 3.66%, up 2 basis points from the 3.64% reported last quarter. The increase was impacted by the favorable effects of higher yields on earning assets, primarily loans and investments securities and higher loan volumes. These favorable variances were mostly offset by higher funding cost on both deposits and customer repos during the third quarter. The taxable equivalent loan yield for the third quarter was 5.04%, up 14 basis points from the 4.90% reported in the second quarter. Looking at our Investment portfolio. The total investment portfolio averaged 12.1 billion during the third quarter, up about $125 million from the second quarter average of $11.9 billion. The taxable equivalent yield on the investment portfolio was 3.41% in the third quarter, up 5 basis points from the second quarter. Our municipal portfolio averaged about $7.9 billion during the third quarter, up about $160 million from the second quarter. The municipal portfolio had a taxable equivalent yield for the third quarter of 4.15%, up 5 basis points from the previous quarter. At the end of the third quarter, about two thirds of the municipal portfolio was pre-refunded or PSF ensured. The duration of the investment portfolio at the end of the quarter was 4.7 years flat with the previous quarter. Looking at our funding sources, the cost of total deposits for the third quarter was 34 basis points, up 7 basis points from the second quarter. The cost of combined Fed funds purchased and repurchase agreements which consists primarily of customer repos, increased to 90 basis points for the third quarter from 25 basis points in the previous quarter. We instituted a tier rated to our customer repost during the third quarter, but we are also seeing quite a bit exception pricing in this product. Those balances averaged about $1 billion during the third quarter, flat with the previous quarter. Regarding income taxes, our effective tax rate for the quarter was 11.4%, up slightly from the 11.1% reported last quarter, impacted by higher net income and a lower benefit from stock option settlements during the third quarter as compared to the second. On a year-to-date basis, our effective tax rate was 10.7%. Regarding the Huston expansion, Phil mentioned in his comments our plan for expansion of our Houston presence by adding 25 new financial centers over the next 25 months. We are currently projecting that the program will be used next year's earnings per share by approximately $0.19. Regarding estimates for full year 2018 earnings, we currently believe that based on our third quarter results, the mean of analyst estimates for the year of $6.77 is a little low. With that, I'll now turn the call back over to Phil for questions.

Thank you, Jerry. I will now open up the call for questions.

[Operator Instructions] And your first question comes from the line of Ebrahim Poonawala with Bank of America Merrill Lynch. It looks like he dropped off. Your first question comes from the line of Brett Rabatin with Piper Jaffray. Please go ahead.

I wanted to I guess first ask on the Houston expansion. I’m just trying to understand you're in a house and more locations. What’s the trend of those going to look like in terms of -- are you trying to build out more of a commercial platform in Houston? Or is just going to be a broad-based we’re trying to penetrate further with consumer as well? If you could just give us little more color on what you want to achieve in terms of the growth in Houston, I'd appreciate that.

We want to continue to do what we have been doing in Houston in really all our markets, which is growing relationships both consumer and commercial. If you look at our overall deposit base today and our book of business, our deposit base runs around 55% commercial, 45% consumer. And historically, it's been closer to 50-50, but that's what it is these days. If you look at the asset base from a loan side, we run about 85% commercial and 15% consumer. So those are the metrics we're to continue to expect. If you look at the markets that we're going into and the 25 different locations that we've sought for the next 25 months, they have deposits in those submarkets equal to the size roughly of the San Antonio. And so, here you've got a market that basically gives us the opportunity to penetrate something the size of San Antonio where we were not there today but we do have name and brand recognition in that market. So, it's really just opportunity that we left on the table and we haven't -- we just have made investment to grow that. And we know how to do it and I'm excited about the opportunity to do it and I'm really confident of our ability to be successful with it.

And then the deposit trends were a little better this quarter. And I know that I believe we've talked about what is not a string to and it could not be stable, or can you grow that. Was there anything that changed in 3Q? And then as you're thinking about your deposit betas, are you expecting anything to change in terms of the pace of betas?

I think what we said on last quarter was that historically for us, we have seen uptick in those second part of the year. So really not really too surprised by the way what. We saw we continue to see that our demand deposits, compared to the third quarter last year, they were actually down 0.6% but our total time to our interest-bearing were up 3.1% given this 1.6 blended. So, we are seeing good growth on the interest bearing, we are still happy with that. And continue to see pressure on the commercials. And regarding our deposit betas, what I am going to say is that we feel like we've done a lot of the heavy lifting. We'll continue to look at what's going on with the competition and want to be fair to the customers obviously. But I think in a lot of ways, we feel like we're ahead of the game and feel comfortable with where we're at.

And would you -- just housekeeping. Would you guys happen to have average interest bearing funds for the quarter and then interest expense?

I am not sure I get that, hold on a second. So you are looking for the quarter. Total interest bearing liabilities for the quarter were $16.7 billion.

And what was the actual interest expense?

The interest expense was [27.051].

And your next question comes from the line of Dave Rochester with Deutsche Bank. Please go ahead.

On the $0.19 impacts to earnings next year the Houston expansion. I was just wondering what are the expected revenue and expense components of that. I would imagine you have some estimate for loan and deposit growth that you are expecting to get in the first year. I was just trying to back into that for 2019 and then the expected impact on expense dollars for next year will be great. Thanks.

I don’t think Jerry wants to [Multiple Speakers] right now, not to give that sort of color at this point…

But I think what we can do as we talk generally about what we've been accomplishing, we're going to let you guys build your model. The estimates that Jerry gave are based upon looking at what we've done on new locations, let's say, 40 new locations since early 2006. And on average, those locations have grown to about $80 million after five year period of time. And after five years, they were on somewhere between 1.75% and 2% ROA on using marginal costs associated and direct costs associated with the units. And that are off about in round numbers about $1.5 million once they've reached that five year period of time. And there is significant growth that happens after that. So, the numbers that we viewed are based on what we’ve done and that’s the overview for it. And one thing we don't do and Jerry I would tell you this is we don’t give guidance on 2019 until the first quarter of 2019. So, we’re not going to give you specific expenses and revenues related to 2019 but we can give you -- we've given you the answer to the podcast and you just have to do your own writing on that.

And I guess bigger picture, your loan growth goal this year was high singles up to 10%. As you’re thinking about it next year, you're expecting that you could possibly see that just given the opening of the branches you're talking about.

I think we’ll do the comments on next year until January next year.

As it pertains to next quarter perhaps, how are you guys thinking about NIM expansion with future rate hikes. We got a little bit of expansion this quarter. Is this what we should expect going forward with the December -- or the September hike?

I guess what I'd say is this quarter of course was impacted by LIBOR. LIBOR didn’t move the way everybody expected. I think in the case of the three month, it was pretty flat. So I think some of that would be dependent on that. What I said last quarter about the NIM percentage was that we expected slight upward trends and I get to continue to say that as I said you in the third quarter, looking forward.

And then just switching to fee income, obviously, you had a little of a bump up in the trust fee income line this quarter. I was just wondering what drove that and then how you're expecting that to trend from here.

So what we did see was about $2 million of the increase was an investment fees. And obviously, we had some help from the market but we've also had some account growth there, so that’s been good. And then we saw oil and gas fees were up $1 million dollars. And obviously, we’re helped by the increase in the oil prices but also we've gained some new customers. And we've got an enhanced product offering that’s helping those revenues there.

Is this a good level to grow from here, or do you think that some of those fees were low this quarter?

I’m not aware of anything that was unusual this quarter in that line item.

And then just one last one, just on other income. It looked like that was really a couple million above the core line from last quarter. Anything in that or is that a pretty good run rate, going forward?

I think that’s pretty choppy. Looking at the detail, there's really not a whole lot there. I think we had an insurance settlement probably was the biggest piece of it, which was maybe $700,000, something like that. But everything else, there's just a lot of choppiness in there, but nothing else popped up.

And your next question comes from the line of Ebrahim Poonawala with Bank of America. Please go ahead.

So I guess just first question, Phil, you mentioned that new customer growth and I think you mentioned 60% year-over-year of customer growth. What is that mean? If you can help us think through around, obviously, you’re investing in the franchise. But what does that mean in terms of fee income growth, deposit growth as we think about Frost 12 months from now, or the next few years? If you could help put a framework around that, that would be helpful.

First of all, just let me give you the raw number. So customer growth in this quarter was up 60% higher than new customer growth third quarter last year in raw numbers what they was. We grew new customer consumer side a little over 2,000 customers in the third quarter over the last year. We grew 3,300 customers in the third quarter of this year. And we did that by increasing new customers and expanding that number by 6% from it was and we reduced the number on attrition by 6%. So we are doing well on both sides. We are increasing the growth on a gross basis and we're reducing the amount of attrition that we're having. And we're doing what it tells me is how healthy is your value proposition and are you getting your name out in the marketplace and are you becoming a viable alternative for people who are deciding to switch back. And I really believe that we were getting traction there. Just some examples of things were doing to help develop that. We've got a number of things going on. For the first -- few quarters ago we were really developing our marketing message and we were reducing the amount. We really hadn’t that much of marketing spends so we've increased that and we've built that around something we call opt for optimism. And what it actually like our start or company, I would encourage you to go all of you to go to opt for optimism Web site with Frost that’s opt number four optimism. And just looking at what the content there and what is it we're trying to do. We're trying to build community. We're trying to inspire generosity. I think that 30 day optimism challenge it will make you a better person. And so those kinds of things have actually begin getting some, I'll call it, little bit of a viral movement with it as enlist partners on the Web. And so I think our awareness is better. You might have noticed as I've mentioned we're the Jersey partner for the San Antonio's first. We are getting real ultimately on that deal, we'll get hundreds of millions of brand impressions that we wouldn't have gotten before. So it's a really unique opportunity there, a more limited but still significant range with Houston Rocket. So there are things that we're doing there to get our brand impression out there. And I think we're doing a better job digitally of just improving our spending and messaging and targeting on people that we represent a good fit for and letting to know of our capabilities and other things. And so it's also interesting I think that we've done all that and really just opened up one location this year, it was a small one in Fort Worth and two last year. So it's not like we've been expanding our footprint and developing those numbers. We know that expanded locations help with that. But we've been doing this I think just by doing a better job. And I think to your question, it will result -- you can't tie it to the one quarter. But directionally, it's going to result in more fee income, more deposits just through more relationships. And one thing I'll say with regard to the digital side. We do a really nice job on the digital side. You can open an account -- you can download our app on your phone and open up an account. And we've done that development ourselves. You know we do that work and do that development at Frost. And when you look at the digital accounts we've opened in Houston, 60% of the digital accounts that we've opened in Houston are within 5 mile driving distance of the Frost bank branch. So, I think even though digital is important, physical locations are as well. And what we're doing is we're giving both alternatives to the customer. And whenever I see numbers like that and that was customers. If you look at account growth, new accounts were actually up 120% during that same period of time. So, I'm really energized about that. And I think all these positives, along with the operating leverage that we've been developing -- I think earnings were up about 20% last year then 27%, 28% this year. We were deciding to invest that increased operating leverage and expanding in these great markets, at a time whenever our recognition and our capabilities and really our performance on customer development is improving.

Got it, that was very thorough and helpful. Thank you very much. And just going back to the Houston expansion. So a lot of what you say applies in term of, I guess, how you think about growing in Houston. But would love to get your thoughts around why Houston versus Dallas Fort Worth. Obviously, you have presence in both markets. Just wondering whether any specific attributes to Huston that causes you to want to expand there versus Dallas?

We’re going to expand in both. I heard -- and so 25 we're talking about over the next two years, really is an addition to normal expansion we do in the market anyway. And our plan is to continue to grow our loan growth. As we said many times, it has been high single digits I assume. If it continued to do that, I mean, you might want to consider growing your branches in something similarly. And so, we will continue to expand in other markets. And we've got a number of locations on the board right now for Dallas. And I think that we'll want to do that. The thing is that our basin in Huston is just bigger than Dallas right now. And Dallas-Fort Worth is a -- I know they don’t like to be lumped together, but government does it when they do the MSA. And so if you add all our locations there together, we're very well represented in Fort Worth. We're underrepresented in Dallas. But the absolute size of the market in Houston is geographically about the size of Dallas-Fort Worth when you look at going from Katie to the Eastern markets that we're going in. And so, it's just a -- we just got more opportunity, I believe, to leverage what we are in Houston what we've been for 40 years or so. And Dallas is a good opportunity for us. We're going to grow in Dallas and we’re going to grow significantly there. But right now, we felt like the best place for us to allocate our energy and capital and resources and to make the biggest impact was in the Houston market.

And just one last one, I appreciate that you don’t want to give a lot of moving pieces around your expansion. But just from an efficiency and ROE perspective we’re about -- around 55% efficiency ratio this year. Do you see that improving over the next few years given all the things that you talked about?

I think that, I guess we can think to say really don't give guidance, going forward. I think that what you really -- if I was modeling it the way you need to think through this and as Phil mentioned that we're talking about targeting one a month for opening. And you've got certainly basically grow the business from there, if you will. So that's the thought process I would use if you're talking about either mix between revenue and expenses as you do your model.

And I'll just ask so comment there just conceptually a couple of things. One is that remember we're doing this in a period of time when we've been expanding and creating operating leverage. So we've seen our ROEs and profitability increase significantly is really because of two things; one is higher interest rates; and second thing is, what I would call, more efficient balance sheet and more consistent loan growth. And we've been able to do that. We still got runway on interest rates. We still got runway I think -- we've got runway on the loan growth as well. So those few things will -- and notwithstanding Houston, I think we will continue to have with regard to our operating leverage on the company. And then the second thing I'll say is that our efficiency ratio runs in the -- I think you said like mid-50s or so. If you look at the various segments of our business, really the traditional intermediation part of the business is a lower efficiency ratio than our total company, because we've got a number of businesses like wealth management and others, which are great return on equities but fairly high efficiency ratios by the nature of those businesses. And while we'll have some of that growth with the Houston expansion, it's going to be primarily a traditional intermediation business with loans and deposits. And I think the nature of that over long-term is going to be a lower efficiency ratio for that part of the business. So, I think that let's just say, I don’t expect to hurt our efficiency ratio as this investment matures.

Your next question comes from the line of Jennifer Demba with SunTrust. Please go ahead.

Any thoughts or interest on share repurchases with the bank stocks now significantly lower over the last several weeks?

Jennifer, we've got -- I think, we've got $150 million in buyback program authorized and we've said we're going to be opportunistic, and we have not utilized any of that. So, I'll just leave it that, how about that…

Your next question comes from the line of Rahul Patel with Evercore ISI. Please go ahead.

Just could you discuss your thoughts on funding loan growth using cash flow in your securities book and accordingly allowing that -- the loan to deposit ratio, which is been around 52% to just higher, going forward. I understand if you look at it in terms of loans and munis together as a percentage of your total base. But just curious about how you're thinking about funding loan growth, going forward?

I think it's a main thing we want to do. And as you talk about going forward, we're a long-term -- we've got a long-term view. We'd like to fund it with deposit growth. But we also -- we'll use the securities portfolio and liquidity as well. And so the thing I think you'd see us use -- so let's rank order how you'd use it. I would like use deposit growth to fund loans, which is going to continue to get us runway and a loan deposit ratio of below peer but growing. And secondly, we've got -- Jerry in which we have the fed now…

Just about 2.8…

So just under $3 billion there, so there's lots liquidity there to be used. And then there's the -- not municipals per se, but we can get attractive portfolio that we also have available which is fairly significant part and that’s a lower yielding piece.

And then could you talk about the drivers of the pay down activity that you saw this quarter in terms of products and markets? And then just wondering with the long-term rates up since at least quarter end, is that pay down activity abated in recent weeks?

The programs really were -- I think a lot of them in commercial real estate, people moved projects to permanent. It was pretty widespread. If I had to take one market where it was probably little bit heavier, I would call just in talking with our folks at Forth Worth, it's fairly high. But I think that's abated some. So it's just the nature of the business. I mean we do -- we've got great core loan activity and we worked on that, you all know about that. But half of our loans are large loans and you're just going to see things happen and things that -- people take advantage of different things. So, I wouldn't read anything more into it other than just what business works.

And then just one last question about the Huston expansion. In the press release, I think you highlighted that the deposit market share is low 2% in that market. How much of your focus is deposit generation with this back in Huston? And given that deposit competition is pretty clearly intense in this market. How will that influence deposit costs at least to what degree going forward?

Well, deposit is big part of it. If you look at -- just say look historically at say a bridge breakeven analysis -- everyone's got their own analysis. I would say it probably runs around, let's say, $35 million and new loan out a third of that. So deposits are important for that analysis and then -- that's you probably reach breakeven in about somewhere between two and three years, probably maybe 27 months on average, I guess. And so from that point on if you continue to grow loans and deposits, that’s really where you add to that. We talked a little bit about it, so they're both important. But our growth in deposits is really checking account. Do you want to talk about the deposit base little bit, Jerry?

I think if you know anything about our deposit franchise, about 60% of it is in checking accounts. And I think we performed pretty well there. Big part of who we are is relationship driven. And so in lot of cases we may get the deposit first before we get the long relationship even on the commercial side. So, I think that we've been able to be competitive with deposits. I think that our rates, our deposit rates currently, are very competitive. And I think also if you look at J.D. Power awards that we've won for customer service over the last eight years, we performed better than most or than all really in the State of Texas. So, I think that really from that standpoint, at this point, we think that our rates are competitive. We don’t think, at this point that we'll have to do anything special there. But again, we've got a lot of visibility and exposure and deposits are important to us and we'll continue to focus on doing what we needed to do to grow.

If what's you're asking is because of this strategy, do we plan on really increasing deposit betas to bring in cost of money, that's not our plan. Our plan is very relational plan, which means it's a very, first, a checking account driven plan and then build from there. And it's going to be core type accounts.

And we are historically are very competitive. I think Phil talked about marketing dollars, so certainly we'll spend some marketing dollars there to make sure that we're competitive on those -- to the deposits to mark to the deposit customers there. So, we'll be doing some new things there in Houston to make sure that we're able to grow the fractions

Your next question comes from Jon Arfstrom with RBC Capital Markets. Please go ahead.

A question for you on the commitment comments that you made, you talked about commitments being down about 8%. But if you exclude CRE and Energy, it's actually up quite a bit in C&I. Can you just talk a little bit about CRE and energy and what's going on there? Is that the market is that your caution that's driving that?

Well, the energy, as we discussed before. We're just been really careful in that segment, because we were reducing concentration down but we're still growing. We were up little -- I guess, we were up a little bit below our growth rate somewhere between 5% and 7% year-over-year for energy, as I recall. So, I talked to our folks about it. We probably saying yes for every four no's and we're just being careful. And we're building great relationships, some that we haven't had the opportunity to build before. And we're curating some others. So that's what's going on with energy. And I'm not concerned about that at all. Our people are doing a great job and building good business there, and I'm really proud of what they're doing out. We've got a great brand in that space. With regard to CRE, I think a lot of those -- we had huge year last year in CRE, particularly early on and then it's --. And so the nature of that business is -- it's a little bit choppy. With regard to our view on it, competition we're seeing is priced probably first, but that's everywhere. And then you see it on guarantees and term loan projects. We are relational driven. We bank customer net here we don’t just bank projects. And so I feel really good about what we're doing. And I think that we've done good opportunity. Probably Dallas is, as I talk to our folks, probably Dallas we're being a little bit more careful but because you're seeing supply, which is really strong. So you got to see good 2019 to absorb it. But I was asking and I was saying them, what’s the view, because we bank a certain way. We bank people. We've got great reputation. So what's the view? They really respect us but they go to the easy money. And so we’re losing some deals. But I think we're still seeing opportunities to get the projects that we want, but it was just a little bit lumpy. But the fact that we're down from last year I think has more to do with last year. I wouldn't read it as we are just totally pulling back on CRE. We've always been careful. And as you know, we said for years, we don’t swing one way or the other and they think we are a consistent source and player because we deal with relationships in these markets. I think that helps us really. But we’re not really -- it's not a sign that we’re afraid of it and we're moving out of things.

Two more things I want to touch on, I know you don't give the forward guidance on the margin. But I think what you're saying is, you don't feel any unusual pressure on deposits and you still have an upward bias on the earning asset yields. Is that fair, is that big picture enough?

Yes, I would be okay with that.

And then I guess back to Huston, the hiring plan. I know 200 people is not a lot in terms of the grand scheme of things in Houston. But I think culturally you have to get it right with such expansion. Can you talk a little bit about the hiring plan and how you plan to approach it?

First of all, you’re dead right, I’m so proud of you John for calling about culture as it relates to this, because that's who we are. And that's the piece that we've got to get right. We’re going to do the hiring plan two ways; one, is it, it really gives our people there an opportunity. I think people like to be part of the company that's growing and it's developing its business. So, I think we're going to have -- and we already have some buzz internally about growing these positions. And it's tough to get around. There will be some opportunity for people to work closer to home, frankly, which I think will be good. And I think it will help employee satisfaction and retention. But we're going to be boarding new people and new leaders in new markets that we're going into. And I think that the early indications of our efforts there have been really positive, in my view. I’m really excited about what we're seeing. I think a lot of it --- and sure we’re competitive in terms of paying all those things, everyone has to be. But I think people are excited about joining the company with a reputation like ours that is investing for the future. And so -- but a specific part of our efforts in hiring these new people is on-boarding of new employees and cultural indoctrination, if I can use that word. We don't want to do -- what we want to do is expand the brand and expand the culture. We don't want to have it polluted. And what we're looking for is people who want to buy into that, which is what we've always done. So we’re dead focused on it and we are not going to let that get away from us, we've just not.

Your next question comes from the line of Michael Rose with Raymond James.. Please go ahead.

Sorry if I missed this earlier, but you guys done nice drop in non-performers, just wanted to get some color there. And then as I look at the reserve ratio, it's about 1%, I know you've been below that before. Credit looks pretty good at this point. Just any commentary on how comfortable you are with just generally credit, at this point? Thanks.

I'm extremely comfortable, but you always have to knock on all of your credit, right? When we have Frost Bankers, we wouldn't worry about credit. But the trends are just great. But the trends are just great. Third quarter inflow problems was only $83 million, it averaged 112 for the year and last year to 166 per quarter. If you look at 2018 resolutions of problems, we have $469 million of favorable events, which include upgrades, payments and payoffs. The unpaid will advance, which is really charge-offs $34 million. So we're just seeing good movement there. And as you look, our level of non-performers, which today is $82 million, it's still heavily weighted towards couple of energy and particularly one energy credit, because it continues to move through the slate and at some point, it wouldn’t get that resolved. And so I really look forward to our non-performing levels being in the low. The charge-offs we elevated this quarter. They were really, as I said, full credits. They were one of them came on in '16 as a problem, some in '17, one of them was at the end of last year is a potential problem. About half of those were energy related and the other two were just general business, and that just happens. You had a company that had a loss to major customer, you have another company we've talked about the other before and had problems with sourcing the inventory and lost some relationships. And it really, really hurt their business, saying that it's liquidating. So, that's still happens, I am not proud of it but that's bank. And we're going to probably get better from all those, so I feel really good about it.

And maybe one follow-up question, I think last quarter you guys talked about savings of $8 million to $9 million pretax from the FDIC surcharge roll-off. So just wanted to get the sense that that’s still the right estimate and then if that played into the investment decision in Houston as it relates to the number of centers and the size, which will take some of those savings when they actually do hit, and roll it into the expansion?

The number that you quoted, the 8 to 9, I think it's still where we're at. And really I think the Houston decision, you're right. There may be some offset there. But really the Houston decision was really just the right decision to make for us. So even regardless of whether that we were aware of that savings or not, it was just something that we needed to do and wanted to do to continue to grow our business.

Your next question comes from the line of Peter Winter with Wedbush. Please go ahead.

I was just wondering, the 2018 expense guidance, so 4.5% and I guess it's off the base of $747 million. It seems like you could come in below that level unless you are expecting a big step up in 4Q expenses?

We’re going to stick with our guidance. I think that there was some concern that maybe the guidance was too high given the low second quarter and we did mentioned that we expected that some costs would be higher. We talked about the advertising program in such. And so at this point, I think the guidance yes is -- we’re going to stick to that.

And then just one more question on the Huston expansion, as I think about 2020, when you are going to continue to open up another 12 branches and the hiring. Should we expect a similar type of earnings impact in 2020 or we get some of the -- start to see some earnings accretion from what you do in 2019 and this should be less?

The real take of it is if you continue to open up branches and you just have reached profitability, and it'll be more just the math of it. And then you reach -- it's like with any other investments or it's a burn rate and then it become less and becomes accretive to what it was the previous year and then it becomes accretive to where you were before you started. So, it's just the nature of rhyming. And I think we said earlier things -- historically we think they averaged about 1.5 million. But when you look at what it throws off after a five-year point and what that does for our company on any reasonable fee, I'm very excited about what it's doing and about what it does. The only question about this, because the math is simple, the only question is can we do it. That’s the only to me relevant question. And I’m confident about our ability to do it, because this is what we do. If we can't do this, why are we in banking right now? I mean, this is what we do. And so I feel very confident about our ability to achieve it. And I'm really excited about what it does for our growth trajectory over the next five to seven years in Huston.

If I could just ask one more question, Phil. How have you come to decision to do it de novo versus buying something, or buying another bank?

The reason is -- and look, Peter, Jerry and I've bought -- I don’t have any banks have and have any brokerage companies -- insurance brokers. We've probably bought 40 companies. So we've done in a lot. We've normally done it to build out markets but we're in markets now where we have mature viable platforms. And so the question that we've been asking is do we take and spend shareholder money to just increase mass in the market, or do we spend operating leverage, do we spend our balance sheet release or do we spend our operating income statement and developing these markets. I'm convinced that we build greater shareholder value if we can grow it organically but you have the opportunity and ability to do it. But I’m convinced, everything we bring to the table and I hope that things we've been talking about and people who know see that we are a viable candidate to develop these markets. I think we've got the second largest free ATM market network in Houston. That means we’re bigger than two other, too big to fail. And so we've got the chance in my view to get this done. And so, do I want to pay -- and look everything I've got is tied up in this company and I always say if my family is going to have anything, it's because this company is going to do well. And I'm just going to take 150 year company with the valuation and quality we have and just give ex-percent of it to someone, because they put together a few branches and hired few lenders, just so I can get bigger to market I'm already in. I don’t want to do that. I think that we can reward our shareholders better as long as we have the opportunity to grow organically. Now, with all that said, I want you to think that, we'll never do an acquisition ever. We may not in my tenure, but we might. But if we ever did, my view is that best use of something like that and when we do them rarely, but the best use we've had of those is when it put us in a market where we weren’t that gave us the ability then to grow organically. I will give you an example of that. 20 years ago, we did Overton and we wouldn't be in the North Texas market today. I don’t think what we would be if we haven't done that acquisition. Another example would be the Permian basin that we did four years ago and that market is had its loss for a couple of years but I was talking to our regional President out there, and it is harder than it's ever been. And it's the best report I've ever had for that market. And he made an interesting comment that stuck with me. He I said, we used to be a niche bank in a niche market but now we're broadening our base, and that's really what we do. We go into a market we grow long-term relationships and we broaden. So I don’t want to say or give any impression that I'm holding -- acquisitions in contempt, it's just to me and to our team when you've got the ability to grow organically and you are in fantastic markets than we are in Texas, let's leverage it out that's the way it create value that's mastering the consciousness of thinking on acquisitions right now.

And your final question comes from the line of Brady Gailey. Please go ahead.

So, Phil, just to clarify as you talk about the 1.5 million burn per branch. You are saying that each branch once it's up and running has an expense base of roughly $1.5 million pretax annually. Is that what you're saying?

No, I'm saying that the net income of the branch would be a net loss of $1.5 million for the -- as it burns its way through profitability. And Brady, these are averages. We've had some branches that reach profitability slower, some sooner, some we do a great, others we don’t do as well. But this is the average of what we've done for a long period of time on the location. And so, it's like a burn for a business. You'll lose money for ex period of time between two to three years and it's -- and the burn has been on average about $1.5 million.

And then just so we can sense the magnitude. What's your current branch count approx?

133, hope we've got that right within one or two…

And then lastly from me, you reserve and it looks like you'll charge off some allocated reserves with the four credits. Your loan loss reserve ratio is now right at 1%. I know that you look back three or four years ago before the energy thing popped up, you'll were below at 1% reserve. Is there any reason to think you'll wouldn't head back below 1%, going forward?

Brady, I would have answered the question just how the way you asked it, to be quite honest with you. We have been below 1% before. And of course it's formulaic based on our allowance calculations. So, as long as credit quality is where it is, I would not necessarily be surprised that we're below 1%.

And then actually on the reserve, CECL we're still over a year way. But any comments on the impact that CECL could have on your reserve?

Well, I guess I have to say we don’t like CECL obviously. But it's too early to tell. Obviously, what ends up happening is that you'll have to look at how your target loan make up at 2020 and what’s your economic forecast is at that time. I think right now we’re in good shape. We're at where we need to be from a planning standpoint. But no, we wouldn’t be anywhere near ready to give any impact at this point.

There are no questions in the queue.

Well, thanks everyone for your interest and we are adjourned.

This concludes today’s conference call. You may now disconnect.