Greetings and welcome to Cullen/Frost Bankers, Inc. Third Quarter 2021 Earnings Conference Call. [Operator Instructions]. It is now my pleasure to introduce your host, A.B. Mendez, Senior Vice President and Director of Investor Relations. Thank you. You may begin.

Thanks, Rob. Our conference call today 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 such statements to 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 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 website 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 afternoon, 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. In the third quarter, Cullen/Frost earned $106.3 million or $1.65 per share compared with earnings of $95.1 million or $1.50 per share reported in the same quarter of last year. And this compared with $116.4 million or $1.80 per share in the second quarter. We continue to focus on our organic strategy while the economy works to move past supply chain issues and other lingering effects of the pandemic. Average deposits continued their strong increase in the third quarter and were $39.1 billion, an increase of 19% compared with $32.9 billion in the third quarter of last year. Overall, average loans in the third quarter were $16.2 billion compared with $18.1 billion in the third quarter of 2020, but this included the impact of PPP loans. Excluding PPP loans, third quarter average loans of $14.8 billion were essentially flat from a year ago but up an annualized 6% on a linked quarter basis. And looking forward, we're very encouraged about the outlook for loan growth. New loan commitments booked through the third quarter excluding PPP loans were up by 11% compared to the first 9 months of last year. For the quarter, new loan commitments were up by 6% on a linked quarter basis. We were especially pleased that the linked quarter increase was due primarily to C&I commitments, which were up 30%. Our current weighted pipeline is 41% higher than 1 year ago and 22% higher than last quarter. The increases are in both C&I, up 22%; and CRE, up 28%. The market continues to be very competitive. In the third…

Thank you, Phil. Looking first at our net interest margin. Our net interest margin percentage for the third quarter was 2.47%, down 18 basis points from 2.65% reported last quarter. The decrease was primarily the result of a higher proportion of earning assets being invested in lower-yielding balances at the Fed in the third quarter as compared to the second quarter, and to a lesser extent, the impact of a lower PPP loan volumes and their related yields compared to the prior quarter. Interest-bearing deposits at the Fed averaged $15.3 billion or about 35% of our average earning assets in the third quarter, up from $13.3 billion or 31% of average earning assets in the prior quarter. Excluding the impact of PPP loans, our net interest margin percentage would have been 2.27% in the third quarter, down from an adjusted 2.37% for the second quarter, with all of the decrease resulting from the higher level of balances at the Fed in the third quarter. The taxable equivalent loan yield for the third quarter was 4.16%, down 12 basis points from the previous quarter. Excluding the impact of PPP loans, the taxable equivalent loan yield would have been 3.74%, down 6 basis points from the prior quarter. To add some additional color on our PPP loans, total PPP loans at the end of September were $828 million, down from $1.9 billion at the end of June. Forgiveness payments received during the third quarter were higher than we had projected, resulting in an acceleration in the recognition of the net deferred fees during the quarter. At the end of the third quarter, we had only about $11.5 million in net deferred fees remaining to be recognized, and we currently expect about 75% of that to be recognized in the fourth quarter. Looking…

Thank you, Jerry. Okay. We'll open it up for questions now.

[Operator Instructions]. Our first question comes from Brady Gailey with KBW.

I just wanted to start with mortgage. I remember you guys got out of the mortgage business. I think it's been a couple of decades ago. And now you're getting back in it. Maybe just 2 things here. Is this an originate-and-sell model or is this an originate-and-keep-it-at-Frost model? And then if it's originate and sell, how big of an investment do you think you're going to make? Like will this be a meaningful fee income contributor?

Brady, actually, this is going to be a -- it will not be a sell model. We're wanting to do this to expand relationships, and it's our intention to keep all these books on the -- keep all these loans on the balance sheet. So it won't be really a fee-based model. It's going to be more of a portfolio model. We'll be in charge of the experience from beginning to end, including servicing. And as I said, it's our objective to make this a world-class customer experience that people have with our general products. And in addition, which is what we have with our current consumer real estate products that I mentioned in my comments earlier, which include home equity, home equity line of credit, purchase money seconds and home improvement. So I am really excited about this opportunity. And I think it's important because I realized we were the poster child for getting out the mortgage business before the meltdown. I think it's important to realize what we're doing and what we're not doing. What we're not doing is going back into essentially the model that we had utilized before, which was very consistent with what was out there, which was a commission-based sales structure and one where technology -- size was so important in order to achieve scale with the technology at that time. What we're doing today is this will be Frost bankers providing this service and really, it's in response to customer demand. It will be done through our branch network, which, as you know, is expanding significantly these days into major significant markets in the state. And we're going to -- and I think really importantly, and this is a differentiator between where we were 20 years ago, is the technology that's available today is much more accessible, it's much more scalable at an appropriate level. There's a lower cost to entry and a lower cost to support as we use cloud and SaaS technology providers. So it's mainly about providing a great customer experience in this sector. And I believe we've got a great opportunity.

And Phil, how big would you like resi mortgage to be over time, like as a percent of total loans at Frost?

Our consumer real estate today runs about $1.3 billion, so it's a little below 10% of the portfolio. I think pound for pound, residential mortgage could be at least that size in the next 5 years. And I would think it has a chance to be bigger than that. That won't take a tremendous amount of volume. Frankly, I think if we got less than -- a little bit less than 2 loans per month for our branches, that would be a good target for us to shoot for. And in the markets that we're in, that will give us some pretty good volume over time.

All right. And then my second question is just more about deploying cash into the bond book. I mean the pile of cash you guys are sitting on just keeps growing. It's now 35% of average earning assets. We've seen the long end of the curve move a little bit from 90 days. I mean the 10-year bond yield's now at almost 1.60%. So how do you think about the timing on when you start putting more of this cash to use in the bond portfolio?

Well, Brady, just for some perspective. Right now, really, as we look out into the fourth quarter, I only see projections per se, another $0.75 billion being spent this year. So we did $1.5 billion in September. I see us maybe doing another $0.75 billion. We're not going to get rushed into it. Obviously, we're -- we spend a lot of time looking what's out in the marketplace looking at those yields, just as you've discussed. And we really like the optionality that we have. We're not going to be rushed into something. So I don't think we've got a time frame in mind to do that. Obviously, if the yields turn our way, we'll jump in. But we're not in a rush to do that. I think that we feel like when the right time comes, we'll jump in. We're not afraid to make purchases. We just don't feel like it's the right time right now given the current environment.

Our next question comes from the line of Ebrahim Poonawala with Bank of America.

Just one follow-up, Jerry, on the PPP fees. Sorry if I missed it. What was the PPP fees in the third quarter?

The fee itself or you want all the interest income?

All the interest income.

Yes. So the total interest income associated with PPP loans was $30 million.

$30 million.

That was down from $45.5 million in the second quarter.

$45.5 million. And you mentioned that there's $11.5 to go plus whatever the 1% on the rest of the loan balances?

Correct.

Understood. So if I x out the $30 million, NII would be about, whatever, for the third quarter around $240 million? Is that a good base? Like do you think NII should grow from there?

You're talking about -- help me, Ebrahim. Are you talking about net interest income or...

Yes, net interest income. When you look at it from an ex-PPP basis, should -- have that paid off?

Yes. Let me get that. Let me kind of look at my information here. Yes. So I think on a non-PPP basis, in the third quarter, I think that -- if you take that -- I'd say that -- really, again, with the purchases we made, we made late in the third quarter. So you need to take that into account. But yes, that run rate, I would say, is really kind of the bottom, if you will. We'll get a little bit of that PPP in the fourth quarter. But if you pull that out, I think from here on -- I mean you heard Phil talk about the loan growth that we've had in the fourth -- in the third quarter. The pipeline looks good. And then we -- I mentioned that we made some purchases in September that we really didn't feel the impact of it in the third quarter. So yes, from the way I look at it, hopefully, that was the bottom as far as the net interest income dollars.

That's helpful. And I guess just going back to the mortgage conversation earlier, Phil. So you announced a partnership with Blend, I think, in middle of October. Just talk to us, one, is there more to it beyond mortgage in terms of what you think that partnership does for you on the consumer side? And what else are you looking at? Like you've been a little bit ahead of the pack in terms of either reacting or staying afoot on overdraft fees on early sort of payment for pay payments for employment checks. Just give us a sense of what to make -- what we should make of the Blend partnership? And what else are you looking at when you think about fintech partnerships?

Well, Blend has been a product that we have been utilizing for -- I know it's been well over a year. It was pre-COVID. So this is an expansion of that. And I would say also, Ebrahim, as we look at the other segments, you've got the application and the decisioning and then the servicing piece, we're looking at best-in-class software for all 3 of those segments. And it could be that those last 2 could be 1 provider. It could be 2 providers. And so it's -- I think it's exciting because it's not often in this business that you get to really choose the technology you want for a strategy and where you don't have a legacy system involved that you've got to work off of. So it gives us the ability, along with the work we're doing with Infosys, to create the best workflow and the best customer experience with the best software. And what I think we're going to see happen is it will take the software that we've utilized for the mortgage experience, in the mortgage product, and we'll see that reengineered into our workflow that we currently do for that large portfolio of consumer real estate. So I think there's some real advantages that we can look forward to getting in this.

Understood. And just one more, if I could. Like you sounded pretty upbeat on the outlook for loan growth. Just give us a sense of -- is that growth based on optimism that things start easing on the supply chain and customer sentiment improves? Or are you actually seeing tangible signs of activity levels picking up, where you do feel like fourth quarter and at least first half of next year should be pretty good loan growth-wise?

In talking with the people, they're optimistic. I mean a couple of additional things. our look-to-book ratio has been, I think, pretty good versus a year ago. Our numbers on look's up 33%, and our bookings are up 33%. So it's good to see that those are consistent with each other. One thing to keep in mind is as we continue to adjust the energy portfolio and you look at that linked quarter increase, which was 6% not annualized for new commitments booked, that included a 58% reduction in energy commitments book. So little -- still a little headway there as we rationalize that portfolio where we want to be, still in the mid-single digits, still an important portfolio. But as you know, we've been working down our concentration there. And then I think another thing is -- that I look at is if you look at our -- and I mentioned this, our pipeline, essentially, let's call it, 90-day outlook and the weighted pipeline, as I said, it was about 41% over last year, 22% up on a linked quarter basis. That weighted pipeline is what our people expect to happen. So it tells me that they're somewhat optimistic on our -- on what we're going to actually be able to execute there. So I'll say another thing. As I've looked at just utilization under lines of credit, we've seen that pick up, particularly in the commercial business. I think it hit a low point in May. Utilization of working capital lines, this is for C&I, was about 28.7%. At the end of the third quarter, I think that was, yes, 31%, pretty much 31% even. So we've seen that contribute to some volumes. And I think we'll -- because we've had some good execution on commercial real estate recently. We're sort of early in the game on those projects. And as they mature, I think we'll see some funding up on that. So just the sense we get, that's really indicative what we've been experiencing over the last several months as opposed to people expecting supply chains to get better, that type of thing, because frankly, I don't think the supply chains are getting any better. And labor is not any better. So to see this in that environment was encouraging.

Our next question comes from Jennifer Demba with Truist Securities.

Phil, you said you're going to kind of employ some lessons learned from the Houston expansion with the future branch adds in Dallas and the rest of them in Houston. Can you just talk about what you have learned over the past 2 or 3 years with this branch expansion?

Well, I don't want to give well, secret sauce. But how about this, it's all about people, right? It's all about getting the right people and getting them early enough before you open up these locations to get them engaged with the market and make sure that you're bringing in people that really believe in the culture of the company and what we're trying to do. As I've said before, we haven't done and don't do teams of people. We do individuals who are making a decision that Frost is the right place for them to be. And I think it's really -- the success of our Houston strategy was really related to having great focus and commitment of resources on our part of really talented individuals to lead that effort and then selecting the right people that have really executed to create these results. And that's what it's got to be. So it's -- I will say it's a little -- probably a little tougher market than it was when we started Houston 3 years ago because of some of the supply chain stuff, some of the cost stuff, people are not getting any easier to hire, but I think we've had pretty good results thus far. So -- but I think we can -- and we are utilizing the same procedures in the company and the same focus that we did in Houston, let's just say that. And I'm very confident of our ability to execute that plan.

And can you just talk about -- someone asked before about the excess liquidity. How long do you think it's going to take to deploy Cullen's excess liquidity? You guys have a lot more than most of your peers.

Yes. What I'd say, Jennifer is, number one, we typically have more liquidity than most. And obviously, we're not going to carry 35% of our earning assets in cash. But let me give that sort of backdrop that we do tend to keep a little bit higher level. We're not going to -- I'll say that we won't jump in all at once. I think that it will take a -- most of 2022 to make a major dent in it.

Yes. Jennifer, with the loan-to-deposit ratio where it is hovering around 40%, that's kind of where we were at the last low point historically for our company. When you look at what it took to get to, let's say, an 80% -- high 70s, 80%, I mean, that was an extended period of time. I think whenever we saw the last decline in loan-to-deposit ratio, it was into the 50s, and that was in the Great Recession. I think it took us 5 years to get back to a -- for us, a more normalized number. I think it's -- I mean, honestly, I think it's going to be at least that for us because one thing is -- and as I always said, this is a high-class problem. Because if you're doing your job growing deposits, you've got plenty of liquidity, plenty of dry powder, and you're able to generate funding at a really good competitive cost because you can generate so much demand deposits, which are very low cost. So I'm not so much worried about utilization of liquidity per se as I am just about making sure that our loan growth is solid. Our new relationship growth is solid, and our strategies for organic growth are being successful. I think the earnings will take care of itself. And then we'll be opportunistic as you've seen us be on when we employ that liquidity into the bond market or, frankly, if we don't employ into the bond market. I mean, frankly, the optionality that Jerry talks about, I think, becomes increasingly important as we see what happens with inflation, and not just supply chain but what we're seeing with labor costs. And I tend to think that the short end is going to have more volatility than the long end over the next year or so, just my opinion. But we got the opportunity to take a look and see on that.

Our next question comes from the line of Steven Alexopoulos with JPMorgan.

This is Anthony Elian on for Steve. Phil, you mentioned that you've had close to 20,000 net new checking accounts added so far this year. Are you able to parse out how much of these new customers are choosing Frost because of services you offer, including Early Pay Day and overdraft grace, that not many banks offer?

I can't tell you that because they don't tell us why they're joining us. I can tell you, though, that Early Pay Day was, see July, the big overdraft grace in April. And so we broke the record for our all-time annual number in June. So you'd basically see no impact there for Early Pay Day and pretty limited impact from overdraft grace. I think one of the things that's really helping us, aside from just reputationally what our service and Net Promoter Score tells us about how people think about us is, I mean, the Houston expansion strategy has been a really big contributor to growth, and so there's that. And they are really helping us see increases there. And then secondly, we've done a great job of developing our capability and marketing for online. I think 41% of the accounts that we've opened this year have been opened online. So doing a good job in both those areas, in the digital side and then expanding on the physical side and the geographic distribution. Both of those things, I think, have really helped us get to a new level in terms of consumer growth.

Okay. Great. And then my follow-up, you mentioned in the prepared remarks you plan to open 8 more Houston locations in the coming months. Any more details you can provide on this in terms of the expense run rate beyond 4Q as you build these branches?

What I'd say to that is -- I think we've kind of given a little bit of this guidance before. We do have our planned Dallas expansion that Phil talked about and then also our expanding on the locations in Houston that we've already opened. And the guidance that we gave originally when we announced the Houston plan was it was going to cost us about $0.19 in the first year. And that's really based on what I'm looking at -- I think we're going to be pretty close to that right now given what we're looking at. Obviously, some of that will be dependent on the timing of the locations, the hiring of the people, et cetera. But I think you'd be pretty close about something $0.19 in 2022. And also, I guess I'll mention, I think your comment mentioned that we do Houston all in a year, and those will come over a 2-year period. And Dallas will be a 2.5-year period. So those will be coming in over a period of time.

Our next question comes from Jon Arfstrom with RBC Capital Markets.

Phil, one of your comments earlier about the competitive environment and 69% loss to structure versus 50% in the prior quarter. What's changed? And do you expect competition to get even tougher from here?

I was talking to our people last week about what they're seeing. It is just I'd say largely the same thing: burndown rates, guarantees, terms, loan-to-cost, et cetera. The one thing that was a little different than they had seen on the permanent side was a trend towards -- again, these are permanent deals, interest-only deals for 5 and 10 years, which is sort of new. I haven't seen as much of it. So I think that around the margins, around the edges, it continues to be more competitive. There was one -- I remember they told me about one person who was putting together a deal. I guess they were a broker for a permanent deal for a customer. And they had said, "I don't know what else I can ask for. They said yes to everything." So I mean that just tells you how accommodative the markets are being. All that said, though, our people are optimistic about our ability to get deals. And we have great relationships with key customers. And so you'd think that there'd be more pessimism as you see this thing get more competitive. But I think just -- and we'll -- we know what to compete on when and yet still keep our disciplines. But we seem to be doing okay.

Yes. Yes, the new commercial relationship numbers are certainly good and same with consumer as well. And I guess that's what you control, right, is activity?

Exactly.

Yes. And I guess back on the loan-to-deposit question. I know it's not the most critical ratio out there. But it seems to me that maybe the excessive deposit growth is starting to abate a bit and you're seeing a bottoming in loans. And perhaps over the next couple of quarters, that starts to reverse itself and climb back up again. Is that a fair way to think about it?

I think that certainly deposit growth was a little bit softer in the third quarter. It was still 9% on an annualized basis. So still strong, but it's not the double digits that we've been seeing, the high teens. So from that standpoint, you're right. I mean, if anything, at that level with loan growth continuing or starting to improve now that, that number could get better. But at the end of the day, we're all about relationships, as Phil said. And if those deposits keep coming in, we want them, right? And so to the extent that those deposits ticked up again, we'd certainly be happy about that. So I think, theoretically, you're right. If deposit growth slows down and loan picks up, yes, that will kind of take care of itself. But we're still adding new locations. We continue to offer top-quality service. We're still interested in opening new accounts. When I look at a 12-month rollback, looking backwards about where our growth came from in a rolling 12 months in the deposit side, 70% of it was augmentation from our existing customers, and 30% of it was from new customers. And that's a little bit higher than we've been seeing. We've been seeing like a 75-25. So it's good to see that. So yes, I think you're right. But we'd love to continue to see deposits growing.

Okay. Yes, that was one of my next questions. I guess that 70-30 split is -- I was curious on that. And I guess the last one, Phil, you touched on it in your very early comments about Houston when you were giving some of the numbers. But you touched on the fee businesses. Can you talk a little bit about what you're seeing in -- from the new branches in terms of the fees and fee generation?

Jon, honestly, I don't have that breakdown with me in terms of that for the expansion branches. I can't tell, and I'll ask Jerry to talk a little bit about fee income. We've really had a nice year at this point in wealth management and wealth advisers, a little bit tougher in the insurance, but still holding our own there. Jerry, you want to talk a little bit about the noninterest?

Yes. I think Phil mentioned, we thought -- I thought we had a pretty solid quarter on the noninterest income side. The trust side of the business had some good growth there and with the investment fees growing, I think, 13%, and then good oil and gas revenues there. Obviously, with the higher commodity prices, that's helping us compared to where we were, say, in the third quarter last year. And they continue to have new accounts growth there. So good growth there. I think on the deposit service charges, even with overdraft grace, I think NSF, OD combined, commercial and consumer, might have been down 100,000 compared to the third quarter a year ago. But we did see good growth on the commercial service charges with higher billable services. And interchange fee, I thought, was really strong. We were up almost $1 million, and we had introduced a new commercial account that's responsible for about half of that. But it's also interesting that we're seeing the numbers of transactions, debit card usage is obviously going up significantly, and the dollar size of the transactions that are running through are also up. So I thought we had a good solid quarter all the way around, a lot of customer derivative activity also in the other categories. So yes, I think overall, it was a good quarter. A little bit of softer on the insurance side. As Phil said, we've been fighting a little bit of an uphill battle there on the net new customer business there.

Our next question comes from the line of Ken Zerbe with Morgan Stanley.

Just a couple of questions on expenses. I heard your guidance that you still expect expenses to be up 3% for the year. I guess what kind of range are you putting around that 3%? Because if we actually put in 3% exactly, it does apply -- or it does imply a very sizable increase in fourth quarter expenses, like just over $230 million. I just want to make sure I'm thinking about that right.

Yes. No, I think it's a fair question, Ken. I was looking at it this morning. And the one thing I'd point you to is our historical growth between third and fourth quarters. When you go back and look last year, it's not too different than that. We do have some incentives that -- some incentive awards that get awarded in the fourth quarter. Some of them, because of the nature of the award and the age of the recipient, get recognized immediately. And so that's going to have -- those awards will happen in October. And so that's going to affect salaries in the fourth quarter. And then also marketing. Historically, we've been strong in marketing expense in the fourth quarter, and I expect that we'll see that as well. So yes, I agree with you. When I -- the numbers do look high, but if you look at our history and look at what -- where our projections are at, I think we're right in there. Would I love for it to be lower than that? Sure. But I think right now, based on what I'm seeing, that's really where we're at. And I think those 2 things, it's really that salaries category and the other expense category where I'm seeing most of the pressure.

Got it. Understood. Okay. And then just sort of a follow-up back to 2022 expenses. I appreciate the $0.19, totally makes sense. But what is the base? I mean, should we assume -- let's say, whatever the 3% growth happens in '21, and then we grow another 3% on top of that. And then we add $0.19? I'm just trying to make sure I know what we're talking about.

Well, obviously, we're not giving any sort of '22 guidance. We're still in that planning process. There's a lot of work going on there. I will say that -- Phil alluded to a little bit about the inflation that we're seeing out there. We are starting to see -- continue to see wage inflation. I was looking at something from the Dallas Fed this morning, if I could put my hands on it. It was just interesting a couple of the comments that they were making about the Texas economy, and it said, "Lack of applicant still top hiring constraint, but paid demands are an increasing concern." And then there was another bullet point that said, "Average hourly wage is now rising faster in Texas than the U.S." So we are dealing with that environment, but we are in the planning stages, so don't hear me saying anything about what our guidance is for '22 expenses. But you're right. Yes, whatever base level you believe you'd start off with on 2022, I'm suggesting that the Houston expansion 2.0, if you will, plus our Dallas expansion is going to cost us something around $0.19 over our more normalized run rate, if you will.

We've reached the end of the question-and-answer session. At this time, I'd like to turn the call over to Phil Green for closing comments.

Okay. Well, thanks, everyone, for your continued interest and your great questions. And with that, we will be adjourned. Thank you.

This concludes today's conference. You may disconnect your lines at this time, and we thank you for your participation.