Greg Parker - IR Phil Green - Chairman & CEO Jerry Salinas - EVP & CFO.

Scott Murphy - JPMorgan Brady Gailey - KBW Brett Rabatin - Piper Jaffray Brenden Stoner - Stoner Equities John Moran - Macquarie.

Good morning. My name is Kellie and I will be facilitating the audio portion of today's interactive broadcast. At this time, I would like to welcome everyone to the Cullen/Frost Bank’s Third Quarter Earnings Conference Call. All lines have been placed on mute to prevent any background noise.

After the speaker's remarks there will be a question-and-answer session. [Operator Instructions] Thank you. I would now like to turn today’s call over to Mr. Greg Parker, Executive Vice President and Director of Investor Relations. Mr. Parker, you may begin..

Thank you, Kellie. 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 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 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 at our website or by calling the Investor Relations department at 210-220-5632. At this time, I will turn the call over to Phil..

Thanks Greg. Good morning and thanks for joining us. Today, I will review third quarter 2016 results for Cullen/Frost. 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 $1.24 per diluted common share from a $1.17 in the same quarter last year and was from $1.11 reported in the second quarter of this year. Overall our third quarter results showed general improvements compared with the previous quarter and with the third quarter of 2015.

Credit quality was stable and continued to show signs of improvement over the first half of this year. Net charge-offs in the third quarter of 2016 fell to $5 million, which was down from $21.4 million in the previous quarter. Energy-related charge-offs in the third quarter totaled less than $1 million.

Our provision for loan losses was $5 million and that was the lowest level since second quarter of 2015. Nonperforming assets totaled $101 million, an increase from $89.5 million in the second quarter and this was mostly due to credit and a shared national credit exam that had been classified as a potential problem loan for about a year.

I'll talk about growth in more detail a little later, but I wanted to point out that this has been the best year ever for new loan opportunities with our total in the third quarter up 10% compared with this time last year, but first, let me offer some details in the third quarter credit quality.

Regarding the nonperforming assets I mentioned earlier, one energy-related credit accounted for the majority of the increase from the second quarter to the third.

Total remained at about half the total reported at the end of the first quarter and at their current level nonperforming assets represent only 34 basis points of total assets and only a seven basis points of total loans. Despite continued regulatory sensitivity, conditions are moving in the right direction as commodity prices have stabilized.

Loans placed on nonaccrual during the third quarter totaled $24.1 million compared to $16.5 million in the second quarter. That increase also largely is related to one energy sector borrower that I mentioned earlier. Annualized charge-offs represent 33 basis points year-to-date and 17 basis points for the third quarter.

Earlier this year, we said net charge-offs for 2016 can reach 50 basis points of total loans and currently we believe third quarter levels to be more representative of what we'll see in the near term.

On problem loans defined as risk rate higher -- risk rate 10 and higher non-energy related were $461 million for the third quarter, representing only 4.5% of total non-energy loans.

We've seen only a very modest contagion from the energy sector and given the recent rebound in energy prices as well as Texas' economic advantages, we continue to believe that significant contagion is unlikely. As I mentioned, despite some lingering effects, rebounding energy prices are removing headwinds.

There's some additional detail about our energy portfolio. Outstanding energy loans at the end of the third quarter totaled $1.38 billion or 12% of total loans. That compares with peaked at over 16% in early 2015 and at yearend the energy portfolio has decreased by nearly $400 million or almost from 2%.

No material change from prior quarters has occurred in the proportions of energy segments. Energy-related problem loans decreased by $156 million in the third quarter from $566 million in the second quarter. Production-based borrowers made up about 75% of the third quarter total and service manufacturing made up the remainder.

Energy-related borrowers that are on nonaccrual, totaled $51.4 million at the end of the third quarter, now as compared to $42.8 million at the end of the second quarter. The specific loan-loss allocation for these credits total $2.5 million for the third quarter, which is flat compared to the second.

Now I would like to turn briefly to growth in the third quarter; our total loan commitments have grown at an annualized rate of about 3%. Compared with the third quarter of 2015, total average non-energy loans grew by 5.6%. 71% of the growth in non-energy loans was commercial real estate, 11% was in C&I and the remaining 18% was in consumer and other.

Regarding commercial real estate, the vast majority of the new extension in credit has been the strong existing customers. A significant portion of this is financing for retail centers in Houston. Our retail development is lagging behind population growth for some time now.

We also are working with customers on projects supporting major corporate relocations in the North DFW sector.

Run off rates in the energy sector continue to offset some of the gains but our non-energy C&I commitments have grown at an annualized rate of 5% and our CRE commitments and consumer lines of credit have both grown at an annualized rate of about 13%. Year-to-date new relationships are up by 9% compared with this time last also.

Also year-to-date customer calls were up by 9% and prospect calls are up by 13%. We booked 13% more new non-energy C&I commitments year-to-date than last year's. This total represents 41% of the total new commitments. At yearend,, we've increased our personal lines of credit and home equity lines by $163 million or annualized rate of 13%.

The balances under those lines have increased at an annualized rate of 11%. Consumer loan growth is supported by expanded penetration in the Texas home equity market, which is underdeveloped compared to the rest of the country. With a strong product base and acceptable asset quality, Frost is positioned well in Texas.

We're maintaining our credit disciplines and that served us well. We're also pleased to see good growth in our current weighted pipeline and that growth exclude the C&I commercial real estate and public finance.

You've heard us say many times that through our 148-year history, Frost has grown and expanded through good times and bad and has endured wars, depressions, recessions and financial crises.

It's worth noting, that despite the headwinds from recent low energy prices, Frost has posted solid earnings, increased its dividend and kept earning accolades for its customer experience. During the third quarter, Frost opened five new financial centers in growing attractive markets.

None of that could be achieved without a strong team and a strong corporate culture. So in, closing I would like to thank our people for all their hard work and dedication through the headwinds in the previous quarter.

They are the ones interacting with our customers on a daily basis and nurturing a long-term relationship that have been part of the Frost customer experience and which gives us such optimism as we move through the end of 2016 and into the new year. Now I'll turn the call over to our Chief Financial Officer, Jerry Salinas for some additional details..

Thank you, Phil. I'm going to make some comments about the economy; then I'll give some additional color on our financial performance, before giving an update on 2016 guidance. I'll then turn the call back over to Phil for questions. The Texas economy continues to improve and expand, a testament to its diversity and resiliency.

The Dallas fed reports of Texas employment grew 2.1% in September and is expected to expand at a similar pace in the fourth quarter. The Dallas fed now projects 1.2% employment growth for the entire year in Texas with more than 142,000 new jobs. That's a significant improvement from the first quarter when Texas jobs declined 1.3%.

In September alone, Texas gained more than 38,000 jobs, which was the biggest monthly jump in almost two years. According to the US Bureau of Labor Statistics, Texas led the nation in September job growth. Stabilization in the energy sector and continued strength in the service sectors suggest ongoing moderate growth in Texas in the months ahead.

The state unemployment rate is 4.8% compared to the 5% national average. Looking at individual markets, Dallas has the highest job growth in Texas this year.

In recent months, jobs in the Metroplex increased at a 4.1% annual rate, growth is broad-based across sectors, employment is particularly strong in construction due in part to the new corporate relocations in the Metroplex. The unemployment rate in Dallas Fort Worth is 4.1%.

Annualized job growth in Austin is 3%, which is a bit slower than earlier this year. The unemployment rate is the lowest in the state at 3.5%. Construction in Austin grew 16.5% in August, while tech-related industry expanded double-digit -- at double-digit rates.

San Antonio employment slowed a bit during the past three months with declines in manufacturing, retail jobs and a sharp drop in outpatient healthcare services. Construction however remained strong. San Antonio unemployment rate ticked up to 4% due largely to a recent surge in the labor force.

Houston's economic outlook is showing improvement with several months of employment growth and stabilization in the energy sector. That said, there's still some caution about the potential for more layoffs. Jobs in Houston grew at an annualized 1.9% over the past three months with notable gains in leisure, hospitality and transportation and utilities.

Thanks to recent gains, overall employment in Houston is nearly level for the year. Houston's unemployment rate increased to 5.1% due to an increase in the labor force. For Texas overall, the Dallas fed once again expects 2.1% growth in the fourth quarter of this year.

Looking at our financial performance, our net interest margin for the quarter was 3.53%, down four basis points from the 3.57% reported last quarter. The decrease in the net interest margin was impacted by a proportionately higher level of balances at the fed, earning only 50 basis points, compared to the previous quarter.

The taxable equivalent loan yield for the quarter was 4.02% up two basis points from the second quarter.

The taxable equivalent yield on the investment portfolio was 3.97%, down three basis points from 4% for the previous quarter and was impacted by a lower taxable equivalent yield on our municipal portfolio, which was down 11 basis points from the previous quarter to 5.53%.

The duration of the investment portfolio at the end of the third quarter was 4.8 years, the same as last quarter. Total investment portfolio averaged $12.38 billion during the third quarter up about $582 million from the second quarter average of $11.79 billion.

Our municipal portfolio at the end of the third quarter was $7.2 billion up $120 million from the $7.1 billion at the end of June. At the end of the third quarter, about 68% of the municipal portfolio was pre-refunded or PSF insured.

Regarding income taxes, during the third quarter, we chose to early adopt an accounting standard which becomes effective next year related to the recognition of income tax effects associated with the settlements of share-based payment like when a stock option gets exercised.

Previously those tax-related effects were recorded as increases or decreases in paid-in capital under the new standard the tax effective settlement go through income tax expense. The early adoption of that statement had a favorable impact on income tax expense for the quarter of $1.5 million.

Without that discrete tax item, our effective tax rate for the quarter would have been 13.6%. Our capital levels remained strong with our common equity Tier 1 ratio at 12.4% at the end of September.

Regarding full-year 2016 earnings, we currently believe given year-to-date reported earnings through the third of $3.42 that the current full-year mean of analyst estimate of $4.50 is low. Estimates are little higher than the current mean of $4.50 would be more reasonable. I'll now turn the call back over to Phil for questions..

Thank you, Jerry. Now we'll open up the call for questions..

[Operator Instructions] Your first question comes from the line of Steve Alexopoulos of JPMorgan. Your line is open..

Hi. This is Scott Murphy on for Steve Alexopoulos.

Could you give a little more color around where you expect the runoff from the energy portfolio to stabilize? Is there any idea of where that portfolio might be headed?.

The portfolio actually I don't believe will decline a lot more deals and it's going to depend on specific deals and what happens with specific customers, but we're seeing good opportunity today. The thing is we're just being really selective.

Deals that are coming in are mainly higher equity deals, some acquisition loans and so there is lots of opportunity and we could growth it as much as we want it, but we're just being careful.

We talked before we want to prune the hedge in the downtime and make sure that the customers that you're adding are the cream of the front off and cut off the stuff on the bottom that doesn’t make sense for you to be in.

So I don't think we'll have a lot of drop in the energy portfolio unless we get some one-off customer that lose a deal or cashes out..

Great. Thank you. That's helpful.

And then can you give a little more color regarding that larger energy credit that moved into nonperforming this quarter?.

Yeah it's a deal that is a offshore deal, it's cash deal, it's a shallow offshore and since it's natural gas cut, it's got more leverage then it needs and it needs a higher gas prices that really be effective in its business model.

So it's that kind of thing, but it's been, like I said it's been a potential problem loan for us and one that's not a new credit for us. We've been watching and working with them for let's say a year to year and half and so it will work its way up. We're not dependent upon the environment but not to worry about..

Great. Well great. Thank you very much..

And your next question comes from the line of Brady Gailey of KBW. Your line is open..

Hey, good morning, guys..

Good morning..

So it looks like -- your loan growth was kind of flat linked quarter. And now we know why. The energy book was down a decent amount.

Was there anything else going on besides energy paydowns that impacted the flat loan growth into 3Q?.

I think payoffs in general have been higher and we've been experience that all year along. And you are just seeing people finance deals long term. You are seeing people sell businesses. I think our amortization and payoffs have been about double that we expect doing every year. So I think that's the main thing..

And do you see that changing as we move into 2017?.

I hope so.

It's hard to call and I think one thing that happens when rates were this low is you get multiples really high on a business and with price for those things generally and they go and hit the big and for you to get liquidity in that regard to see people financial deals out and like maybe selling real estate deals because of low cap rates and I think we get a little bit of increase in rates.

You might see a little bit of a slowdown in that. So I think it's hard to tell if it will be the same levels this year, but I hope it will be and I hope it will be better..

And then the energy loan loss reserve, I think last quarter it was a little over $66 million, did that change much in 3Q?.

Could you repeat your question Brady?.

Yes, the energy loan-loss reserve, last quarter it was a little over $66 million and I was just wondering if that changed much in the third quarter?.

Brady that's down to $62 million at the end of….

$62 million. Okay..

That's a reserve of about 4.5%..

Okay. And then you mentioned the one-time impact on the tax rate that you adjust for that, it's 13.6%.

Is that a pretty good forward run rate for taxes?.

Brady, what I would do is that tax effect on year-to-date for the quarter was $1.5 million. On a year-to-date basis it was $1.6 million. So if you pull out that discrete item out of the year-to-date tax rate, you would come back to about 12% and that's probably more reasonable for the fourth quarter. That's what I would go..

Okay. Great. Thank you, guys..

Thanks Brady..

Your next question comes from the line of Brett Rabatin of Piper Jaffray. Your line is open..

Hey. Good morning, guys..

Good morning..

I joined a few minutes late, but just was hoping for some color on the margin outlook from here.

And what you guys are doing in the securities portfolio -- I mean, what you did during 3Q as well?.

What I said last quarter on the net interest margin that we were looking at flat to down a little bit. We were actually down four basis points this quarter. What I said during my comments was that a lot of it was related to higher balances at the fed are proportionately. So what I guess I said for the fourth quarter is really kind of consistent.

We're still looking at that flat to down. A lot of it will depend on what happens with deposit balances and what we do at the fed, people or balances at the fed. So that's what I would if I were modeling something..

And as far as what we did during the quarter, we actually had purchases in quarter of $324 million of the investment portfolio and with all in municipal security they had a TE yield an average TE yield of 453 and about a 19-year average life with 10-year call..

Okay, that's helpful. And then just thinking about the outlook as we go into 2017, obviously energy prices are better. And I know there's probably everyone's got one or two credits that they have to deal with that may not be currently sort of through the snake yet.

But as we think about 2017, can you guys give any color on how you think about provisioning? The reserve obviously has come down a little bit on the energy book.

Can you give us any color on that?.

Actually the portfolio and particular regarding energy is stable and improving and you're exactly right. There are some credits that are still moving through the snake. I like the term that you used.

We just have to see how those and not to worry about that situation, but we got a lot more credits for the momentum to improve and our reserves always been most sensitive to classified levels and we've got some credits that many more credits if you look at the energy portfolio are directionally improving and others that are moving through the snake.

So I think that the trend there is for improvement once you began to see any improvements in the cycle, they will come fast but they tend to gain momentum over time and I think that what we're seeing and another thing to keep in mind is the improvement that we're seeing in the energy portfolio.

You can tend to think as well as price movements, prices are growing up and so that's great, but what happens if they move -- as prices move around, but most of the improvement recently I think has been because of deleveraging as opposed to just price movement and that deleveraging is hard work and as I said last time, you see these properties sell, you see these transaction happen and Tennessee's I think okay well prices are up and so now we can do deals.

But these are things that are being worked on a long time and same holds to our customer and so when the opportunity happens in the markets, you're able to take advantage of it and so I am really proud of the work our people have done and I would like given what's happening with acreage sales and prices you're seeing there, you see improvement and opportunities for people to deleverage going forward.

So I expect that the outlook provision, particularly compared to this year is better as we see it today..

Okay. Great, appreciate all the color..

[Operator Instructions] Your next question comes from the line of Brenden Stoner from Stoner Equities. Your line is open..

Hey, good morning guys. .

Good morning..

So I just wanted to ask couple question here. I don’t know I was a little bit late. So I apologize if the question was already asked, but could just talk about how do you guys think about the low interest rate environment? I know the loan growth was a little tepid and I applaud you guys for not -- to lock up capital at such low rate.

So could you just discuss a little bit about how you think about allocating capital moving forward into the next few years and for you guys the rates going?.

Okay.

First of all, as it relates to low rates, I think that the thing to keep in mind about our company is we continue to be largely asset sensitive and so we’re, we want to maintain that position and we’re going to have to make some investments in securities as we move along just because we don’t expect to have a loan demand to deal with all the funds we are producing, but we will have to produce some investment.

But while we do those, we’ll continue to maintain ourselves in a position that that's going to take advantage of higher rates and ultimately that’s what's going to happen in the short term but not a lot, but some. It does have to happen -- does have to be a lot of rate increase to be really beneficial to us.

I would say that’s our view and the other thing I would say is when you look at our company's balance sheet, we got may be one of the lowest cost of funds in the country, because we're not paying fair rates because we are in the right in the median rates, but it's because we have a relational deposit base and this kind of deposit base cost to us and so we know that we got the opportunity to compete on price as it relates to the asset pricing on loans bonds and the interest of growing long-term relationship and so, we’ll be allocating capita that way..

I appreciate the comment. One more question for you guys, definitely you realize that you have a nice balance in your deposit base there, could you touch on a little bit at the energy loans, I apologize I got on call late and was already discussed, I know last annual report mentioned most of those energy loans ensuring within the 12 months or so.

Is that still the case and do you have any figures on most of the maturities for those finances as they roll off prepaid what not?.

We actually don’t that hand but just think of it like a traditional commercial portfolio. They’re evolving facilities.

They did different things and their structuring price different ways then what it but just like a commercial portfolio would be, I don’t think there is anything in my view that’s dramatically different about that portfolio, but you should influence you one way or the other.

Really the main thing they are as relationship and we work with those customers to take care of their needs, to inform them what’s going on in the business going forward and may be a short term deal and maybe longer term deal. It depend on just what they're doing. So that’s not on my radar right now..

Okay. I appreciate that and congratulations on the quarter and thank you for your hard work..

Thank you..

Your next question comes from the line of John Moran of Macquarie. Your line is open. .

Hey, how is it going?.

Good..

I've got a couple of housekeeping questions around the securities book and then one just circling back on credit. And I guess I'll hit credit first. The one on the SNC, I think, Phil, you said it was leverage-driven.

Was that sort of the EBITDA look back that's kind of the new bright-line test in the OCC guidelines? Is that what drove that?.

The increases in classified is related to SNC exam or definitely related to that..

Okay..

I don’t remember any of them having of those new classifications having a reserve deficiency.

In fact most of the payoff will be on the economic half life and those were -- that’s why we use underwrite energy loans for generations, but what’s happened is the regulators are using a bright line test and if it’s a 3.5 times EBITDA, cash flow versus cash flow, you’re going to get a special mentioned credit.

And if its four or more, you’re going to get a substandard credit and don't taken into account the life of the half of the property, it will include all debt even unsecured debt positions the first lien position and its very different than the industry has been underwritten for years and years and its reduced liquidity in the industry, but that’s where the regulators are looking at it and so you got to play by their rules and so that’s what drove the increase as it relates to SNC exam..

Understood and then…..

That wasn’t just in the non-performer increase. It was -- that was -- the increase was related to classifications as well..

Got you, got you. And you said that the credit, the one larger one that slipped was gassy, right? And gas has obviously had a nice recovery and I think some folks are sort of thinking that that's sustainable. So I guess that the follow-up question would be, if that's the case and the EBITDA improves kind of quickly, that could come back in..

Well, the problem is that they're using the cash or the EBITDA from trailing 12 months and so they’re not looking forward right and so you don’t get -- so they're using periods and a lot for June 30 and so you’re using that period first part of this year which is horrible and then the first and last half of last year, which was not good either and so, what producing you can use with your current prices and current projections of prices and so you won’t really see that work its way really until you get some calendar behind you know what I am saying..

Understood, yes. So it could take a whole year. Okay, okay, got you. That's really helpful. And then the housekeeping item is just around the securities book. Yields -- I think you guys said were down 3 basis points linked quarter.

Do you have handy if prem am ticked up and caused some of that? And then the muni yields were down 11 basis points, if I got you right. Just a little bit more color on that..

Yes, so the purchase that we made in the fourth quarter on the muni book we're at I said an average TE yield the 453 and that for most of the year-to-date if you look at the purchases that yield is about 455. So obviously if we our current yield is 553 that current year purchases that we had, had an impact on that, on the CE yield..

Okay, got you.

And then prem am?.

Say that one more time, I am sorry..

I'm sorry. The premium amortization.

If any of you have that number handy, what it was 3Q versus 3Q?.

You’re looking for premium amortization on the muni portfolio..

On the whole book..

Whole book, give me a second. It should be $13.1 million..

Okay. $13.1 million this quarter.

And was that up or reasonably flat from 2Q?.

That was let me see, it was third quarter, it was up from third quarter, second quarter I guess we were $1.5..

Okay. Perfect. Thanks very much. .

Sure..

And there are no further questions at this time. I pass the call back to Phil for closing remarks..

Well, thank you very much for your interest and support and this will conclude our call. Thank you..

And this concludes today’s conference call. You may now disconnect..