Greg Parker - Executive President and Director, Investor Relations Phillip Green - Chairman and CEO Jerry Salinas - Group Executive Vice President and CFO.

Brett Rabatin - Piper Jaffray David Rochester - Deutsche Bank Brady Gailey - KBW Ebrahim Poonawala - Bank of America Ben Lario - J.P. Morgan Jon Arfstrom - RBC Capital Markets.

Good morning and welcome to the Cullen/Frost Bank’s Fourth Quarter and Year-End 2016 Conference Call. I would now like to turn today’s call over to Mr. Greg Parker, Executive President and Director of Investor Relations. Mr. Parker, you may begin..

Thank you, Anny. 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 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..

Thank you, Greg. Good morning and thanks for joining us. Today, I will review fourth quarter and full year 2016 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 fourth quarter, Cullen/Frost earned $1.28 per diluted common share which is up from $0.90 in the same quarter last year and up from $1.24 reported in the third quarter of this year. For the full year of 2016, Cullen/Frost earned $4.70 per diluted common share which is up from $4.28 in 2015.

The fourth quarter represented strong finished to 2016 and it gives us some good momentum going into 2017. Our average loan balance during the fourth quarter was $11.7 billion, about 3.1% higher than the fourth quarter of 2015. However, without energy loans, they were up 8.2%.

Additionally, on a period-end basis, fourth quarter annualized loan growth was 13.6% versus the linked quarter as loans grew to just under $12 billion. This gives us some great momentum going into 2017.

Net charge-offs in the fourth quarter of 2016 stayed low at $5.7 million, up slightly from $5 million in the previous quarter, but down from $8.5 million in the fourth quarter of 2015. Energy related net charge-offs was zero in the fourth quarter. That compare to less than $1 million in the third quarter.

Our provision for loan losses was just under $9 million far lower than the provision $34 million in the fourth quarter of 2015. Non-performing assets totaled $102.6 million, virtually flat when compared with the third quarter. Our allowance for loan loss was 1.28% of period-end loans in the fourth quarter.

Annualized net charge-offs represented 19 basis points for the fourth quarter. Total problem loans defined as risk rate 10 and higher were down about 8% in the fourth quarter when compared to the third quarter.

Energy related problem loans decreased by about 19% to $453 million in the fourth quarter from $556 million in the third quarter as the sector continued to recover. Energy-related borrowers that are on non-accrual totaled $57.6 million at the end of the fourth quarter compared to $51.4 million at the end of the third quarter.

The specific loan-loss allocation for these energy credits total $3.5 million in the fourth quarter. Finally, outstanding energy loans at the end of the fourth quarter totaled $1.39 billion or 11.6% of total loans. That compares with peaked at over 16% in early 2015.

Now, I would like to mention several items about the fourth quarter and 2016 overall that it’s given us some momentum going into New Year. 2016 was the best year Frost has seen for new loan commitments with new loan commitments up by 7% compared to last year.

New non-energy C&I commitments grew by 14% for full year 2016 compared to 2015 and they represented 39% of total new commitments. New real estate commitments rose by 18% over 2015 and represented 41% of the new commitments. Consumer commitments rose by 12% over 2015 and represented 12% of the new commitments.

New relationships for 2016 Rose by 13% compared to 2015. Customer calls for 2016 increased 1% and prospect calls were up by 2%. In the fourth quarter of 2016, consumer loans grew by 7.7% compared with the fourth quarter of 2015. This is another area where we believe Frost can build the strong foundation for future growth.

With the strong product mix and exceptional asset quality Frost is position well in Texas. We're maintaining our credit disciplines which have served us well. And we're pleased to see good growth in our current weighted pipeline. The growth was split between C&I, commercial real estate and public finance.

One particular item I'd like to mention is that in the fourth quarter we completed the sale of $57.6 million in downtown San Antonio real estate including our office tower and other properties. This resulted in a net gain of $10.3 million that was reflected in other income.

However, this net gain is largely offset our write-downs from properties we intent is to dispose of this year as we continue our program of up grading, consolidating and expanding our financial centers across the state. The remainder of the gain was contributed to the Frost Charitable Foundation.

As mentioned these items essentially offset the large real estate gains. Overall, despite the headwinds in 2016 from low energy prices Frost continue to move forward. We continue to post solid and positive financial results. We increased our dividend for the 23rd consecutive year. We grew our loan portfolio at all levels.

And most important, we continued enhancing the customer experience through personal contact and through the latest technologies. No matter how our customers choose to be served, Frost keeps winning awards for helping to make peoples’ lives better.

We're company that's going to turn 150 years old next year and we have never been more optimistic about the future than we are today. And that can only happen in an organization with a strong culture and with people who are dedicated to keeping the culture vibrant.

So, in closing, I'd like to thank everyone at Frost for all their hard work and dedication through this past year. They worked with our customers to nurture the long-term relationships and have been parked at Frost customer experience. And they are the force that keeps Frost going as we embark upon our next 150 years of service.

Now, I will turn the call over to our Chief Financial Officer, Jerry Salinas for some additional details..

Thank you, Phil. I am going to make some comments about the economy then I will give some additional information about our financial performance before giving 2017 guidance. I will then turn the call back over to Phil for questions. The diverse and resilient Texas economy expanded 1.6% in 2016 and the Dallas Fed expects even stronger growth in 2017.

Despite lingering low oil prices in the first half of 2016, the Texas economy grew faster than the national average and all other energy states. The service sector and the I-35 corridor remain strong throughout the downturn. According to the Texas Workforce Commission, Texas added 210,000 jobs last year. The unemployment rate in December was 4.6%.

Texas employers continue to express concerns about finding skilled and qualified workers to meet the ongoing labor demand. This is particular concern in major cities along the I-35 corridor where unemployment rates are even lower. The Dallas Fed expect the Texas economy to grow about 1.9% in 2017 with resurgent optimism in the energy sector.

Looking at the individual market. Dallas Fort Worth led the state in job growth in 2016. DFW employment grew 3.2% for the year. Growth was broad-based across sectors. The Metroplex construction boom continues, with major corporate relocations from other state and population influx. Home prices in DFW increase more than 10% last year.

The unemployment rate in the Metroplex declined to 3.7%. San Antonio employment grew 1.8% in 2016, the second fastest among large Texas metro areas. Aside from a notable decline in construction, San Antonio jobs have been steady or increasing in all major industries.

San Antonio's unemployment rate fell to 3.7% despite a recent surge in its labor force. Austin employment growth slowed to 1.5% in 2016, even so its unemployment rate declined to 3.2%, that's the lowest of any major city in the state. Despite the strong dollar the value of exports from Austin increased 15.2% in 2016.

In Houston, total employment is growing modestly. Higher oil prices and rig counts indicate an increasingly positive outlook, but energy jobs have yet to follow. While many sectors improved in the second half of 2016, the construction and manufacturing sectors continue to lose jobs. For the year, Houston employment grew 0.2%.

Unemployment stands at 4.9%. For Texas overall, the Dallas Fed expects 1.9% growth and 233,000 new jobs in 2017. Looking at our financial performance. Our net interest margin for the fourth quarter was 3.55%, up two basis points from the 3.53% reported last quarter.

We had some positive and some negative affecting the net interest margin percentage this quarter as compared to the third quarter.

On the positive side, we had higher yields and volumes in investments and loans, partially offsetting these positives with the negative effect of keeping a higher proportion of balances at the Fed as compared to the third quarter. The taxable equivalent loan yield for the quarter was 4.04%, up two basis points from the third quarter.

Average loans for the fourth quarter were $11.73 billion, up $269 million or 9.4% on an annualized basis from the $11.46 billion last quarter.

The taxable equivalent yield on the investment portfolio was also 4.04%, up seven basis points from 3.97% for the previous quarter and was impacted by a higher proportion of the portfolio being in higher yielding municipal securities compared to the third quarter.

The duration of the investment portfolio at the end of the fourth quarter was 4.8 years, the same as the previous quarter. Total investment portfolio average $12.51 billion during the fourth quarter, up about $132 million from the third quarter average of $12.38 billion.

Our municipal portfolio at the end of the fourth quarter was up $171 million from September to $7.35 billion. During the fourth quarter we purchased approximately 559 million in municipal securities, yielding 4.70% with an average life of 17 years. At the end of the fourth quarter, about 70% of the municipal portfolio was pre-refunded or PSF insured.

Regarding income taxes, as I mentioned in last quarter during the third quarter we chose to early adopt an accounting standard which became effective in 2017 related to the recognition of income tax effect associated with the settlement of share-based payments, like when a stock option gets exercise.

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 exercise of stock options during the fourth quarter had a favorable impact on income tax expense for the quarter of approximately $3.5 million.

Our effective tax rate for the fourth quarter was 9.24%. Without the tax benefit from the stock option exercises, our effective tax rate for the quarter would've been 13.0%. Our capital levels remain strong with our common equity Tier 1 ratio at 12.52% at the end of December.

Regarding full year 2017 earnings, we currently believe that the current full year means of analyst estimates of $5.01 is reasonable. I will now turn the call back over to Phil for questions..

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

[Operator Instructions] Your first question today comes from the line of Brett Rabatin of Piper Jaffray. Your line is open. .

Hi, guys. Good morning. .

Good morning. .

Good morning. .

Wanted to, first, is asked about the loan pipeline and thinking about this year, obviously a lot better growth in the fourth quarter and I assume that was may be partially a function of lower payoffs.

But could you maybe give a little more color on the growth in the quarter? And then just thinking about 2017, are you hopefully to get closer to double-digit, or how do you think about the year look at it today?.

Well, I would it’s mainly activity as oppose to any really significantly changing in payoffs and then we still payoffs. The most interesting thing to me is just the level of activity has improved.

As I have gone around the state, visiting all our locations during the month of December, one thing it was a consistent message was how many customers particular I would say mid and small customers are moving forward with plans that they had, had delayed, right? Somebody had a piece of equipment they want to put in and they can wait for six months, after they got the clarity from the political situation, the word was let's move forward, let's move forward now.

So I think you are definitely seeing just general optimism in the market moving forward. I think our people are doing a great job being responsive to those opportunities.

We're trying to do a better job of getting decision-making authority closer to the customer and working closely with our concurrence and credit people and in doing that in a faster way I think we're giving a better customer experience. So, just things like that..

Would -- does your crystal ball tell you that maybe you can grow double-digit in the loan portfolio this year?.

I don’t think we are projecting a number. I think we are seeing momentum increase. I would expect loan growth to be better than 2016 for sure. .

Okay. And then quite a few things to ask, but I guess the other thing I really wanted to touch on was the expense base and thinking about obviously noise in 4Q.

But is $183 million, $184 million kind of a good run rate to base things off of starting for this quarter?.

Yeah, I think other than the items that Phil mentioned I think it's a good run rate to go forward with..

Okay. .

Excluding $10 million..

Yeah, excluding the $10 million, I think he said that..

Okay. Great. Thanks for the color..

Your next question comes from the line of Dave Rochester of Deutsche Bank. Your line is open. .

Hey, good morning guys. .

Good morning. .

Good morning. .

I think you guys had mentioned previously in calls last year that you were going to revert to a more normalized level of muni purchases. It looked like that level is a little bit elevated this quarter around 550, I think, was the number you said.

Is this sort of the level we should expect going forward or should we see these taper?.

No, you should see them taper. Part of what we were doing is we expect to have some municipal calls during 2017, and we really were doing some purchases in anticipation of that. And so going forward I wouldn’t expect that we see that sort of level going forward..

Okay. Great. And just outside of liquidity changes, how are you guys thinking about the NIM trend heading into at least the first quarter? I would imagine you have got the full quarter impact of the LIBOR increase flowing through. That should support. And then you have got the full quarter impact of these muni purchases.

I was just wondering if you could kind of frame it for us..

Sure. I guess I would say a couple of things as we look at the NIM for 2017, first of all, let me just say that we are projecting just one rate increase and we are projecting that in November of this year. In addition, we are projecting that we're going to have increases in deposit rates during the year.

Now we didn't see any in all of 2016, but we are projecting deposit increases in 2017 related with the Fed increase that we just saw in December. And then as I mentioned we are projecting to have about $670 million in muni cash flow during the year and as I mentioned some of that we purchased early in the fourth quarter.

But some of the yields that are dropping off are probably north of 6.5% on a TE basis, and so we will be replacing those with TE yields around 4.5%. So we do have a few -- a bit of headwind going forward.

So as I looked at 2017 NIM compared to the fourth quarter, I am thinking it going to be relatively flat given those two headwinds of our assumptions on deposit rates and then our -- the impact of the munis that are being called..

That's great color. I appreciate that.

Have you actually seen any evidence -- I know you didn't see any last year in terms of deposits re-pricing upward? Have you seen any of that in January so far?.

We have not -- we heard some conversations going on, but we've not seen any..

Okay. Great. And then just one last one on the tax rate. I was just wondering how you are thinking about that in 2017 now with the accounting change, and you have got potentially some more options exercise coming..

Right. I think the fourth quarter was pretty heavy there on option exercises. That 13%, you know, that excluded that, if you look at what I said about earnings going forward we are obviously projecting earnings growth. So the way I would look at it is I tend to take that 13% kind of as a run rate going forward.

It’s going to be affected obviously by option exercises, but that's the run rate I would assume..

Okay. Great.

And just one last one quickly on the runoff in the muni portfolio, what's the timing of that during the year?.

It’s about two-thirds in the first quarter and the remaining third in early third quarter. .

Okay. Great. Thanks, guys. Appreciate it..

Sure..

Your next question comes from the line of Brad Gailey of KBW. Your line is open..

Hey, good morning, guys. It's Brady..

Hey, Brady. .

When you think about the tax rate, a lot of people are talking about what might happen with the reduction in corporate tax rates. I know you guys wouldn't be as big of a beneficiary just because of the size of your muni book.

But have you all looked at the sensitivity to what your earnings could do with a lower tax rate?.

I guess, what I'll answer back to you Brady is that we did look at it and certainly when you are looking at an effective tax rate of 13% compared to peers at 35%, if rates went down, you know, to 15%, if you will, we still have -- our effective tax rate doesn’t have whole lot of room to go down.

It would go, we would be talking probably in the 5% or 6% range, so we still see a benefit. But, obviously, we have used up some of that benefit, if you will, through the years with this -- with the large muni portfolio and lower effective tax rate that we have had. .

Okay. All right. And then looking at loan balances, how much loans were purchased SNCs in the fourth quarter? I think last quarter it was around $796 million.

Did that number change much in 4Q?.

No. It’s -- at the period-end, I think the SNCs were $772 million, that's down from $796 million last quarter. .

Okay. And then lastly as we start to think about higher deposit costs with higher rates, you guys have a very nice inexpensive funding base. So, I would expect your deposit beta to be less than some of your peers.

But how are you all thinking about deposit betas as we start to see rates head higher?.

Well, the way we look at the positives is, first, I guess, I would say we're not going to lose deposits to pricing. So we tend to price at the median of the big banks. And so we and our assumptions for 2017, you know, we're pretty conservative. We assume that we're not going to lose deposits.

We have seen the rates are going to go up, deposit rates are to go up. But we will be providing a fair market price when we compare ourselves to the big banks, is our pricing philosophy. .

All right. Great. Thanks, guys. .

Thanks, Brady. .

Your next question comes from the line of Ebrahim Poonawala of Bank of America. Your line is open. .

Good morning, guys. My question was actually just asked and answered. But I had one follow-up question regarding what you mentioned on the tax rate, the fact that it could go to 5% to 6%. I am assuming that assumes that you expect under that scenario that the muni tax credit holds.

In the event where the elimination or the tax benefit of the muni securities were to go away, could we have a scenario where you don't really pick up any benefit from a deduction in the statutory federal tax rate, or you would still benefit?.

I think we would still benefit and really when we talk about the yields that we're earning and looking at our investment philosophy, the munis are still even on non-TE basis are really still better than anything else we could invest in. So I don’t see us changing philosophically too much right now based on what we know..

Understood.

And just one other question in terms of -- would you say if rates stay where they are today, the move in the rates and the impact on the AOCI was fully captured at the end of the fourth quarter, or could we see more incremental impact which might have flown through into 1Q on your DC?.

I would assume -- again, we will make additional purchases, but we will have some, -- you know, so we have made some additional purchases, well, in the fourth quarter we will make some of the first. So there could be some additional movement, but I don't expect a whole lot more from where we are at..

Got it.

And is there a targeted sort of capital ratio that you look at? Is DC about 7% something that you would like to maintain on an ongoing basis, or are you looking more at the regulatory ratios?.

We look primarily at the regulatory ratios and we want to make sure they are strong and we think we have got great growth prospects, and so we're trying to keep some dry power here. .

Understood. .

We do have a buyback in place today that -- it’s not fully utilized. So, that tool as well if we needed it. .

Understand. Thanks for taking my questions. .

Sure. .

Thanks. .

[Operator Instructions] Your next question comes from the line of Steven Alexopoulos of J.P. Morgan. Your line is open. .

Hey, everyone. This is actually Ben Lario on for Steve. Most of my questions have been asked and answered. But I guess just turning back to expenses, so even if we took out the $5.9 million write-down and $4.4 million contribution, it still seems like that other line was elevated.

Is there anything else in there that's maybe one-time or just unusual that drove that higher? Thanks. .

Yeah, from a -- if you are looking at the comparison sake to a year ago fourth quarter, I think that's what you're talking about.

We did have -- I guess the only thing I would say that our Visa check card expenses were higher by about 900,000 and most of that was associated with our EMV card issuance, so that would be a one-time expense that was included in the fourth quarter. Other than that I don't see anything really too different than a normal run..

Okay. Got it. And then I guess can you just update us on where the reserve on energy loans stands? I think it was $62 million or something last quarter..

It’s $60.653 million, so $60.653 million. That's 4.38% number. .

Okay. Great. That's all for me. Thanks..

Your next question comes from the line of Jon Arfstrom of RBC Capital Markets. Your line is open. .

Thanks. Good morning, guys..

Hey, Jon..

Hey, Jon. .

Not much to pick on here, but maybe a couple of things to ask about that haven't been covered. Phil, you talked about customer calls and prospect calls, and I think you said they were up 1% and 2%..

Right. .

And that's lower than it's historically been and I remember times when you guys were growing those numbers in the teens and not seen the loan growth. And now you are seeing the loan growth and that number seems to be down a little bit. Maybe help us understand what's happening there..

Yeah, I don’t think any particular program it's just -- I think it’s just timing in the numbers. We're still very active. And the thing I really like about that I think we're really being effective with the calls that we're undertaking and you can see that through the numbers we have shown..

Yeah, yeah, clearly showing up. Okay. And then one of the other comments, Jerry, I think you made it when you were talking about some of the unemployment rates, but you talked about the lack of skilled and qualified workers is an issue for some of your customers.

How probably one is that and how often do you hear that from your borrowers?.

Yeah, I mean, I think that the conversations that we're hearing. Yeah, it’s a challenge. I think it’s a challenge along that I-35 corridor in Dallas and in Austin and yeah, it’s something that that all the cities are dealing with. .

Okay. And I guess the last question I have is on Houston. Do you guys feel like the Houston economy has really bottomed and we are just kind of flat lining here? Do you feel like we will see some growth in Houston, maybe give us a little more detail on that..

Yeah, I think we feel pretty good about Houston. Houston grew jobs, as Jerry mentioned, in 2016 which I think a lot of people were surprised that. Their parts of the market that our soft, construction soft. You need to be careful of multifamily there. We're not really doing any multifamily in Houston. We're doing in some other markets.

And I think the attitude is pretty good. We talk to our people there, we ask him what beatitude is, what people are feeling, I think it's been very consistent. I think we will still see some more employment shake out from the integrated firms and energy firms, but the rate on that has slowed.

And so we feel good about it and we are seeing some good momentum in Houston over the last quarter when you look at the loan growth and deposit growth. So, I don't really see Houston is being different in terms of what is able to do and produce compare to our other markets right now. .

Okay. Good. Thanks for the help..

Your next question comes from the line of Scott Buck [ph] of Macquarie. Your line is open. .

Yeah, it's Scott on for John Moran. Just real quick, circling back on credit, the energy reserve at north of 4% and then the overall reserve is still looking pretty healthy. You guys are running kind of 20 basis points on charge-offs.

Could you give us some help in terms of how to think about provision into 2017?.

It’s going to continue to be formula based. And there will be two factors that I -- that I hope will continue to see. One is we are going to continue to see upgrades. We had some really nice upgrades during the first -- I mean, during this last quarter about $100 million worth of improvement in what we call problem loans risk grade 10 and in higher.

And what we are seeing is credits that are moving to move that might have been say risk grade 10 primarily and a lot of this are production loans they got caught up in the new OCC standard, the EBITDA standard on debt to EBITDA you recall, and you got to correct that by improving your 12-month trailing cash flow sufficient so that you can that ratio down below the 3.5 times cut line, and we're beginning to see that as we move through these quarters.

So, we are seeing some improvement there. That will help the reserve. Remember, we do have a few credits that are still moving through the SNC as someone mentioned last time and we will just continue to work through those. Their impact on reserves and what they require, we will just see what that is. It is nothing I am worried about.

And then in terms of -- it’s a high-class problem. But if you have good loan growth we will want to make sure that we are keeping up with them with regard to reserve and our formulas are going to require us to do that.

So I certainly don't expect the provisions in 2017 that we had in 2016 and would see how those factors -- the ones that use up reserve and ones that get back are going to be impacting us. .

And I would now like to turn the call back over to Mr. Phil Green for closing remarks..

Okay. Great. We appreciate everyone’s interest in the call today and with that we will be adjourned. .

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