Greetings, ladies and gentlemen, and welcome to the Cullen/Frost Bankers Inc. Fourth Quarter Earnings Conference Call. At this time, all participants are on a listen-only mode. A brief question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Mr. A.B. Mendez, Senior Vice President and Director of Investor Relations. Thank you. Please go ahead.

Thanks, Donna. 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 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., and good afternoon, everybody. Thanks for joining us. Today, I'll review the fourth quarter results for Cullen/Frost and our Chief Financial Officer, Jerry Salinas, will provide additional comments before we open it up for your questions. Well, in the fourth quarter, Cullen/Frost earned $189.5 million or $2.91 a share compared with earnings of $99.4 million or $1.54 a share reported in the same quarter of last year. That represented an increase of 90%. You don't get to say that very often. Our return on average assets and average common equity in the fourth quarter were 1.44% and 27.16%, respectively, that compares with 0.81% and 9.26% for the same period last year. These are very strong results and along with our strategy of sustainable organic growth, they position us well heading into 2023. Now taking a closer look at the quarter, loan growth was solid and above our long-term expectation of high single-digit annual growth, average loans, excluding PPP in the fourth quarter were just over $17 billion compared with average loans of $15.4 billion in the fourth quarter of 2021, an increase of 10.6%. For the full year 2022 average total loans, excluding PPP were up 11.3%. Our growth in loan balances for the fourth quarter versus the third quarter represented approximately two-thirds C&I growth and one-third consumer. CRE balances were basically flat. We booked $2.2 billion in new commercial commitments in the fourth quarter and this is up by a non-annualized 9% from the third quarter and demonstrated our staff success from our calling and prospecting efforts earlier in the year. That said, I believe it's clear that the Fed's program of interest rate increases is having an impact on economic activity, especially in the commercial real estate sector as more borrowers evaluate the impact of the…

Thank you, Phil. Looking first at our net interest margin. Our net interest margin percentage for the fourth quarter was 3.31%, up 30 basis points from the 3.01% reported last quarter. Higher yields on both balances held at the Fed and loans had the largest positive impact on our net interest margin percentage. The increase was also positively impacted to a much lesser extent by a higher yield on investment securities and by higher volumes of both investment securities and loans. These positive impacts were partially offset by higher costs on deposits and both higher volumes and cost of repurchase agreements. Looking at our investment portfolio. The total investment portfolio averaged $20.1 billion during the fourth quarter, up $727 million from the third quarter average as we continue to deploy some of our excess liquidity during the quarter. We made investment purchases during the quarter of approximately $1.2 billion, which included $735 million in Agency MBS securities with a yield of 5.43% and $470 million in municipal securities with a taxable equivalent yield of about 5.38%. For 2023, our current expectation is that we would invest an additional $4 billion of our excess liquidity into investment purchases during the year or about $2.2 billion net of projected inflows during the year. The taxable equivalent yield on the total investment portfolio in the fourth quarter was 3.09% up 15 basis points from the third quarter. The taxable portfolio, which averaged $12 billion, up approximately $534 million from the prior quarter had a yield of 2.41% up 21 basis points from the prior quarter, impacted by the higher yields on recently purchased Agency MBS securities. Our tax-exempt municipal portfolio averages about $8.1 billion during the fourth quarter, up about $193 million from the third quarter and had a taxable equivalent yield of…

Jerry, we'll open it up for questions now.

Thank you. The floor is now open for questions. [Operator Instructions] The first question today is coming from Ebrahim Poonawala of Bank of America. Please go ahead.

Hey, good afternoon.

Hey, Ebrahim.

Just first wanted to follow up on remarks, Phil, around commercial real estate. So you noted two things. One, you mentioned the impact from rate hikes was having an impact on the pipeline cooling off. But at the same time, we talked about the strength of your book. But give us -- like how do you see this playing out if interest rates don't get cut. one, and maybe this may not play out at Frost, but do you see credit pain in the sector across your markets to manifest themselves over the next 12 months across multifamily office. And how do you think that translates to impacting cash flows for your customers? Maybe it has a pressure on rent rolls as we look out? Would love some color around that? And just your thought process around both the risk for the market and how it may come back and translate in terms of risk to Frost? Thank you.

Okay. Thanks, Ebrahim. Well, we are seeing some tightening on debt service coverage ratios, as I mentioned. But we don't expect, let's say, multifamily, for example, to be underwater on those the word that I got from our credit people was, I'll quote, so we feel pretty good about it. If you look at -- I think I gave you what our loan-to-value on offices was about 56%. If you look at our loan-to -value on multifamily, it's 58%. About half of our deals will be completed in '23, the other half in '24. So I don't think there's a lot of pressure today as it relates to our portfolio. I also hear from our people that rents are keeping up for now. So that's helping things, but costs are also increasing. I think in this market, if you have issues, it's been kind of what everyone's been hearing. It's going to be the lower-class office buildings where you've got you're losing tenants and you've got some risk around that. But I don't want to give the feeling that we've got problems. I just want to make sure I'm being honest, if things are tightening up. If you took a look at our portfolio, I was asking about, I guess, the office portfolio, I think we have $44 million of what might be problem credits on what is the portfolio. It's probably over $1 billion, right? So you don't really have much that are issues and they're kind of specific. So again, I don't want to give the impression things are too negative, but I do want to give the impression things are not as good as they were. I would also say that property tax is a big problem around here, and they've seen a big increase. So when you combine that with interest rates and then also operating costs on apartments, multifamily. It's going to create some pressure, but at this point, not so much. Again, offices are probably the biggest concern, I'd say, generally in the market because I don't think anybody has figured out what's going to happen with offices over the next couple of years, we're still trying to figure it out as a business. So I'm sorry I don't have any better clarity than that but that's what we're seeing Ebrahim.

No. That's helpful color. And then one, Jerry, you mentioned about the earnings outlook for the year. Give us a sense of what you expect in terms of net interest income growth for the year? And how you see that trending, do you expect NII continues to grow given just what you expect in terms of loan and deposit growth or do you see some trajectory where NII declines quarterly at some point in '23?

Yes, sure. I think that I said last quarter, we got a little bit into 2023, and we were talking about the NIM percentage. I think that we're currently, I don't expect that the fourth quarter was our peak. I still think that, obviously, we had a nice increase between the third and fourth quarter, 30 basis points, I don't see that sort of a growth coming into the first quarter. But certainly, we do expect some improvement. And in my mind, I think given our assumptions that we'll see a rate increase in February and then a decrease in July. I would expect that our NIM is probably given our assumptions, probably peaks in the third quarter. As far as we're not going to give specific percentage growth on net interest income. But it's year-over-year, I think we grew between '21 and '22, say, 30%. I don't think we'll be there based on kind of what I'm seeing. But I think we're going to have strong growth this year compared to last.

Got it. Thank you.

Sure.

Thank you. The next question is coming from Steven Alexopoulos of JPMorgan. Please go ahead.

Hi everybody.

Hi, Steven.

I wanted to start on the deposit side. So the outflows of non-interest-bearing were fairly sharp a bit more than we were looking for. And I know you mentioned repos, but could you give a little bit more color what you saw in the quarter, what you might still see at risk moving out of non-interest bearing. And where do you see that mix stabilizing?

Yes, the non-interest-bearing. I think what I said on the non-interest-bearing is that's really been kind of the area that I've been concerned about that we had some exposure there. And I continue to think that's really the area where we have the most exposure. With rates where they're at today, and we all know there's some pretty nice rates out there. I think that it really is compelling a lot of treasurers and CFOs to make sure that they're managing their liquidity well and looking for alternatives. I think that certainly, we can be competitive in a lot of situations, but there's probably going to be cases where we're going to see some deposit outflow, especially on some of the larger balances, especially, I think that's where most of the risk is. I don't think it's anywhere unique to anybody. I think that from a deposit rate standpoint, our rates, I think, are competitive with banks. I think the challenge becomes trying to compete with some alternative sources. But I do expect that the commercial side on the commercial DDA is probably the most at risk in my mind.

Got it. Okay. And then, Jerry, in terms of the loan-to-deposit ratio moved up slightly through 2022. I hear what you're saying I'm putting liquidity to work in the securities book. But should we expect a similar trend through 2023, just basically funding loan growth with deposit growth?

I think that for 2023, I think probably the bigger unknown in my mind, is more what happens on the deposit side than what happens on the loan side. I think Phil given some good color of what we're seeing in loans. I think without knowing exactly what happens in the economy, there might be a little uncertainty there. But I think we feel pretty confident, I think it's that deposit side. So you could because we've always said the loan-to-deposit ratio from our standpoint is really a results in fact, right, because we're really out to grow both deposits from a relationship standpoint and loans. So I think that given that I don't project that we'll have the sort of increase in deposits that we've had the last couple of years, I expect that to be much more muted in 2023. You may get some improvement in that ratio just simply because the denominator decreases.

Got it. Okay. And then, finally, on the expense side, so you reported mid-teens expense growth in 2022, basically in line with what you had guided for the year, now guiding mid-teens for 2023, more investments that you'll have to make. When you guys take a longer-term view, do you think for a period of time, beyond 2023, we stay in this mid-teens range or do you see this as sort of a two-year scenario, and then we get back to something more normal after that? Thanks.

Steve, it's a good question. I think the simple answer is 2023 is an unusual year for us. I expect to see our run rate on expense growth to go down in 2024. And Jerry mentioned the IT investments mentioned marketing. As I've talked to investors over the last couple of years, I've been pretty open that there are some things we are going to invest in. We're going to invest in physical distribution and I hope by now we've proved to everyone that's a payoff for shareholders are going to continue to be. We're going to continue to do that. We sort of set that aside. Okay. But we're also going to invest in people, and you saw those numbers on salaries, I mean, they are pretty sobering, but we were competing in the marketplace. I think we're being successful there. I think we've reached a place where we're touching bottom. And I was looking at our turnover rates. Last year, it was in 2021, our turnover was -- say call it 23% this year. In 2022, it was 14%. It was down from 23% in '21. So that tells me that we are hitting the right balance on what we need to be paying people. We've done a lot on benefits, making sure that we have comparative and really top-quality benefits in areas of health care and retirement and those kind of things. So we're really focused on that. We said that we're going to invest in marketing that was one area that we really hadn't done, one of the key areas that we hadn't done, we needed to. And we've hired some great talent there. We did that last year. So we've got those costs, but we've also got some additional media that we're going to be…

Got it. Thanks for all that color. Really appreciate it.

You're welcome.

Thank you. The next question is coming from Dave Rochester of Compass Point. Please go ahead.

Hey, good afternoon guy. Just a quick one on the NII guide. I was curious what the impact is you see for the rate hike in February and then the rate cut in July, what the NIM sensitivity is for those moves that you're baking in? And it sounded like you're assuming a positive, but maybe more muted deposit growth trend for the year. I was just wondering if you could give an update on the total deposit beta assumption, you're not baking into that? Thanks.

Right. I guess I'll just start with the deposit betas. I mean, I think we ended up a year kind of where we expected we would be. We had said that we'd be about 30% on interest-bearing at about 20%, 20% to 25% on total. And that's really kind of where we ended up. So I think for -- we were higher in the fourth quarter. I think I said in the third quarter that I thought we have to be a little bit more aggressive than we were. But we ended up cumulatively exactly where we expected. As far as betas for next year or for this year, excuse me. And I think basically what we're assuming is that we would have the same sort of increase that we had in the first quarter in February is kind of where we go back. I think we're assuming a little bit more aggressive betas, say, where we were at about 30% on interest-bearing, I think we're probably assuming right now that we'd be somewhere closer to the 33% to 35% and then our assumptions are that we take all that back in July. And we'll just have to see, I think we said all along is, we want to see kind of where the market is, but those are our current assumptions today. And I think you had one other question on.

The sensitivity to the right moves that you guys are looking at, the hike in February, and then the cut in July, how much of that we think will move the NIM?

Yes. From a NIM standpoint, I don't think it's going to have a significant impact on the percentage itself. Like I said, we want to be careful. We don't really give all that sort of level detailed guidance. But what I have said is, I do think the percentage will peak in the third quarter just right before our projected decrease. And I think that we're feeling good about where we're at. A lot of it will be dependent on what happens on those deposits. As I've said, yes, do I feel like it's a little bit more muted in 2023 than it was in 2022? Yes, most certainly. I mean, I think we saw some of that just in the linked-quarter movement, although a lot of it was moving into repo. And so we had certain customers coming out of the money market account and choosing to move into the repo account because of some sort of operational processes and money flow issues that they liked more in the repo. And also the fact that, that product is collateralized. So we did see some movement there. So I tend to have less concerns, although it's still going to be relatively soft, it's going to be softer than we saw this year on the interest-bearing side, but most of the risk is on the commercial DDA in my opinion. As far as what we think a 25 basis point hike gives us, it gives us about on a pretax basis, a little over $3 million a quarter.

Okay. Great. And maybe just one last quick one. On the 159-debt service coverage ratio you gave on the office book, that's an updated figure for today's rates. Is that right?

Yes, that's where we stand on average today.

Okay. Great. Thanks guys.

Hey Dave. I just want to make sure when I said around a little over 3%, that's on an after-tax basis. I couldn't remember if I said pretax or after tax.

Okay. Thanks.

All right. Sure.

Thank you. The next question is coming from Brady Gailey of KBW. Please go ahead.

Hey, thanks. Good afternoon guys.

Hey, Brady.

I wanted to start with your comment about growing the bond portfolio. I think on a net basis of about $2.2 billion in 2023. If you look at the amount of cash that Frost still has at least on an average basis in the fourth quarter, it was 24% of average earning assets. It feels like you could do potentially more than the $2 billion adding to the bond book, especially as the rates are more attractive today. Is there some possible upside to the amount of bonds that you'll consider adding in '23?

I think, yes, that's a possibility, obviously. Right now, what we're really concerned with is, it's just making sure we understand exactly what's going on with deposits. I guess what I'd say is that it's something that we're talking about. Should we get the opportunity, if we think something we get an opportunity on the yield side with some sort of market correction, we could jump in. So there is that possibility. But I think right now, we're really -- the numbers that we're giving is really kind of the way we're modeling. Like I said, I never say never sort of thing, but I'd go with our projections. I don't expect -- let's not forget that in 2022, we spent $8.6 billion, I think, grows. And in that year, we only had a little over $8.6 billion, we only had a little bit over $1 million in inflows. So net we spent $7.5 million. So we've moved the needle quite a bit. And so, we've made some purchases already in January of this year of $1 billion, I think, roughly. So could we, yes, I don't see that as a high probability at this point. But, yes, that's always a possibility given what happens in the market.

Okay. And then my second question is on mortgage. Is that relatively new unit gets up and running for you guys, I think that's an originated keep model, not an originated sell model. So as that business continues to mature, do you think that, that will push the loan growth outlook beyond the high single-digits just because you'll have that new lever of loan growth as you keep those mortgages.

Good question, Brady. I don't know if it goes above high single-digits, but it will be additive to it. I don't really have it in my mind enough to know how much that would move the needle. But it's going to be a significant part of the portfolio. The way I hope it turns out is, if you look five years out, it'd be the 10-ish percent of the portfolio back when we used to have them on the book before, I think we're around that area, 10%, 12% of the portfolio. So I just think directionally, we'd be in that same level. So if you kind of took what would that be and what kind of volumes would that be, you could sort of pencil out how much that might add to growth.

Okay. Great. Thanks guys.

Okay.

Thank you. The next question is coming from Manan Gosalia of Morgan Stanley. Please go ahead.

Hi. Good afternoon. I had a quick follow-up on the expense side. Are these expenses that you have pretty much set in stone for 2023? Or do you have some flexibility depending on which way the overall environment goes? And then, I also had a clarification on your comments on the run rate moving lower. Do you think that basically the growth rate moves lower off of the new expense base in 2023 as you go into 2024, or do you think as you get the new loan system and check processing system, et cetera, running and the old one rolls off, that the actual dollars can stabilize or come down as you go into '24? Thanks.

Well, my comments really weren't intended to indicate that the dollars would come down because, obviously, we're growing company. We're going to continue to invest. My point is that I don't see us investing at the same level with some of these. I mean, for example, I didn't mention it, but take mortgage, we have bootstrapped that operation. We spent some serious money doing it. It's a fantastic product. It's going to be a tremendous product for us going forward, but we don't have to rebuild that next year. So we're going to have that same level of cost structure and it will be higher because of inflation and growth, that kind of thing. But we're not going to have to bootstrap it. So that's really what I'm pointing out. I think we're making a lot of these generational investments that we're really going to be trying to harvest and we'll be dealing more with an increasing expense base, but just not increasing at the same level that we have been that's my hope. That's what we're going to try to manage to.

Got it. All right. Perfect. And then, a follow-up on the prior questions on the securities book. I guess even if you don't get a market correction opportunity to make larger purchases you are, given that we've come off the highs in yields, what would change your strategy to maybe accelerate some of the investments in that securities book?

Yes. I think that if we felt like there was a correction that was significant that got our attention. I think that we would accelerate that.

Got it. And any thoughts on what -- once the Fed begins to cut rates, what your cash position should look like as a percentage of earning assets?

You know what, it's really not. We've kind of been all over the board. I think the thing is today, you're right, we've got more liquidity than we have had. I think that we feel comfortable being able to bring that down to something much more normalized. But we don't have a number out there. A lot of it is going to be dependent on what we're seeing. I think if you've got, say, something as far as earning assets are concerned, something in the range of 10% or lower, I mean I think we could be somewhere in that range.

Got it. Thank you.

[Operator Instructions]. The next question is coming from Peter Winter of D.A. Davidson. Please go ahead.

Thanks. Good afternoon. So, you guys are always sitting on very strong capital ratios, low credit risk. I was just curious what your thought is on share buybacks. I know it's not a focus, but what are your thoughts on share buybacks here?

Yes. It's really not something that's top of mind to be quite honest with you. I think that right now, we really don't even have one in place. I think we had $100 million one that expired. We expect that we'll bring that back into the toolbox here in the near future. But we had one for all of 2022, we didn't utilize it. We've got it primarily to ensure that if we did see some market correction on our stock that we'd be in a position to take advantage of that. But right now I think from a multiple standpoint, I think we feel that capital is better served through organic growth. And I think there were some concerns, not that we were concerned, but I think the market had some concerns about tangible capital. And given that concern some of the questions we were getting, I can't see that we pulled the trigger any time soon.

Okay. And then just on office space. Phil, I heard your comments, most of your exposures to the A-type properties. But I was just wondering if you could comment what you're seeing on the B and C properties like Houston and Dallas?

There really aren't many that have come to my radar portfolio wise that I know of because that's going to depend on sponsorship, guarantees, equity, all those kinds of things, right? So but I can just tell you that what you're seeing all over the country is that the B and C properties just hard to get people into and I can imagine there are some issues out there. I don't have anything that's more complex than that, just recognition that people aren't using as much office space, and it better be nice if you're going to try to get employees to go into it.

Got it. Thanks.

Thank you. The next question is coming from Jon Arfstrom of RBC Capital Markets. Please go ahead.

Hey, good afternoon, guys.

Hey, Jon.

Hey, Jon.

I agree, you've got to be nice to get people back. That's a good comment. Most of my questions were scratched off and Peter just took one of them. But you made a comment earlier, Phil, about the prospect pipeline versus your own pipeline and the difference between the two? Can you just talk about that a little bit more and maybe that's more of a competitive environment question, but help us understand that a little bit more? Thanks.

Yes. We are getting lots of calls for deals, right, because we've got liquidity, we've got consistent underwriting. People know what we do in the marketplace. As far as that goes, underwriting is tightening up. It's coming our way as far as guarantees and equity and all that kind of stuff. But my point was, and I should also say that we're not looking to do all those deals. We bank people, not things, right? We bank relationships. So but there might be some relationships that we've been wanting to have that we'll see the opportunity to do, okay? And we're always on the lookout for that. And now the phone rings more. So we see prospect activity, to me, it's more the advantage of us having the balance sheet that we do and reputation we do. But my point on our customers, to me, it's kind of like same-store sales. I know it's not that. But I mean you already have the customers and the deals you have in the pipeline for them are the deals they're looking to do, they're new deals are looking to do, right? They're not necessarily deals that are out there that already have been papered already that are in the marketplace that you might see with the prospect. So my point is, as I looked at it, to me, it was like, okay, our customers, we've got their business. If we're not seeing new deals from them, it's because they're not doing new deals or they're slower on them. But we are still seeing good prospect deals that are out there in the marketplace just because of the advantages that we have. Maybe I'm awful on that, but that's what it meant to me.

Okay. Good. That's helpful. And then just one other thing on the step-up in IT and security expenses. Are you seeing that as a -- that's a permanent step-up or it's just kind of modernization and core spending related just for '23. Are we talking about a growth rate and expenses slowing in '24 or your expenses kind of flattening out and coming down in '24? Thanks.

Yes, Jon, it's growth rate. It's a growth rate coming down. I mean once we make this into our base expense load. I mean it's staying in there. And there'll be some growth on it because inflation and all those kind of things, but we won't be having to do the same thing. Again, our growth rate for four out of the last five years, where three out of the last four years before this year has been 11%. And IT is a cost that is -- it used to be health care with the out-of-control cost. I think it's clearly IT these days. But we'll need to get it back down to those more historical levels.

Okay. All right. Thanks guys.

Thank you. We're showing no additional questions in queue at this time. I would like to turn the floor back over to Mr. Green for closing comments.

All right. Well, we want to thank everyone for participating today. And thank you for your questions and for your interest. We'll be adjourned.

Ladies and gentlemen, thank you for your participation and interest in Cullen/Frost Bankers. This concludes today's teleconference. You may disconnect your lines and log off the webcast at this time and enjoy the rest of your day.