Title

Presentation

Cullen/Frost Bankers, Inc. beats earnings expectations. Reported EPS is $2.38, expectations were $2.14.

Operator: Greetings. Welcome to Cullen/Frost Bankers Incorporated Third Quarter Earnings Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. [Operator Instructions] Please note this conference is being recorded. I will now turn the conference over to A.B. Mendez, Senior Vice President, Director of Investor Relations. Thank you. You may begin.

A.B. Mendez: Thanks, Jerry. This afternoon’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.

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Phillip Green: Thanks, A.B. Good afternoon, everyone, and thanks for joining us. Today, I’ll review the third quarter results for Cullen/Frost, Jerry is going to make some additional comments, and then we’re going to open it up for your questions. In the third quarter, Cullen/Frost earned $154 million or $2.38 per share compared with earnings of $168.1 million or $2.59 per share reported in the same quarter last year. Our return on average assets and average common equity in the third quarter were 1.25% and 18.93%, respectively, and that compares with 1.27% and 20.13% for the same period last year. This solid performance can be attributed to the execution of our sustainable organic growth strategy and the commitment to our culture that develops deep customer relationships and provides world-class customer service.

And all this happens, because of the hard work and dedication of our Frost Bank staff. As in the past, our balance sheet and our liquidity levels remain strong. As an example, at quarter-end, our cash liquidity at the Fed equals 17% of our deposit base. Also during the quarter, Cullen/Frost did not take on any Federal Home Loan Bank advances, participating in any special liquidity facility or government borrowing, access any broker deposits or utilize any reciprocal deposit arrangements to build insured deposit percentages. Let me also say our available-for-sale portfolio represents 82% of our portfolio at quarter end. So, in short, basically with our balance sheet, what you see is what you get. Our average deposits were stable in the third quarter at $40.8 billion, less than a percent change from the previous quarter.

Average loans grew to $18 billion in the third quarter compared to $17.7 billion in the second quarter and annualized growth rate of 6.8%. As I mentioned, we’re laser focused on our efforts to achieve organic growth and I’m very pleased with our results. For example, to update you on our physical expansion efforts for our combined Houston expansions, we stand at 107% of deposit goal, 162% of loan goal, and 127% of our new household goal. As of quarter end, expansion loans represented 22% and deposits represented 18% of our total Houston market presence. For the Dallas market, we stand at 292% of deposit goal, 273% of loan goal, and 216% of our new household goal. While still relatively early in this effort, expansion loans and deposits represent approximately 9% respectively of Dallas market totals.

And we’re excited about our new Austin expansion effort which has opened the first of 17 planned locations to double our presence in that market. But beyond these overall numbers, I wanted to take you a little deeper into the character of the expansion business. For example, in Houston, we stand at $1.4 billion in deposits and $1 billion dollars in loans. Our deposit mix is 53% commercial and 47% consumer, essentially mirroring our company profile. Two-thirds of the deposit relationships are under $1 million and only four are over $10 million. Loans are 73% commercial, 27% consumer, and only 8 customers have over $10 million. Similarly, in Dallas, of our $325 million in deposits, 53% are consumer versus 47% commercial. And 72% of those deposits were under $1 million, no relationships over 10 million.

Our $258 million in loans are 62% consumer and 38% commercial, which I think is remarkable. The reason I labored through that detail is to show you that the kind of business we’ve been successful generating in our expansion is core, stable, grassroots business, which I believe will generate tremendous value over an extended period of time. I’m very pleased with the results of these efforts, and I believe that this strategy is both scalable and durable, and I’m convinced we’ll be doing this for a long time. Looking at our consumer banking business, we continue to see outstanding organic growth. We added 6,220 net new-checking households in the quarter, bringing the year-to-date totaled to 22,800, a 12% improvement on 2022 year-to-date results.

To give a perspective of the power and durability of our organic growth, let me point out that in the past 36 months, we’ve added 80,000 net new consumer-checking households. This means we grew our core customer base by 23% in just 3 years. We believe these are industry-leading numbers and represent tangible evidence that the customer experience we offer and the reputation we’ve built set us up to be successfully competitive. As we look at these new households, we see that the quality of the growth is also high. A high percentage of the accounts are active, the balances are healthy and the growth is balanced across all the segments we serve. These factors are evidence that the growth is sustainable and beneficial. Consumer loan balances outstanding were $2.8 billion at the end of the quarter growing 26% year-over-year.

In the third quarter alone, balances increased to $181 million or 7% from the second quarter. This robust growth was driven by our home equity products. In a market where it’s becoming increasingly expensive to buy, many families are deciding to stay and fix up their home. And we’ve got the right products and services and relationships to help at this time. We have a long history of credit quality in the consumer banks similar to what you’re used to hearing about on the commercial side. And the weighted average credit score on the portfolio is 754. Delinquencies are low and stable at about 80 basis points. Charge-offs are also low and stable at 19 basis points for the year. Also, as we’ve noted, we’re excited about the prospects for our new mortgage product, which is in its very early stages, but just recently opened up to all our markets in the state.

Now, looking at our commercial business, I think it’s an interesting story. Our new opportunities for the quarter were strong, but they were down 17% from the second quarter. However, that was because our second quarter new opportunities were at all-time high after the dislocations brought on by the SVB situation. And as you’d expect, our declines for deals were also high, and we’re almost 2.5 times our quarterly average. Now, looking at the third quarter and focusing on our weighted pipeline, that weighted pipeline is up 22% from last quarter, and it’s our highest of all time at $1.918 billion. Our previous high was during the second quarter of 2022 at $1.832 billion. The increase comes from all categories, both customers of 18% and prospects of 25% both core, which we define as relationships under $10 million in large, core up 26%, large up 20%, and both C&I up 23% and CRE up 24%.

Credit quality continues to be good by historical standards with classified and non-accrual assets flat and net charge-offs down quarter-over-quarter. Non-accrual loans totaled $67 million at the end of the third quarter compared with $68 million at the end of the second quarter essentially flat for the quarter. The third quarter figure represents just 37 basis points of total loans and 14 basis points of total assets. Problem loans, which we define as risk-grade 10 or higher, totaled $513 million at the end of the third quarter that’s up from $441 million at the end of the second quarter and $387 million this time last year. Virtually all the linked quarter growth was in the OAEM risk category or grade 10. Net charge-offs for the third quarter were $5 million.

They were down from $9.8 million in the second quarter. Annualized net charge-offs for the third quarter represented 11 basis points of average loans and year-to-date annualized net charge-offs are 18 basis points of average loans, which is below historic averages. Regarding commercial real estate, our overall portfolio remains stable, with steady operating performance across all types and acceptable debt service coverage ratios and loan-to-values. Within this portfolio, what we’d consider to be the major categories of investor CRE, that is office, multifamily, retail, and industrial, as example, totaled $3.5 billion or 40% of CRE loans outstanding in our flat quarter-over-quarter. Our investor CRE portfolio has held up well with the average performance metrics remaining essentially unchanged quarter-over-quarter and exhibiting an overall loan-to-value of about 54% loan-to-cost of about 60% and acceptable reported debt service coverage ratios.

Higher interest rates continue to be a challenge for our CRE borrowers and have impacted performance of some project as compared to original performance. However, on average, we’re comfortable with the quality of the portfolio. As an example, the investor office portfolio, which has been top of mind since the pandemic, had a balance of $950 million at quarter end and it exhibited an average loan-to-value of 52% and an average debt service coverage ratio of 1.46, up slightly from last quarter. 83% of this portfolio is stabilized with healthy coverage levels and less than 5% of the portfolio is considered spec with even these few projects being in strong sub-markets with good leasing dynamics in strong experienced developers. Our comfort level with our office portfolio continues to be based on the character and experience of our borrowers and sponsors, and the predominantly Class A nature of our office building projects and, again, we’re glad to be operating in Texas.

So, in closing, we remain optimistic for what lies ahead. We’re capitalizing on opportunities and I’m proud of all our bankers as they accomplish all of this across all our communities. Now, I’ll turn the call over to our Chief Financial Officer, Jerry Salinas, for some additional comments.

Jerry Salinas: Thank you, Phil. I wanted to start off first by talking a little bit about – more about our Houston 1.0 expansion results. As Phil mentioned, we’ve been very pleased with the volumes we’ve been able to achieve. Looking at the third quarter, linked quarter annualized growth in average balances for these locations was 46% for deposits that’s $170 million growth linked quarter and on loans of 52% annualized growth or $133 million quarter-over-quarter for loans. [I’m sorry, the 46% was for deposits.] [ph] And for the third quarter, Houston 1.0 contributed $0.06 to our quarterly EPS. Now, moving to our net interest margin, our net interest margin percentage for the third quarter was 3.4% down only 1 basis point from the 3.45% reported last quarter.

Some positives for the quarter included higher yields on loans and balances at the Fed combined with higher loan volumes. These positives were primarily offset by higher cost of deposits and customer repos compared to the second quarter. Looking at our investment portfolio, the investment portfolio averaged $20.6 billion during the third quarter, down $721 million from the second quarter. During the quarter, we did not make any material investment purchases and sold about $361 million in municipal securities at a small net gain as we took advantage of market dislocations, which allowed us to improve interest income going forward. The net unrealized loss on the available for sale portfolio at the end of the quarter was $2.2 billion, an increase of $600 million from the $1.6 billion reported at the end of the second quarter.

The taxable equivalent yield on the total investment portfolio in the third quarter was 3.24% flat with the second quarter. The taxable portfolio which averaged $13.6 billion, down approximately $216 million from the prior quarter had a yield of 2.76%, up 5 basis points from the prior quarter. Our tax exempt municipal portfolio averaged about $7 billion during the third quarter, down $505 million from the second quarter and had a taxable equivalent yield of 4.26%, down 1 basis point from the prior quarter. At the end of the third quarter approximately 71% of the municipal portfolio was pre-refunded or PSF insured. The duration of the investment portfolio at the end of the third quarter was 5.7 years, up from 5.2 years at the end of the second quarter impacted by duration, extension, and both our municipal and MBS agency portfolios.

Looking at deposits, on a linked quarter basis, average deposits of $40.8 billion were basically flat with the previous quarter as they were only down $179 million or 0.4%. We did continue to see a mixed shift during the quarter as noninterest bearing demand deposits decreased $408 million or 2.7%, while interest bearing deposits increased $229 million or 0.9% when compared to the previous quarter. Based on third quarter average balances, noninterest bearing deposits as a percentage of total deposits were 36.3% compared to 37.1% in the second quarter. Noninterest bearing deposits totaled $14.8 billion at the end of the quarter, with 96% of that amount being commercial demand deposits. During the individual months of the third quarter, we did see the average balances in the noninterest bearing accounts begin to stabilize.

During last quarter’s call, I noted that July’s average balance was down $202 million from the June average. The full month-to-date average for July was $14.84 billion, down only $173 million from the June average. Our August average was flat with July, and the September average was down only $60 million to $14.78 billion. For October month-to-date through yesterday, the average non-interest bearing deposit balance is $14.52 billion, down $259 million from the September average. Looking at total interest bearing deposits, they’ve been relatively stable during the period. Average interest bearing deposits were $26.0 billion during the quarter, up $229 million or 0.9% from the second quarter. For October month-to-date average, the balance in interest bearing deposits through yesterday was $26.3 billion, up $102 million from our September average.

We do continue to see a shift in the mix in interest bearing deposits to higher-cost CDs from lower-cost savings, IOC and MMA. The cost of interest bearing deposits in the third quarter was 2.12%, up 25 basis points from 1.87% in the second quarter. Customer repos for the third quarter averaged $3.5 billion, down $183 million from the $3.7 billion averaged in the second quarter. The cost of customer repos for the quarter was 3.67%, up 15 basis points from the second quarter. Looking at our noninterest income on a linked quarter basis, I just wanted to point out a couple of items. Trust and investment management fees were down $1.8 million or 4.5% compared to the second quarter, driven by a decreases in estate fees of $1.1 million, real estate fees of $673,000, and tax fees of $413,000, partly offset by an increase in investment fees of $750,000.

Estate fees and real estate fees can fluctuate based on the number of estates settled or properties sold respectively, while tax fees, by their nature, are typically higher in the second quarter. Other charges, commissions, and fees were up $1.0 million or 8.6% compared to the second quarter, impacted by increases in various accounts, including money market income up $282,000, letter of credit fees up $155,000, and annuity income up $121,000. Other income was up $3.0 million or 29% when compared to the second quarter, impacted by higher public finance underwriting fees up $1.6 million, and higher combined derivative and foreign exchange income up $1.8 million. Looking at our projection of full year 2023 total noninterest expenses, we continue to expect total noninterest expense for the full year 2023 to increase at a percentage rate in the mid-teens over our 2022 reported levels.

This does not include the potential impact of the SBIC special assessment, which has not yet been finalized. The effective tax rate for the first 9 months of the year was 16.3%. Our current expectation is that our full year effective tax rate for 2023 should approximate 16.5% to 17%. But that can be affected by discrete items during this fourth quarter. Regarding the estimates for full year 2023 earnings, our current projections don’t include any additional changes to the Fed funds rate through the rest of the year, through the rest of 2023. Given that rate assumption and our expectation of 2023 noninterest expense growth of mid-teens, which does not include the impact of the SBIC special assessment, and given our strong performance this quarter, we believe that the current need of analysts’ estimates of $9.22 is too low.

With that, I’ll turn the call back over to Phil for questions.

Phillip Green: Thanks, Jerry. And we’ll open it up for questions now.

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Operator: Thank you. [Operator Instructions] Our first question is from Steven Alexopoulos with JPMorgan. Please proceed.

Steven Alexopoulos: Hi, everyone.

Phillip Green: Hi, Steve.

Jerry Salinas: Hi, Steve.

Steven Alexopoulos: I want to start, so on the deposit side, Jerry, to follow-up, where you just left off with the noninterest bearing, that $14.9 billion – $14.8 billion. It’s pretty stable. In the fourth quarter, we typically see some window dressing from companies that it picks up a bit. Can we safely say that we’re now at a bottom for the noninterest bearing deposits?

Jerry Salinas: Steven, I think that certainly when I look at it, I feel today versus 3 months ago feel a lot more comfortable with where they’re at. Obviously, you’ve seen, and I kind of tried to give that sort of color in my commentary. We are seeing little downward ticks, but it’s really been stable. In my mind, those small $100 million, $200 million decreases have been relatively stable as you’ve said, and we’ve seen historically the fourth quarter is the best quarter, right, as companies try to do some window dressing. So, I don’t know that I can confidently say that we’re at the bottom, but I certainly feel a whole lot better today than I did a quarter ago.

Steven Alexopoulos: Got it. Okay. And then on the loan side, I didn’t – I mean, it will be pieced together all the color you gave on consumer and commercial, but there’s no doubt loan growth picked up this quarter. Can you give us – drill down why is it just these new markets coming online when you look at the growth? And it sounds like you’re pretty optimistic. You think it’s sustainable, this improvement you’re seeing.

Phillip Green: No, Steven, with all of that, it’s still, I think, high-single-digits number. And that’s kind of what our sustainable target has been for a while. So I would hope that it is. It would be our goal that it is. We’ve looked hard at where it’s coming from, like I said, with that really big spike in the second quarter. We talked about where it came from and it was by and large a lot of good credits. It just didn’t meet our structure that what we wanted to do, maybe we were full in a category and didn’t want to reach out in one particular area. And, I think in just talking to our people, a lot of banks have just put their pencils down. And we have liquidity, people know that we’re not always the place where people like to go to get the leggiest structure on a deal.

But we’re consistent through the good times and bad times, I think people realize that. And I think that we got a lot of phone calls and a lot of opportunities to do stuff. And I mentioned how many we declined, because I didn’t want people thinking that, oh, well. Look, Cullen/Frost got some loan growth, they must be just taking other people’s problems. That’s not what’s happening. And we’re just seeing a lot of good opportunity. I think part of it is – what’s a lot of things. It’s our reputation for strength and stability in times like these. But now, our people are great at sales and calling in developing relationships. They’re held accountable to it. They’ve been doing a good job. When you have a balance sheet like ours, it puts you in a good place to take advantage of opportunities.

And I think that’s what we’ve been seeing. It’s hard to pin down on any one particular thing, because I think it’s been pretty consistent. I might speak a little bit more about it, because I just had a recent conversation about the expansion growth. I tried to give you some feel for – it’s pretty granular in terms of what’s coming on. But I had a conversation about what kind of deals are we seeing. And a lot of it is its owner businesses, right? They have a business to consumer model. They’re not really sexy [ph] businesses. But in a sense, but they’re just good stable long-term businesses that are a result of hiring community bankers in these communities we’ve gone in. And so it is very diverse. The commercial real estate that we see there is mainly because someone wants to not pay rent anymore.

They want to own their own building for their business. That’s slowdown some, because rates are so high, but that’s still going to be the arc, I think, of the kind of business we’re doing. When I hear that, it makes me feel really good about just how core and how stable it is, because that’s really our wheelhouse.

Steven Alexopoulos: So if I could ask, but final one, so as we’re probably, I don’t know, two-thirds through earning season, what we’re hearing from the industry, particularly the larger regionals, because most of them are on this RWA Ozempic diet, right? They’re just shrinking assets. They’re almost all tightening on expenses, right? A lot of them are guiding to flattish expenses for 2024. And to be quite frank, I don’t know how to think about Cullen/Frost for 2024. And I’m not looking for a number, but I want to know how you’re thinking about it because in many ways, this is going to be a great market for you to take bankers, right? I mean, as everybody’s sort of on the sidelines, which you mentioned. So I don’t know, I think number’s 14% year-over-year.

Are you thinking about, “Hey, this is a year that we’re going to continue to expand and maybe expense growth stays at that rate? Or are you share some of your other CEOs like, no, we need to tighten also just because the environment’s a little more challenging.” How do you think about that?

Phillip Green: Well, what we’re thinking is that we’ve got a great opportunity to expand. And we have plans in place. We started the process of doubling Austin, in the middle of tripling Dallas. We think these are great opportunities. And we are getting good applicant flow and put it that way. And in these markets, so it’s not like we’re going, “Oh, we need to hire more bankers, because we’ve got an opportunity for this or that.” I mean, we are hiring tons of bankers as a part of this expansion. And there’s plenty of work to go around there. So we are hiring, but it’s a part of our strategy that we’ve put in place already, we’re having good success there. We are not backing off and saying, “Oh, look, we need to cut expenses now, because I don’t know because for whatever.” We’re winning competitively, I’ll just say it.

And now is the time for us to keep moving forward. Now, Jerry and I talked with the folks about what they’re spending and what the trend is. And we want it to be lower next year, just because there’s a limit to what you can do over time. And we want to be prudent about all this stuff. But, no, we’re not in a retrenchment mode at all. Jerry, do you want to talk something about expenses?

Jerry Salinas: No, I mean, I think Phil said it. And we’ve been very focused, as he said. And, Steven, as our focus on expenses continues, certainly, when you look at the percentage, you might – someone may roll their eyes. But, obviously, we’ve talked about the things that we’re doing to grow the business, grow our product selection, and expand our marketing. I think those have all been in improve our technology, those have all been smart things that we’re doing. And as he said, our guidance for our team has really been that, we’ve kind of given guidance to this mid-teen sort of growth this year. But certainly would expect that, when we talk in January that’s not the sort of growth we’ll be giving from a target standpoint.

Steven Alexopoulos: Okay. Thanks for all the color.

Operator: Our next question is from Dave Rochester with Compass Point. Please proceed.

David Rochester: Hey, good afternoon, guys. Nice quarter.

Phillip Green: Thank you.

Jerry Salinas: Thank you.

David Rochester: On your outlook for higher EPS versus consensus, are you guys assuming you’ve reached a bottom now in NIM and NII giving your rate outlook? You’ve been pretty stable here for a couple quarters now. Are you thinking that trend continues? And then when do you think you could get back to NII growth?

Jerry Salinas: Yeah, I think that – and I think I’ve been pretty consistent. The fourth quarter for us, I think, is going to be a little bit weaker, I don’t think it’s – and it’s not significant. The guidance I gave last quarter was, I thought they’d be flattish, and I could even still say that with a downward bias. I mean, we were down 1 basis point between these quarters. So I’m kind of feeling that same pressure. I think that as I look out into 2024, and we’ll get more color in January, as I said. But, I think we talked a couple of times that we have some opportunities with some reinvestment of some proceeds that are going to be coming to us pretty early in 2024 from maturities on our investment portfolio.

And even though we haven’t really decided what sort of an investment plan we’ll put in place, just putting it on our imbalances at the Fed would be a significant improvement. I think we’ve made no secret of the fact that we bought $1 billion in treasury securities that mature, I think the first tranche, say, first $250 million is on December 31. So I really say, basically, they’re all in early 2024 and it’s at a 1%. So that’s sort of a pickup that we’re kind of projecting for most of 2024s as those securities get to be reinvested, a lot of it will be dependent on what our assumptions are for lower rates, if that’s the case in 2024 when we get to that forecasting period in January. But, right now, I do think that the same guidance I gave last quarter about kind of flattish to a little bit downward bias.

It’s kind of where I’m at for this fourth quarter.

David Rochester: Okay. I appreciate that. And then going back to the stats that you were talking about on the noninterest bearing, it sounded like October was down. If I heard this right, maybe $260 million-ish from the September average, I know that’ll bounce around. I was just wondering if you had isolated what drove that pickup in the runoff here at this month.

Jerry Salinas: To be honest with you, there’s so many accounts in there, and there’s a lots of positives and negatives and a lot of volatility that goes in with those accounts. And to be honest with you, from my end, when I see a movement like that in a month, I tend to think it’s pretty flattish. And we hope, certainly that we’ve seen the drop at the bottom, as we said, Phil talked about the new relationships that we’re adding on the commercial side. It typically takes us a few months, from 3 months to 6 months to get those commercial deposits on. So we continue to be pretty optimistic about it and hope the worst is behind us.

David Rochester: Good. Maybe one last one just on expenses. You mentioned the mid-teens growth guide. And that implies a little bit of a wider range, I guess, since we only have one quarter left. And it seems like a midpoint would imply a little bit of a step up in expense growth in 4Q. Are you thinking maybe more at the bottom into that range at this point, that you came in a little bit lower this quarter?

Jerry Salinas: Yeah, I was joking a little bit earlier of what its mid-teens mean, right? Because in my mind, that’s one number and it could be a different number in your case. Yeah, I will say, David, that my expectation today versus where we were a quarter ago is that we’ll be lower. We had a really – we beat for the quarter and some of it was on the expense side coming in lower than we had expected. And we do a lot of settlements on incentives and kind of look and see where all those incentive plans come in. Some of our incentive payments all vest and our issued invest in the fourth quarter. So there’s a little bit uncertainty there. But if you’re looking at where I was a quarter ago versus where I am today. Yeah, I certainly feel like it will be a little bit lighter than I thought we would be.

David Rochester: Yeah, when I saw the growth at the slower rate this quarter versus what we expected I figured that that was going to be a response. I appreciate it. Thank you guys.

Jerry Salinas: Sure.

Operator: Our next question is from Ebrahim Poonawala with Bank of America. Please proceed.

Ebrahim Poonawala: Good afternoon.

Jerry Salinas: Hey, Ebrahim.

Ebrahim Poonawala: Hey, so Phil, you talked about growth may be somewhat flowing as we look into next year. Just give us a sense of how customers are holding up when we think about this lagged effect of the Fed rate hikes, may be consumer demand slowing down a bit. I’m not sure whether or not that’s happening in your markets. But give us a sense of just the resiliency of the customer base, where if any place where you think softness from a credit quality perspective, and it may not be within Frost loan book, but just in the market where you think some softness?

Phillip Green: Ebrahim, I think they’re pretty well known, right? The deals that were underwritten that have seen – on a floating basis that have seen the higher rates and operating costs are up. There are – honestly, I mean, I don’t pay a lot of attention to other banks, but I mean, I know our credit numbers are really strong. I don’t get the sense we’ve had a tremendous problem here in the state. We said we’re glad we’re operating in Texas, we really are, I think it makes a huge difference. I don’t see things, imagine, I said it was slower next year, I don’t remember that. I don’t feel like it’s going to be that much slower. I talked to customers, it’s kind of funny. When you go out and talk to them, I was with the construction guy, and he looked at me, and he said, I’m really interested in how you see the economy.

And I said, well, I almost embarrassed saying it, I said, I don’t think it’s that bad. And he looked at me and said, that’s how I think too. And we almost felt embarrassed for each other that we said it. We’d like we’re going to get canceled or something, because there’s – I guess if you watch too much TV, you think it’s supposed to be bad. But, I think there’s more worry about than there are actual problems today. And I’m not trying to be pollyanna. It’s just most people, when you talk about their business and there are some problems here and there. We talked about some increase in our risk-grade 10s. So there are some issues, but it’s not bad. If I had to pick, let’s say, okay, let me see. So I would say probably you buy here or pay here, use card, it’s got some pressure, because they’re a rate-sensitive business.

And so that’s probably some issues. I mean, if you’ve got an office building that’s refi-ing [ph] now and you don’t have the capacity or the willingness to right size it, there could be some issues there. And then there’s just the one off thing that’s just business that we see. We’ve seen some things in, let’s say, contractors. There was a big electrical contractor, but they had government work, which is always a little bit dicey, and for our experience, but they’re working hard to write that shift. But if you didn’t bid the right way and cost went up, you got a fixed rate deal, fixed cost deal, that could be some issues. So those are the kind of things we’re seeing. But like we said on our prepared comments, they’re holding in there and look, I’ll say – let’s say multi-family.

They were underwritten it 2 years ago, 2.5 years ago. It’s in construction, they’re going to have to – if rates don’t go down, they’ll have to right size some of the stuff, but they know that, and we’ve been talking to them about that. And it matters who you’re doing business with and who your sponsors are, and so it’s not something that we’re really worried about at this point, and I think most of that stuff matures, or has to be dealt with in 2025 and 2026. There’s very little of it, I think there’s 17% in 2024, yeah. And I’ll give you one other thing that, because maybe you think I’m whistling past the graveyard, there was a multifamily deal, we’re aware of, and we’re Texas a customer, it was right at one times coverage, okay?

And that thing sold at a 4.5% cap, and again to the borrower. So, just because, I mean, it tells me there’s still a lot of demand for that out there, and so even though you might not be making a debt service coverage ratio somewhere that if you’re in the right asset class, there’s still some demand for what you’ve got. So, I know I didn’t answer very specifically, but I think things are still hanging in there pretty well right now. And, finally, I’ll say is, as a relation to the consumer, they still got a job. In taxes, the unemployment numbers look pretty good. And as long as they’ve got a job, even though maybe spending down their savings, they’re able to hang in there, spend money.

Ebrahim Poonawala: Got it. That was a good color. Thanks, Phil. And apologies if I missed it, but can you remind us in terms of new branch of store openings over the next year like what’s in the pipeline beat in Austin or Dallas?

Phillip Green: That’s a good question. I’m going to have to guess a little bit here, but I’m going to guess 15-ish or so locations.

Jerry Salinas: Yeah, I think some of it’s going to be dependent. We’re having some conversations earlier this week. I’m especially when you talk about a market like Austin, where we’ve got the permitting process is different, we’re having to deal with different municipalities and such. So that can kind of affect certainly the number that we’re talking about. But I think the last number I saw combined in 2024 was around 15, I think, across all three markets.

Phillip Green: Yeah, I think it makes sense.

Ebrahim Poonawala: Got it. 15 combined. And how would that compare, Jerry, to what we did this year in 2023?

Jerry Salinas: I think it would be right now a little bit lower than where we were in 2023.

Ebrahim Poonawala: Understood. All right. Thank you for taking my questions.

Jerry Salinas: Sure.

Operator: Our next question is from Manan Gosalia with Morgan Stanley. Please proceed.

Manan Gosalia: Hey, good afternoon.

Phillip Green: Good afternoon.

Manan Gosalia: I wanted to check in on deposit beta. You spoke about seeing a mixture from lower cost to high cost deposits, again this quarter. Can you help us think through peak deposit betas in 2024 as rates stay higher for longer, and also give some color on the competition that you’re seeing?

Jerry Salinas: Yeah. So right now, I guess I’ll talk a little bit about 2023. So for the third quarter, I think cumulatively on this cycle were up 2%. On interest bearing, we were at 37% in the second quarter. We’re at 39% at the end of the third quarter. I’d expect that same sort of a little clip between the third and the fourth quarter on interest bearing and on same sort of movement on total deposits. I think we increased from 23% to 25% through the end of the third quarter. Right now from a competitive standpoint, we’re really – we try to keep an eye and we do keep an eye on our competitors really at all levels. We don’t feel like we need to be the top, but we do want to be competitive and we look at rates weekly.

One thing we’ve seen more competitive pressure today in the last couple of recent weeks, it’s been more on the CD side. I think that’s really what large consumers and commercial customers are looking for is kind of what the CD rates are to keep it at the bank. And so that’s what we’re seeing most of the price. And we tend to price – we keep an eye on what the comparable treasury security is doing to determine our pricing there. So, I think we’re really pretty competitive and feel good about where we’re at.

Manan Gosalia: Got it. And maybe a follow-up on expenses. I know you noted the expense growth rate would likely come down next year. But at the start of this year, when you got it to the mid-teens expense growth, I think you’d mentioned you’d be investing in some IT and cyber projects, upgrading a couple of core systems. And I think you also noted that the timing of several large projects were just coinciding in 2023. So should we think about some of these one-time costs coming out next year? Or are these multi-year investments that you’re making in the business?

Jerry Salinas: Yeah, I think most of the things that we’re talking about are multi-year investments. Most of these are going to be either positions that we hired from new IT staff or projects that will get capitalized. I think what we’ve seen is that some of this has moved into latter parts of 2023 a little bit. And so feeling a little bit of some of the upside that we probably are seeing when we talked about earning expense guidance, being a little bit lighter than where we originally thought had a little bit to do with some of that timing. So we’re not really – I’m not thinking anything that comes to mind immediately of one-time sort of expenses that we’re driving that expense growth this year. It was more people and capitalized projects.

And like I said, we have a little bit that’s moving into next year, but as Phil said, we don’t expect, certainly, that our expense growth for next year will be in the double-digits that the mid-teens that I’ve been discussing for this year. Does that help?

Manan Gosalia: It doesn’t sound like there’s a lot chunk of investments that are getting delayed and moving from this year to next year.

Jerry Salinas: Yeah, I think that’d be a good conclusion.

Manan Gosalia: Thank you.

Operator: Our next question is from Brady Gailey with KBW. Please proceed.

Brady Gailey: Hey, thank you. Good afternoon, guys.

Jerry Salinas: Hey, Brady.

Phillip Green: Hey, Brady.

Brady Gailey: But maybe just to ask the expense question a little differently. As I look over the last, I don’t know, 3 or 4 years, you made a big investment in Houston, big investment in Dallas, now a big investment in Austin. I know that was a big piece of the abnormally high expense growth. As you think about it going forward, are there still markets out there, where you want to make a substantial new investment? Or do you think with these three – I mean, you are kind of in the three big spots there in Texas. With these three, are you kind of done making these large investments in a new market?

Phillip Green: Brady, I mean, look, we’ve got a lot of – first of all, we have a lot of work left to do. Okay. So we got to finish up Dallas, we were just starting Austin. And we’ve got a pretty big network that we’re going to continue to deal with and continue to grow in the normal course of business, right? But I don’t want to be too far out in front of that, but look, like I said earlier, we’re going to be doing this for a long time. I mean, there are great markets to be in, in this state. There are great markets to be in out of this state. I’m looking way down the road. I mean, I’m just saying, I don’t think there’s anything about our business model that ends, when we get through doing 17 branches in Austin.

And so, maybe to answer your question another way, the way to think about our company is probably that we’ve got this legacy part of our company that operates very efficiently and very profitably. And it’s got a lot of control in terms of expenses and that kind of thing. And then we have this expansion element of our company that is a growth and expansion component. And that has higher growth rates, just it’s the nature of that kind of business. And what we believe is the combination of those two, and they do two different things, right? There’s a legacy kind of piece and there’s this new expansion piece. Maybe we’ll probably always be as long as we’re doing it a little bit higher on average than others. But another way to think of it too is a lot of these expansion assets are going to be creating the money and the revenue to fund future expansions too.

So that’s not a real specific answer, but it’s sort of how we think about the business right now.

Brady Gailey: Yeah. That helps. And then we’ve seen some of your peers do a partial bond restructuring. I know you all is bond yield is around 3.25. So if you mark-to-market that bond yield, you probably be picking up at least a couple of 100 basis points. How do you all think about restructuring a piece of the bond book? And your TCE is in the mid-4% range like does that matter? I know Common Equity Tier 1 is a lot higher. But does the TCE matter when you consider a possible bond restructuring?

Jerry Salinas: Brady, I’ll say that we have not discussed any sort of a bond restructuring. I think that, obviously, we’ve got the securities and available for sale. We think it gives us the most amount of flexibility. We like the transparency that it provides through equity. And, I think from a tangible capital standpoint, we don’t spend a lot of time thinking about it. We’re obviously aware of it. As we said earlier, we haven’t made any investment purchases this year. I think if we do put a program in place, we’ll certainly – whatever program we put in place, we will certainly consider the potential implications of the new capital regime that’s out there for banks that are $100 billion, that would have to include OCI.

So we’re not – it’s nothing that we’re not aware of. It’s more that at this point, it’s not been really something that’s been part of our conversation. So anything else I would say, I’d kind of make it up, but it’s not something that we really talked about going forward.

Brady Gailey: Okay. And then finally for me, it looks like the share count went down just modestly in the third quarter relative to the second quarter. So maybe a modest amount of share buybacks. Your stock was at a year-to-date low, I know it’s up pretty nicely today, but it’s still relatively cheap versus where you all have been trading earlier this year. So how do you think about a share buyback with the stock at this level?

Jerry Salinas: Yeah, I think we didn’t spend a lot of money, but we got in earlier than I would have liked in retrospect. I think, I don’t have the numbers right in front of me, but I think it was around $11 million that we spent in the quarter. It’s just something that we’ll talk about. On one side, we’re having the conversation like you said about how much are people paying attention to tangible capital? On the other side, I’m talking about what a great bargain our stock is, even before today, especially. So it’s just a conversation we’ll continue to have. It won’t have big implications. I think at this point, we’re probably, we’ve got a $100 million program that expires in January. We’ve probably utilized $30 million of it, if I remember correctly. So it won’t have huge impacts, but it’s something that we consider to continue to discuss. But, again, it’s not going to have a big impact.

Brady Gailey: Okay. Thanks for the color, guys.

Operator: Our next question is from Michael Rose with Raymond James. Please proceed.

Michael Rose: Hey, good afternoon. Thanks for taking my questions. Phil, I noticed your comments about optimism around home equity and just looking at the average balances. We don’t have them for this quarter, [excuse that out] [ph] but just over the past quarter, couple of quarters, it seems like that’s over half the average loan growth. Just wanted to kind of size the opportunity as we move forward, and particularly as you roll out the mortgage product. Thanks.

Phillip Green: I’m sorry, Michael. Did you ask me the outlook for that, or what would you say? I mean, I agree with your numbers, but what were you asking?

Michael Rose: Just if you could size the opportunities moving forward, because you did sound fairly optimistic going forward. And then as you layer in mortgage, consumer mortgage, I know the market is not great, but you’re in Texas just trying to get a sense for what the growth opportunity is. And I think that home equity consumer line is about 12.5% of the portfolio. Just where do you think that could get to over time? Thanks.

Phillip Green: Yeah. Well, the mortgage portfolio is a great asset class for us. I think over time, this is back a year ago when we started talking about it, I think we said – I can’t remember exactly what we said it. But the impression we wanted to give you was that, “Hey, this could be mortgage itself over time could be what the consumer real estate portfolio was at that time, just by itself.” And so, we still think it’s good. This is a long-term product, a long-term relationship, so we feel really good about it. And, remember, we’re not doing a refi program, so I don’t care that the refi market’s down. In fact, I love it, because it’s allowed us to get, I don’t know, what 90 people or so that we were able to bring in great mortgage professionals to build that infrastructure over the last year.

So we’re all about putting people in homes and that’s, I think, we’re going to have a chance to do that for a long time. I think that I saw a number, Michael, at the percentage of people that had, what was it, a 3% mortgage was like over 60%. It was amazing. And if you looked at the people that had under, “Hey, was it 5?” It’s like 90%-something of the mortgage is so, if you want to, I mean, people are not moving, right? And so, I think that this home equity product has got legs, this home improvement product has got legs for a while. The rate of growth has been so high, 20s, mid-20s sometimes. I think that just by its nature, the law of numbers, it has to go down in terms of percentage, but I still think the volume should be pretty good, because it just fills a gap that people need right now.

Michael Rose: Great. I appreciate the color. And just one final for me, so I guess, the potential problem loans were up, about 16% QonQ, any notable trends in there, anything to read in that, or just more kind of normalization of credit off of a very low base? Thanks.

Phillip Green: Yeah, the numbers I’ve looked at were the – I think where I saw the change was in the risk-grade 10s. Really, there are about, I think there were 4 credits that made up the vast majority of that, and they were like different businesses. There are a couple of real estate properties, actually, they were smaller office buildings, they had kind of idiosyncratic things, and we don’t feel that bad about them. But we felt – remember, this is OAEM. This is a lighter classification. And then there was something a midstream energy trading company that it’s just a business kind of thing. I mean, we find a thing, and then we got…

Jerry Salinas: What was the other one?

Phillip Green: Oh, I think it was a buy here, pay here outfit, I think that’s what that was. And so kind of an interest-sensitive business, we’ve seen some of that. That was the kind of thing. It didn’t give me a lot of heartburn. It’s just reflective of the environment we’re in. But I didn’t think it said anything in particular about how we’re doing. We’re doing things. In fact, I think it shows we were doing our business pretty well. And then, again, I’ve said since the beginning of this that it’s a risk business, and when we see some hiccups here and there, of course we will. But I feel really good about how we’ve done things. I feel really good about the customers, not every one of them has performed like we want, but most of them have. And I feel pretty comfortable with it.

Michael Rose: Great. I appreciate the color. Thanks.

Phillip Green: Okay.

Operator: And our final question is from Brody Preston with UBS. Please proceed.

Brody Preston: Hello, everyone.

Phillip Green: Hello.

Jerry Salinas: Hey.

Brody Preston: I wanted to follow-up on office, I was wondering if you happen to have what the reserve against the office portfolio is and how do you think about that moving forward just given some of the larger banks are putting up pretty hefty reserves against their office portfolios.

Jerry Salinas: I’m looking at what I’ve got. I’ve only got the commercial real estate as a group. I’m looking at, Brody, I don’t have the office, but certainly I think that number if I’m looking at this correctly here is 1.45 on all commercial real estate. Certainly, if you get with A.B., we can certainly provide you that detail. I don’t think I’ve got it here in front of me.

Brody Preston: Okay. Great. I’ll follow up…

Phillip Green: Hey, I will say that I’m not going to do anything just because the large banks are doing something, just sort of you know.

Brody Preston: Got it. I did also – Jerry, I’m sorry to go back to expenses and be the…

Jerry Salinas: Hey, Brody, so I’m getting a chat real quick. It’s saying that our reserve is 2.2% on office.

Brody Preston: Okay. Great. Thank you very much for that.

Jerry Salinas: Sure.

Brody Preston: I did just want to touch on expenses. A couple of quarters ago you said you thought like a long-term kind of expense growth rate for the bank as high-single-digits. I just wanted to ask like would it be fair to say that Austin, the Austin build out will be mildly additive to that kind of long-term growth rate, when you think about planning for next year?

Jerry Salinas: I think that the way we tend to look at it is and, again, it’s going to be dependent on how big an expansion we really typically would originate. But when I gave that sort of guidance that was inclusive, would be inclusive of what we were doing.

Brody Preston: Okay. Got it. That’s helpful. And then the last one that I had was, I’m sorry if you said it earlier and I missed it, do you happen to have for the fixed rate portion of loan portfolio, what’s coming due over the next 12 months and what the yield pickup on that would be?

Phillip Green: No, I don’t think I’ve got that handy with me, Brody, but again I think that’s something certainly, maybe you can get it to you.

Brody Preston: Okay. Maybe if I can ask one more.

Phillip Green: Sure, of course.

Brody Preston: Do you happen to have what the percent of the portfolio that SNCs [ph] is?

Jerry Salinas: Yeah, I think it’s 4%. Let me double check that, but that’s my recollection. Yeah, at the end of September, that portfolio was – the SNC portfolio was $789 million or 4.3% of the period end loans.

Brody Preston: Awesome. Thank you very much. I appreciate it.

Jerry Salinas: Sure.

Operator: We have reached the end of our question-and-answer session. I would like to turn the conference back over to Phil for closing remarks.

Phillip Green: Thanks, everyone. We appreciate your participation today and your interest. We’ll be adjourned.

Operator: Thank you. This will conclude today’s conference. You may disconnect your lines at this time and thank you for your time.