1 Securities and Exchange Commission Washington, D.C. 20549 Form 10-Q Quarterly Report Under Section 13 or 15(d) of the Securities Exchange Act of 1934 For Quarter Ended March 31, 2002 Commission file number 0-7275 Cullen/Frost Bankers, Inc. (Exact name of registrant as specified in its charter) Texas 74-1751768 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 100 W. Houston Street, San Antonio, Texas 78205 (Address of principal executive offices) (Zip code) (210) 220-4011 (Registrant's telephone number, including area code) N/A (Former name, former address and former fiscal year, if changed since last report) Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date: At April 18, 2002, there were 51,204,891 shares of Common Stock, $.01 par value, outstanding.
2 Part I. Financial Information Item 1. Financial Statements (Unaudited) <TABLE> <CAPTION> Consolidated Statements of Income Cullen/Frost Bankers, Inc. and Subsidiaries (dollars in thousands, except per share amounts) Three Months Ended March 31 -------------------- 2002 2001 ------- ------- <S> <C> <C> INTEREST INCOME Loans, including fees $66,602 $98,603 Securities: Taxable 28,304 24,323 Tax-exempt 1,981 1,890 ------- ------- Total Securities 30,285 26,213 Time deposits 50 116 Federal funds sold and securities purchased under repurchase agreements 476 2,244 ------- ------- Total Interest Income 97,413 127,176 INTEREST EXPENSE Deposits 15,311 39,540 Federal funds purchased and securities sold under repurchase agreements 1,187 4,362 Guaranteed preferred beneficial interests in the Corporation's junior subordinated deferrable interest debentures 2,119 2,119 Subordinated notes payable and other borrowings 1,883 536 ------- ------- Total Interest Expense 20,500 46,557 ------- ------- Net Interest Income 76,913 80,619 Provision for possible loan losses 6,800 15,031 ------- ------- Net Interest Income After Provision For Possible Loan Losses 70,113 65,588 NON-INTEREST INCOME Trust fees 12,115 12,006 Service charges on deposit accounts 18,407 16,500 Insurance commissions 5,606 3,895 Other service charges, collection and exchange charges, commissions and fees 6,045 5,934 Net gain on securities transactions 10 Other 8,620 8,413 ------- ------- Total Non-Interest Income 50,793 46,758 NON-INTEREST EXPENSE Salaries and wages 36,140 35,610 Employee benefits 8,926 8,911 Net occupancy 7,413 7,203 Furniture and equipment 5,824 6,012 Intangible amortization 1,877 3,880 Other 20,059 20,985 ------- ------- Total Non-Interest Expense 80,239 82,601 ------- ------- Income Before Income Taxes and Cumulative Effect of Accounting Change 40,667 29,745 Income taxes 12,950 10,215 ------- ------- Income before cumulative effect of accounting change 27,717 19,530 Cumulative effect of change in accounting for derivatives, net of tax 3,010 ------- ------- Net Income $27,717 $22,540 ======= ======= Basic per share: Income before cumulative effect of accounting change $ .54 $ .38 Cumulative effect of change in accounting, net of taxes .06 ------- ------- Net Income $ .54 $ .44 ======= ======= Diluted per share: Income before cumulative effect of accounting change $ .52 $ .36 Cumulative effect of change in accounting, net of taxes .06 ------- ------- Net Income $ .52 $ .42 ======= ======= Dividends per common share $ .215 $ .195 See notes to consolidated financial statements. </TABLE>
3 <TABLE> <CAPTION> Consolidated Balance Sheets Cullen/Frost Bankers, Inc. and Subsidiaries (dollars in thousands, except per share amounts) March 31 December 31 March 31 2002 2001 2001 ---------- ----------- ---------- <S> <C> <C> <C> Assets Cash and due from banks $ 846,975 $ 994,622 $ 881,280 Time deposits 14,305 6,530 5,028 Securities held to maturity 46,631 51,231 67,419 Securities available for sale 2,020,110 2,105,247 1,634,643 Trading account securities 646 118 863 Federal funds sold and securities purchased under resale agreements 107,150 129,550 243,075 Loans, net of unearned discount of $6,288 at March 31, 2002; $5,005 at December 31, 2001 and $6,945 at March 31, 2001 4,559,092 4,518,608 4,586,733 Less: Allowance for possible loan losses (77,300) (72,881) (64,065) ---------- ---------- ---------- Net loans 4,481,792 4,445,727 4,522,668 Premises and equipment 144,856 148,871 150,306 Accrued interest and other assets 409,294 487,688 314,640 ---------- ---------- ---------- Total Assets $8,071,759 $8,369,584 $7,819,922 ========== ========== ========== Liabilities Demand deposits (non-interest bearing): Commercial and individual $1,802,284 $2,317,926 $1,925,730 Correspondent banks 521,389 298,055 229,187 Public funds 53,023 53,848 29,336 ---------- ---------- ---------- Total demand deposits 2,376,696 2,669,829 2,184,253 Time deposits (interest bearing): Savings and Interest-on-Checking 1,042,347 1,063,923 990,597 Money market deposit accounts 1,846,255 1,804,796 1,830,254 Time accounts 1,168,964 1,202,246 1,278,564 Public funds 339,604 357,213 306,075 ---------- ---------- ---------- Total time deposits 4,397,170 4,428,178 4,405,490 ---------- ---------- ---------- Total deposits 6,773,866 7,098,007 6,589,743 Federal funds purchased and securities sold under repurchase agreements 317,849 305,384 400,358 Accrued interest and other liabilities 125,132 120,499 135,286 Subordinated notes payable and other notes payable 152,043 152,152 3,486 Guaranteed preferred beneficial interest in the Corporation's junior subordinated deferrable interest debentures, net 98,636 98,623 98,582 ---------- ---------- ---------- Total Liabilities 7,467,526 7,774,665 7,227,455 Shareholders' Equity Common stock, par value $.01 per share 536 536 536 Shares authorized:90,000,000 Shares issued: 53,561,616 Surplus 193,376 191,856 189,849 Retained earnings 493,915 478,432 456,822 Accumulated other comprehensive (loss) income, net of tax (13,680) (14,005) 1,961 Treasury stock (2,373,125; 2,206,381; 2,010,170 shares) (69,914) (61,900) (56,701) ---------- ---------- ---------- Total Shareholders' Equity 604,233 594,919 592,467 ---------- ---------- ---------- Total Liabilities and Shareholders' Equity $8,071,759 $8,369,584 $7,819,922 ========== ========== ========== See notes to consolidated financial statements. </TABLE>
4 <TABLE> <CAPTION> Consolidated Statements of Changes in Shareholders' Equity Cullen/Frost Bankers, Inc. and Subsidiaries (dollars in thousands) Accumulated Other Comprehensive Common Retained Income/(Loss) Treasury Stock Surplus Earnings net of tax Stock Total ------ -------- -------- ------------- -------- -------- <S> <C> <C> <C> <C> <C> <C> Balance at January 1, 2001 $536 $187,673 $448,006 $ (4,023) $(59,166) $573,026 Net Income for the twelve months ended December 31, 2001 80,916 80,916 Unrealized loss on securities available for sale of $4,672, net of tax and reclassification adjustment for after-tax gains included in net income of $51 (4,723) (4,723) Additional minimum pension liability, net of tax (5,259) (5,259) -------- Total comprehensive income 70,934 -------- Transactions from employee stock purchase plan and options (6,234) 5,193 (1,041) Tax benefit related to exercise of stock options 3,475 3,475 Purchase of treasury stock (10,424) (10,424) Issuance of restricted stock 708 2,497 3,205 Restricted stock plan deferred compensation, net (960) (960) Cash dividend (43,296) (43,296) ---- -------- -------- -------- -------- -------- Balance at December 31, 2001 536 191,856 478,432 (14,005) (61,900) 594,919 Net Income for the three months ended March 31, 2002 27,717 27,717 Unrealized gain on securities available for sale, net of tax 325 325 -------- Total comprehensive income 28,042 -------- Transactions from employee stock purchase plan and options (1,604) 4,947 3,343 Tax benefit related to exercise of stock options 1,447 1,447 Purchase of treasury stock (13,113) (13,113) Issuance of restricted stock 73 152 225 Restricted stock plan deferred compensation, net 364 364 Cash dividend (10,994) (10,994) ---- -------- -------- -------- -------- -------- Balance at March 31, 2002 $536 $193,376 $493,915 $(13,680) $(69,914) $604,233 ==== ======== ======== ======== ======== ======== See notes to consolidated financial statements. </TABLE>
5 <TABLE> <CAPTION> Consolidated Statements of Cash Flows Cullen/Frost Bankers, Inc. and Subsidiaries (dollars in thousands) Three Months Ended March 31 ---------------------- 2002 2001 ---------- ---------- <S> <C> <C> Operating Activities Net income $ 27,717 $ 22,540 Adjustments to reconcile net income to net cash provided by operating activities: Provision for possible loan losses 6,800 15,031 Credit for deferred taxes (467) (662) Accretion of discounts on loans (1,297) (408) Accretion of securities' discounts (489) (1,558) Amortization of securities' premiums 1,177 341 (Increase) decrease in trading account securities (528) 1,608 Net realized gain on securities transactions (10) Net loss (gain) on sale of assets 78 (1,206) Depreciation and amortization 6,911 9,032 Increase (decrease) in interest receivable 2,795 (1,560) Decrease in interest payable (6,766) (2,178) Originations of loans held-for-sale (21,019) (20,426) Proceeds from sales of loans held-for-sale 10,801 11,877 Tax benefit from exercise of employee stock options 1,447 2,106 Net change in other assets and liabilities 85,133 22,753 ---------- ---------- Net cash provided by operating activities 112,293 57,280 Investing Activities Proceeds from maturities of securities held to maturity 4,588 3,715 Proceeds from sales of securities available for sale 74,843 Proceeds from maturities of securities available for sale 169,364 76,391 Purchases of securities available for sale (84,402) (180,566) Net increase in loan portfolio (31,122) (57,026) Net increase in premises and equipment (1,053) (4,538) Proceeds from sales of repossessed properties 275 662 ---------- ---------- Net cash provided (used) by investing activities 57,650 (86,519) Financing Activities Net (decrease) increase in demand deposits, IOC accounts, and savings accounts (290,859) 86,778 Net (decrease) increase in certificates of deposits (33,282) 3,275 Net increase in short-term borrowings 12,465 37,247 Proceeds from employee stock purchase plan and options 3,568 2,290 Purchase of treasury stock (13,113) Dividends paid (10,994) (10,051) ---------- ---------- Net cash (used) provided by financing activities (332,215) 119,539 ---------- ---------- (Decrease) increase in cash and cash equivalents (162,272) 90,300 Cash and cash equivalents at beginning of year 1,130,702 1,039,083 ---------- ---------- Cash and cash equivalents at the end of the period $ 968,430 $1,129,383 ========== ========== Supplemental information: Interest Paid $ 27,266 $ 44,374 See notes to consolidated financial statements. </TABLE>
6 Notes to Consolidated Financial Statements Cullen/Frost Bankers, Inc. and Subsidiaries (tables in thousands) Note A - Basis of Presentation The consolidated financial statements include the accounts of Cullen/Frost Bankers, Inc. ("Cullen/Frost" or the "Corporation") and its wholly-owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation. The consolidated financial statements have not been audited by independent accountants, but in the opinion of management, reflect all adjustments necessary for a fair presentation of the financial position and results of operations. All such adjustments were of a normal and recurring nature. For further information, refer to the consolidated financial statements and footnotes thereto included in Cullen/Frost's Annual Report on Form 10-K for the year ended December 31, 2001. The balance sheet at December 31, 2001 has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. Certain reclassifications have been made to make prior periods comparable. Note B - Allowance for Possible Loan Losses An analysis of the transactions in the allowance for possible loan losses is presented below. The amount maintained in the allowance for loan losses reflects management's continuing assessment of the potential losses inherent in the portfolio based on evaluations of industry concentrations, specific credit risks, loan loss experience, current loan portfolio quality, present economic, political and regulatory conditions and unidentified losses inherent in the current loan portfolio. Three Months Ended March 31 ------------------- (in thousands) 2002 2001 - ---------------------------------------------------------------------- Balance at beginning of the period $72,881 $63,265 Provision for possible loan losses 6,800 15,031 Net charge-offs: Losses charged to the allowance (3,726) (14,976) Recoveries 1,345 745 ------- ------- Net charge-offs (2,381) (14,231) ------- ------- Balance at the end of the period $77,300 $64,065 ======= ======= Note C - Impaired Loans A loan within the scope of Statement of Financial Accounting Standard ("SFAS") No. 114 is considered impaired when, based on current information and events, it is probable that Cullen/Frost will be unable to collect all amounts due according to the contractual terms of the loan agreement, including scheduled principal and interest payments. All impaired loans are on non- accrual status and included in non-performing assets. At March 31, 2002, the majority of the impaired loans were commercial loans and collectibility was measured based on the fair value of the collateral. Interest payments on impaired loans are typically applied to principal unless collectibility of the principal amount is reasonably assured, in which case interest is recognized on a cash basis. Subsequent to classification as an impaired loan, there was no interest income recognized on these loans for the first three months of 2002 and 2001. The total allowance for possible loan losses includes activity
7 related to allowances calculated in accordance with SFAS No. 114 and activity related to other loan loss allowances determined in accordance with SFAS No. 5. The average recorded investment in impaired loans was $31.5 million and $13.8 million for the three months ended March 31, 2002 and 2001 respectively. The following is a summary of loans considered to be impaired: March 31 ------------------- (in thousands) 2002 2001 - -------------------------------------------------------------------------- Impaired loans with no allocated allowance $12,006 $ 1,682 Impaired loans with an allocated allowance 21,348 14,015 ------- ------- Total recorded investment in impaired loans $33,354 $15,697 ======= ======= Allocated allowance $ 7,068 $ 6,009 Note D - Common Stock and Earnings Per Common Share A reconciliation of earnings per share follows: Three Months Ended March 31 -------------------- (in thousands, except per share amounts) 2002 2001 - ------------------------------------------------------------------- Numerators for both basic and diluted earnings per share, net income $27,717 $22,540 ======= ======= Denominators: Denominators for basic earnings per share, average outstanding common shares 51,253 51,518 Dilutive effect of stock options based on the average price for the period 1,992 2,244 ------- ------- Denominator for diluted earnings per share 53,245 53,762 ======= ======= Earnings per share: Basic $ .54 $ .44 Diluted .52 .42 Note E - Capital At March 31, 2002 and 2001, Cullen/Frost's subsidiary bank was considered "well capitalized" as defined by the Federal Deposit Insurance Corporation Improvement Act of 1991, the highest regulatory rating, and Cullen/Frost's capital ratios were in excess of "well capitalized" levels. A financial institution is deemed to be well capitalized if the institution has a Tier 1 risk-based capital ratio of 6.0 percent or greater, a total risk-based capital ratio of 10.0 percent or greater, and a Tier 1 leverage ratio of 5.0 percent or greater, and the institution is not subject to regulatory actions such as an order, written agreement, capital directive or prompt corrective action directive to meet and maintain a specific capital level for any capital measure. Cullen/Frost and its subsidiary bank currently exceed all minimum capital requirements. Management is not aware of any conditions or events that would have lowered the Corporation's regulatory capital rating since March 31, 2002. Cullen/Frost's Tier 1 Capital consists of shareholders' equity before unrealized gains and losses related to securities available for sale plus $100 million of 8.42 percent Trust
8 Preferred Securities, less intangible assets. Total Capital is comprised of Tier 1 Capital plus $150 million of 6.875 percent subordinated bank notes and the permissible portion of the allowance for possible loan losses. Risk- adjusted assets are calculated based on regulatory requirements and include total assets and certain off balance sheet items (primarily loan commitments), less intangible assets. The Tier 1 and Total Capital ratios are calculated by dividing the respective capital amounts by the risk-adjusted assets. The leverage ratio is calculated by dividing Tier 1 Capital by average total assets (excluding intangible assets) for the period. Cullen/Frost is subject to the regulatory capital requirements administered by the Federal Reserve Bank. Regulators can initiate certain mandatory actions if the Corporation fails to meet the minimum requirements, which could have a direct material effect on the Corporation's financial statements. The table below reflects various measures of regulatory capital at March 31, 2002 and 2001 for Cullen/Frost. <TABLE> <CAPTION> March 31, 2002 March 31, 2001 ------------------- ------------------- (in thousands) Amount Ratio Amount Ratio - -------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Risk-Based Tier 1 Capital $ 593,775 10.54% $ 566,133 10.30% Well capitalized requirement 338,151 6.00 329,886 6.00 Total Capital $ 813,044 14.43% $ 630,198 11.46% Well capitalized requirement 563,586 10.00 549,810 10.00 Risk-adjusted assets, net of goodwill $5,635,858 $5,498,104 Leverage ratio 7.90% 7.73% Well capitalized requirement 5.00 5.00 Average equity as a percentage of average assets 7.57 7.92 </TABLE> Note F - Income Taxes The following is an analysis of the Corporation's income taxes included in the consolidated statements of operations for the quarters ended March 31, 2002 and 2001: Three Months Ended March 31 -------------------- (in thousands) 2002 2001 - -------------------------------------------------------------------------- Current income tax expense $13,417 $10,877 Deferred income tax benefit (467) (662) ------- ------- Income tax expense as reported $12,950 $10,215 ======= ======= Current income tax expense related to the cumulative effect of change in accounting for derivatives $ 1,620 Income tax payments $ -- $ -- Net deferred tax assets at March 31, 2002 were $33.2 million with no valuation allowance necessary because they were supported by recoverable taxes paid in prior years.
9 Note G - Acquisitions Cullen/Frost regularly evaluates acquisition opportunities and conducts due diligence activities in connection with possible acquisitions. As a result, acquisition discussions and, in some cases negotiations, may take place, and future acquisitions involving cash, debt or equity securities may occur. Acquisitions typically involve the payment of a premium over book and market values, and, therefore, some dilution of the Corporation's book value and net income per common share may occur in connection with any future transactions. On March 6, 2002, Frost Bank signed a definitive agreement to acquire the location and certain deposits of the Harlingen branch of JPMorgan Chase Bank. This acquisition allows the Corporation to expand its presence in the Rio Grande Valley, which began when it acquired Valley Bancshares and its bank in McAllen, Valley National Bank in 1995. A second McAllen location was opened in 1997. Frost Bank will assume approximately $20 million in deposits associated with its acquisition of the Harlingen branch. Completion of the acquisition is expected to occur during the second quarter of 2002 following regulatory approval, at which time the Harlingen location will become a Frost Bank financial center. This transaction is not expected to have a material impact on Cullen/Frost's 2002 results of operations. On August 1, 2001, Frost Insurance Agency ("FIA"), a subsidiary of The Frost National Bank, completed its acquisition of AIS Insurance & Risk Management ("AIS"), an independent insurance agency based in Fort Worth. AIS offered a broad range of commercial insurance for small to mid-size businesses, including property and casualty, employee benefits (health, life and retirement plans), business succession planning and risk management services. This acquisition was accounted for as a purchase transaction and did not have a material impact on Cullen/Frost's 2001 results of operations. Note H - Accounting for SFAS No. 133 On January 1, 2001, Cullen/Frost adopted SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities", and at that time, designated anew the derivative instruments used for risk management into hedging relationships in accordance with the requirements of the new standard. SFAS No. 133 requires the recognition of all derivatives on the balance sheet at fair value. Cullen/Frost enters into derivative contracts to hedge interest rate exposure by modifying the interest rate characteristics of related balance sheet instruments. To qualify for hedge accounting, derivatives must be highly effective at reducing the risk associated with the exposure being hedged and must be designated as a hedge at the inception of the derivative contract. Derivative contracts are carried on the balance sheet at fair value in other assets and other liabilities. Derivatives used for hedging purposes at March 31, 2002 consisted entirely of interest rate swaps used to hedge changes in the fair value of assets and liabilities due to changes in interest rates. As a result of changes in interest rates, hedged assets and liabilities will appreciate or depreciate in market value. The effect of this unrealized appreciation or depreciation will generally be offset by income or loss on the fair value of the derivative instruments that are associated with the hedged assets and liabilities. When a fair value type hedge no longer qualifies for hedge accounting, previous adjustments to the carrying value of the hedged item are reversed immediately to current earnings and the hedge is reclassified to a trading position recorded at fair value.
10 Note I - Accounting Changes In July 2001, the FASB issued SFAS No. 141, "Business Combinations", and SFAS No. 142, "Goodwill and Other Intangible Assets." These Statements make significant changes to the accounting for business combinations, goodwill and intangible assets. SFAS No. 141, which replaces APB Opinion No. 16, eliminates the pooling-of-interests method of accounting for business combinations initiated after June 30, 2001. In addition, it establishes criteria for recognition of indefinite lived intangible assets separately from goodwill. SFAS No. 141 is effective for purchase-accounting business combinations completed after June 30, 2001. SFAS No. 141 will impact future acquisitions by the Corporation, but had no impact on 2001 results of operations, financial position or liquidity. With the adoption of SFAS No. 142, goodwill and indefinite lived intangible assets are no longer amortized. Instead they are reviewed for impairment at least annually or when certain indicators are encountered to determine if they should be written down with a charge to earnings. At March 31, 2002 the Corporation did not have indefinite lived intangible assets other than goodwill. Intangible assets, such as core deposit intangibles, with a determinable useful life will continue to be amortized over their respective useful lives. The Corporation has adopted SFAS No. 142 effective on January 1, 2002. The non-amortization provisions were effective immediately for goodwill and intangible assets acquired after June 30, 2001 and prior to the adoption. Application of the non-amortization provisions of SFAS No. 142 is expected to result in additional net income of approximately $6.9 million or approximately $.13 per diluted common share in 2002. SFAS No. 142 requires a transitional impairment test be applied to all goodwill and other indefinite-lived intangible assets within the first six months after adoption. The impairment test involves identifying separate reporting units based on the reporting structure of the Corporation, then assigning all assets and liabilities, including goodwill, to these units. Goodwill is assigned based on the reporting unit benefiting from the factors that gave rise to the goodwill. Each reporting unit is then tested for goodwill impairment by comparing the fair value of the unit with its book value, including goodwill. If the fair value of the reporting unit is greater than its book value, no goodwill impairment exists. However, if the book value of the reporting unit is greater than its determined fair value, goodwill impairment may exist and further testing is required to determine the amount, if any, of the actual impairment loss. Any impairment loss determined with this transitional test would be reported as a change in accounting principle. The Corporation has completed a preliminary transitional impairment test of goodwill and based on current information does not expect to record an impairment loss as a result of this test. The following table presents a reconciliation of reported net income and earnings per share to the amounts adjusted for the exclusion, in 2001, of goodwill amortization, net of tax: Three Months Ended March 31 -------------------- 2002 2001 ------- ------- Net Income: Net income, as reported $27,717 $22,540 Goodwill amortization, net of tax 1,840 ------- ------- Adjusted Net Income $27,717 $24,380 ======= ======= Basic per share: Net income, as reported $ .54 $ .44 Goodwill amortization, net of tax .03 ------- ------- Adjusted Net Income $ .54 $ .47 ======= ======= Diluted per share: Net income, as reported $ .52 $ .42 Goodwill amortization, net of tax .03 ------- ------- Adjusted Net Income $ .52 $ .45 ======= =======
11 In October 2001 the FASB issued SFAS No. 144, "Accounting for the Impairment of Long-Lived Assets". This Statement addresses financial accounting and reporting for the impairment or disposal of long-lived assets. SFAS No. 144 replaces SFAS No. 121, "Accounting for the Impairment of Long- Lived Assets and for Long-Lived Assets to Be Disposed of", as well as the provisions of APB Opinion No. 30, "Reporting Results of Operations - Reporting the Effects of Disposal of a Segment of a Business", for the disposal of segments of a business. The Statement requires that those long-lived assets be measured at the lower of carrying amount or fair value less cost to sell, whether reported in continuing operations or in discontinued operations. This statement is effective for fiscal years beginning after December 15, 2001 and did not have a material effect on the Corporation's first quarter 2002 results of operations, financial position or liquidity. Note J - Operating Segments The Corporation has three reportable operating segments: Banking, the Financial Management Group and Frost Securities Inc. These business units were identified through the products and services that are offered within each unit. Banking includes both commercial and consumer banking services. Commercial banking services are provided to corporations and other business clients and include a wide array of lending and cash management products. Consumer banking services include direct lending and depository services. The Financial Management Group includes fee-based services within private trust, retirement services, and financial management services, including personal wealth management, insurance, and brokerage services. Frost Securities Inc. is a full-service investment bank offering financial advisory services, mergers and acquisitions support, equity research, and institutional equity sales and trading. The firm provides institutional investors with in-depth research coverage in energy and communications technology. The accounting policies of each reportable segment are the same as those of the Corporation except for the following items, which impact the Banking and Financial Management Group segments. The Corporation uses a match-funded transfer pricing process to assess operating segment performance. Expenses for consolidated back-office operations are allocated to operating segments based on estimated uses of those services. General overhead-type expenses such as executive administration, accounting and internal audit are allocated based on the direct expense level of the operating segment. Prior period amounts have been reclassified to conform to the current year's presentation. <TABLE> <CAPTION> Financial Management Frost Consolidated (in thousands) Banking Group Securities Non-Banks Total - ------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> <C> March 31, 2002 Revenues from (expenses to) external customers $111,138 $16,045 $ 2,587 $(2,064) $127,706 ------------------------------------------------------------- Net income (loss) $ 28,023 $ 3,181 $ (915) $(2,572) $ 27,717 ============================================================= - ------------------------------------------------------------------------------------------------------------------- March 31, 2001 Revenues from (expenses to) external customers $110,718 $16,460 $ 2,403 $(2,204) $127,377 ------------------------------------------------------------- Net income (loss) $ 22,687 $ 2,892 $(1,055) $(1,984) $ 22,540 ============================================================= </TABLE>
12 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations Financial Review Cullen/Frost Bankers, Inc. and Subsidiaries (taxable-equivalent basis - tables in thousands) Forward-Looking Statements Certain statements contained in this Quarterly Report on Form 10-Q that are not statements of historical fact constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 (the "Act"), even though they are not specifically identified as such. In addition, certain statements in future filings by Cullen/Frost with the Securities and Exchange Commission, in press releases, and in oral and written statements made by or with the approval of the Corporation which are not statements of historical fact will constitute forward-looking statements within the meaning of the Act. Examples of forward-looking statements include, but are not limited to: (i) projections of revenues, income or loss, earnings or loss per share, the payment or nonpayment of dividends, capital structure and other financial items; (ii) statements of plans and objectives of Cullen/Frost or its management or Board of Directors, including those relating to products or services; (iii) statements of future economic performance; and (iv) statements of assumptions underlying such statements. Words such as "believes", "anticipates", "expects", "intends", "targeted" and similar expressions are intended to identify forward-looking statements but are not the exclusive means of identifying such statements. Forward-looking statements involve risks and uncertainties that may cause actual results to differ materially from those in such statements. Factors that could cause actual results to differ from those discussed in the forward- looking statements include, but are not limited to: (i) local, regional and international economic conditions and the impact they may have on Cullen/Frost and its customers; (ii) the effects of and changes in trade, monetary and fiscal policies and laws, including interest rate policies of the Federal Reserve Board; (iii) inflation, interest rate, market and monetary fluctuations; (iv) political instability; (v) acts of war or terrorism; (vi) the timely development and acceptance of new products and services and perceived overall value of these products and services by users; (vii) changes in consumer spending, borrowings and savings habits; (viii) technological changes; (ix) acquisitions and integration of acquired businesses; (x) the ability to increase market share and control expenses; (xi) changes in the competitive environment among financial holding companies; (xii) the effect of changes in laws and regulations (including laws and regulations concerning taxes, banking, securities and insurance) with which Cullen/Frost and its subsidiaries must comply; (xiii) the effect of changes in accounting policies and practices, as may be adopted by the regulatory agencies as well as the Financial Accounting Standards Board; (xiv) changes in the Corporation's organization, compensation and benefit plans; (xv) the costs and effects of litigation and of unexpected or adverse outcomes in such litigation; (xvi) costs or difficulties related to the integration of the businesses of Cullen/Frost being greater than expected; and (xvii) the Corporation's success at managing the risks involved in the foregoing. Such forward-looking statements speak only as of the date on which such statements are made. Cullen/Frost undertakes no obligation to update any forward-looking statement to reflect events or circumstances after the date on which such statement is made, or to reflect the occurrence of unanticipated events.
13 Results of Operations The results of operations are included in the material that follows. All balance sheet amounts are presented in averages unless otherwise indicated. Certain reclassifications have been made to make prior periods comparable. Taxable-equivalent adjustments are the result of increasing income from tax- free loans and investments by an amount equal to the taxes that would be paid if the income were fully taxable assuming a 35 percent federal tax rate, thus making tax-exempt yields comparable to taxable asset yields. Dollar amounts in tables are stated in thousands, except for per share amounts. Cullen/Frost reported net income of $27.7 million or $.52 per diluted common share for the quarter ended March 31, 2002 compared to $13.1 million or $.25 per diluted common share and $22.5 million or $.42 per diluted common share for the fourth and first quarters of 2001, respectively. Earnings per diluted common share would have been $.28 and $.45 for the fourth and first quarters of 2001, respectively, if SFAS No. 142 (see Note I "Accounting Changes") had been in effect. Earnings in the fourth and first quarters of last year were also affected by the factors described in the following paragraphs. Net income for the fourth quarter 2001 included $19.9 million in pre-tax restructuring charges associated with an early retirement program, a two percent reduction in workforce and the freezing of the Corporation's defined benefit plan that was replaced by a deferred profit sharing plan. Excluding these restructuring charges, fourth quarter operating earnings were $26.0 million or $.49 per diluted common share. First quarter earnings a year ago included a provision for possible loan losses of $15 million, of which $13 million was related to a single shared national credit that was placed on non-accrual status at the end of February 2001. Partially offsetting this impact on first quarter 2001 results was a pre- tax gain of $5.7 million related to the sale of interest rate floors which had been purchased to hedge interest rate exposure in an environment of falling interest rates. Of the gain, $1.1 million was included in other non-interest income, with the remainder included, net of tax, as the cumulative effect of adopting SFAS No. 133, which went into effect January 1, 2001. Excluding the after-tax net impact of the additional provision and the gain on the sale of the interest rate floors, earnings per diluted common share for the first quarter of 2001 would have been $.51. Returns on average equity and average assets were 18.36 percent and 1.39 percent, respectively, for the first quarter of 2002 compared to return on average equity and average assets of 15.48 percent and 1.23 percent, respectively, for the first quarter of 2001. <TABLE> <CAPTION> Summary of Operations ------------------------------------- Three Months Ended ------------------------------------- 2002 2001 -------- ----------------------- March 31 December 31 March 31 - ---------------------------------------------------------------------------------- <S> <C> <C> <C> Taxable-equivalent net interest income $78,126 $78,359 $81,809 Taxable-equivalent adjustment 1,213 1,199 1,190 ------- ------- ------- Net interest income 76,913 77,160 80,619 Provision for possible loan losses 6,800 4,000 15,031 Non-Interest income: Net gain on securities transactions 10 Other 50,793 48,861 46,748 ------- ------- ------- Total non-interest income 50,793 48,861 46,758 Non-Interest expense: Intangible amortization 1,877 3,763 3,880 Restructuring charges 19,865 Other 78,362 79,337 78,721 ------- ------- ------- Total non-interest expense 80,239 102,965 82,601 ------- ------- ------- Income before income taxes and cumulative effect of accounting change 40,667 19,056 29,745 Income Taxes 12,950 5,991 10,215 ------- ------- ------- Income before cumulative effect of accounting change 27,717 13,065 19,530 Cumulative effect of change in accounting for derivatives, net of tax 3,010 ------- ------- ------- Net Income $27,717 $13,065 $22,540 ======= ======= ======= Net income per diluted common share: $ .52 $ .25 $ .42 Return on Average Assets 1.39% .63% 1.23% Return on Average Equity 18.36 8.18 15.48 </TABLE>
14 Net Interest Income Net interest income is the difference between interest income on earning assets, such as loans and investment securities, and interest expense on liabilities, such as deposits and borrowings, which are used to fund those assets. The level of interest rates and the volume and mix of earning assets and interest-bearing liabilities impact net interest income. Net interest income on a taxable-equivalent basis for the first quarter of 2002 was $78.1 million, flat with $78.4 million recorded for the fourth quarter of 2001 and down from $81.8 million recorded for the first quarter of 2001. Change in Taxable-Equivalent Net Interest Income ------------------------------------ First Quarter First Quarter 2002 2002 vs. vs. First Quarter Fourth Quarter 2001 2001 ------------------------------------ Amount Amount - ---------------------------------------------------------------- Due to volume $ 5,417 $ 1,404 Due to interest rate spread (9,100) (1,637) ------ ------- $(3,683) $ (233) ====== ======= Net interest margin is the taxable-equivalent net interest income as a percentage of average earning assets for the period. Net interest margin was 4.68 percent for the first quarter of 2002 compared to 4.60 percent and 5.18 percent for the fourth and first quarters of 2001, respectively. The decrease in net interest income and net interest margin from the first quarter of 2001 reflects the impact of sharply reduced interest rates on the Corporation's asset-sensitive balance sheet (the company's earning assets have repriced to a greater degree than its interest-bearing liabilities). The federal funds rate declined eight times during the last 12 months, resulting in an average federal funds rate of 1.75 percent for the first quarter of 2002 and 2.28 percent for the fourth quarter of 2001, compared with 5.63 percent for the first quarter of 2001. The 5.7 percent growth in average earning assets partially offset the negative impact of the rate decline. The Corporation is funded primarily by core deposits, with demand deposits historically being a strong source of funds. This low cost funding base has historically been a positive to net interest income and margin. However, in a falling rate environment the Corporation suffers margin compression as its earning assets reprice and deposit pricing does not decrease proportionately. The increase in net interest margin over the fourth quarter of 2001 reflects the impact of a redeployment of available funds from Federal funds sold into investment securities, which earn a higher yield. Also, the net interest margin was favorably impacted by lower interest expense related to the subordinated debt interest rate swap. Net interest spread, which represents the difference between the rate earned on earning assets and the rates paid out on funds, was 4.24 percent for the first quarter of 2002. This was an increase of 18 basis points from the fourth quarter of 2001 and flat with the 4.23 percent for the first quarter of 2001.
15 Non-Interest Income Total non-interest income increased $1.9 million or 4.0 percent from the fourth quarter of 2001 and up $4.0 million or 8.6 percent from the first quarter of 2001. Growth in non-interest income from both periods is primarily related to an increase in service charges on deposit accounts for commercial accounts and an increase in insurance commissions. Three Months Ended -------------------------------- 2002 2001 -------- --------------------- Non-Interest Income March 31 December 31 March 31 - ---------------------------------------------------------------------------- Trust fees $12,115 $11,477 $12,006 Service charges on deposit accounts 18,407 18,214 16,500 Insurance commissions 5,606 4,953 3,895 Other service charges, collection and exchange charges, commissions and fees 6,045 6,219 5,934 Net gain on securities transactions 10 Other 8,620 7,998 8,413 ------- ------- ------- Total $50,793 $48,861 $46,758 ======= ======= ======= Trust fee income was up $638 thousand or 5.6 percent when compared to last quarter and up from the first quarter of 2001 by $109 thousand or .9 percent. Trust income was up from the fourth quarter 2001 due to an increase of $290 thousand in investment fees, an increase of $191 thousand in securities lending revenue and higher tax fees partially offset by lower oil and gas fees. Investment fees are based on the market value of assets within a trust account. The market value of trust assets and the related investment fees have been favorably impacted during the first quarter of 2002. The market value of trust assets at the end of the first quarter of 2002 was $13.6 billion, up $287 million and $662 million from the fourth and first quarters of 2001, respectively. Trust assets were comprised of managed assets of $6.0 billion and custody assets of $7.5 billion compared to $5.6 billion and $7.3 billion, respectively, a year ago. The securities lending program, which the Corporation began to offer in the fourth quarter of 2001, offers institutional investors the opportunity to add incremental returns on their investment and pension portfolios by lending custodial-held securities to broker/dealers. The increase in trust fees from the first quarter of 2001 was the result of higher income related to the new securities lending program discussed above, higher investment fees, as well as higher estate and custody fees partially offset by a decrease in oil and gas fees. Service charges on deposit accounts for the first quarter of 2002 increased $193 thousand or 1.1 percent from fourth quarter 2001 and $1.9 million or 11.6 percent from the first quarter a year ago. These increases can be attributed to higher revenues associated with commercial accounts resulting primarily from higher treasury management revenues. These higher fees are due in large part to a lower earnings credit rate, which resulted in the Corporation receiving more payment for services through fees than through the use of balances. Lower overdraft fees and non-sufficient funds charges substantially offset the increase in treasury management revenues from the fourth quarter last year. Insurance commissions increased $653 thousand or 13.2 percent when compared to the fourth quarter of 2001 and increased $1.7 million or 43.9 percent from the first quarter of 2001. The increases from both periods was the combined result of the impact of continued selling efforts and the effect of higher insurance premiums on commission revenues, as the insurance market has started to tighten the availability of certain products. In addition, the increase in insurance commission income from the first quarter of 2001 was positively impacted by the acquisition of AIS Insurance & Risk Management.
16 Other service charges and fees decreased $174 thousand or 2.8 percent when compared to the fourth quarter of 2001 and increased by $111 thousand or 1.9 percent when compared to the first quarter of last year. The decrease from the previous quarter was related to lower equity sales commission revenue and corporate finance fees at Frost Securities. Higher corporate finance fees were primarily responsible for the increase from a year ago. Other non-interest income increased $622 thousand or 7.8 percent when compared to the fourth quarter of 2001 and was up from the first quarter of 2001 by $207 thousand or 2.5 percent. The increase from the fourth quarter of 2001 is mainly due to rebate income related to the favorable performance of insurance policies placed with various insurance carriers, offset by $340 thousand that resulted from lower gains from the sale of student loans. The increase from the first quarter of 2001 is mainly due to the purchase in the second quarter of 2001 of bank owned life insurance on certain bank officers where the Corporation is the beneficiary. The increase in cash surrender value on these insurance policies during the first quarter of 2002 was $1.3 million and was recorded in other non-interest income. The first quarter of 2001 included a $1.1 million gain on the sale of interest rate floors. See Results of Operations on page 13. Non-Interest Expense Total non-interest expense was down $2.9 million or 3.4 percent from the fourth quarter of 2001 excluding the $19.9 million restructuring charges and down $2.4 million or 2.9 percent from the first quarter of 2001. For more information concerning the restructuring charges see the non-interest expenses section in Cullen/Frost's Annual Report on Form 10-K for the year ended December 31, 2001. The decrease from both the fourth and first quarters of 2001 wass primarily related to lower intangible amortization resulting from the implementation of SFAS No. 142. Three Months Ended ------------------------------- 2002 2001 -------- --------------------- Non-Interest Expense March 31 December 31 March 31 - ----------------------------------------------------------------------------- Salaries and wages $36,140 $ 36,602 $35,610 Employee benefits 8,926 8,925 8,911 Net occupancy 7,413 7,467 7,203 Furniture and equipment 5,824 5,888 6,012 Intangible amortization 1,877 3,763 3,880 Restructuring charges 19,865 Other 20,059 20,455 20,985 ------- -------- ------- Total $80,239 $102,965 $82,601 ======= ======== ======= Salaries and wages were down $462 thousand or 1.3 percent when compared to the fourth quarter of 2001 and up $530 thousand or 1.5 percent from the first quarter of 2001. During the fourth quarter of 2001, four percent of the staff accepted voluntary early retirement and an additional two percent were impacted by a reduction in workforce. The decrease from the fourth quarter is a result of these events and is offset primarily by the resumption of the accrual for potential performance related bonuses. The increase from the first quarter a year ago is due to higher compensation related to the issuance of restricted stock, as well as normal market and merit increases based on performance and the bonus accrual previously mentioned. Employee benefits were flat when compared to both the fourth and first quarters of 2001. When compared to the fourth quarter of 2001, medical expense decreased, which was offset by an increase in payroll taxes paid. When compared to the first quarter of 2001, lower payroll taxes were offset by higher medical expense. Net occupancy expense was flat from the fourth quarter of 2001 and up $210 thousand or 2.9 percent from the first quarter of 2001. The increase from the first quarter a year ago
17 was related to lease expenses for new locations. Furniture and equipment expense was flat from the fourth quarter of 2001 and decreased by $188 thousand or 3.1 percent from the first quarter of 2001 due to lower depreciation and repair costs, as well as software maintenance, partially offset by higher service contracts expense. Intangible amortization decreased $1.9 million or 50.1 percent and $2.0 million or 51.6 percent from the fourth and first quarters of 2001, respectively. This decrease was almost all due to the implementation of SFAS No. 142, which replaced the practice of amortizing goodwill and indefinite lived intangible assets with an annual review for impairment. See Note I "Accounting Changes" on page 10 for further discussion on this statement. Other non-interest expense decreased $396 thousand or 1.9 percent from the fourth quarter of 2001 and $926 thousand or 4.4 percent from the first quarter of 2001. The decrease from the previous quarter was mainly due to decreases in professional expenses, travel, stationery printing and supplies, and donations. The decrease from the first quarter of 2001 was primarily related to lower consulting, professional and travel expenses, offset by higher Federal Reserve service charges due to the lower interest rate environment. Results of Segment Operations The Corporation's operations are managed along three Operating Segments: Banking, the Financial Management Group ("FMG") and Frost Securities Inc. A description of each business and the methodologies used to measure financial performance are described in Note J to the Consolidated Financial Statements on page 11. The following table summarizes net income by Operating Segment for the quarters ending March 31, 2002 and 2001: Three Months Ended March 31 ------------------ 2002 2001 - -------------------------------------------------------- Banking $28,023 $22,687 Financial Management Group 3,181 2,892 Frost Securities Inc. (915) (1,055) Non-Banks (2,572) (1,984) ------- ------- Consolidated Net Income $27,717 $22,540 ======= ======= Banking Net income was $28.0 million for the first quarter of 2002, up 23.5 percent from $22.7 million for the same period of 2001. The increase in net income in the first quarter of 2002 versus 2001 primarily reflects the impact of a $8.2 million decrease in the provision for possible loan losses, mainly related to the deterioration of a large credit in the first quarter of 2001. Higher non-interest income (up $3.3 million)as the result of higher service charges on deposit accounts (see Service charges discussion in non-interest income on page 15) and FIA's higher insurance commissions also contributed to the improvement. Net interest income was down $2.8 million due to the impact of sharply reduced interest rates on the Corporation's asset-sensitive balance sheet. The average federal funds rate declined from 5.63 percent for the first quarter of 2001 to 1.75 percent for the first quarter of 2002. Offsetting the impact of lower net interest income, non-interest expense decreased $2.9 million, reflecting the non-amortization of goodwill as the result of the implementation of SFAS No. 142, and lower salaries and benefits as the result of the early retirement program and reduction in force implemented in the fourth quarter of 2001. FIA, which is included in the Banking operating segment, had gross revenues of $6.7 million during the first quarter of 2002 as compared with $4.8 million in the same period of 2001. Insurance commissions were the largest component of these revenues, increasing $1.7 million or 43.9 percent over 2001. This increase reflects the acquisition on August 1, 2001 of AIS, the impact of tightening insurance markets for some products, as well as continued selling efforts. Financial Management Group Net income for the first quarter of 2002 was $3.2 million, up $289 thousand or 10.0 percent compared to $2.9 million for the same period of 2001. Lower net interest income was
18 offset by higher non-interest income combined with lower non-interest expense for the first quarter of 2002 as compared with the first quarter of 2001. Net interest income was down $836 thousand compared to the previous year quarter as the lower rate environment has reduced the funds transfer price paid on FMG's securities sold under repurchase agreements. Non-interest income was up $421 thousand from first quarter of 2001, primarily due to higher annuity income (up $362 thousand) and the securities lending program ($197 thousand), which is further described in the "Non-Interest Income" section. These higher revenues were slightly offset by lower earnings on balances associated with cashiers checks and gains from sales of assets, which in total declined $213 thousand, as well as a decrease in brokerage commissions of $59 thousand resulting from fewer equity transactions. Most of the decrease in operating expenses, down $883 thousand from last year, was due to lower professional fees and sundry losses. Salaries and benefits were essentially flat with the first quarter of last year. Frost Securities Inc. FSI's operating loss of $915 thousand for the first quarter of 2002 was a 13.3 percent improvement from the loss for the same period last year. Total revenues were up $184 thousand or 7.7 percent over 2001 driven primarily by higher corporate finance fees. FSI revenues represented approximately five percent of the Corporation's non-interest income during the first quarter of 2002. Non-interest expenses for the first quarter of 2002 were down slightly to $3.9 million from $4.0 million, primarily related to lower professional services. Non-Banks The increase in operating loss for non-banks in the first quarter of 2002 when compared to the same period of 2001 was due to the reinstatement of the accrual for potential performance related bonuses. Income Taxes Cullen/Frost recognized income tax expense of $13.0 million for the first quarter of 2002, compared to $6.0 million for the fourth quarter of 2001 and $11.8 million in the first quarter of 2001. The effective tax rate for the first quarter of 2002 was 31.84 percent compared to 31.45 percent for the fourth quarter of 2001 and 34.43 percent for the first quarter of 2001. The lower effective tax rate in the first quarter of 2002 compared to the first quarter in 2001 was mainly due to an increase in tax exempt income resulting from the purchase of bank owned life insurance during the second quarter of 2001, and to the decrease in intangible amortization in the first quarter of 2002.
19 Balance Sheet Average assets of $8.1 billion were down $105.7 million or 5.2 percent on an annualized basis from the fourth quarter of 2001 and up $633.8 million or 8.5 percent from the first quarter of 2001. Total deposits averaged $6.7 billion for the current quarter down $86 million or 5.1 percent on an annualized basis compared with the previous quarter and up $491 million or 7.9 percent when compared to the first quarter of 2001. The largest increase over the first quarter of 2001 was in average demand deposits, up $445 million or 23 percent, primarily due to the increase in deposits related to a large mortgage originator and servicing customer for which Cullen/Frost is the depository and clearing bank. Without this account, average demand deposits were up 5.8 percent from the first quarter last year. Average loans for the first quarter of 2002 were $4.5 billion. This represents a decrease in average loans of 1.5 percent on an annualized basis from the fourth quarter of 2001 and 2.7 percent from the first quarter of last year. Loans Total period-end loans for the first quarter 2002 were $4.6 billion, up $40.5 million or 3.6 percent on an annualized basis compared to the fourth quarter 2001 and down $27.6 million or down less than one percent compared to the first quarter 2001. However, excluding shared national credits purchased ("SNCs"), 1-4 family residential mortgages and the indirect lending portfolio, loans increased by 7.4 percent on an annualized basis from year-end 2001 and grew 4.2 percent over the first quarter of 2001. The Corporation withdrew from the mortgage origination business as well as the indirect lending business during 2000, and these portfolios continue to decrease through payoffs and refinancings. The SNCs portfolio, discussed later in this section, remained constant with the fourth quarter of 2001 and decreased from the first quarter a year ago. The mortgage and indirect portfolios are also discussed in more detail later in this section. <TABLE> <CAPTION> 2002 2001 ----------------------- ----------------------- Loan Portfolio Percentage Period-End Balances March 31 of Total December 31 March 31 - ------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Real estate: Construction: Commercial $ 390,724 8.6% $ 373,431 $ 356,448 Consumer 41,500 .9 44,623 49,534 Land: Commercial 120,496 2.6 128,782 141,077 Consumer 10,550 .2 7,040 8,935 Commercial real estate mortgages 1,000,888 22.0 994,485 1,007,466 1-4 Family residential mortgages 224,372 4.9 244,897 298,850 Other consumer real estate 279,183 6.1 278,849 269,986 ---------- ----- ---------- ---------- Total real estate 2,067,713 45.3 2,072,107 2,132,296 Commercial and industrial 2,052,952 45.0 1,985,447 1,951,077 Consumer: Indirect 52,667 1.2 65,217 116,688 Other 371,197 8.1 345,899 342,637 Other, including foreign 20,851 .5 54,943 50,980 Unearned discount (6,288) (.1) (5,005) (6,945) ---------- ----- ---------- ---------- Total $4,559,092 100.0% $4,518,608 $4,586,733 ========== ===== ========== ========== </TABLE> At March 31, 2002, the majority of the loan portfolio was comprised of real estate loans totaling $2.1 billion or 45.3 percent of total loans and the commercial and industrial loan portfolio totaling $2.1 billion or 45.0 percent of total loans. The real estate total includes both commercial and consumer balances.
20 The majority of the annualized 7.4 percent growth in total loans over the fourth quarter 2001 (excluding SNCs, mortgage loans and indirect lending) was in the commercial and industrial loan portfolio, which increased to $2.1 billion at March 31, 2002. The Corporation's commercial and industrial loans are a diverse group of loans to small, medium and large businesses. The purpose of these loans varies from supporting seasonal working capital needs to term financing of equipment. While some short term loans may be made on an unsecured basis, most are secured by the assets being financed with appropriate collateral margins. The commercial and industrial loan portfolio also includes the commercial lease portfolio and asset-based lending. At March 31, 2002, the commercial lease portfolio totaled $43.5 million and asset-based loans totaled $45.1 million compared with December 31, 2001 balances of $41.0 million and $48.6 million, respectively, and March 31, 2001 balances of $39.5 million and $38.4 million, respectively. In addition, at March 31, 2002, over 97 percent of the outstanding balance of SNCs were included in the commercial and industrial portfolio, with the remainder included in the real estate categories. The Corporation had a total SNCs portfolio of approximately $237 million outstanding at March 31, 2002, flat compared with December 31, 2001 and down from $290 million at March 31, 2001. Of the outstanding total at the end of the first quarter 2002, approximately 38 percent were energy related with the remainder diversified throughout various industries. These participations are done in the normal course of business to meet the needs of the Corporation's customers. General corporate policy towards participations is to lend to companies either headquartered in or having significant operations within our markets. In addition, the Corporation must have an existing banking relationship or the expectation of broadening the relationship with other bank products. Total real estate loans at March 31, 2002 were $2.1 billion, flat with December 31, 2001. However, excluding the decline in the 1-4 family residential mortgage portfolio, which is discussed below, total real estate loans increased $16.1 million or 3.5 percent on an annualized basis from year- end 2001, and $9.9 million or 0.5 percent from March 31, 2001. The commercial real estate portfolio, which totals $1.5 billion, represents over 73 percent of the total real estate loans at March 31, 2002. The majority of this portfolio is commercial real estate mortgages, which includes both permanent and intermediate term loans. The diversity in the commercial real estate portfolio allows the Corporation to reduce the impact of a decline in any single industry. The primary focus of the commercial real estate portfolio has been loans secured by owner-occupied properties. These loans are viewed primarily as cash flow loans and secondarily as loans secured by real estate. Consequently, these loans must undergo the analysis and underwriting process of a commercial and industrial loan, as well as a commercial real estate loan. At March 31, 2002, approximately 48 percent of the Corporation's commercial real estate loans were secured by owner-occupied properties. The consumer loan portfolio, including all consumer real estate, at March 31, 2002 totaled $979 million, down 2.9 percent on an annualized basis from December 31, 2001. However, excluding the decrease in the 1-4 family residential mortgage and the indirect lending portfolios, total consumer loans increased by 15.4 percent on an annualized basis. As the following table illustrates, the consumer loan portfolio has four distinct segments - consumer real estate, consumer non-real estate, indirect consumer loans and 1-4 family residential mortgages. 2002 2001 Consumer Portfolio ---------- ------------------------- Period-End Balances (in millions) March 31 December 31 March 31 - ----------------------------------------------------------------------------- Construction $ 41.5 $ 44.6 $ 49.5 Land 10.5 7.0 8.9 Other consumer real estate 279.2 278.9 270.0 ------ ------ ------- Total consumer real estate 331.2 330.5 328.4 Consumer non-real estate 371.2 345.9 342.6 Indirect 52.7 65.2 116.7 1-4 Family residential mortgages 224.4 244.9 298.9 ------ ------ ------- Total Consumer loans $979.5 $986.5 $1086.6 ====== ====== =======
21 The majority of the 15.4 percent growth in consumer loans, excluding mortgage and indirect lending, has occurred in the consumer non-real estate loan segment. The consumer non-real estate loan segment has grown to $371 million at March 31, 2002 from $346 million at year-end 2001. Loans in this segment include automobile loans, unsecured revolving credit products, personal loans secured by cash and cash equivalents, and other similar types of credit facilities. The indirect consumer loan segment was $53 million at March 31, 2002, a decrease of $64 million or 55 percent since March 31, 2001. At March 31, 2002, the majority of the portfolio was comprised of new and used automobile loans (57.5 percent of total), as well as purchased home improvement and home equity loans (40.1 percent of total). The portfolio is not expected to completely pay off by year-end 2002 due to the longer life of the non-auto loans in this portfolio. However, the portfolio is expected to be substantially reduced by that time. The Corporation also discontinued originating 1-4 family residential mortgage loans in 2000. These types of loans are now offered through the Corporation's co-branding arrangement with GMAC Mortgage. At March 31, 2002, the 1-4 family residential loan segment totaled $224 million down from $245 million at year-end 2001. This portfolio will continue to decline due to the decision to withdraw from the mortgage origination business and the high level of mortgage refinancings during the current low rate environment. Loans to Mexico based borrowers, secured by liquid assets held in the United States, were $10.3 million at March 31, 2002, $10.7 million at December 31, 2001, and $16.2 million at March 31, 2001. Cullen/Frost's cross-border outstandings to Mexico excluding these loans totaled $415 thousand at March 31, 2002 up from $63 thousand at December 31, 2001 and from $32 thousand at March 31, 2001. At March 31, 2002 and 2001, none of the Mexico-related loans were on non-performing status. Loan Commitments In the normal course of business, in order to meet the financial needs of its customers, Cullen/Frost is a party to financial instruments with off- balance sheet risk. These include commitments to extend credit and standby letters of credit which commit the Corporation to make payments to or on behalf of customers when certain specified future events occur. Both arrangements have credit risk essentially the same as that involved in extending loans to customers and are subject to the Corporation's normal credit policies. Collateral is obtained based on management's credit assessment of the customer. Commitments to extend credit and standby letters of credit amounted to $2.3 billion and $125.8 million, respectively, at March 31, 2002. Included in the allowance for possible loan losses at March 31, 2002 was approximately $1.8 million associated with unfunded loan commitments. Commercial and industrial loan commitments represent approximately 74.7 percent of the total loan commitments outstanding at March 31, 2002. Acceptances due from customers at March 31, 2002 were $2.1 million.
22 Non-Performing Assets NON-PERFORMING ASSETS -------------------------- Real March 31, 2002 Estate Other Total -------------------------------------------------------------------------- Non-accrual $ 7,493 $28,997 $36,490 Foreclosed assets 4,139 4,139 ------- ------- ------- Total $11,632 $28,997 $40,629 ======= ======= ======= As a percentage of total non-performing assets 28.6% 71.4% 100.0% Non-performing assets totaled $40.6 million up 8.5 percent from $37.4 million at December 31, 2001 and up 76.3 percent from $23.0 million at March 31, 2001. The majority of the increase during the first quarter of 2002 is related to loans that were considered potential problem loans at December 31, 2001. The increase from a year ago also includes two large SNCs that went on non-accrual status during 2001. One loan, to an electronics distribution company, went on non-accrual status during the first quarter of 2001. Approximately $13 million of this credit has been charged-off with $6.1 million remaining in non-accrual loans. The second loan, which went on non-accrual status in the third quarter of 2001, was made to a private company in the marketing and sales promotion industry, an industry that was dramatically affected by the terrorist attack on September 11, 2001. Approximately $9 million of the second loan has been charged-off with $8.0 million remaining in non-accrual loans. Non-performing assets as a percentage of total loans and foreclosed assets increased to .89 percent at March 31, 2002 from .50 percent one year ago. Non- performing assets as a percentage of total assets were .50 percent for the first quarter 2002 compared to .29 percent for the first quarter 2001. The level of non-performing assets at March 31, 2002 at .50 percent of total assets was within the range of previous guidance. Subsequent to March 31, 2002, the Corporation sold its remaining interests in a non-accrual loan with a carrying value of $7.7 million. This transaction resulted in a recovery of $1.25 million which was credited against the reserve for loan losses. This sale decreased non-performing assets by the amount of the carrying value. Non-performing assets include non-accrual loans and foreclosed assets. Generally, loans are placed on non-accrual status if principal or interest payments become 90 days past due and/or management deems the collectibility of the principal and/or interest to be in question, as well as when required by regulatory provisions. Once interest accruals are discontinued, accrued but uncollected interest is charged to current year operations. Subsequent receipts on non-accrual loans are recorded as a reduction of principal, and interest income is recorded only after principal recovery is reasonably assured. Foreclosed assets represent property acquired as the result of borrower defaults on loans. Foreclosed assets are valued at the lower of the loan balance or estimated fair value, less estimated selling costs, at the time of foreclosure. Write-downs occurring at foreclosure are charged against the allowance for possible loan losses. On an ongoing basis, properties are appraised as required by market indications and applicable regulations. Write- downs are provided for subsequent declines in value. Expenses related to maintaining foreclosed properties are included in other non-interest expense.
23 The after-tax impact (assuming a 35 percent marginal tax rate) of lost interest from non-performing assets was approximately $561 thousand for the first quarter of 2002, compared to approximately $652 thousand for the fourth quarter of 2001 and approximately $649 thousand for the first quarter of 2001. Accruing loans past due are summarized below: ACCRUING LOANS PAST DUE ------------------------------- March 31 December 31 March 31 2002 2001 2001 - --------------------------------------------------------------------------- 30 to 89 days $29,345 $35,549 $44,744 90 days or more 6,568 13,601 8,174 ------- ------- ------- Total $35,913 $49,150 $52,918 ======= ======= ======= Allowance for Possible Loan Losses The allowance for possible loan losses was $77.3 million or 1.70 percent of period-end loans at March 31, 2002, compared to $72.9 million or 1.61 percent for the fourth quarter of 2001 and $64.1 million or 1.40 percent at March 31, 2001. The allowance for possible loan losses as a percentage of non- accrual loans was 211.8 percent at March 31, 2002, compared to 219.5 percent and 309.6 percent at the end of the fourth and first quarters of 2001, respectively. The Corporation recorded a $6.8 million provision for possible loan losses during the first quarter of 2002, compared to $4.0 million and $15.0 million recorded during the fourth and first quarters of 2001. The higher provision from the fourth quarter 2001 is reflective of the continued uncertainty in the economy. The higher provision in the first quarter of 2001 resulted from the actions taken on the SNC loan to an electronics distribution company. See the Non-Performing Assets section on page 22 for further information. Net charge-offs in the first quarter of 2002 totaled $2.4 million, compared to net charge-offs of $11.3 million and $14.2 million for the fourth and first quarters of 2001, respectively. The fourth quarter 2001 charge-off level was related to the SNC loan in the marketing and sales promotion industry and the first quarter 2001 charge-off level was related to the SNC loan previously mentioned. The allowance for possible loan losses is maintained at a level considered appropriate by management, based on estimated probable losses in the loan portfolio. NET CHARGE-OFFS (RECOVERIES) ------------------------------- 2002 2001 ------- ------------------ First Fourth First Quarter Quarter Quarter - --------------------------------------------------------------------------- Real Estate $ 59 $ 67 $ 77 Commercial and industrial 1,830 10,598 13,563 Consumer 413 647 594 Other, including foreign 79 (5) (3) ------- ------- ------- $ 2,381 $11,307 $14,231 ======= ======= ======= Provision for possible loan losses $ 6,800 $ 4,000 $15,031 Allowance for possible loan losses 77,300 72,881 64,065 Capital and Liquidity At March 31, 2002, shareholders' equity was $604.2 million compared to $594.9 million at December 31, 2001 and $592.5 million at March 31, 2001. In addition to net income of $27.7 million, activity in the first quarter of 2002 included $11.0 million of dividends paid and $13.1 million paid for repurchasing shares of the Corporation's common stock. The unrealized loss on securities available for sale and additional minimum pension liability, net of deferred taxes, were $13.7 million as of March 31, 2002 compared to $14.0 million as of December 31, 2001, which had the effect of increasing capital by $300 thousand. Included in these amounts is a minimum pension liability, net of tax of $5.3 million. Currently, under regulatory requirements, the unrealized gain or loss on securities available for sale
24 does not reduce regulatory capital and is not included in the calculation of risk-based capital and leverage ratios. The Federal Reserve Board utilizes capital guidelines designed to measure Tier 1 and Total Capital and take into consideration the risk inherent in both on-balance sheet and off-balance sheet items. See Note E "Capital" on page seven for a discussion of Cullen/Frost's capital ratios. Cullen/Frost paid a quarterly dividend of $.215 per common share during the first quarter of 2002 and fourth quarter of 2001 compared to $.195 per common share in the first quarter of 2001. This equates to a dividend payout ratio of 39.7 percent, 84.5 percent and 44.6 percent for the first quarter of 2002 and the fourth and first quarters of 2001, respectively. In addition, the Corporation announced in 2001 that its board of directors had authorized the repurchase of up to 2.6 million shares of its common stock over a two-year period from time to time at various prices in the open market or through private transactions. As of March 31, 2002, 798 thousand shares at a cost of $23.5 million had been repurchased under this program. Funding sources available at the holding company level include a $25 million short-term line of credit. There were no borrowings outstanding from this source at March 31, 2002. Liquidity measures the ability to meet current and future cash flow needs as they become due. Cullen/Frost seeks to ensure that these needs are met at a reasonable cost by maintaining a level of liquid funds through asset/liability management. Asset liquidity is provided by liquid assets which are readily marketable or pledgeable or which will mature in the near future. Liquid assets include cash, short-term time deposits in banks, securities available for sale, maturities and cash flow from securities held to maturity, and Federal funds sold and securities purchased under resale agreements. Liability liquidity is provided by access to funding sources, which include core deposits and correspondent banks in Cullen/Frost's natural trade area that maintain accounts with and sell Federal funds to Frost Bank, as well as Federal funds purchased and securities sold under repurchase agreements from upstream banks. The liquidity position of Cullen/Frost is continuously monitored and adjustments are made to the balance between sources and uses of funds as deemed appropriate.
25 <TABLE> <CAPTION> Consolidated Average Balance Sheets and Interest Income Analysis-By Quarter Cullen/Frost Bankers, Inc. and Subsidiaries (dollars in thousands - taxable-equivalent basis) March 31, 2002 December 31, 2001 --------------------------- --------------------------- Interest Interest Average Income/ Yield/ Average Income/ Yield/ Balance Expense Cost Balance Expense Cost ---------- -------- ------ ---------- -------- ------ <S> <C> <C> <C> <C> <C> <C> ASSETS Time deposits $ 15,504 $ 50 1.30% $ 8,433 $ 44 2.06% Securities: U.S. Treasury 14,065 85 2.47 62,885 346 2.18 U.S. Government agencies and corporations 1,869,473 27,917 5.97 1,741,198 26,488 6.09 States and political subdivisions Tax-exempt 177,035 3,086 6.97 174,457 3,038 6.97 Taxable 2,234 37 6.62 2,250 37 6.57 Other 29,328 268 3.65 29,859 285 3.82 ---------- -------- ---------- -------- Total securities 2,092,135 31,393 6.00 2,010,649 30,194 6.01 Federal funds sold and securities purchased under resale agreements 102,674 476 1.85 202,824 1,155 2.23 Loans, net of unearned discount 4,533,639 66,707 5.97 4,551,040 72,881 6.35 ---------- -------- ---------- -------- Total Earning Assets and Average Rate Earned 6,743,952 98,626 5.90 6,772,946 104,274 6.12 Cash and due from banks 866,962 930,601 Allowance for possible loan losses (74,912) (80,382) Premises and equipment 147,677 149,950 Accrued interest and other assets 401,632 417,922 ---------- ---------- Total Assets $8,085,311 $8,191,037 ========== ========== LIABILITIES Demand deposits: Commercial and individual $1,927,435 $2,087,115 Correspondent banks 408,367 303,831 Public funds 43,689 43,766 ---------- ---------- Total demand deposits 2,379,491 2,434,712 Time deposits: Savings and Interest-on-Checking 1,020,878 475 .19 981,430 475 .19 Money market deposit accounts 1,808,156 5,835 1.31 1,859,110 7,418 1.58 Time accounts 1,186,800 7,624 2.61 1,236,146 10,413 3.34 Public funds 353,275 1,377 1.58 323,523 1,601 1.96 ---------- -------- ---------- -------- Total time deposits 4,369,109 15,311 1.42 4,400,209 19,907 1.79 ---------- -------- ---------- -------- Total deposits 6,748,600 6,834,921 Federal funds purchased and securities sold under repurchase agreements 327,692 1,187 1.45 316,599 1,435 1.77 Guaranteed preferred beneficial interests in the Corporation's junior subordinated deferrable interest debentures 98,630 2,119 8.60 98,616 2,119 8.60 Subordinated notes payable and other notes payable 152,170 1,648 4.33 152,142 2,053 5.40 Other borrowings 22,929 235 4.16 30,068 401 5.30 ---------- -------- ---------- -------- Total Interest-Bearing Funds and Average Rate Paid 4,970,530 20,500 1.66 4,997,634 25,915 2.06 ---------- -------- ---- ---------- -------- ---- Accrued interest and other liabilities 123,173 124,902 ---------- ---------- Total Liabilities 7,473,194 7,557,248 SHAREHOLDERS' EQUITY 612,117 633,789 ---------- ---------- Total Liabilities and Shareholders' Equity $8,085,311 $8,191,037 ========== ========== Net interest income $ 78,126 $ 78,359 ======== ======== Net interest spread 4.24% 4.06% ==== ==== Net interest income to total average earning assets 4.68% 4.60% ==== ==== The above information is shown on a taxable-equivalent basis assuming a 35% tax rate. Non-accrual loans are included in the average loan amounts outstanding for these computations. </TABLE>
26 <TABLE> <CAPTION> Consolidated Average Balance Sheets and Interest Income Analysis-By Quarter Cullen/Frost Bankers, Inc. and Subsidiaries (dollars in thousands - taxable-equivalent basis) September 30, 2001 June 30, 2001 --------------------------- --------------------------- Interest Interest Average Income/ Yield/ Average Income/ Yield/ Balance Expense Cost Balance Expense Cost ---------- -------- ------ ---------- -------- ------ <S> <C> <C> <C> <C> <C> <C> ASSETS Time deposits $ 6,104 $ 72 4.67% $ 7,751 $ 99 5.11% Securities: U.S. Treasury 17,738 164 3.66 17,028 192 4.52 U.S. Government agencies and corporations 1,596,137 25,251 6.33 1,337,607 21,427 6.41 States and political subdivisions Tax-exempt 168,484 2,959 7.03 163,453 2,908 7.12 Taxable 2,796 46 6.53 3,388 55 6.46 Other 29,426 254 3.46 32,751 469 5.73 ---------- -------- ---------- -------- Total securities 1,814,581 28,674 6.32 1,554,227 25,051 6.45 Federal funds sold and securities purchased under resale agreements 331,845 2,864 3.38 315,871 3,520 4.41 Loans, net of unearned discount 4,512,277 82,637 7.27 4,559,623 90,157 7.93 ---------- -------- ---------- -------- Total Earning Assets and Average Rate Earned 6,664,807 114,247 6.81 6,437,472 118,827 7.40 Cash and due from banks 820,091 806,665 Allowance for possible loan losses (65,561) (65,728) Premises and equipment 150,157 150,376 Accrued interest and other assets 387,047 351,930 ---------- ---------- Total Assets $7,956,541 $7,680,715 ========== ========== LIABILITIES Demand deposits: Commercial and individual $1,955,445 $1,828,870 Correspondent banks 262,399 248,370 Public funds 40,859 35,709 ---------- ---------- Total demand deposits 2,258,703 2,112,949 Time deposits: Savings and Interest-on-Checking 962,999 588 .24 970,673 1,115 .46 Money market deposit accounts 1,839,010 10,571 2.28 1,824,869 12,857 2.83 Time accounts 1,268,349 13,355 4.18 1,276,765 15,741 4.95 Public funds 297,830 2,316 3.09 293,816 2,709 3.70 ---------- -------- ---------- -------- Total time deposits 4,368,188 26,830 2.44 4,366,123 32,422 2.98 ---------- -------- ---------- -------- Total deposits 6,626,891 6,479,072 Federal funds purchased and securities sold under repurchase agreements 366,360 2,840 3.03 360,786 3,417 3.75 Guaranteed preferred beneficial interests in the Corporation's junior subordinated deferrable interest debentures 98,602 2,118 8.60 98,589 2,119 8.60 Subordinated notes payable and other notes payable 99,678 1,575 6.32 3,060 47 6.17 Other borrowings 32,338 464 5.70 31,405 455 5.81 ---------- -------- ---------- -------- Total Interest-Bearing Funds and Average Rate Paid 4,965,166 33,827 2.70 4,859,963 38,460 3.17 ---------- -------- ---- ---------- -------- ---- Accrued interest and other liabilities 103,718 105,602 ---------- ---------- Total Liabilities 7,327,587 7,078,514 SHAREHOLDERS' EQUITY 628,954 602,201 ---------- ---------- Total Liabilities and Shareholders' Equity $7,956,541 $7,680,715 ========== ========== Net interest income $ 80,420 $ 80,367 ======== ======== Net interest spread 4.11% 4.23% ==== ==== Net interest income to total average earning assets 4.80% 5.00% ==== ==== The above information is shown on a taxable-equivalent basis assuming a 35% tax rate. Non-accrual loans are included in the average loan amounts outstanding for these computations. </TABLE>
27 <TABLE> <CAPTION> Consolidated Average Balance Sheets and Interest Income Analysis-By Quarter Cullen/Frost Bankers, Inc. and Subsidiaries (dollars in thousands - taxable-equivalent basis) March 31, 2001 ---------------------------- Interest Average Income/ Yield/ Balance Expense Cost ---------- -------- ------ <S> <C> <C> <C> ASSETS Time deposits $ 6,383 $ 116 5.37% Securities: U.S. Treasury 102,556 1,592 6.29 U.S. Government agencies and corporations 1,341,398 22,098 6.59 States and political subdivisions Tax-exempt 162,943 2,943 7.22 Taxable 3,368 55 6.50 Other 36,858 580 6.30 ---------- -------- Total securities 1,647,123 27,268 6.63 Federal funds sold and securities purchased under resale agreements 160,578 2,244 5.59 Loans, net of unearned discount 4,563,963 98,738 8.77 ---------- -------- Total Earning Assets and Average Rate Earned 6,378,047 128,366 8.14 Cash and due from banks 675,168 Allowance for possible loan losses (63,316) Premises and equipment 150,581 Accrued interest and other assets 311,015 ---------- Total Assets $7,451,495 ========== LIABILITIES Demand deposits: Commercial and individual $1,658,802 Correspondent banks 236,020 Public funds 39,282 ---------- Total demand deposits 1,934,104 Time deposits: Savings and Interest-on-Checking 950,311 1,427 .61 Money market deposit accounts 1,780,012 17,166 3.91 Time accounts 1,283,226 17,592 5.56 Public funds 309,713 3,355 4.39 ---------- -------- Total time deposits 4,323,262 39,540 3.71 ---------- -------- Total deposits 6,257,366 Federal funds purchased and securities sold under repurchase agreements 361,864 4,362 4.82 Guaranteed preferred beneficial interests in the Corporation's junior subordinated deferrable interest debentures 98,575 2,119 8.60 Subordinated notes payable and other notes payable 3,637 62 6.92 Other borrowings 31,843 474 6.04 ---------- -------- Total Interest-Bearing Funds and Average Rate Paid 4,819,181 46,557 3.91 ---------- -------- ---- Accrued interest and other liabilities 107,756 ---------- Total Liabilities 6,861,041 SHAREHOLDERS' EQUITY 590,454 ---------- Total Liabilities and Shareholders' Equity $7,451,495 ========== Net interest income $ 81,809 ======== Net interest spread 4.23% ==== Net interest income to total average earning assets 5.18% ==== The above information is shown on a taxable-equivalent basis assuming a 35% tax rate. Non-accrual loans are included in the average loan amounts outstanding for these computations. </TABLE>
28 Item 3. Quantitative and Qualitative Disclosures About Market Risks There has been no material change in the market risks faced by the Company since December 31, 2001. For information regarding the Company's market risk, refer to the Company's Annual Report on Form 10-K for the year ended December 31, 2001.
29 Part II: Other Information Item 6. Exhibits and Reports on Form 8-K (a) Exhibits None (b) Reports on Form 8-K None
30 Signatures Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. Cullen/Frost Bankers, Inc. (Registrant) Date: April 24, 2002 By: /s/ Phillip D. Green --------------------------------- Phillip D. Green Group Executive Vice President and Chief Financial Officer (Duly Authorized Officer and Principal Accounting Officer) 28