Cullen/Frost Bankers, Inc.

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1 December 26, 2014 Cullen/Frost Bankers, Inc. Current Recommendation SUMMARY DATA NEUTRAL Prior Recommendation Neutral Date of Last Change 11/30/2001 Current Price (12/25/14) $70.74 Target Price $ Week High $ Week Low $67.46 One-Year Return (%) Beta 0.81 Average Daily Volume (sh) 880,243 Shares Outstanding (mil) 63 Market Capitalization ($mil) $4,457 Short Interest Ratio (days) Institutional Ownership (%) 77 Insider Ownership (%) 6 Annual Cash Dividend $2.04 Dividend Yield (%) Yr. Historical Growth Rates Sales (%) 2.0 Earnings Per Share (%) 6.6 Dividend (%) 3.6 using TTM EPS 17.0 using 2014 Estimate 16.5 using 2015 Estimate 15.5 Zacks Rank *: Short Term 1 3 months outlook 2 - Buy * Definition / Disclosure on last page SUMMARY Risk Level * (CFR-NYSE) Cullen/Frost s third-quarter 2014 earnings outpaced the Zacks Consensus Estimate and also came above the prior-year quarter figure. An improvement in the top line was partially offset by higher expenses. Further, provisions for credit losses declined year over year. Going forward, we expect the company s profitability to be aided by growth in loans and deposits. Moreover, capital deployment activities of the company remained encouraging. Further, the WNB Bancshares merger proved to be accretive to the company s overall growth. However, the prevalent low-interest rate environment and surging expenses will continue to restrict bottom-line improvement. But with the ongoing revival of the economy, we expect the company to deliver better earnings. Below Avg., Type of Stock Large-Value Industry Banks-Southwest Zacks Industry Rank * 180 out of 267 ZACKS CONSENSUS ESTIMATES Revenue Estimates (In millions of $) Q1 Q2 Q3 Q4 Year (Mar) (Jun) (Sep) (Dec) (Dec) A 234 A 239 A 248 A 957 A A 247 A 253 A 264 A 1,015 A A 278 A 290 A 285 E 1,118 E ,146 E Earnings Per Share Estimates (EPS is operating earnings before non-recurring items, but including employee stock options expenses) Q1 Q2 Q3 Q4 Year (Mar) (Jun) (Sep) (Dec) (Dec) 2012 $0.99 A $0.94 A $0.95 A $0.98 A $3.86 A 2013 $0.91 A $0.94 A $0.96 A $0.99 A $3.80 A 2014 $0.96 A $1.02 A $1.19 A $1.13 E $4.30 E 2015 $4.56 E Projected EPS Growth - Next 5 Years % Zacks Investment Research, All Rights reserved S. Riverside Plaza, Chicago IL 60606

2 OVERVIEW Headquartered in San Antonio, TX, Cullen/Frost Bankers, Inc. (Cullen/Frost) is a financial holding company and a bank holding company, which through its subsidiaries provide a broad array of products and services throughout numerous Texas markets. In addition to general commercial and consumer banking, other products and services offered include trust and investment management, investment banking, insurance, brokerage, leasing, asset-based lending, treasury management and item processing. As of Sep 30, 2014, Cullen/Frost had consolidated total assets of $27.4 billion. The corporation is managed under a matrix organizational structure with two primary operating segments: Banking and Frost Wealth Advisors. Banking: This operating segment includes both commercial and consumer banking services, Frost Securities, Inc. and Frost Insurance Agency. 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. Frost Insurance Agency provides insurance brokerage services to individuals and businesses covering corporate and personal property and casualty products, as well as group health and life insurance products and human resources consulting services. Frost Securities, Inc. provides advisory and private equity services to middle market companies. Frost Wealth Advisors: This operating segment includes fee-based services within private trust, retirement services and financial management services, including personal wealth management and brokerage services. The third operating segment, Non-Banks, is for the most part the parent holding company, while certain other insignificant non-bank subsidiaries of the parent that, for the most part, have little or no activity. The parent company s principal activities include direct and indirect ownership of the corporation s banking and non-banking subsidiaries and issuance of debt and equity. Its principal source of revenue is dividends from its subsidiaries. On May 30, 2014, Cullen/Frost completed its acquisition of WNB Bancshares, Inc. including its subsidiary Western National Bank for about $198.1 million. As a result of the merger, in which WNB was merged with Cullen/Frost, the latter issued two million shares of the common stock, valued at $0.01 per share, of Cullen/Frost and paid approximately $49.1 million in cash. Western was integrated into Frost Bank as of Jun 20, At closing, WNB had total assets of about $1.8 billion, total loans of about $668.3 million and total deposits of about $1.6 billion. Additionally, WNB paid approximately $20.1 million in connection with a reverse stock split completed during the first quarter of 2014, resulting in a reduced WNB equity amount of about $64.4 million, at closing. This marks the first bank acquisition for Cullen/Frost since 2006, when it bought Fort Worth-based Summit Bancshares Inc. for about $360 million. The merger is strategically advantageous for Cullen/Frost, as it enabled the company to reinforce its Texas franchise and enter the profitable Midland and Odessa markets. REASONS TO BUY Organic growth remains a key strength at Cullen/Frost, as reflected by its revenue growth story. Revenues grew at a CAGR of 2.7% over the last 5 years ( ). Moreover, net revenue increased 8.7% year over year in first nine months of We believe the company is well positioned to maintain this trend, going forward. Moreover, the low-cost funding source non- Equity Research CFR Page 2

3 REASONS TO SELL interest bearing deposits representing 33.6% of total deposits are expected to boost the net interest income and margin driven by low interest expenses when interest rates rise. Cullen/Frost continues to expand through acquisitions. In May 2014, it completed the merger with WNB Bancshares, Inc, its first acquisition since 2006 when it bought Summit Bancshares Inc. The merger enabled the company to reinforce its Texas franchise and enter the profitable Midland and Odessa markets. The merger has also been accretive to the company s loans, deposits and overall growth and therefore we expect it to continue benefiting the company, going forward. Cullen/Frost remains in a relatively good shape from the capital perspective. As of Sep 30, 2014, the company s capital ratios Tier 1 risk-based capital ratio of 13.91%, total risk-based capital ratio of 14.81% and leverage ratio of 8.27% were well above the regulatory requirements. The capital rules by the Federal Reserve, which requires banks to maintain higher capital ratios, are not anticipated to impact Cullen/Frost much due to its robust capital position and this could prove to be a major differentiator for the company. Cullen/Frost exhibits a strong liquidity position. As of Sep 30, 2014, deposits grew 13.5% over the last nine months, while loans were up 12.9%. Notably, while deposits recorded a 5-year CAGR of 11.7% in 2013, loans grew at a 3-year CAGR of 9%. Therefore, the growing deposit base would help the company generate more loans and meet other general business purposes. Cullen/Frost looks attractive for income-seeking investors due to its steady capital deployment activities. In Apr 2014, the company announced a 2% hike in its quarterly cash dividend on common stock. Moreover, the company has paid and increased dividend annually for 20 consecutive years. Notably, during first nine months of 2014, the company paid $94.9 million as common stock dividends. This reflects its commitment to return value to shareholders on the back of its strong cash generation capabilities. With the growing level of non-interest expenses, the company is exposed to operational risks. Non-interest expenses grew 6.2% year over year for the nine months ended Sep 30, Notably, it recorded a CAGR of 3.4% over the 4 years ( ). Continuation of this trend will remain a hindrance for bottom-line growth. Though the level of credit losses and net charge-offs have declined significantly from the peak, the current levels still remain higher than the company s comfort zone, as a result of an extended period of economic downturn. We do not expect any significant improvement in credit quality in the near term, as the pace of economic recovery still remains sluggish. Cullen/Frost has significant exposure to real estate loans. As of Sep 30, 2014, the company s exposure to these loan portfolios was nearly 44.9% of the total loans. Though the housing sector has been showing signs of improvement, any further deterioration in real estate prices will act as a significant headwind. Following the latest recession, the regulatory environment has become tougher and costlier for the U.S. banks. In the last few quarters, banks had to face a number of regulatory requirements under several laws. Many other regulatory headwinds are expected to hinder growth of the U.S. banks, including Cullen/Frost, in the upcoming quarters, as regulators are focusing on global alignment. Though the aim is to meaningfully change the banks business models so that they become self-sufficient over the longer term, the cost of compliance will drag down profitability in the near to midterm. Equity Research CFR Page 3

4 RECENT NEWS Cullen/Frost Q3 Earnings Beat on High Revenue Oct 30, 2014 Driven by strong top-line growth, the company reported earnings of $1.19 per share, significantly outpacing the Zacks Consensus Estimate by $0.09 per share. Moreover, results were up 24% from the prior-year quarter figure of $0.96 per share. Cullen/Frost s impressive results were aided by an improved top line along with continued growth in loan and deposit balances. Moreover, credit quality recorded significant improvement. However, increased non-interest expenses were a concern. The company s net income available to common shareholders of $75.6 million in the reported quarter reflects a 29.5% increase from the year-ago quarter. Performance in Detail Cullen/Frost s total revenue (net of interest expenses) on a taxable equivalent basis increased 14.4% year over year to $289.5 million. Further, it surpassed the Zacks Consensus Estimate of $273 million. Net interest income on a taxable-equivalent basis amounted to $208.6 million, up 16.5% from the yearago quarter. The rise was primarily driven by an increased average volume of interest earning assets. Moreover, net interest margin (NIM) climbed 1 basis point year over year to 3.39%. Cullen/Frost s non-interest income of $80.9 million was up 9.3% on a year-over-year basis. The surge was primarily attributable to an increase in trust and investment management fees, insurance commissions and fees, service charges on deposit accounts and other non-interest income. Non-interest expense climbed 7.9% year over year to $163.8 million. This was mainly due to an increase in personnel expenses, net occupancy costs and other non-interest expenses. Credit Quality Credit metrics showed a marked improvement in the reported quarter. Non-performing assets declined 35.8% year over year to $63 million. The allowance for loan losses, as a percentage of total loans, stood at 0.91%, as of Sep 30, 2014, down 9 basis points (bps) from the prior-year quarter. Further, net charge-offs were $0.4 million, down 92.6% year over year. Provision for loan losses descended 92.2% year over year to $0.4 million. Capital Position Cullen/Frost exhibited a strong capital position. Tier 1 Risk-Based Capital Ratio was 13.91%, compared with 14.53% in the prior-year quarter. Total Risk-Based Capital Ratio was 14.81% versus 15.68% at the end of the prior-year quarter. Leverage ratio was 8.27% compared with 8.61% in the prior-year quarter. Return on average assets were up 12 bps year over year to 1.13%, while return on average common equity rose 125 bps to 11.32%. Total loans increased 15.1% year over year to $10.7 billion while total deposits came in at $23.5 billion, up 17.5%. Equity Research CFR Page 4

5 Capital Deployment Update During 2013, Cullen/Frost implemented an accelerated share repurchase, as part of stock repurchase program authorized by the company's board of directors in Dec 2012, to buy up to $150.0 million of the common stock. The company repurchased 2.24 million shares at a total cost of $144.0 million under the accelerated share repurchase. No shares were repurchased year-to-date. On Oct 30, Cullen/Frost s board of directors declared a cash dividend of $0.51 per common share. The dividend was paid on Dec 15, 2014 to shareholders of record on Nov 28. Equity Research CFR Page 5

6 VALUATION On a price-to-book basis, Cullen/Frost s shares currently trade at 1.8x, which is at a 12.5% premium to the industry average of 1.6x. On a price to earnings basis () basis, the valuation looks attractive as the shares trade at 16.5x the Zacks Consensus Estimate for 2014, which is at an 8.3% discount to the industry average of 18.0x. Cullen/Frost has a trailing 12-month ROE of 10.6%, compared with the industry average of 10.2%. This implies that the company reinvests its earnings more efficiently than its industry peers. Our 6-month target price of $74.00 equates to 17.2x the Zacks Consensus Estimate for Combined with a quarterly dividend of $0.51 per share, this target price implies an expected return of about 6.1% over that period. This is consistent with our long-term Neutral recommendation on the shares. Currently, Cullen/Frost carries a Zacks Rank #2 (Buy). Key Indicators F1 F2 Est. 5-Yr EPS Gr% P/CF 5-Yr High 5-Yr Low Cullen/Frost Bankers, Inc. (CFR) Industry Average S&P BOK Financial Corporation (BOKF) Prosperity Bancshares Inc. (PB) International Bancshares Corporation (IBOC) BOK Financial Corporation (BOKF) N/A N/A N/A TTM is trailing 12 months; F1 is 2014 and F2 is 2015, CF is operating cash flow P/B Last Qtr. P/B 5-Yr High P/B 5-Yr Low ROE D/E Last Qtr. Div Yield Last Qtr. EV/EBITDA Cullen/Frost Bankers, Inc. (CFR) Industry Average S&P N/A 1.9 N/A Equity Research CFR Page 6

7 Earnings Surprise and Estimate Revision History Equity Research CFR Page 7

8 DISCLOSURES & DEFINITIONS The analysts contributing to this report do not hold any shares of CFR. The EPS and revenue forecasts are the Zacks Consensus estimates. Additionally, the analysts contributing to this report certify that the views expressed herein accurately reflect the analysts personal views as to the subject securities and issuers. Zacks certifies that no part of the analysts compensation was, is, or will be, directly or indirectly, related to the specific recommendation or views expressed by the analyst in the report. Additional information on the securities mentioned in this report is available upon request. This report is based on data obtained from sources we believe to be reliable, but is not guaranteed as to accuracy and does not purport to be complete. Because of individual objectives, the report should not be construed as advice designed to meet the particular investment needs of any investor. Any opinions expressed herein are subject to change. This report is not to be construed as an offer or the solicitation of an offer to buy or sell the securities herein mentioned. Zacks or its officers, employees or customers may have a position long or short in the securities mentioned and buy or sell the securities from time to time. Zacks uses the following rating system for the securities it covers. Outperform- Zacks expects that the subject company will outperform the broader U.S. equity market over the next six to twelve months. Neutral- Zacks expects that the company will perform in line with the broader U.S. equity market over the next six to twelve months. Underperform- Zacks expects the company will under perform the broader U.S. Equity market over the next six to twelve months. The current distribution of Zacks Ratings is as follows on the 1139 companies covered: Outperform %, Neutral %, Underperform 5.9%. Data is as of midnight on the business day immediately prior to this publication. Our recommendation for each stock is closely linked to the Zacks Rank, which results from a proprietary quantitative model using trends in earnings estimate revisions. This model is proven most effective for judging the timeliness of a stock over the next 1 to 3 months. The model assigns each stock a rank from 1 through 5. Zacks Rank 1 = Strong Buy. Zacks Rank 2 = Buy. Zacks Rank 3 = Hold. Zacks Rank 4 = Sell. Zacks Rank 5 = Strong Sell. We also provide a Zacks Industry Rank for each company which provides an idea of the near-term attractiveness of a company s industry group. We have 264 industry groups in total. Thus, the Zacks Industry Rank is a number between 1 and 264. In terms of investment attractiveness, the higher the rank the better. Historically, the top half of the industries has outperformed the general market. In determining Risk Level, we rely on a proprietary quantitative model that divides the entire universe of stocks into five groups, based on each stock s historical price volatility. The first group has stocks with the lowest values and are deemed Low Risk, while the 5 th group has the highest values and are designated High Risk. Designations of Below-Average Risk, Average Risk, and Above-Average Risk correspond to the second, third, and fourth groups of stocks, respectively. Coverage Team QCA Lead Analyst Analyst Copy Editor Content Ed. 11B Kalyan Nandy Priti Dhanuka Pooja Patel Anuja Mitra Priti Dhanuka Equity Research CFR Page 8