Cullen/Frost Bankers

Cullen/Frost reported solid second-quarter results with earnings per share of $2.70, a 13% year-over-year increase. This quarter's results translated into a 15.4% return on average common equity.

Why it matters: We think the bank's strong results vindicate its branch expansion strategy, despite rising competition in Texas. Management has broadly raised its full-year guidance, expecting stronger loan growth, better fees, and lower expenses than previously expected. Despite increasing loan competition, Frost increased loans about 8.1% from the prior year. We think this was driven by increased customer activity, along with the maturation of newer branches. A standout sign of this was accelerated growth of 17.2% in service charges and 16.5% in interchange. Similar to peer banks, Frost also noted increasing deposit competition and expects the second half of 2026 will see higher deposit costs, as demonstrated by a lower interest-bearing deposit beta guidance in the low-40s from its current 46%.

The bottom line: We plan to increase our $139-per-share fair value estimate for narrow-moat-rated Cullen/Frost by a mid-single-digit percentage after incorporating results and updated guidance. Based on our anticipated update, we assess shares as overvalued at current prices. The biggest driver of our projected fair value estimate increase is stronger net interest income from a stable federal-funds rate for the remainder of the year, keeping floating-rate loan pricing relatively higher than we previously expected.

We now have higher confidence in Cullen/Frost's ability to keep expenses relatively low while continuing to open new branches at a consistent pace. The bank is on track to open 12 branches this year, which is at the high end of its target range, while keeping expense growth under 5%. We expect Frost's operating efficiency to benefit from the seasoning of its newly opened branches, and we have seen encouraging results so far this year.

From a credit standpoint, the market was somewhat concerned about Cullen/Frost's results this quarter. Nonperforming assets as a percentage of total loans increased 16 basis points to 49 basis points. Management indicated two specific loans that caused this one-time spike. One of these was a large $55 million multifamily CRE loan that was underwritten in 2022 and is not reflective of larger credit-quality problems within the bank's portfolio. We view Cullen/Frost as a strong underwriter amongst regional banks, and we don't have concerns over its credit costs.

Frost remains an asset-sensitive bank, and management indicates that a 25-basis-point increase in the federal-funds rate will lead to a $2 million increase in its monthly net interest income, which translates into around 1.3% of its 2025 net interest income. That said, we think the market has already priced in its net interest income benefit from a potential rate hike. We currently do not include any federal-funds rate hikes in 2026 or 2027 in our base case forecast.

We are increasing our fair value estimate for Cullen/Frost to $149 per share from $147 after updating our benchmark interest rate assumptions and the time value of money since our last update. These increases were partially offset by incorporating higher deposit costs in the short and medium term. Our higher deposit cost expectations are driven by higher short-term rates, creating more deposit competition. This means providing higher deposit rates to attract and retain customers, leading to some pressure on funding costs. Our new fair value estimate is equivalent to 2.0 times the bank’s tangible book value, excluding AOCI, as of the end of the second quarter of 2026.

We forecast an average loan growth of 7.1% in 2026, which is at the low end of management's updated guidance range of 7% to 8% and similar to 2025's 7.3% growth. We forecast 5.0% growth in net interest income in 2026, down from 6.7% previously, mostly driven by higher deposit costs. After interest rates have normalized, which we anticipate during 2030, we forecast that Cullen/Frost will see annual net interest income growth of about 4%. We give the bank credit for branch expansion efforts and forecast an average loan growth rate of about 5% over the next decade. We think the bank has the potential to take more share in the Texas market, despite the increasing competition from other regional banks using mergers and acquisitions to gain exposure in the state.

We forecast the bank's 2026 fee income to grow at 7.5%. Our solid fee growth assumptions primarily stem from higher trust and investment management fees, as well as improved service charges and interchange fees. The majority of our increase is due to a higher volume, driven by the bank acquiring new customers at a quick pace, given the continued positive performance of Frost's branch expansions. We expect 7% growth in trust and investment management fees, and double-digit growth in service charges and interchange fees through 2026, as Cullen/Frost continues to expand its presence in core Texas markets.

Branch expansion and technology investment are near-term expense drivers for Cullen/Frost. After seeing double-digit adjusted expense growth in the past three years, we expect expenses to grow just over 5% in 2026 before falling further to 4.7% in 2027. Much of the needed investments in technology and modernization of systems should already be completed, allowing the bank to scale up without many marginal costs. Over the longer term, we see the bank’s normalized efficiency ratio around 59.4% on a fully taxable-equivalent basis.

We expect credit costs to continue to normalize in 2026, with a net charge-off ratio of 20 basis points, up from a very low base of just 16 basis points in 2025. On a normalized basis, we project a normalized net charge-off ratio of 0.28% as Cullen/Frost remains a conservative underwriter. Overall, we expect to see a normalized return on tangible common equity around 17.9%, well above our 8.9% estimate of Cullen/Frost’s cost of equity.

We believe Cullen/Frost Bankers has carved out a narrow Morningstar Economic Moat Rating, based on durable cost advantages and switching costs that are consistent with our moat framework for banks. The bank has consistently earned returns on tangible equity in excess of our estimated cost of equity of 8.9% over the past decade, and we forecast the bank to generate returns on tangible common equity in the high teens on a normalized basis.

We believe bank moats are derived primarily from two sources: cost advantages and switching costs. We see cost advantages coming from three primary factors: a low-cost funding base, excellent operating efficiency, and conservative underwriting. Regulatory costs must also be considered.

We assess Cullen/Frost's overall funding costs as better than the US regional banks under our coverage. Cullen/Frost has had a lower cost of deposits than the peer banks we cover. The bank has a better deposit mix, with a higher proportion of non-interest-bearing deposits to total deposits than most peers. The bank also tends to pay lower interest on its pool of interest-bearing deposits. This deposit cost advantage provides Cullen/Frost with the ability to grow its interest expense more slowly than peers (that typically have a larger proportion of interest-bearing deposits) when it is expanding its deposit base. We expect this deposit cost advantage to persist going forward, as we expect Cullen/Frost to maintain its relationship focus and efforts to gather deposits from commercial clients. The vast majority of Cullen/Frost’s non-interest-bearing deposits come from commercial clients, so it is evident that strong relationships with commercial clients are a core part of its deposit gathering. As it continues to expand within Texas (one of the fastest-growing states population-wise), Cullen/Frost should continue to reap the benefits from lower deposit costs relative to peers.

Considering the second pillar of our framework, operating efficiency, we don't believe Cullen/Frost has an advantage relative to its peers going forward. Cullen/Frost’s efficiency ratio (noninterest expenses to revenue) has shot up due to its branch expansion since 2018, and we believe it is likely to trail larger peers. It is focused on expansion in Houston, Dallas, and Austin markets, which we think will continue to drag on the firm's operating efficiency and expenses before these newly opened branches' productivity matures. Another factor that plays into efficiency is scale, and Cullen/Frost is currently a smaller bank among its peer set of large US regional banks. We see a pattern where banks that are better at managing expenses in relation to their revenue tend to be larger banks. A midcycle efficiency ratio of high-50s to mid-50s would be needed for confidence that operating efficiency contributes materially to a cost advantage. On a normalized basis, we expect Cullen/Frost’s midcycle efficiency ratio (on a fully taxable equivalent basis) to be a touch below 60% and worse than most of its narrow-moat-rated peers.

In terms of credit costs, we think that Cullen/Frost has demonstrated superior underwriting capabilities compared with peers. Cullen/Frost’s net charge-offs (losses on loans that must be recorded as uncollectible) to average loans were 3 times lower than its peers from 2009 to 2012. Cullen/Frost’s provisioning (allowance for expected loan losses) to NII was 5 times less than its peers from 2009 to 2012. This demonstrates that Frost was a better underwriter than peers throughout the economic environment immediately following the global financial crisis. Cullen/Frost’s net charge-off ratio advantage has declined to only 4 basis points better than peers from 2016 to 2025. This is because the economy was strong at most points in this period and underwriting improved in the US banking industry after the GFC. Hence, the entire industry benefited in the underwriting space from relatively lower losses compared with the global financial crisis. Cullen/Frost has demonstrated better underwriting than its peers while having greater exposure to the energy market (one of the riskiest loan categories) than they do. While Cullen/Frost's edge over peers in credit costs might be lower in future credit cycles, we expect some edge to persist.

Lastly, regulatory costs matter for both the broader banking industry and for Cullen/Frost specifically. The company is not large enough to be considered a global systemically important bank or a Category IV bank (between $100 billion and $250 billion in assets); therefore, it avoids some of the more onerous regulatory capital requirements. It is not large enough to be subject to the Fed's stress tests. The bank also avoids extra liquidity coverage and funding ratio requirements. The bank is still not large enough to be materially affected by proposed regulatory changes for banks to include accumulated other comprehensive income into common equity Tier 1 capital. Because Cullen/Frost avoids much of the extra regulation required for larger banks, we would view the bank’s regulatory burden as slightly advantageous. We don’t expect Cullen/Frost to pass the $100 billion asset threshold within the next 10 years with organic growth. Additionally, the bank already has a strong capital position and manages duration risk quite well.

We view switching costs as complementing these cost advantages for Cullen/Frost. We think that the bank’s expertise in local markets and its ability to address customer needs enable it to build deep client relationships, which increase customer switching costs.

Texas is one of the fastest-growing states, by population and economy, which is beneficial to Cullen/Frost.

Cullen/Frost’s organic expansion efforts should lead to significant revenue growth for years after more of its newer branches mature.

Cullen/Frost has excellent risk management and a very consistent culture, and it does not sacrifice underwriting standards to achieve growth, items that can be hard to replicate.

Cullen/Frost's lack of scale can limit some growth opportunities compared with its larger competitors with a national presence.

Cullen/Frost’s branch expansion strategy makes its expense base difficult to predict, and there could be higher expense growth than investors expect.

Competition in Texas banking is getting more intense, with new entrants entering the market via acquisitions and smaller regional banks/community banks in Texas merging to get a better scale. Cullen/Frost could lose market share to these players.