Our Favorite Texas Banking Franchises

There are two Texas banks in our coverage list we think have not only survived the crisis unscathed, but have actually fortified their franchises during the last 18 months. While the downturn has hit all financial institutions,  Cullen/Frost Bankers (CFR) and  Prosperity Bancshares (PRSP) have maintained decent levels of profitability and strong credit quality metrics relative to their peers. We attribute this to the banks' sensible management teams and the resilience of the Texas economy, which has weathered the recession better than other states.

Texas has long been a great place for business as the state's economy has grown steadily over the past decade. Despite strong ties to energy, we think the Texas economy is reasonably diversified across the technology and health-care industries, in addition to its exports. More importantly, it was not hurt by the real estate bubble nor the phenomenal collapse that eventually drowned the rest of the nation. Texas boasts an affordable cost of living and appealing demographic prospects, as its population is expected to grow by more than 20% over the next two decades. Although the Standard & Poor's Case-Shiller Home Price Index only tracks home prices in Dallas, the contrast to the rest of the U.S. is striking.

Twenty years ago, Texas' economy suffered a painful transformation. As the oil and real estate boom of the late 70s and early 80s ended, the state's economy collapsed. This destroyed many businesses, including banks which--not unlike in the mid and late 2000s--overzealously funded real estate and other projects with outrageous expectations. Only one of Texas' 10 largest banking companies, Cullen/Frost, survived that massacre. The rest were acquired by non-Texas banks or taken over by the FDIC and sold afterward.

Similarly, in today's environment, as bank products are increasingly becoming commodities, cost management has proven to be one of the most effective ways to create economic value and remain profitable. For banks, this means controlling three types of costs: credit, funding, and operating costs. Sticking to stringent credit standards, both Cullen/Frost and Prosperity have outperformed their peers. Better credit helps a bank's bottom line in three ways. Most obviously, as the bank books loan losses, it has to replenish its reserves through provision expenses. In addition, more nonperforming loans mean fewer sources of interest revenue. Finally, foreclosing and administering a property is costly, so the firm takes another hit through noninterest expenses.

Another way to increase profitability is by funding loans through deposits, which are typically the cheapest source of funds. In this aspect these two banks have historically outperformed the industry. Here is where the argument on "strong relationships" typically iterated by financial institutions can make a difference. Having deep ties with customers presumably helps banks keep their deposits, and a strong brand name also attracts deposits from other firms. This has been the case with Cullen/Frost and Prosperity, as both have recently increased their deposit market share, further strengthening their competitive advantage. Indeed, through the past 17 years, these two banks' costs have run between 0.8% and 1.2% less than the average U.S. bank, which makes a huge impact on returns.

Additionally, as other banks have made riskier loans in search for growth and higher yields, these two banks have managed their organic expansion appetite. While loans make up around 80% of deposits at the average American bank, the ratios are a very healthy 65% and 50% at Cullen/Frost and Prosperity, respectively. This is a luxury enabled by having cheap funds, as these firms can decline risky loans and instead park their money in safer securities while still earning a decent spread.

Keeping operating costs in check can help produce healthy returns, and Prosperity is remarkable in this field. The efficiency ratio (noninterest expense/revenues) hovers around 55% for the average bank, but Prosperity has traditionally outperformed by a whopping 15 percentage-point difference. Cullen/Frost has historically performed near the average, by contrast.

In our view these two banks' sensible policies, bolstered by Texas' resilient economy, have rewarded shareholders well, especially during the worst moments of this crisis. Neither Cullen/Frost nor Prosperity has suffered a single unprofitable quarter, and their returns on equity have been respectable. Moreover, neither firm has experienced problems with capital. Through the crisis, neither received TARP money, raised dilutive equity, nor slashed dividends. In fact, both have raised their payouts. Although the dividend increases have been mild, we think the fact these companies are able to hand out cash while others are cutting dividends is a clear sign of financial strength.

Going forward, we think Cullen/Frost and Prosperity will continue to outperform their peers. In our opinion, the only reason to hold off on buying shares is that valuations are somewhat rich at the moment (the table compares the four Texas banks under our coverage). Still, we are convinced these two sturdy institutions are worth owning and do not require the same high discounts to fair value as other financial firms.

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