Frost (CFR): Interest Rate Expense and Cyclically Adjusted Earnings
A reminder: 40% of my portfolio is in Frost. It’s the stock I like best.
Someone wrote me to ask about Frost’s interest expense:
“Hi Geoff,
I have not read your report on Frost…but right now I am looking at the latest balance sheet and (am) very surprised…the average interest expense is…paltry…the cost of funding is 0.032%. That’s extremely low, almost free. Am I right on this calculation? Or is it a mistake?”
My response goes into way more arithmetic than anyone wants to read. But, if you want the full picture of how I personally value Frost – read on…
First of all, a bit more than half of Frost’s deposits are in accounts that pay pretty close to 0% interest because they provide a lot of services and these customers are not hunting for yield. Frost pays “credits” to reduce the fees customers are charged for banking services. I think when we wrote our report it was about 1.5% combined interest and non-interest expense. Frost generally has the lowest non-interest expense of a bank I know of. They’re always a little lower than Wells Fargo (WFC).
Anyway, I did the calculation for last year’s interest expense that you did using average interest bearing deposits and annual interest paid on those deposits (the information is in the 2016 10-K at EDGAR). They paid 0.03% on average in interest (3 basis points). Which is what you said. However, remember, the Fed Funds Rate started 2016 at 0.25% to 0.50%. So, the 2016 interest rate expense for any bank is very misleading.
In the long-run, I expect Frost to pay 0.5 times what the Federal Reserve pays for the same amount of money. So, if we end this year at say a 1.5% Fed Funds Rate and then it just stayed there, I’d expect Frost’s interest expense to rise to 0.75% eventually.
The formula:
FFR * 0.5 = Frost’s interest expense is pretty accurate.
That’s only the cash interest rate though.
On some accounts, Frost also pays an “earnings credit rate” that customers use to offset fees for services the bank would otherwise charge for. So, back in 2016, Frost might have been paying 0.03% on an account in cash interest but then 0.25% in credits you can use to offset bank fees.
Of course, it’s the total expense that matters for a bank. You have to count both the interest expense and the net non-interest expense when calculating cost of funds. Frost pays maybe 1.4% of deposits in net non-interest expense and then you have the interest expense.
So, the bank’s total economic cost of funding would really be:
FFR * 0.5 + 1.4% = Frost’s total cost of funding.
So, if we end 2017 at a 1.5% Fed Funds rate and the rate stayed there, Frost should be getting their money at about 0.75% (interest expense) + 1.40% (net non-interest expense) = 2.15%.
If the Fed Funds Rate was a more “normal” 3% to 4%, then Frost’s total cost of funding would be 1.5% + 1.4% equals 2.9% to 2% + 1.4% equals 3.4%. So, at a 3-4% Fed Funds Rate, Frost’s total cost of funding would be like 3% to 3.5%. Frost would basically have the same cost of funding as the Fed.
The way interest rates drive Frost’s earnings is that:
· Frost has a constant 1.4% net non-interest expense regardless of where rates are
· The relationship between interest expense and Fed Funds Rate is multiplicative (0.5 times the Fed Funds Rate)
· The relationship between yield on loans and securities and the Fed Funds Rate is additive (FFR plus 3.3%)
So, what Frost actually earns before loan loss provisions and taxes on each dollar of deposits works like this:
(FFR + 3.3%) – (0.5 times FFR + 1.4%).
So, if the Fed Funds Rate ends 2017 at 1.5%, you’d expect Frost’s pre-tax and pre-provision earnings per dollar of deposits to be:
4.8% (1.50% + 3.30%) – 2.15% (0.75% + 1.40%) = 2.65%.
And, if the Fed Funds Rate eventually hits a more “normal” 3% to 4%, you’d expect Frost’s pre-tax and pre-loan loss provision earnings per dollar of deposits to be:
6.80% (3.50% + 3.30%) – 3.15% (1.75% + 1.40%) = 3.65%
Based on past experience, they’ll charge-off about 0.50% of loans per year. So, let’s call after-provision earnings 3% and then you pay a third of that in taxes and so you’ve got earnings of 2% after taxes for every dollar of deposits you have.
In other words, in a 3% to 4% Fed Funds Rate world, Frost should report $1 of EPS for every $50 of deposits. Right now, they have $400 a share in deposits. So, if the Fed Funds Rate was 3% to 4% right now, they’d probably have $8 a share in EPS.
That’s what I mean when I say Frost is interest rate sensitive. EPS should be about $5.50 a share when the Fed Funds Rate is 1.5% and about $8 a share when the Fed Funds Rate is 3.5%.
Those numbers won’t be exactly right, because I overstated what the combination of loan losses and taxes will really be. But, the pre-tax and pre-provision formula I gave you is an excellent estimate for all interest rate environments.
If you want to go through all the details of how (my newsletter co-writer) Quan and I got these figures, you have to read the “Value” section of the notes in this PDF report on Frost. It starts on page N56 (that’s page 81 of the PDF).
I don’t recommend reading that though. I went into way more arithmetic here in this post than I think most people want to get hit with at once. The notes section is much more detailed in providing evidence for why the Fed Funds Rate based earnings model shown here should correctly predict (with some lag) what EPS for Frost will be in any future year as long as you know just 2 things:
· Frost’s deposits per share
· The Fed Funds Rate
We know Frost’s deposits per share are about $400 now. And I think I know that in the very long-run, the Fed Funds Rate has the same or better odds of being above 3% in any year as it does being below 3%. Most people disagree with me on that assumption. If you assume today’s Fed Funds Rate is normal, then you’d assume normalized EPS on Frost is now about $5.50 or so. If you assume a 3% to 4% Fed Funds Rate is normal (like I do), then you’d assume normalized EPS on Frost is now about $8 or so. Obviously, that means if most people believe the Fed Funds Rate is normal now, then most people are going to value Frost stock about 30% lower than I do.
Personally, I value Frost at about 0.40 times deposits. That’s about $160 a share. If you think a Fed Funds Rate of 1.5% is normal, you should value Frost at about 0.28 times deposits. That’s about $110 a share. The stock now trades at just under $90 a share. So, if you think a normal Fed Funds Rate is 1.5%, you shouldn’t buy the stock. It’s a terrible idea to pay $90 for something you think is only worth $110.