KeyCorp — Q2 2017 Form 10-Q
Reporting period: Quarter and six months ended June 30, 2017. Figures are unaudited. KeyCorp operates through Key Community Bank and Key Corporate Bank, with other activities reported in Other Segments.
Business context and financial performance
Year-over-year comparisons are significantly affected by KeyCorp’s August 1, 2016 acquisition of First Niagara; 2017 results include its operations, while Q2 2016 does not. The acquisition expanded Key’s branch network and balance sheet.
| Metric | Q2 2017 | Q2 2016 |
|---|---|---|
| Net interest income, GAAP | $973 million | $597 million |
| Net interest income, taxable-equivalent | $987 million | $605 million |
| Net interest margin, taxable-equivalent | 3.30% | 2.76% |
| Noninterest income | $653 million | $473 million |
| Provision for credit losses | $66 million | $52 million |
| Noninterest expense | $995 million | $751 million |
| Income from continuing operations before tax | $565 million | $267 million |
| Income from continuing operations attributable to Key common shareholders | $393 million | $193 million |
| Diluted EPS from continuing operations | $0.36 | $0.23 |
Q2 earnings included a reported $43 million pretax net benefit from notable items, including a $64 million merchant-services gain, purchase-accounting finalization, $44 million of merger-related charges, and a $20 million charitable contribution. Management reported this as approximately $0.02 per common share after tax. First Niagara purchase-accounting accretion contributed $100 million to Q2 net interest income, including $42 million from finalizing prior estimates.
For the six months ended June 30, net income attributable to Key was $736 million versus $390 million a year earlier. Net interest income was $1.891 billion versus $1.201 billion; noninterest income was $1.230 billion versus $904 million; and noninterest expense was $2.008 billion versus $1.454 billion.
Balance sheet, credit, liquidity and capital
- At June 30, loans were $86.5 billion, deposits $102.8 billion, total assets $135.8 billion, and long-term debt $13.3 billion. The year-ago figures were $62.1 billion, $75.3 billion, $101.2 billion, and $11.4 billion, respectively. The loan-to-deposit ratio was 87.2%.
- Six-month cash flows: operating activities used $589 million, investing activities provided $1.268 billion, and financing activities used $755 million. Cash and due from banks declined $76 million to $601 million. These cash-flow totals should be considered alongside the bank’s balance-sheet and funding activity.
- Nonperforming loans were $507 million, or 0.59% of portfolio loans, versus $619 million and 1.00% a year earlier. Nonperforming assets were $556 million versus $637 million. Q2 net charge-offs were $66 million, or 0.31% of average loans, versus $43 million, or 0.28%.
- The allowance for loan and lease losses was $870 million, or 1.01% of period-end loans, compared with 1.38% a year earlier. Management attributed the lower coverage ratio in part to the larger, acquired loan portfolio; it expects provision for the rest of 2017 to slightly exceed charge-offs to support loan growth.
- Common Equity Tier 1 was 9.91% at quarter-end (estimated 9.82% fully phased-in), versus 11.10% a year earlier. Tangible common equity to tangible assets was 8.56% versus 9.95%; management attributed the decline in capital ratios principally to First Niagara.
- Key reported $23.4 billion of liquid assets, $23.4 billion of unused Federal Reserve borrowing capacity secured by loans, and $6.0 billion of comparable FHLB capacity. Its estimated Modified LCR was above 100%. KeyCorp held $2.3 billion in cash, which management said was sufficient for projected obligations under its liquidity guidelines.
Material changes and management commentary
- Revenue and lending scale expanded following First Niagara. Average loans rose $25.4 billion year over year to $86.5 billion; average deposits rose $28.9 billion to $102.8 billion. Both major bank segments reported higher revenue and net income year over year.
- Fee growth included investment banking and debt placement fees of $135 million, up 37.8%, supported by commercial mortgage banking, underwriting, and advisory activity. Noninterest income also benefited from the one-time merchant-services gain.
- Noninterest expense increased 32.5% year over year, largely due to First Niagara, higher activity and incentive compensation. Excluding merger charges, expense rose $245 million. Key reported $400 million in annualized First Niagara cost savings and remained on track for a further $50 million by early 2018.
- On June 30, Key acquired the remaining 51% of Key Merchant Services, taking ownership to 100%. It recognized a provisional $64 million noncash gain on its previously held interest. The HelloWallet acquisition was scheduled to take effect July 1, 2017, with results to be consolidated from Q3.
- Q2 cash efficiency ratio was 59.3% (59.4% excluding notable items); year-to-date it was 62.4% (59.9% excluding notable items). Q2 return on average tangible common equity was 13.80%, or 12.86% excluding notable items; year-to-date it was 12.43%.
Outlook, capital actions and risks
- 2017 outlook: net interest income of $3.8–$3.9 billion, without assuming further 2017 rate increases; noninterest income of $2.35–$2.45 billion; and noninterest expense excluding merger charges of $3.7–$3.8 billion.
- Management anticipated 4%–6% loan growth from Q4 2016 levels, implying average loans of $87–$88 billion for 2017, and average deposits of $102.5–$103 billion. It expected charge-offs to remain below its 0.40%–0.60% target range for the rest of 2017.
- Long-term targets include cash efficiency below 60%, net charge-offs of 0.40%–0.60%, and return on tangible common equity of 13%–15%. Q2 met the efficiency and return targets on the reported measures; year-to-date return on tangible common equity remained below target.
- The Federal Reserve did not object to Key’s 2017 capital plan. It permits up to $800 million in share repurchases from Q3 2017 through Q2 2018. Key repurchased $94 million of common shares in Q2 and paid a $0.095 per-share dividend. The Board planned to consider dividend increases, subject to approval and relevant factors.
- Key identifies risks including commercial real estate conditions, commercial and industrial credit concentration, credit deterioration, interest-rate and funding changes, regulation, cybersecurity and operational failures, litigation, and realization of First Niagara acquisition benefits. Legal proceedings remain inherently uncertain; the company stated established reserves were believed adequate but outcomes could exceed them.
- Guarantees had maximum potential undiscounted payments of $18.224 billion, with $129 million of recorded liabilities; management assessed payment/performance risk as low. The largest categories included standby letters of credit and written put options.
Most important facts for investors to verify
- How much of earnings and net interest income growth is sustainable after excluding merchant-services and purchase-accounting benefits, and as acquired-loan accretion runs down.
- Whether First Niagara savings, integration costs, and acquired-loan credit performance track management’s expectations.
- Whether loan growth and credit migration lead to higher provisions or charge-offs, particularly in commercial lending and commercial real estate.
- Capital and liquidity capacity after planned repurchases, potential dividends, funding costs, and applicable regulatory requirements.
- The period-to-period comparability of expenses and profitability, including merger charges, acquisition effects, and the company’s non-GAAP adjustments.