KeyCorp (KEY) — Q3 2013 Form 10-Q
Reporting period: Quarter and nine months ended September 30, 2013. Unless otherwise indicated, dollar amounts are in millions. The interim financial statements were reviewed by Ernst & Young; this was not an audit.
Business context and reporting period
KeyCorp is a bank holding company operating primarily through Key Community Bank and Key Corporate Bank. Results distinguish continuing operations from discontinued education lending, Victory Capital and Austin. Key completed the sale of Victory in July 2013.
Financial results and position
| Metric | Q3 2013 | Comparable period / change |
|---|---|---|
| Net interest income, GAAP | $578 | $572 in Q3 2012; up 1.0% |
| Net interest margin, taxable-equivalent | 3.11% | 3.23% in Q3 2012 |
| Noninterest income | $459 | $518 in Q3 2012; down 11.4% |
| Noninterest expense | $716 | $712 in Q3 2012; up 0.6% |
| Continuing income attributable to Key common shareholders | $229; $0.25 per diluted share | $211; $0.22 per diluted share in Q3 2012 |
| Net income attributable to Key common shareholders, including discontinued operations | $266; $0.29 per diluted share | $214; $0.23 per diluted share in Q3 2012 |
- Nine-month results: GAAP net interest income was $1.742 billion versus $1.663 billion; noninterest income was $1.313 billion versus $1.417 billion; noninterest expense was $2.108 billion versus $2.084 billion. Continuing income attributable to Key common shareholders was $618 million versus $623 million. Net income attributable to common shareholders, including discontinued operations, was $663 million versus $639 million.
- Balance sheet at September 30: Assets were $90.7 billion; loans were $53.6 billion; deposits were $68.5 billion; long-term debt was $6.2 billion; and total shareholders’ equity was $10.2 billion. Loans were up $2.2 billion from September 2012, and deposits were up $4.3 billion.
- Cash flows, nine months: Operating activities provided $1.020 billion; investing activities used $1.446 billion; financing activities provided $590 million. Cash and due from banks increased $164 million to $748 million. These cash-flow totals should be interpreted in the context of a bank’s operating and investing activities.
- Asset quality: Provision for loan and lease losses was $28 million in Q3, versus $109 million a year earlier. Net charge-offs were $37 million, or 0.28% of average loans, versus $109 million, or 0.86%. Nonperforming loans were $541 million (1.01% of portfolio loans), down from $653 million; nonperforming assets were $579 million, down from $718 million. The allowance was $868 million, 1.62% of loans and 160.4% of nonperforming loans.
- Capital and liquidity: Tier 1 common equity ratio was 11.17%, Tier 1 risk-based capital 11.92%, total risk-based capital 14.37%, and leverage 11.33%. The reported liquid asset portfolio was $9.8 billion, with $18.3 billion in unused borrowing capacity secured by loan collateral. Period-end loan-to-deposit ratio was 84%.
- Margins and returns: Q3 return on average assets from continuing operations was 1.12%; cash efficiency ratio was 67.5%, or 63.6% excluding efficiency initiative and pension settlement charges. The common dividend declared was $0.055 per share.
Material changes versus the prior comparable period
- Q3 continuing common earnings and diluted EPS improved year over year, while nine-month continuing common earnings were slightly lower. Q3 total common earnings also included a larger contribution from discontinued operations.
- Net interest income rose modestly, but the net interest margin declined as earning-asset yields fell faster than funding costs. Management attributed pressure to lower asset yields and relatively high liquidity.
- Noninterest income fell primarily because the prior-year quarter included a $54 million gain on redemption of trust preferred securities and larger leveraged-lease termination gains. Fee growth in trust services, cards and payments, and principal investing partly offset the declines.
- Credit measures improved: provision, net charge-offs and nonperforming assets were lower than a year earlier. Management cited improving credit quality, lower delinquencies and continued runoff of exit portfolios.
- Loans grew, led by commercial, financial and agricultural lending; average deposits increased, including from corporate clients and escrow balances associated with the servicing acquisition. The lower-cost deposit mix reduced domestic deposit costs.
- Capital ratios were below year-earlier levels, while remaining well above stated minimums. Common share repurchases reduced shares outstanding.
Outlook, management commentary, risks and unusual items
- Management maintained its outlook for mid-single-digit year-over-year loan growth, primarily from commercial, financial and agricultural lending. It expected the net interest margin to be relatively stable around Q3 levels over the next couple of quarters, with possible downward pressure depending on liquidity.
- Management expected net charge-offs to remain at or below the lower end of its 0.40%–0.60% target range for the balance of 2013, with provision near that level. Its long-term targets also included NIM above 3.50%, cash efficiency of 60%–65%, and return on average assets of 1.00%–1.25%.
- Key reported $207 million in annualized efficiency savings, exceeding its $200 million target. It planned to provide further savings information with full-year 2013 results. Q3 included a $25 million pretax pension settlement charge; management said another settlement loss was expected in Q4 from additional lump-sum payments.
- Victory’s sale generated a $92 million after-tax gain, of which $72 million was cash. Further gain could be recognized for client consents received through January 31, 2014; none was accrued at quarter-end. The education lending trusts generated a $48 million after-tax fair-value loss in Q3, based on updated default and recovery assumptions. Together with other discontinued items, discontinued operations contributed $37 million after tax in Q3.
- Key cited economic and business risks including slow U.S. recovery, interest-rate changes, deterioration in credit or real estate, liquidity and funding costs, regulatory requirements, valuation uncertainty, operational and cybersecurity failures, and adverse litigation. The Metyk ERISA matter was on appeal; an overdraft class action had been dismissed after KeyBank’s motion to compel arbitration was granted, with plaintiff appeal pending.
- Outstanding guarantees included standby letters of credit with $10.7 billion maximum potential payments and $79 million recorded liability; FNMA recourse with $1.254 billion maximum exposure and $5 million recorded liability; and LIHTC return guarantees of $16 million. Total listed maximum undiscounted potential payments were $14.146 billion, with $129 million of recorded liabilities. The filing assessed payment/performance risk for these guarantees as low.
- New Basel III-based capital rules were scheduled to begin applying to Key as a standardized-approach institution in 2015, with transition through 2019. Key estimated a fully phased-in common equity Tier 1 ratio of 10.6% at September 30, 2013, and said it expected to meet the new framework. A proposed modified liquidity coverage ratio could apply to KeyCorp; the filing described a proposed phase-in beginning in 2015.
Important facts for investors to verify
- Whether underlying revenue and margin trends support management’s loan-growth and relatively stable NIM outlook, particularly given asset-yield and liquidity pressures.
- Whether credit quality continues to improve and whether the $868 million loan-loss allowance remains adequate as lending grows and the economy, collateral values and delinquencies change.
- The repeatability of earnings after separating continuing results from Victory sale proceeds, education-loan fair-value changes, pension charges and prior-year securities and lease gains.
- Progress toward recurring efficiency savings, and the effect of planned repurchases and dividends on capital ratios and share count.
- Potential effects of regulatory capital and liquidity rules, legal proceedings, contingent guarantees and fair-value assumptions—especially education-loan trust defaults, recoveries and discount rates.