Business Context and Reporting Period
Company: KeyCorp (KeyCorp and subsidiaries, referred to as "Key")
Filing Type: Form 10-Q (Quarterly Report)
Period Ended: September 30, 2006
Business Overview: KeyCorp operates as a financial services company with two major business groups: Community Banking (Regional and Commercial Banking) and National Banking (Real Estate Capital, Equipment Finance, Institutional and Capital Markets, and Consumer Finance). The company provides deposit, lending, investment, and wealth management services.
Key Financial Metrics
| Metric | Three Months Ended Sep 30, 2006 | Nine Months Ended Sep 30, 2006 | Three Months Ended Sep 30, 2005 | Nine Months Ended Sep 30, 2005 |
|---|---|---|---|---|
| Net Income (in millions) | $312 | $909 | $278 | $833 |
| Diluted EPS | $0.76 | $2.21 | $0.67 | $2.01 |
| Total Revenue (TE) (in millions) | $1,294 | $3,830 | $1,257 | $3,680 |
| Net Interest Income (in millions) | $730 | $2,188 | $693 | $2,072 |
| Noninterest Income (in millions) | $543 | $1,571 | $531 | $1,517 |
| Noninterest Expense (in millions) | $808 | $2,394 | $781 | $2,303 |
| Provision for Loan Losses (in millions) | $31 | $94 | $43 | $107 |
| Total Assets (in millions) | $96,155 | N/A | $92,323 | N/A |
| Total Loans (in millions) | $65,551 | N/A | $65,575 | N/A |
| Allowance for Loan Losses (in millions) | $944 | N/A | $1,093 | N/A |
| Shareholders' Equity (in millions) | $7,947 | N/A | $7,522 | N/A |
| Return on Average Equity | 15.88% | 15.82% | 14.84% | 15.36% |
| Net Interest Margin (TE) | 3.63% | 3.69% | 3.67% | 3.68% |
Material Changes vs. Prior Period
- Profitability Growth: Net income increased 12.2% year-over-year for the quarter and 9.1% for the nine-month period. This was driven by revenue growth outpacing expense growth and a reduction in the provision for loan losses.
- Revenue Drivers: Total revenue increased due to solid commercial loan growth (up 7% year-over-year in average balances) and higher fee-based income. Net interest income rose 5.3% for the quarter, supported by an 8% increase in average core deposits.
- Expense Management: Noninterest expense increased 3.5% for the quarter, primarily due to higher personnel costs, marketing, and operating lease expenses. A $10 million contribution to the Key Foundation was recorded in the third quarter.
- Asset Quality: Net loan charge-offs decreased to $43 million (0.25% of average loans) for the quarter, down from $49 million (0.30%) in the prior year. Nonperforming assets totaled $329 million, or 0.50% of loans and OREO, down from 0.60% a year ago.
- Portfolio Restructuring: In August 2006, Key transferred $2.5 billion of home equity loans from the loan portfolio to "loans held for sale" in connection with the potential sale of its Champion Mortgage finance business. This transfer significantly impacted the composition of the loan portfolio and loans held for sale balances.
Guidance, Outlook, and Risks
- Outlook: Management expects fourth-quarter 2006 earnings to be in the range of $0.72 to $0.76 per share. Long-term goals remain an annual return on average equity of 16% to 18% and earnings per share growth of 8% to 10%.
- Strategic Developments:
- Sales: Agreed to sell the McDonald Investments branch network (approx. 340 advisors) to UBS Financial Services Inc., expected to close in Q1 2007. Considering the sale of the Champion Mortgage finance business.
- Acquisitions: Acquired Austin Capital Management, Ltd. (asset management) in April 2006 and the commercial mortgage servicing business of ORIX Capital Markets, LLC in December 2005.
- Accounting Changes: Adoption of SFAS No. 123R (Share-Based Payment) in Q1 2006 resulted in a $5 million cumulative after-tax adjustment increasing earnings. Pending adoption of SFAS No. 158 (Pension Plans) is expected to result in an after-tax charge of approximately $145 million to equity in 2006. Pending adoption of guidance on leveraged leases (Staff Position No. 13-2) is estimated to result in a cumulative after-tax charge of $50 million to $65 million to retained earnings in 2007.
- Risks and Contingencies:
- Tax Litigation: The IRS has disallowed deductions related to Lease-In, Lease-Out (LILO) and other lease financing transactions for tax years 1995-2000 and is auditing 2001-2003. Key has paid assessments for 1997 and is pursuing appeals. An adverse outcome could have a material adverse effect on results of operations.
- Legal Proceedings: Ongoing litigation regarding residual value insurance for automobile leases (Reliance/Swiss Re). Key has recorded a receivable for estimated losses ($342-$357 million), but an adverse court determination could result in a material one-time expense.
- Interest Rate Risk: Key maintains a neutral to slight asset-sensitive position. A 200 basis point increase in short-term rates is projected to decrease net interest income by approximately 0.12% over the next 12 months.
Investor Verification Checklist
- Champion Mortgage Sale: Verify the status and potential financial impact of the proposed sale of the Champion Mortgage finance business, including the $2.5 billion transfer of loans to "held for sale."
- IRS Tax Disputes: Monitor the resolution of IRS audits regarding LILO and lease financing transactions (1995-2003) and the potential for material interest and penalty assessments.
- Insurance Litigation: Track the progress of the residual value insurance litigation against Swiss Re and the collectibility of the recorded receivable.
- Accounting Impacts: Confirm the timing and magnitude of the expected $145 million charge related to SFAS No. 158 (pension plans) and the $50-$65 million charge related to leveraged lease accounting changes.
- Asset Quality Trends: Review the composition of nonperforming assets, specifically the concentration in commercial real estate and the impact of the commercial lease financing portfolio charge-offs from the prior year.