KeyCorp (KEY) — Q1 2011 Form 10-Q
Reporting period: Three months ended March 31, 2011. KeyCorp is a bank holding company operating through Key Community Bank and Key Corporate Bank. Financial statements are unaudited; the independent accountant performed a review, not an audit.
Financial performance and condition
- Earnings: Net income attributable to Key was $263 million, versus a $55 million loss in Q1 2010. Income from continuing operations attributable to Key common shareholders was $184 million, or $0.21 per share; net income attributable to common shareholders was $173 million, or $0.20 per share ($0.19 diluted). Q1 earnings included a $49 million one-time deemed dividend, reducing common EPS by $0.06. Discontinued operations contributed an $11 million after-tax loss.
- Revenue and margin: Taxable-equivalent revenue from continuing operations was $1.061 billion, down 1.9% year over year. GAAP net interest income was $597 million, down from $625 million; noninterest income was $457 million, up from $450 million. Continuing-operations net interest margin was 3.25%, up 6 basis points year over year but down 6 basis points from Q4 2010.
- Credit costs and asset quality: The loan-loss provision was a $40 million credit, compared with $413 million of expense a year earlier. Net charge-offs fell to $193 million, or 1.59% of average loans, from $522 million, or 3.67%. Nonperforming loans were $885 million and nonperforming assets $1.089 billion, both lower than at year-end and a year earlier. The allowance was $1.372 billion, or 2.83% of loans, and 155% of nonperforming loans.
- Expenses and profitability: Noninterest expense declined 10.7% to $701 million. Pre-provision net revenue from continuing operations, a non-GAAP measure, was $360 million versus $297 million. Return on average assets from continuing operations was 1.32%.
- Loans and deposits: Continuing-operations loans were $48.552 billion, down from $50.107 billion at December 31, 2010 and $55.913 billion a year earlier. Deposits totaled $60.810 billion, versus $60.610 billion at year-end and $65.149 billion a year earlier. The reported loan-to-deposit ratio was 90.76%.
- Cash flow and liquidity: Operating cash flow was $412 million; investing activities provided $1.392 billion and financing activities used $1.542 billion. Cash and due from banks rose by $262 million to $540 million. Management reported a $12.4 billion liquid-asset portfolio and unused secured borrowing capacity of $11.7 billion at the Federal Reserve Bank of Cleveland and $3.8 billion at the Federal Home Loan Bank of Cincinnati.
- Debt and capital: Long-term debt was $11.048 billion. Key repurchased $2.5 billion of Treasury Series B preferred stock after issuing $625 million of common shares and $1 billion of 5.1% senior notes. Tier 1 common equity was 10.74%, tangible common equity to tangible assets 9.16%, Tier 1 risk-based capital 13.48%, and total risk-based capital 17.38%. Common dividends declared were $0.01 per share.
Material changes versus comparable periods
- Profitability improved substantially from Q1 2010, principally because credit-loss expense and noninterest expense declined; common shareholders’ continuing-operations results shifted from a $98 million loss to $184 million of income.
- Credit indicators improved: year-over-year net charge-offs fell by $329 million, nonperforming loans by about $1.2 billion, and nonperforming assets by about $1.3 billion. The lower provision contributed materially to earnings; management also expected further allowance reductions if credit trends continued to improve.
- Net interest income fell year over year as loan balances and earning assets contracted, partly offset by lower deposit funding costs. Loans declined across most portfolios, with commercial loans down 16% from March 2010.
- Noninterest income increased slightly. Stronger investment banking and capital-markets income, loan-sale gains, and letter-of-credit and loan fees offset weaker deposit service charges, operating lease income, and other income.
- Q1 common equity issuance increased shares outstanding by approximately 70.6 million. The Series B preferred-stock redemption reduced preferred dividends going forward but generated the one-time $49 million deemed dividend.
Outlook, management commentary, and risks
- Outlook: Management expected net interest income and margin to decline in Q2, citing an anticipated approximately $3 billion reduction in average earning assets and funding-mix changes. Until lending activity improves more significantly, it expected the net interest margin to be 3.15%–3.25% for the remainder of 2011.
- Goals: Long-term targets include a 90%–100% loan-to-core-deposit ratio, net charge-offs of 0.40%–0.50%, net interest margin above 3.50%, noninterest income above 40% of total revenue, return on average assets of 1.00%–1.25%, and $300–$375 million of Keyvolution annualized savings by year-end 2012. At Q1, reported metrics included 1.59% net charge-offs, 3.25% margin, 43% noninterest income, and $317 million in implemented savings. Management said the Board would consider raising the quarterly common dividend from $0.01 to $0.03; the Federal Reserve had no objection to the proposed capital action.
- Operating and market risks: Management cited a fragile economic recovery, weak housing conditions, elevated commercial real estate vacancies and uncertain property values, and the possibility of adverse credit trends. It noted particular exposure in nonowner-occupied commercial real estate, including retail and office properties. Interest-rate, liquidity, valuation, counterparty, operational, legal, and regulatory risks also remain.
- Funding and ratings: Following a Moody’s downgrade, KeyBank transferred approximately $1.5 billion of mortgage-servicing escrow deposits to another institution. Management described liquidity as strong. A further credit-rating decline could raise funding costs, restrict access to funding, or trigger collateral requirements.
- Regulatory and other matters: Dodd-Frank implementation remained ongoing. The filing noted possible effects from interchange-fee rules, deposit-insurance changes, incentive-compensation rules, derivatives restrictions, and future Basel III capital and liquidity standards. A shareholder derivative settlement involving executive-compensation governance enhancements was approved on April 28, 2011; separate litigation concerning leveraged leasing and related tax matters remained pending at the filing date.
- Discontinued operations and unusual items: The education lending business and Austin Capital Management were reported as discontinued operations. The quarter’s discontinued-operations loss was primarily tied to fair-value adjustments in education loan securitization trusts. The filing also describes fair-value estimates and contingent exposures, including guarantees with $12.503 billion of maximum potential undiscounted future payments and $184 million of recorded liabilities; management assessed the payment/performance risk for the listed guarantees as low.
Important facts for investors to verify
- Whether improving credit quality persists and supports further reserve releases without weakening loss coverage; review commercial real estate exposures, delinquency trends, and charge-offs.
- Whether loan growth recovers enough to offset declining earning assets and the forecast Q2 margin pressure.
- How the $1.5 billion escrow transfer, deposit mix, and temporary foreign-office deposit flows affect liquidity and net interest income.
- Capital and dilution effects of the preferred-stock redemption, common-share offering, $1 billion debt issuance, and April warrant repurchase; confirm any dividend decision.
- Potential revenue and cost effects of regulatory changes, including interchange fees, FDIC assessments, Dodd-Frank rules, and Basel III.
- Valuation assumptions and realized outcomes for education-loan trust assets, commercial real estate, and other Level 3 or nonrecurring fair-value positions; monitor the pending legal matters and guarantee exposures.