KeyCorp (KEY) — Q2 2011 Form 10-Q
Reporting period: Quarter and six months ended June 30, 2011. Financial statements are unaudited; the independent accountant performed an interim review, not an audit. Amounts below are in U.S. dollars unless stated otherwise.
Business context and results
KeyCorp is a bank holding company whose principal subsidiary is KeyBank. Its two main segments are Key Community Bank and Key Corporate Bank. Education lending and Austin are reported as discontinued operations.
- Q2 revenue: Net interest income of $564 million plus noninterest income of $454 million produced GAAP revenue of $1.018 billion, down about 8% from $1.109 billion a year earlier. Taxable-equivalent net interest income was $570 million.
- Q2 earnings: Continuing-operations income was $252 million; income attributable to Key common shareholders from continuing operations was $243 million, or $0.26 per diluted share. Including a $9 million discontinued-operations loss, net income attributable to Key common shareholders was $234 million, or $0.25 per diluted share. The year-ago amounts were $56 million and $0.06 per share from continuing operations, and $29 million and $0.03 per share overall.
- First-half earnings: Net income attributable to Key common shareholders was $407 million, or $0.44 per diluted share, versus a $67 million loss, or $0.08 loss per share, in the first half of 2010. Continuing-operations common earnings were $427 million versus a $42 million loss.
- Net interest margin: Taxable-equivalent NIM was 3.19%, compared with 3.17% a year earlier and 3.25% in Q1 2011. Management attributed lower net interest income versus a year ago chiefly to reduced earning assets, partly offset by lower funding costs.
- Costs and credit: Q2 noninterest expense fell 11.6% to $680 million. The loan-loss provision was an $8 million credit, compared with a $228 million expense a year earlier. Pre-provision net revenue from continuing operations, a non-GAAP measure, was $344 million versus $346 million.
Financial position, liquidity and capital
- At June 30, total assets were $88.8 billion, gross continuing-operations loans $47.8 billion, deposits $60.4 billion, long-term debt $11.0 billion, and total equity $9.7 billion. Cash and short-term investments together were $5.4 billion. The loan-to-deposit ratio was 86.1%.
- First-half cash flows were $1.454 billion provided by operating activities, $2.064 billion provided by investing activities, and $2.943 billion used in financing activities. Cash and due from banks increased $575 million to $853 million. These bank cash-flow categories should not be interpreted like industrial-company free cash flow.
- Capital ratios at quarter-end included Tier 1 common equity of 11.14%, tangible common equity to tangible assets of 9.67%, Tier 1 risk-based capital of 13.93%, and total risk-based capital of 17.88%. Tier 1 common and tangible common equity ratios improved year over year; Tier 1 and total risk-based capital ratios declined from year-end 2010.
- Liquidity resources included a $13 billion liquid-asset portfolio, plus unused secured borrowing capacity of $11.9 billion at the Federal Reserve Bank of Cleveland and $4.2 billion at the Federal Home Loan Bank of Cincinnati. Management described liquidity as strong.
Material changes versus comparable periods
- Q2 common earnings from continuing operations rose to $243 million from $56 million, mainly reflecting substantially lower credit costs and lower expenses, despite lower revenue.
- Nonperforming assets declined to $950 million from $2.086 billion a year earlier; nonperforming loans fell to $842 million from $1.703 billion. Q2 net charge-offs were $134 million, or 1.11% of average loans, versus $435 million, or 3.18%, a year earlier.
- The allowance for loan and lease losses declined to $1.230 billion, or 2.57% of loans, from $2.219 billion, or 4.16%, a year earlier. Coverage was 146% of nonperforming loans, versus 130% a year earlier.
- Continuing-operations loans fell about 10% year over year to $47.8 billion; commercial real estate loans declined 28% to $9.7 billion. Commercial, financial and agricultural average loans grew 3.7% sequentially, while total loans continued to decline, but at a slower pace.
- Key repurchased the $2.5 billion Treasury Series B preferred stock and related warrant in March. The first quarter included a $49 million deemed dividend; redemption eliminated preferred dividends and discount amortization totaling about $140 million annually. A $625 million common-stock offering and $1 billion debt issuance helped fund the transaction. The quarterly common dividend was raised to $0.03 per share.
Outlook, commentary and risks
- Management said NIM would remain under pressure given the interest-rate outlook and Key’s asset-sensitive position. It anticipated little change in average earning assets in Q3, expected CRE loan declines to slow and stabilize or potentially turn to growth by Q4, and said it expected further allowance reductions during the remainder of 2011. These are expectations, not formal earnings guidance.
- Management cited a slowing U.S. recovery, weak housing, elevated unemployment and food and energy costs. It noted improving credit trends but warned that renewed economic weakness could reverse progress, particularly in commercial real estate, where vacancies, rental income and collateral values remain risks.
- Key had achieved $320 million in annual run-rate savings under its Keyvolution cost initiative. Its stated target efficiency ratio was 60%–65%; Q2 was 66%. Long-term goals also included NIM above 3.50%, loan-to-core-deposit ratio of 90%–100%, and net charge-offs of 0.40%–0.50% of average loans.
- Debit interchange rules effective October 1, 2011 could reduce annual revenue by an estimated $50–$60 million before offsets. Management believed Key would qualify for the fraud-prevention adjustment. Deposit service-charge income was already down 12.2% year over year for the first half, consistent with expectations following Regulation E changes.
- Moody’s-related movement of about $1.5 billion in mortgage-servicing escrow deposits affected liquidity and contributed to lower average earning assets. Key said it funded the transfer with securities sales and had ample liquidity.
- Material legal matters include Madoff-related claims involving Austin and a 2011 acquisition-related suit by Austin’s former owners. Key disputes the allegations and intends to defend itself; management said it could not determine whether the claims would have a material adverse effect. The filing also reports $12.476 billion of maximum potential undiscounted payments under guarantees, with $179 million recorded as liabilities; management rated the payment/performance risk of each guarantee category low.
- Regulatory change remains a risk: Dodd-Frank may affect derivatives, capital requirements, deposit insurance and consumer banking. The filing also notes planned phase-out of certain capital securities from Tier 1 capital beginning in 2013 and uncertainty over future Basel III rules.
Most important facts for investors to verify
- Whether credit improvement and declining charge-offs continue, and whether the smaller allowance remains adequate as loans and the economy evolve.
- Whether loan contraction turns to growth as management expected, especially in commercial lending and commercial real estate.
- Whether NIM and revenue withstand low rates, asset runoff, regulatory changes and the reduced deposit-service-charge stream.
- How much of reported earnings improvement is sustainable versus driven by lower provisions, expense reductions, and other period-specific factors.
- Developments in Austin-related litigation, guarantee exposures, ratings-sensitive escrow funding, and regulatory capital plans.