KeyCorp 10-Q Summary — Quarter Ended September 30, 2016
Business context and reporting period
KeyCorp reported unaudited results for the third quarter and first nine months of 2016. The major event was its August 1 acquisition of First Niagara for approximately $4.0 billion. First Niagara contributed two months of operations to Q3; the bank merger and systems and client conversion followed in the fourth quarter. Key also sold 18 Buffalo-area branches, including $439 million of loans and $1.6 billion of deposits, as required in connection with the merger.
Financial performance and position
| Metric | Q3 2016 | Q3 2015 | Nine months 2016 | Nine months 2015 |
|---|---|---|---|---|
| Net interest income, GAAP | $780 million | $591 million | $1.981 billion | $1.746 billion |
| Net interest income, taxable-equivalent | $788 million | $598 million | $2.005 billion | $1.766 billion |
| Net interest margin, taxable-equivalent | 2.85% | 2.87% | 2.84% | 2.88% |
| Noninterest income | $549 million | $470 million | $1.453 billion | $1.395 billion |
| Noninterest expense | $1.082 billion | $724 million | $2.536 billion | $2.104 billion |
| Net income attributable to Key common shareholders | $166 million | $213 million | $545 million | $673 million |
| Diluted EPS attributable to Key common shareholders | $0.17 | $0.25 | $0.61 | $0.79 |
Q3 continuing-operations income attributable to Key common shareholders was $165 million, or $0.16 diluted EPS, versus $216 million and $0.26 a year earlier. The quarter included $207 million of merger-related charges: $189 million in expense and $12 million in noninterest-income reductions, plus $6 million in net interest income charges. Nine-month merger-related charges totaled $276 million. Management reported Q3 noninterest expense of $893 million excluding merger-related charges and First Niagara’s $140 million contribution.
At September 30, total assets were $135.8 billion, loans $85.5 billion, deposits $104.2 billion, and long-term debt $12.6 billion. Total assets and loans were substantially higher than year-end 2015, mainly due to First Niagara. The period-end loan-to-deposit ratio was 84.7%. Nine-month operating cash flow was $860 million, investing cash flow was negative $4.444 billion, and financing cash flow was positive $3.726 billion; cash and due from banks ended at $749 million.
Q3 average earning assets were $110.6 billion and the taxable-equivalent net interest margin was 2.85%. The reported cash efficiency ratio was 80.0%, or 64.9% excluding merger-related charges. For the first nine months, it was 72.5%, or 64.7% excluding those charges.
At quarter-end, the allowance for loan and lease losses was $865 million, 1.01% of loans; Q3 provision for credit losses was $59 million and net charge-offs were $44 million, or 0.23% of average loans. Nonperforming loans were $723 million (0.85% of period-end loans) and nonperforming assets were $760 million. Reported capital ratios were 9.56% Common Equity Tier 1, 10.53% Tier 1 risk-based, 12.63% total risk-based, and 10.22% leverage. The fully phased-in estimated CET1 ratio was 9.42%.
Material changes versus prior periods
- Compared with Q3 2015, reported common-shareholder earnings and diluted EPS declined, while revenue grew. The acquisition and merger costs make reported year-over-year comparisons less representative of underlying operations.
- Excluding First Niagara and merger-related charges, Q3 net interest income increased 4% year over year and noninterest income increased 8%. Investment banking and debt placement fees reached a record quarter, up 43% reported year over year.
- First Niagara added approximately $23 billion of loans and $27.3 billion of deposits at period-end. Excluding the acquisition, average loans increased about $3 billion year over year and average deposits increased about $5.7 billion.
- Nonperforming assets rose to $760 million from $417 million a year earlier, including $167 million from First Niagara. Management cited commercial credit migration, particularly in oil and gas, as a factor. The allowance increased from $790 million, while the allowance-to-loan ratio fell due in part to the acquired loan growth.
- Capital ratios and tangible common equity ratio declined from a year earlier, which management attributed primarily to the acquisition. Common shares outstanding increased by approximately 240 million through acquisition consideration.
Outlook, management commentary, risks and unusual items
- Management expected for the remainder of 2016 that provision for credit losses would slightly exceed net loan charge-offs and that net charge-offs would remain relatively stable with Q3. It also expected elevated merger-related charges to continue and five months of First Niagara activity in full-year 2016.
- Management’s long-term targets include a 90%–100% loan-to-deposit ratio, a 3.00%–3.25% net interest margin, a cash efficiency ratio below 60% excluding merger charges, and return on average assets of 1.00%–1.25% excluding merger charges. Q3 measures remained below several of these targets.
- The company’s Modified Liquidity Coverage Ratio was above 100% in Q3. Its liquid asset portfolio totaled $21.3 billion, with additional unused secured borrowing capacity of $16.5 billion at the Federal Reserve Bank of Cleveland and $5.5 billion at the FHLB of Cincinnati.
- The Federal Reserve did not object to the 2016 capital plan, which authorized up to $350 million of share repurchases through Q2 2017. Key repurchased $65 million of common shares in Q3. A possible quarterly dividend increase to as much as $0.095 per share was to be considered for Q2 2017, subject to Board action.
- Key identified risks including acquisition integration and realization of expected benefits, credit deterioration, commercial real estate conditions, interest-rate and funding changes, regulatory and compliance costs, cybersecurity and operational failures, and litigation. The filing notes that legal outcomes could exceed established reserves; management did not believe other proceedings were expected to materially adversely affect financial condition based on information then available.
- First Niagara purchase accounting valuations were preliminary and could change for up to one year after acquisition. The acquired loan valuation was incomplete at September 30; the reported estimate was subject to fourth-quarter refinement. The filing also reports $207 million of Q3 merger-related charges and a $686 million estimated fair-value adjustment on the acquired loan portfolio.
- Ernst & Young performed an interim review, not an audit, and reported no material modifications it believed were needed for conformity with GAAP.
Important facts for investors to verify
- Whether integration, systems conversion, cost savings, and purchase-accounting adjustments develop as expected, including the final acquired-loan valuation.
- Underlying earnings and expense trends after separating First Niagara contributions and merger-related charges; also track progress toward management’s margin and efficiency targets.
- Credit quality in the acquired portfolio and in commercial, oil-and-gas, and commercial real estate exposures, including nonperforming loans, criticized credits, charge-offs, and allowance adequacy.
- Capital and liquidity after the acquisition, including fully phased-in capital estimates, the Modified LCR, funding costs, and any further shareholder distributions.
- Potential exposure from guarantees, contingencies, litigation, and newly acquired consumer products; the filing lists $17.244 billion of maximum potential undiscounted guarantee payments and $111 million of recorded guarantee liabilities.