KeyCorp (KEY) — Q2 2012 Form 10-Q
Reporting period: Quarter and six months ended June 30, 2012. KeyCorp is a bank holding company operating primarily through KeyBank, with Key Community Bank and Key Corporate Bank as its major business segments. Dollar amounts are in millions unless noted. Interim financial statements are unaudited; the independent accountant performed a review, not an audit.
Financial performance and condition
| Metric | Q2 2012 | Comparable period / context |
|---|---|---|
| Continuing income attributable to Key common shareholders | $221; diluted EPS $0.23 | $243; $0.26 in Q2 2011 |
| Net income attributable to Key common shareholders, including discontinued operations | $231; diluted EPS $0.24 | $234; $0.25 in Q2 2011 |
| Net interest income (GAAP) | $538 | $564 in Q2 2011 |
| Net interest income (taxable-equivalent) | $544 | $570 in Q2 2011 |
| Net interest margin (taxable-equivalent) | 3.06% | 3.19% in Q2 2011 |
| Noninterest income | $485 | $454 in Q2 2011 |
| Noninterest expense | $714 | $680 in Q2 2011 |
| Provision for loan and lease losses | $21 | $8 credit in Q2 2011 |
| Efficiency ratio | 69% | Long-term target: 60%–65% |
- First-half results: Continuing income attributable to common shareholders was $420 (diluted EPS $0.44), versus $427 ($0.46) in first-half 2011. Net income attributable to common shareholders, including discontinued operations, was $425 versus $407. First-half 2011 included a $49 deemed dividend related to the TARP preferred-stock repurchase.
- Balance sheet at June 30: Total assets were $86.5 billion, down from $88.8 billion at December 31, 2011. Loans were $49.6 billion, broadly flat from year-end and up from $47.8 billion a year earlier. Deposits were $62.2 billion, versus $62.0 billion at year-end. Long-term debt was $7.5 billion, down from $9.5 billion at year-end and $11.0 billion a year earlier. Shareholders’ equity was $10.2 billion.
- Cash flow, first half: Operating activities provided $235, compared with $1.454 billion in first-half 2011; investing activities provided $1.730 billion versus $2.064 billion; financing activities used $1.942 billion versus $2.943 billion. Cash and due from banks increased $23 to $717.
- Credit quality: Nonperforming assets were $751, or 1.51% of portfolio loans plus OREO and other nonperforming assets, down from $950 and 1.98% a year earlier. Nonperforming loans were $657. Net charge-offs were $77, or 0.63% of average loans, versus $134 and 1.11% in Q2 2011. The allowance for loan and lease losses was $888, or 1.79% of loans, versus $1.230 billion and 2.57% a year earlier; coverage was 135.16% of nonperforming loans.
- Capital: At quarter-end, Tier 1 common equity was 11.63%, Tier 1 risk-based capital 12.45%, total risk-based capital 15.83%, and leverage 11.35%. Tangible common equity to tangible assets was 10.44%.
- Liquidity: Management reported a $10.4 billion liquid-asset portfolio and unused secured borrowing capacity of $13.2 billion at the Federal Reserve Bank of Cleveland and $5.0 billion at the Federal Home Loan Bank of Cincinnati. The loan-to-deposit ratio was 86.38%, below the company’s 90%–100% long-term target.
Material changes and management commentary
- Q2 common-shareholder continuing earnings declined year over year as lower net interest income and higher expenses and provision outweighed stronger noninterest income. The NIM decline reflected low interest rates compressing lending spreads and, in part, a $13 write-off of fees and capitalized loan-origination costs related to leveraged-lease terminations.
- Noninterest income increased, helped by leased-equipment gains and loan-sale gains. Management identified a $31 gain associated with early leveraged-lease terminations; the related fee and cost write-offs reduced net interest income. Management said the lease gains were nontaxable under a prior IRS settlement and anticipated further early terminations in the second half of 2012.
- Asset quality improved for an eleventh consecutive quarter. Management expected modest further improvement in asset quality and charge-offs, with net charge-offs moving toward its 0.40%–0.50% long-term target. The allowance was expected to decline as a percentage of loans if credit quality continued to improve.
- Management expected NIM to rise to about 3.20% in the second half of 2012, citing debt maturities, repricing of higher-cost CDs, and the July redemption of trust preferred securities; it cautioned that asset repricing would offset part of the funding-cost benefit.
- Key announced company-wide efficiency actions targeting $150–$200 of expense reductions by December 2013, with full run-rate benefits expected in 2014. The actions include organizational changes, strategic sourcing, and branch rationalization.
- On July 13, 2012, after quarter-end, KeyBank completed its purchase of 37 HSBC branches in Buffalo and Rochester for approximately $95, adding about $2.1 billion in deposits and $260 in loans; approximately $70 in credit-card receivables were expected in September. On August 1, Key announced acquisition of Key-branded credit-card assets from Elan, covering about 400,000 accounts and approximately $725 in assets, and a new Elavon processing agreement expected to take effect in the first half of 2013.
- Key repurchased $82 of common shares in the open market and $3 through employee programs in Q2. Remaining repurchase authority was $259, with activity expected through Q1 2013. The quarterly common dividend increased from $0.03 to $0.05 per share.
Risks, contingencies and unusual items
- Management cited a slowing economic recovery, weak job creation and consumer spending, persistently low interest rates, credit deterioration risk, market and valuation uncertainty, liquidity and funding access, regulatory change, and operational and cybersecurity risks.
- Proposed Basel III rules would change capital definitions and raise minimum requirements, including a fully phased-in 2.5% conservation buffer. Key reported pro forma fully phased-in ratios of 10.90% Tier 1 common equity, 11.20% Tier 1 capital, and 14.80% total capital under the proposals. Trust preferred securities were being phased out of Tier 1 capital; $707 of securities were redeemed on July 12, 2012.
- Guarantees had maximum potential undiscounted payments of $13.2 billion, principally standby letters of credit ($10.1 billion) and written put options ($2.0 billion); recorded liabilities totaled $177. Management assessed payment/performance risk for these guarantee categories as low.
- Legal matters included a settled Austin acquisition-related claim with an immaterial payment, a proposed settlement in the Monday shareholder derivative action awaiting a fairness hearing, and pending Metyk litigation. Management said established legal reserves were believed adequate but outcomes could exceed reserves and affect a particular period.
- Discontinued education lending operations generated $10 of after-tax income in Q2 2012 versus a $9 loss in Q2 2011, primarily reflecting fair-value adjustments. The education-loan securitization trusts had $2.6 billion of assets and $2.4 billion of liabilities on the balance sheet; trust assets are restricted to settling trust obligations and have no recourse to Key.
- A new regulatory classification policy prospectively included $36 of accruing home-equity second liens as nonperforming where associated first liens were seriously delinquent, in foreclosure, or delinquency status was unknown. Management did not expect a similar one-time increase.
Most important facts for investors to verify
- Whether the projected second-half NIM recovery to about 3.20% materializes, and how much the leveraged-lease terminations contributed to reported income and tax benefits.
- Whether the $150–$200 expense-reduction target is achieved on schedule and improves the efficiency ratio without impairing revenue growth or client service.
- Whether continued credit improvement supports lower provisions while nonperforming assets, charge-offs, and the allowance remain adequate—especially in commercial real estate and home-equity second liens.
- How the HSBC branch purchase and Elan credit-card acquisition affect deposits, loan growth, expenses, and returns; confirm the stated transaction timing and integration progress.
- Capital and liquidity effects of Basel III implementation, trust-preferred redemptions, debt maturities, shareholder distributions, and the comparatively weak first-half operating cash flow.
- Developments in pending litigation, guarantee exposures, and the fair-value assumptions used for education-loan trusts and other Level 3 assets.