KEYCORP quarterly report, Q2 FY2016

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Business context and reporting period

KeyCorp is a U.S. bank holding company with community banking and corporate and investment banking businesses. This unaudited Form 10-Q covers the quarter and six months ended June 30, 2016; comparisons below are with the corresponding 2015 periods unless otherwise noted. Ernst & Young performed an interim review, not an audit.

Financial results and condition

  • Quarter earnings: Continuing income attributable to Key common shareholders was $193 million, or $0.23 diluted per share, versus $230 million, or $0.27, a year earlier. Net income attributable to Key was $202 million versus $238 million. For the first half, continuing income attributable to Key common shareholders was $375 million versus $452 million; diluted continuing EPS was $0.44 versus $0.52.
  • Revenue and margin: Second-quarter GAAP net interest income was $597 million, up from $584 million; taxable-equivalent NII was $605 million versus $591 million. Noninterest income was $473 million versus $488 million, leaving total taxable-equivalent revenue essentially flat at $1.078 billion versus $1.079 billion. Net interest margin fell to 2.76% from 2.88%. Management attributed NII growth to loan growth and repricing, partly offset by lower securities and derivatives reinvestment yields; higher liquidity and lower loan fees weighed on margin.
  • Expenses and profitability: Noninterest expense rose to $751 million from $711 million, including $45 million of First Niagara merger costs. Excluding merger costs, expense was $706 million, $5 million below the prior-year quarter. The cash efficiency ratio was 69.0%, or 64.8% excluding merger costs. Continuing-operations return on average assets was 0.82% for Q2.
  • Credit: Provision for credit losses was $52 million versus $41 million. Net charge-offs were $43 million, or 0.28% of average loans, versus $36 million, or 0.25%. Nonperforming loans increased to $619 million (1.00% of period-end portfolio loans), from $419 million a year earlier and $387 million at year-end 2015; management cited oil-and-gas-related credit migration. The $854 million allowance was 1.38% of loans and 138% of nonperforming loans.
  • Balance sheet and funding: At June 30, assets were $101.2 billion, loans $62.1 billion, deposits $75.3 billion, long-term debt $11.4 billion, and total equity $11.3 billion. Compared with June 30, 2015, loans grew about 6.6% and deposits about 6.6%. The period-end loan-to-deposit ratio was 85.3%. The liquid asset portfolio was $20.0 billion; the Modified LCR was above 100% in Q2.
  • Capital: Reported ratios at June 30 included Common Equity Tier 1 of 11.10%, Tier 1 risk-based capital of 11.41%, total risk-based capital of 13.63%, and leverage of 10.59%. Key estimated fully phased-in CET1 at 11.05%. The Federal Reserve did not object to the 2016 capital plan, which permits up to $350 million in share repurchases through Q2 2017.
  • Cash flow, first half: Operating activities provided $724 million; investing activities used $6.182 billion; financing activities provided $5.347 billion. Cash and due from banks ended at $496 million, down $111 million from year-end. These bank cash flows include substantial movements in short-term investments, loans, and deposits and should not be read as conventional free cash flow.

Material changes versus comparable periods

  • Second-quarter common-shareholder income from continuing operations declined 16% year over year, despite slightly higher taxable-equivalent revenue; higher credit provision and merger expense were among the pressures.
  • For the first half, net income attributable to Key was $390 million versus $471 million. Net interest income increased, but noninterest income declined and noninterest expense increased; merger costs were $69 million for the half.
  • Commercial loans grew substantially: total commercial loans were $46.8 billion, up 10.4% year over year, while consumer loans declined. Nonperforming loans rose materially, concentrated in commercial lending.
  • Common dividends increased to $0.085 per share for Q2 from $0.075. Open-market repurchases remained suspended during the quarter; Q2 share purchases shown in the filing were employee-plan surrenders, not repurchases under a public plan.

Outlook, commentary, risks, and unusual items

  • Management outlook: For full-year 2016, management expected low- to mid-single-digit NII growth without higher rates, or mid-single-digit growth with higher rates; stable to low-single-digit noninterest-income growth; and relatively stable noninterest expense excluding merger costs. It anticipated mid-single-digit average loan growth, a relatively stable allowance-to-loans ratio, and charge-offs below its 0.40%–0.60% target range.
  • First Niagara: The merger closed August 1, 2016, after quarter-end, for approximately $4.0 billion of consideration. First Niagara had about $40 billion of assets, $29 billion of deposits, and 390 branches as of June 30. An agreement provided for the sale of 18 Buffalo-area branches. Systems and client conversion was expected in Q4 2016, subject to pending regulatory approval, according to the filing.
  • Risks and contingencies: Key highlighted commercial real estate, borrower-default, oil-and-gas, interest-rate, funding, regulatory, cybersecurity, operational, litigation, and acquisition-integration risks. It reported $15.76 billion of maximum potential undiscounted payments on listed guarantees, against $121 million of recorded liabilities, and characterized payment/performance risk as low. Management said other litigation was not expected, based on information then available, to have a material adverse effect on financial condition, but outcomes could exceed reserves and affect results in a period.
  • Other items: The education lending business remained a discontinued operation, with $1.7 billion of discontinued assets at June 30. Oil-and-gas price weakness contributed to increased commercial credit-loss estimates. Regulatory changes, including the forthcoming FDIC assessment surcharge and new ERISA fiduciary requirements, could affect costs or business activity; the fiduciary rule’s financial impact was not yet clear.

Important facts for investors to verify

  1. Whether First Niagara integration, branch divestitures, conversion costs, and expected merger benefits progress as planned.
  2. Whether elevated commercial nonperforming loans—especially oil-and-gas exposures—and the allowance remain manageable; track charge-offs, criticized loans, and reserve coverage.
  3. Whether NII guidance and margin performance hold as rates, deposit costs, liquidity levels, and reinvestment yields change.
  4. Whether fee income recovers from weaker investment banking and debt-placement activity, and whether expense control meets guidance excluding merger costs.
  5. Capital-plan execution, including the timing and amount of repurchases and any Board action on the proposed dividend increase; also confirm capital and liquidity ratios after the acquisition.
  6. Developments in legal proceedings, guarantee exposures, cybersecurity and regulatory requirements, and any changes to management’s disclosed risk assessments.