KeyCorp (KEY) — Q3 2018 Form 10-Q
Business context and reporting period
KeyCorp is a bank holding company operating through KeyBank, with Key Community Bank and Key Corporate Bank as its principal segments. This unaudited report covers the quarter and nine months ended September 30, 2018; comparisons are primarily with the corresponding 2017 periods. Dollar amounts are in millions unless stated otherwise.
Key financial metrics
| Metric | Q3 2018 | Q3 2017 | Change |
|---|---|---|---|
| Net interest income | $986 | $948 | +4.0% |
| Net interest margin, taxable-equivalent | 3.18% | 3.15% | +3 bps |
| Noninterest income | $609 | $592 | +2.9% |
| Provision for credit losses | $62 | $51 | +$11 |
| Noninterest expense | $964 | $992 | -2.8% |
| Income before tax, continuing operations | $569 | $497 | +14.5% |
| Net income attributable to Key | $482 | $364 | +32.4% |
| Diluted EPS attributable to common shareholders | $0.45 | $0.32 | +$0.13 |
Q3 total taxable-equivalent revenue was $1.602 billion, up 3.1%; the cash efficiency ratio was 58.7%, improving from 62.2%. The effective tax rate was 15.5%, versus 26.9%, aided by tax-advantaged investments and discrete tax benefits. For the first nine months, net income attributable to Key was $1.382 billion versus $1.101 billion, and diluted EPS was $1.26 versus $0.96.
At September 30, total assets were $138.8 billion, loans $89.3 billion, deposits $105.8 billion and long-term debt $13.8 billion. Loans rose $2.9 billion and deposits $545 million from year-end 2017; the loan-to-deposit ratio was 87.0%. Cash and due from banks was $319 million, while the liquid asset portfolio was $23.5 billion and unused secured borrowing capacity was $33.2 billion. Nine-month operating cash flow was $794 million, compared with $1.079 billion in 2017; investing cash flow was negative $1.383 billion and financing cash flow positive $237 million.
Common Equity Tier 1 was 9.95%, Tier 1 risk-based capital 11.11%, and total risk-based capital 12.99%. Tangible common equity to tangible assets was 8.05%. Key reported its Modified Liquidity Coverage Ratio above the 100% minimum.
Material changes and management commentary
- Higher rates and earning-asset growth lifted net interest income, partly offset by increased deposit and wholesale funding costs and lower purchase-accounting accretion. Q3 accretion was $26 million, down $22 million year over year.
- Commercial and industrial lending drove loan growth. Commercial loans totaled $66.0 billion, up 5.2% from year-end 2017; C&I loans were $45.0 billion. Consumer loans declined 1.6%, mainly due to home-equity paydowns.
- Investment banking and debt placement fees rose $25 million year over year, reflecting organic growth and the Cain Brothers acquisition. Trust and investment services income fell $18 million for the quarter, partly reflecting the KIBS sale and lower capital-markets commissions.
- Key Community Bank Q3 net income increased to $241 million from $163 million; Key Corporate Bank net income rose to $199 million from $190 million. Corporate Bank revenue growth was offset by lower net interest income and higher credit provision and expenses.
- Key completed the KIBS sale in May and recognized a $78 million gain in the first nine months ($73 million at closing and $5 million upon final purchase-price determination). The gain contributed to reported results.
- Key repurchased $542 million of common shares in Q3 and raised its quarterly dividend to $0.17 per share from $0.12. It issued $425 million of Series F preferred stock in July.
Outlook, risks and contingencies
For Q4 2018, management expected net interest income to increase 1%–3% from Q3, average loans to increase 1%–3%, average deposits to remain within 2% of Q3, noninterest income to rise 4%–6%, and noninterest expense to remain within 2%. Provision and net loan charge-offs were expected to remain relatively stable with Q3.
Long-term targets include a 54%–56% cash efficiency ratio, 16%–19% return on tangible common equity, and net loan charge-offs of 0.40%–0.60% of average loans. Q3 results were 58.7%, 16.81%, and 0.27%, respectively.
- Credit indicators weakened from year-end: nonperforming loans rose to $645 million from $503 million and nonperforming assets to $674 million from $534 million. Q3 net charge-offs were 0.27% of average loans, versus 0.15% a year earlier; management attributed much of the comparison to a large recovery in Q3 2017 and described overall credit trends as benign.
- The securities portfolio had $1.401 billion of gross unrealized losses at quarter-end, primarily on fixed-rate agency mortgage securities. Management considered these losses temporary and reported no securities impairment losses in earnings for the first nine months.
- Key expects adoption of the CECL credit-loss standard in 2020 to generally increase its allowance, but said the amount could not yet be reasonably estimated. Lease accounting adoption in 2019 was expected to add approximately $850 million–$950 million of assets and liabilities based on the then-current portfolio estimate.
- Risks include commercial real estate and C&I credit exposure, interest-rate and funding changes, cybersecurity and operational events, regulation, litigation, and economic deterioration. Management did not expect pending litigation to materially affect financial condition based on currently available information, but noted outcomes could exceed reserves.
- Guarantees had $10.695 billion of maximum potential undiscounted payments and $168 million of recorded liabilities; management assessed payment/performance risk as low. The largest stated exposures included standby letters of credit and FNMA mortgage recourse.
- Regulatory changes under EGRRCPA could reduce certain requirements, but the full impact remained under assessment. Key’s fully phased-in estimated CET1 ratio was 9.87%.
Most important facts for investors to verify
- Whether Q4 revenue and expense trends met the stated outlook, particularly net interest income growth amid rising deposit costs.
- Whether nonperforming loans and commercial credit losses continued to rise, and how allowance coverage tracked loan growth and credit migration.
- How much reported earnings benefited from the KIBS gain, tax benefits, and other nonrecurring or accounting-related items.
- Progress toward the cash efficiency and return-on-tangible-equity targets, alongside capital ratios after dividends and repurchases.
- The eventual quantified CECL impact, implementation of lease accounting, and any material changes in regulatory or legal contingencies.
Ernst & Young reported that its interim review found no material modifications needed for conformity with U.S. GAAP; this was a review, not an audit.