KeyCorp (KEY) — Third-Quarter 2011 Form 10-Q
Reporting period: Quarter and nine months ended September 30, 2011. Amounts are in U.S. dollars; financial figures are generally in millions unless stated otherwise. The interim financial statements were reviewed by the independent accountant, not audited.
Business context and results
KeyCorp is a bank holding company operating through Key Community Bank and Key Corporate Bank. Its education lending business and Austin investment-management business are reported as discontinued operations. Management described the U.S. recovery as moderate but fragile, with weak employment, housing-market pressure, low interest rates, and uncertainty related to U.S. fiscal and European sovereign-debt concerns.
- Third-quarter continuing results: Net interest income was $549 million and noninterest income was $483 million. Income from continuing operations attributable to Key common shareholders was $229 million, or $0.24 per diluted share, versus $163 million, or $0.19, in third-quarter 2010.
- Third-quarter total results: Net income attributable to Key common shareholders was $212 million, or $0.22 per diluted share, compared with $178 million, or $0.20, a year earlier. Discontinued operations recorded a $17 million loss after tax, primarily associated with education-loan trust fair-value changes.
- Nine-month results: Continuing income attributable to Key common shareholders was $656 million, or $0.71 per diluted share, versus $121 million, or $0.14, in 2010. Total net income attributable to Key common shareholders was $619 million, or $0.67 per diluted share, compared with $111 million, or $0.13.
- Net interest margin: Taxable-equivalent NIM was 3.09%, down from 3.35% in the year-earlier quarter and 3.19% in the prior quarter. Management attributed pressure to lower asset yields, reduced earning assets, and a larger mix of low-yield short-term investments.
Financial position, credit, and liquidity
- Balance sheet at September 30: Total assets were $89.3 billion, loans were $48.2 billion, deposits were $61.0 billion, long-term debt was $10.7 billion, and total equity was $9.9 billion. Total assets were $94.0 billion a year earlier.
- Cash flows for the first nine months: Operating activities provided $1.875 billion and investing activities provided $1.363 billion; financing activities used $2.688 billion. Cash and due from banks increased $550 million to $828 million.
- Credit trends improved: Nonperforming loans were $788 million and nonperforming assets were $914 million, down from $1.372 billion and $1.801 billion, respectively, a year earlier. Third-quarter net charge-offs were $109 million, or 0.90% of average loans, versus $357 million, or 2.69%.
- Reserves: The loan-loss allowance was $1.131 billion, or 2.35% of loans, versus $1.957 billion, or 3.81%, a year earlier. Allowance coverage was 143.5% of nonperforming loans. Management said the reserve decline reflected improving credit quality and anticipated further reductions during the remainder of 2011 if credit conditions continued to improve.
- Funding and liquidity: The period-end loan-to-deposit ratio was approximately 86%. The reported liquid-asset portfolio was $13.3 billion, with additional unused secured borrowing capacity of $11.6 billion at the Federal Reserve Bank of Cleveland and $4.3 billion at the Federal Home Loan Bank of Cincinnati. KeyBank could not pay dividends to the parent without regulatory approval as of quarter-end.
- Capital: Tier 1 common equity ratio was 11.28%, tangible common equity to tangible assets was 9.82%, Tier 1 risk-based capital was 13.49%, and total risk-based capital was 17.05%. Tier 1 and total risk-based ratios were lower than at year-end 2010, while Tier 1 common equity and tangible common equity ratios were higher than a year earlier.
Changes, outlook, and material items
- Compared with third-quarter 2010, total noninterest expense declined 6% to $692 million; nine-month expense declined 9.5% to $2.073 billion. Lower FDIC assessments, OREO expense, and other expense contributed, while third-quarter personnel expense increased 6.4% to $382 million.
- For the first nine months, GAAP net interest income fell to $1.710 billion from $1.882 billion, and noninterest income fell to $1.394 billion from $1.428 billion. The year-over-year earnings improvement principally reflected lower credit costs and expenses, not revenue growth.
- Loans were down from a year earlier, although commercial, financial, and agricultural lending grew for a second consecutive quarter. Management said average loan balances might begin to increase on a linked-quarter basis and expected fourth-quarter NIM to be stable to higher, with average earning assets relatively stable.
- Management’s long-term targets include NIM above 3.50%, an efficiency ratio of 60–65%, return on average assets of 1.00–1.25%, and net charge-offs of 0.40–0.50% of average loans. Third-quarter NIM was 3.09%, efficiency ratio 67%, continuing-operations return on average assets 1.14%, and net charge-offs 0.90%.
- Key repurchased the $2.5 billion Series B TARP preferred stock and related warrant in 2011, funded in part with a $625 million common-stock offering and $1 billion of senior notes. The repurchase eliminated approximately $140 million in annual preferred dividends and discount amortization, but increased common shares outstanding substantially from year-end 2010.
- In the third quarter, Key corrected an error in the 2010 consolidation accounting for education-loan securitization trusts: accrued income and other assets and retained earnings were each reduced by $30 million. Key concluded the error was not material to prior periods or the current quarter, did not restate prior periods, and reported no impact on operating results.
- Regulatory and market risks include Dodd-Frank implementation, Basel III capital and liquidity rules, weak economic and commercial-real-estate conditions, interest-rate sensitivity, valuation uncertainty, and credit-rating changes. Debit interchange limits effective October 1, 2011 were estimated to reduce annual revenue by $50–60 million before offsets; management separately estimated a $12–15 million quarterly impact before mitigation.
- Key had no objection from the Federal Reserve to its updated capital plan. Management was developing its 2012 plan and said it would assess possible dividend increases and share repurchases, but could not specify actions pending regulatory guidance. It increased the quarterly common dividend to $0.03 per share in 2011.
Most important facts for investors to verify
- Whether credit improvement and reserve releases continue, particularly in commercial real estate, and whether the lower allowance remains adequate.
- Whether loan growth materializes and offsets continued margin pressure, including the effects of low rates and short-term asset mix.
- Actual impact of debit interchange rules and other regulatory changes on fees, expenses, and capital requirements.
- Capital and liquidity after TARP repayment, debt issuance, common-share dilution, and the transition of capital securities under forthcoming rules.
- The basis and continuing effects of the $30 million education-trust accounting correction, including the assumptions behind trust fair values and discontinued-operation losses.