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UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington D.C. 20549

Form 10-Q

[ü] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

For the Quarterly Period Ended June 30, 2004

or

[  ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

For the Transition Period From ______ To ______

Commission File Number 0-850

(KEYCORP LOGO)

KeyCorp
(Exact name of registrant as specified in its charter)
     
Ohio
   34-6542451
(State or other jurisdiction of   (I.R.S. Employer
incorporation or organization)   Identification No.)
     
127 Public Square, Cleveland, Ohio
   44114-1306
(Address of principal executive offices)   (Zip Code)

(216) 689-6300

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [ü]   No [  ]

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes [ü]  No [  ]

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

     
Common Shares with a par value of $1 each
   406,807,104 Shares
(Title of class)   (Outstanding at July 30, 2004)

 

KEYCORP

TABLE OF CONTENTS

         
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    69  
 
    70  
 
Exhibits
     71  
 EX-10.1 Executive Officer Grants
 EX-15.1 Acknowledgement Letter of Independent Auditors
 EX-31.1 CEO 302 Certification
 EX-31.2 CFO 302 Certification
 EX-32.1 Section 906 CEO Certification
 EX-32.2 Section 906 CFO Certification

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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

Consolidated Balance Sheets

                         
    June 30,   December 31,   June 30,
dollars in millions
   2004
   2003
   2003
    (Unaudited)           (Unaudited)
ASSETS
                        
Cash and due from banks
   $ 2,313     $ 2,712     $ 3,249  
Short-term investments
     2,639       1,604       1,867  
Securities available for sale
     7,023       7,638       7,533  
Investment securities (fair value: $85, $104 and $107)
     81       98       99  
Other investments
     1,231       1,092       1,003  
Loans, net of unearned income of $2,018, $1,958 and $1,788
     64,016       62,711       63,214  
Less: Allowance for loan losses
     1,276       1,406       1,405  
 
    
 		      
 		      
 		  
Net loans
     62,740       61,305       61,809  
Premises and equipment
     600       606       606  
Goodwill
     1,150       1,150       1,142  
Other intangible assets
     31       37       31  
Corporate-owned life insurance
     2,550       2,512       2,470  
Accrued income and other assets
     5,863       5,733       5,670  
 
    
 		      
 		      
 		  
Total assets
   $ 86,221     $ 84,487     $ 85,479  
 
    
 		      
 		      
 		  
LIABILITIES
                        
Deposits in domestic offices:
                        
NOW and money market deposit accounts
   $ 19,956     $ 18,947     $ 17,900  
Savings deposits
     2,014       2,083       2,094  
Certificates of deposit ($100,000 or more)
     4,630       4,891       4,949  
Other time deposits
     10,342       11,008       11,231  
 
    
 		      
 		      
 		  
Total interest-bearing
     36,942       36,929       36,174  
Noninterest-bearing
     10,940       11,175       11,375  
Deposits in foreign office — interest-bearing
     4,541       2,754       2,320  
 
    
 		      
 		      
 		  
Total deposits
     52,423       50,858       49,869  
Federal funds purchased and securities sold under repurchase agreements
     3,794       2,667       3,766  
Bank notes and other short-term borrowings
     2,598       2,947       3,403  
Accrued expense and other liabilities
     5,969       5,752       5,760  
Long-term debt
     14,608       15,294       14,434  
Corporation-obligated mandatorily redeemable preferred capital securities of subsidiary trusts holding solely subordinated debentures of KeyCorp (See Note 9)
     —       —       1,258  
 
    
 		      
 		      
 		  
Total liabilities
     79,392       77,518       78,490  
SHAREHOLDERS’ EQUITY
                        
Preferred stock, $1 par value; authorized 25,000,000 shares, none issued
     —       —       —  
Common shares, $1 par value; authorized 1,400,000,000 shares; issued 491,888,780 shares
     492       492       492  
Capital surplus
     1,469       1,448       1,452  
Retained earnings
     7,072       6,838       6,633  
Treasury stock, at cost (84,646,118, 75,394,536 and 70,815,244 shares)
     (2,121 )     (1,801 )     (1,667 )
Accumulated other comprehensive income (loss)
     (83 )     (8 )     79  
 
    
 		      
 		      
 		  
Total shareholders’ equity
     6,829       6,969       6,989  
 
    
 		      
 		      
 		  
Total liabilities and shareholders’ equity
   $ 86,221     $ 84,487     $ 85,479  
 
    
 		      
 		      
 		  

See Notes to Consolidated Financial Statements (Unaudited).

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Consolidated Statements of Income (Unaudited)

                                 
    Three months ended June 30,
   Six months ended June 30,
dollars in millions, except per share amounts
   2004
   2003
   2004
   2003
INTEREST INCOME
                                
Loans
   $ 816     $ 910     $ 1,649     $ 1,814  
Tax-exempt investment securities
     1       1       2       3  
Securities available for sale
     78       96       166       197  
Short-term investments
     9       8       18       16  
Other investments
     8       7       16       13  
 
    
 		      
 		      
 		      
 		  
Total interest income
     912       1,022       1,851       2,043  
INTEREST EXPENSE
                                
Deposits
     161       183       322       371  
Federal funds purchased and securities sold under repurchase agreements
     10       15       20       29  
Bank notes and other short-term borrowings
     9       15       21       33  
Long-term debt, including capital securities
     96       113       191       233  
 
    
 		      
 		      
 		      
 		  
Total interest expense
     276       326       554       666  
 
    
 		      
 		      
 		      
 		  
NET INTEREST INCOME
     636       696       1,297       1,377  
Provision for loan losses
     74       125       155       255  
 
    
 		      
 		      
 		      
 		  
Net interest income after provision for loan losses
     562       571       1,142       1,122  
NONINTEREST INCOME
                                
Trust and investment services income
     141       130       286       261  
Service charges on deposit accounts
     86       91       170       183  
Investment banking and capital markets income
     69       54       111       89  
Letter of credit and loan fees
     40       40       77       71  
Corporate-owned life insurance income
     25       27       52       54  
Net gains from loan securitizations and sales
     1       14       26       29  
Electronic banking fees
     22       22       40       41  
Net securities gains
     7       3       7       7  
Other income
     55       53       108       96  
 
    
 		      
 		      
 		      
 		  
Total noninterest income
     446       434       877       831  
NONINTEREST EXPENSE
                                
Personnel
     371       371       744       734  
Net occupancy
     61       56       119       115  
Computer processing
     48       44       92       88  
Equipment
     30       34       61       66  
Marketing
     30       33       53       58  
Professional fees
     29       32       54       57  
Other expense
     110       118       215       227  
 
    
 		      
 		      
 		      
 		  
Total noninterest expense
     679       688       1,338       1,345  
INCOME BEFORE INCOME TAXES
     329       317       681       608  
Income taxes
     90       92       192       166  
 
    
 		      
 		      
 		      
 		  
NET INCOME
   $ 239     $ 225     $ 489     $ 442  
 
    
 		      
 		      
 		      
 		  
Per common share:
                                
Net income
   $ .58     $ .53     $ 1.18     $ 1.04  
Net income — assuming dilution
     .58       .53       1.17       1.03  
Weighted-average common shares outstanding (000)
     410,292       423,882       413,486       424,575  
Weighted-average common shares and potential common shares outstanding (000)
     414,908       427,170       418,240       427,628  
 
    
 		      
 		      
 		      
 		  

See Notes to Consolidated Financial Statements (Unaudited).

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Consolidated Statements of Changes in Shareholders’ Equity (Unaudited)

                                                         
                                            Accumulated    
                                    Treasury   Other    
    Common Shares   Common   Capital   Retained   Stock,   Comprehensive   Comprehensive
dollars in millions, except per share amounts
   Outstanding (000)
   Shares
   Surplus
   Earnings
   at Cost
   Income (Loss)
   Income b
BALANCE AT DECEMBER 31, 2002
     423,944     $ 492     $ 1,449     $ 6,448     $ (1,593 )   $ 39          
Net income
                             442                     $ 442  
Other comprehensive income (losses):
                                                        
Net unrealized losses on securities available for sale, net of income taxes of ($10) a
                                             (14 )     (14 )
Net unrealized gains on derivative financial instruments, net of income taxes of $22
                                             37       37  
Foreign currency translation adjustments
                                             17       17  
 
                                                    
 		  
Total comprehensive income
                                                   $ 482  
 
                                                    
 		  
Deferred compensation
                     8                                  
Cash dividends declared on common shares ($.61 per share)
                             (257 )                        
Issuance of common shares and stock options granted under employee benefit and dividend reinvestment plans
     2,130               (5 )             50                  
Repurchase of common shares
     (5,000 )                             (124 )                
 
    
 		      
 		      
 		      
 		      
 		      
 		          
BALANCE AT JUNE 30, 2003
     421,074     $ 492     $ 1,452     $ 6,633     $ (1,667 )   $ 79          
 
    
 		      
 		      
 		      
 		      
 		      
 		          
BALANCE AT DECEMBER 31, 2003
     416,494     $ 492     $ 1,448     $ 6,838     $ (1,801 )   $ (8 )        
Net income
                             489                     $ 489  
Other comprehensive income (losses):
                                                        
Net unrealized losses on securities available for sale, net of income taxes of ($24) a
                                             (41 )     (41 )
Net unrealized losses on derivative financial instruments, net of income taxes of ($20)
                                             (35 )     (35 )
Foreign currency translation adjustments
                                             1       1  
 
                                                    
 		  
Total comprehensive income
                                                   $ 414  
 
                                                    
 		  
Deferred compensation
                     10                                  
Cash dividends declared on common shares ($.62 per share)
                             (255 )                        
Issuance of common shares and stock options granted under employee benefit and dividend reinvestment plans
     4,787               11               116                  
Repurchase of common shares
     (14,038 )                             (436 )                
 
    
 		      
 		      
 		      
 		      
 		      
 		          
BALANCE AT JUNE 30, 2004
     407,243     $ 492     $ 1,469     $ 7,072     $ (2,121 )   $ (83 )        
 
    
 		      
 		      
 		      
 		      
 		      
 		          

(a)   Net of reclassification adjustments.

(b)   For the three months ended June 30, 2004 and 2003, comprehensive income was $102 million and $262 million, respectively.

See Notes to Consolidated Financial Statements (Unaudited).

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Consolidated Statements of Cash Flow (Unaudited)

                 
    Six months ended June 30,
in millions
   2004
   2003
OPERATING ACTIVITIES
                
Net income
   $ 489     $ 442  
Adjustments to reconcile net income to net cash (used in) provided by operating activities:
                
Provision for loan losses
     155       255  
Depreciation expense and software amortization
     93       99  
Net securities gains
     (7 )     (7 )
Net gains from principal investing
     (29 )     (17 )
Net gains from loan securitizations and sales
     (26 )     (29 )
Deferred income taxes
     82       22  
Net increase decrease in mortgage loans held for sale
     (219 )     (26 )
Net increase in trading account assets
     (453 )     (87 )
Other operating activities, net
     (237 )     374  
 
    
 		      
 		  
NET CASH (USED IN) PROVIDED BY OPERATING ACTIVITIES
     (152 )     1,026  
INVESTING ACTIVITIES
                
Net increase in other short-term investments
     (582 )     (148 )
Purchases of securities available for sale
     (911 )     (3,579 )
Proceeds from sales of securities available for sale
     33       2,678  
Proceeds from prepayments and maturities of securities available for sale
     1,425       1,605  
Purchases of investment securities
     —       (19 )
Proceeds from prepayments and maturities of investment securities
     16       40  
Purchases of other investments
     (252 )     (195 )
Proceeds from sales of other investments
     78       69  
Proceeds from prepayments and maturities of other investments
     58       70  
Net increase in loans, excluding acquisitions, sales and divestitures
     (3,807 )     (1,961 )
Purchases of loans
     (33 )     (419 )
Proceeds from loan securitizations and sales
     2,501       1,283  
Purchases of premises and equipment
     (50 )     (26 )
Proceeds from sales of premises and equipment
     4       4  
Proceeds from sales of other real estate owned
     35       33  
 
    
 		      
 		  
NET CASH USED IN INVESTING ACTIVITIES
     (1,485 )     (565 )
FINANCING ACTIVITIES
                
Net increase in deposits
     1,588       514  
Net increase in short-term borrowings
     778       484  
Net proceeds from issuance of long-term debt, including capital securities
     1,349       2,324  
Payments on long-term debt, including capital securities
     (1,875 )     (3,543 )
Purchases of treasury shares
     (436 )     (124 )
Net proceeds from issuance of common stock
     89       26  
Cash dividends paid
     (255 )     (257 )
 
    
 		      
 		  
NET CASH PROVIDED BY (USED IN) FINANCING ACTIVITIES
     1,238       (576 )
 
    
 		      
 		  
NET DECREASE IN CASH AND DUE FROM BANKS
     (399 )     (115 )
CASH AND DUE FROM BANKS AT BEGINNING OF PERIOD
     2,712       3,364  
 
    
 		      
 		  
CASH AND DUE FROM BANKS AT END OF PERIOD
   $ 2,313     $ 3,249  
 
    
 		      
 		  
Additional disclosures relative to cash flow:
                
Interest paid
   $ 556     $ 694  
Income taxes paid
     132       108  
Noncash items:
                
Net transfer of loans to other real estate owned
   $ 50     $ 49  

See Notes to Consolidated Financial Statements (Unaudited).

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Notes to Consolidated Financial Statements

1. Basis of Presentation

The unaudited condensed consolidated interim financial statements include the accounts of KeyCorp and its subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation.

As used in these Notes, KeyCorp refers solely to the parent company and Key refers to the consolidated entity consisting of KeyCorp and its subsidiaries.

The Financial Accounting Standards Board (“FASB”) issued Interpretation No. 46, “Consolidation of Variable Interest Entities,” in January 2003. This accounting guidance significantly changed how companies determine whether they must consolidate an entity depending on whether the entity is a voting rights entity or a variable interest entity (“VIE”). Interpretation No. 46 was effective immediately for entities created after January 31, 2003. As permitted, Key elected to adopt Interpretation No. 46 effective July 1, 2003, for entities created before February 1, 2003.

In December 2003, the FASB issued modifications to Interpretation No. 46 (Revised Interpretation No. 46) to provide additional scope exceptions, address certain implementation issues and promote a more consistent application. Revised Interpretation No. 46 supersedes Interpretation No. 46 and was adopted by Key in the first quarter of 2004. Note 7 (“Variable Interest Entities”), which begins on page 19, provides further information on Revised Interpretation No. 46.

Key consolidates a voting rights entity if Key has a controlling financial interest in the entity. In accordance with Revised Interpretation No. 46, VIEs are consolidated if Key is exposed to the majority of the VIE’s expected losses and/or residual returns (i.e., Key is considered to be the primary beneficiary). Variable interests include equity interests, subordinated debt, derivative contracts, leases, service agreements, guarantees, standby letters of credit, loan commitments and other instruments.

Unconsolidated investments in voting rights entities or VIEs in which Key has significant influence over operating and financing decisions (usually defined as a voting or economic interest of 20% to 50%, but not a controlling interest) are accounted for using the equity method. Unconsolidated investments in voting rights entities or VIEs in which Key has a voting or economic interest of less than 20% are generally carried at cost. Investments held by KeyCorp’s broker/dealer and investment company subsidiaries (primarily principal investments) are carried at estimated fair value.

Prior to the adoption of Interpretation No. 46, KeyCorp generally determined whether consolidation of an entity was appropriate based on the nature and amount of equity contributed by third parties, the decision-making power granted to those parties and the extent of third-party control over the entity’s operating and financial policies. Entities controlled, generally through majority ownership, were consolidated and considered subsidiaries.

Qualifying special purpose entities, including securitization trusts, established by Key under the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities,” are not consolidated. Additional information on SFAS No. 140 is included in Note 1 (“Summary of Significant Accounting Policies”) of Key’s 2003 Annual Report to Shareholders under the heading “Loan Securitizations” on page 52.

Management believes that the unaudited condensed consolidated interim financial statements reflect all adjustments of a normal recurring nature and disclosures that are necessary for a fair presentation of the results for the interim periods presented. Some previously reported results have been reclassified to conform to current reporting practices. The results of operations for the interim periods are not necessarily indicative of the results of operations to be expected for the full year. When you read these financial statements, you should also look at the audited consolidated financial statements and related notes included in Key’s 2003 Annual Report to Shareholders.

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Stock-Based Compensation

Through December 31, 2002, Key accounted for stock options issued to employees using the intrinsic value method outlined in Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees.” This method requires that compensation expense be recognized to the extent that the fair value of the stock exceeds the exercise price of the option at the grant date. Key’s employee stock options generally have fixed terms and exercise prices that are equal to or greater than the fair value of Key’s common shares at the grant date. As a result, Key generally had not recognized compensation expense related to stock options.

Effective January 1, 2003, Key adopted the fair value method of accounting as outlined in SFAS No. 123, “Accounting for Stock-Based Compensation.” Management applied this change prospectively to all awards in accordance with the transition provisions of SFAS No. 148, “Accounting for Stock-Based Compensation Transition and Disclosure.”

SFAS No. 123 requires companies like Key that have used the intrinsic value method of accounting for employee stock options to provide pro forma disclosures of the net income and earnings per share effect of accounting for stock options using the fair value method. Management estimates the fair value of options granted using the Black-Scholes option-pricing model. This model was originally developed to estimate the fair value of exchange-traded equity options, which (unlike employee stock options) have no vesting period or transferability restrictions. As a result, the Black-Scholes model is not a perfect indicator of the value of an employee stock option, but it is commonly used for this purpose. The estimated weighted-average fair value of options granted by Key during the six-month periods ended June 30, 2004 and 2003, was $6.50 and $4.31, respectively.

The Black-Scholes model requires several assumptions, which management developed and updates based on historical trends and current market observations. The level of accuracy achieved in deriving the estimated fair value of options is directly related to the accuracy of the underlying assumptions. The assumptions pertaining to options issued during the three- and six-month periods ended June 30, 2004 and 2003, are shown in the following table.