KeyCorp (KEY) 2016 Q2 法說會逐字稿

Good morning, and welcome to KeyCorp's second-quarter 2016 earnings conference call. This call is being recorded. At this time I'd like to turn the conference over to Beth Mooney, Chairman and CEO. Please go ahead ma'am.

Thank you, operator. Good morning, and welcome to KeyCorp's second-quarter 2016 earnings conference call. Joining me for today's presentation is Don Kimble, our Chief Financial Officer. And available for our Q&A portion of the call is Bill Hartmann, our Chief Risk Officer.

Slide 2 is our statement on forward-looking disclosure and non-GAAP financial measures. It covers our presentation materials and comments, as well as the question-and-answer segment of our call.

I'm now turning to slide 3. Our second-quarter results reflect continued momentum in our core businesses and the progress we have made to complete the acquisition of First Niagara on August 1. Excluding merger-related charges, we generated positive operating leverage and grew pre-provision net revenue relative to the year-ago period. Revenue was stable with the same period last year and up 3% from the last quarter, despite low interest rates and challenging market conditions.

Loan growth was solid again this quarter, driven by a 12% increase in average commercial, financial, and agricultural loans. Our core fee-based businesses continue to perform well, with corporate services and cards and payments both posting double-digit year-over-year gains. Market sensitive businesses, including investment banking and debt placement fees, improved from last quarter but are below the record pace of the year-ago period. Commercial mortgage banking continues to generate strong growth, while other areas are being impacted by challenging market conditions. Don will provide more detail and our outlook for our fee-based businesses in his comments.

Expenses have remained well-controlled, and our ongoing efficiency efforts have allowed us to continue to invest to drive growth. Credit quality was a good story once again, with our net charge-offs to average loans remaining below our targeted level.

And capital management remains an area of focus. We increased our quarterly common dividend to $0.085 per share, or 13% during the quarter. And we were pleased to receive no objection from the Federal Reserve on our 2016 capital plan. We expect to resume common share repurchases after we complete our acquisition and subject to Board approval, we plan to increase our common share dividend to $0.095 per share next year.

Now I am turning to slide 4. We're very excited to be on a path to close our First Niagara acquisition, which is expected on August 1. The merger of KeyBanc and First Niagara Bank is planned for the fourth quarter, subject to the approval by the OCC. We would also expect systems and client conversions to take place during the fourth quarter.

Additionally, we recently announced the plans for our combined branch network, including the consolidation of over 100 existing First Niagara and Key branches. We also plan to continue to invest and grow in New York, which will include in-sourcing some functions and our buildout of the First Niagara's residential mortgage and auto lending businesses to support our broader franchise.

I've been extremely pleased with the way our two Companies have worked together to position us to be successful in meeting our commitments to clients, communities, employees, and shareholders. And I remain confident in and committed to achieving our financial targets and creating value for our shareholders in this slow growth, low rate environment. The combination of Key and First Niagara accelerates our performance beyond what either Company could have otherwise achieve.

We continue to expect the acquisition to be accretive to earnings in 2017 and add 5% to EPS upon the full realization of cost savings. We also expect to increase our return on tangible common equity by 200 basis points, improve our cash efficiency ratio by 300 basis points, and produce a solid return on invested capital.

And as I've said before, our internal target for cost savings is higher than our external target of $400 million. And developments this quarter have only reinforced our confidence in achieving our commitment.

Now I'll turn the call over to Don to discuss the details of our second-quarter results. Don?

Thanks, Beth. I am on slide 6. Second-quarter net income from continuing operations was $0.27 per common share after excluding $0.04 of merger-related expense. This compares to $0.27 per share in the year-ago period and $0.24 in the first quarter, which excluded $0.02 of merger-related expense.

As Beth mentioned, excluding merger expense, we grew pre-provision net revenue and generated positive operating leverage relative to the year-ago quarter. Revenue was stable from the same period last year and up 3% from the first quarter despite the headwinds from low interest rates and the challenging market conditions.

Core expenses were well-managed. Our efficiency ratio adjusted for merger expense was 64.8%.

I will cover many of these items on this slide in the rest of my presentation. So I'm now turning it to slide 7.

Average loan balances were up $3.2 billion, or 5% compared to the year-ago quarter, and up $1 billion, or 2% from the first quarter. Our year-over-year growth was once again driven primarily by commercial, financial, and agricultural loans, and was broad based across Key's business lending segments. Average CF&A loans were up $3.6 billion, or 12% compared to the prior year, and were up $1 billion, or 3% unannualized from the first quarter.

Continuing to slide 8. Average deposits, excluding deposits in foreign office, totaled $73.9 billion for the second quarter of 2016, an increase of $3.6 billion compared to the year-ago period. The year-over-year increase primarily reflects core deposit growth in our retail banking franchise, higher escrow deposits from our commercial mortgage servicing business, and commercial deposit inflows.

Compared to the first quarter 2016 average deposits increased by $2.3 billion. Higher escrow balances, short-term inflows from our commercial clients, and core deposit growth in our retail banking franchise contributed to the linked-quarter increase.

Turning to slide 9. Taxable equivalent net interest income was $605 million for the second quarter of 2016 and net interest margin was 2.76%. These results compare to the taxable equivalent net interest income of $591 million and a net interest margin of 2.88% for the second quarter of 2015. The 2% increase in net interest income reflects higher earning asset balances and yields partially offset by lower reinvestment yields in the securities and derivatives portfolio. Compared to the first quarter of 2016 net interest income was down 1% and net interest margin decreased 13 basis points.

The net interest margin reduction in the second quarter was driven by excess liquidity, which was a function of three things, the first two of which are related to our upcoming First Niagara acquisition. First, we retained higher cash balances needed for funding the First Niagara purchase price and branch divestiture. Second, liquidity was held to position our balance sheet for LCR compliance following the close of the acquisition. And third, during the quarter we had elevated levels of short-term escrow deposits, some of which are seasonal.

Higher levels of liquidity translated into a $2.1 billion linked-quarter increase in our account at the Federal Reserve, which resulted in a 7 basis point decline in our net interest margin. The average balances for the quarter of $5.6 billion was well above the historic levels of approximately $1 billion.

Slide 10 shows a summary of noninterest income which accounted for 44% of total revenue. Noninterest income in the second quarter was $473 million, down $15 million, or 3% from the prior year, and up $42 million, or 10% from the prior quarter. The decrease from the prior year was largely attributed to lower investment banking and debt placement fees.

Although we saw growth in commercial mortgage banking fees, it was more than offset by weaker market conditions resulting in lower revenue compared to the prior year -- excuse me, the year-ago record quarter. In the second half of the year we expect good overall growth in investment banking and debt placement fees, more in line with our original outlook for the business.

We saw continued growth and momentum in a number of our core fee-based businesses, reflecting investments we made over the last few years. Corporate services income was up 23% and cards and payments income was up 11% from the year-ago period. We've also seen a positive trend in service charges on deposit accounts. The growth in other income reflected a number of items including higher gains from real estate investment -- in real estate related investments.

Compared to the first quarter, noninterest income was most notably impacted by $27 million in the higher investment banking and debt placement fees. We also saw growth across various other line items including cards and payments, corporate services, service charge on deposit accounts, and net gains from principal investing.

Turning to slide 11. As you can see on the slide, reported noninterest expense of $751 million includes $45 million of expense related to our acquisition of First Niagara. Excluding these costs, noninterest expense was $706 million for the quarter. We've provided a detailed breakout of our merger-related expense in the appendix of our materials.

Compared to the second quarter of last year and after adjusting for merger-related expense, noninterest expense was down $5 million, or 1%. The decline reflects lower performance-based compensation, occupancy and business services, and professional fees which were partially offset by higher expense related to certain real estate investments and increased non-merger-related marketing. Excluding the merger-related expense linked-quarter expenses were up $27 million, or 4%. The increase was primarily in non-personnel including other expense and non-merger-related marketing. The quarter also reflected an increase in personnel expense related to the higher performance-based compensation.

Turning to slide 12. Overall net charge-offs were $43 million, or 28 basis points of average total loans in the second quarter, which continues to be below our targeted range. Second-quarter provision for credit losses was $52 million, an increase of $11 million from the year-ago period and a decrease of $37 million from the linked quarter.

Nonperforming loans and nonperforming assets both increased relative to the year-ago period but decreased from the prior quarter. At June 30, 2016 our total reserve for loan losses represented 1.38% of period-end loans and 138% coverage of nonperforming loans.

Our outlook for credit quality remains consistent for the remainder of the year with provision levels modestly exceeding net charge-offs, which will support our continued loan growth. We continue to anticipate the allowance as a percentage of period-end loans to be relatively stable with our second-quarter level.

Turning to slide 13. Our common equity tier 1 ratio at the end of the second quarter was 11.1%, up from 10.7% in the year-ago period. As Beth highlighted, disciplined capital management remains a priority for us.

Last month we announced a 13% increase in our quarterly common share dividend. We were also pleased to receive no objection from the Federal Reserve on our 2016 capital plan, which included up to $350 million in share repurchases and an additional increase to our common share dividend next year, subject to Board approval.

Moving onto slide 14. The top portion of the slide provides our 2016 outlook for stand-alone Key, excluding merger-related expense. We have updated our guidance to reflect the second-quarter results. Despite continued headwinds from lower interest rates and more challenging market conditions, we continue to expect to drive positive operating leverage. Consistent with our prior outlook, we expect average loans to grow in the mid-single-digit range, driven by continued strength in our commercial businesses.

Net interest income growth should be in the low to mid-single-digit range compared to 2015 without any benefit from higher interest rates. We expect net interest income to be higher in the second half of the year compared to both the first half of this year and a year-ago period.

Our guidance now reflects the weaker capital markets conditions experienced in the first half of this year. Importantly, our expectations for the second half of this year remain in line with our original outlook. Based on this, we expect noninterest income to be relatively stable to up low single digits for the year.

Full-year reported expenses excluding merger-related expense should be relatively stable with 2015. We continue to expect net charge-offs below our targeted range of 40 to 60 basis points. We also expect provision levels to be modestly -- to modestly exceed net charge-offs, which will support our continued loan growth. The allowance as a percentage of period-end loans is anticipated to be relatively stable with our second-quarter level.

We've also included some guidance for the expected impact of First Niagara, which is scheduled to close next week on August 1. Branch and systems conversions are anticipated for the fourth quarter, after which we expect to begin to see the cost savings. We expect the majority of the benefits to be realized in 2017.

Revenue and expense should be generally consistent with First Niagara's first-quarter operating results, including their 10-Q, adjusted for the five-month period they would be part of Key. Expenses will also reflect approximately a $30 million incremental amortization expense in 2016. Key's share count will also increase by about 240 million shares from the acquisition.

As Beth said, we're excited about the opportunity to bring these two companies together. And our confidence in delivering our financial commitments remains strong.

With that, I'll close the call -- turn the call back over to the operator for instructions for the Q&A portion of our call. John?

Thank you.

(Operator Instructions)

First from the line of Bob Ramsey with FBR. Please go ahead.

Hey, good morning. How is everyone?

Good morning, Bob.

I was wondering if you could maybe talk a little bit about the timing of the CCAR share repurchases? Do you think you guys will start that right after the First Niagara deal closes? Or do you think you'll sort of wait until next quarter, really come back into the market? Or how you're thinking about it?

Our plan anticipated starting the share buybacks here in this quarter. So it'll be shortly after the transaction is closed on August 1.

And will you likely do roughly a quarter of the authorization each quarter through the year? Or will it more market dependent? Or how should we think about the pace?

The plan would have anticipated a relatively stable level of share buybacks each quarter for the rest of the year.

Okay, great. Last question. Maybe you could talk a little bit about net interest margin. I'm just kind of curious. I know some of the liquidity you guys said reflected the build-up into the acquisition.

Next quarter does any of that sort of -- obviously some of it comes back down for the cash piece of the purchase price. How are you thinking about the blended margin with the liquidity movements that are anticipated at this point?

You're absolutely right. Throughout the third quarter we would be using some of that excess liquidity to take care of the acquisition of First Niagara and also provide for the impact of the divestiture.

Purchase accounting adjustments will be determined throughout this next quarter. That will impact the consolidated margin. But we would expect to see our liquidity levels return to more of a normal level, which would be pre this quarter as far as the overall impact. And so we should see a benefit from that prospectively.

Okay. All right. Thank you.

Next we'll go to Steven Alexopoulos with JPMorgan. Please go ahead.

Good morning, everybody.

Good morning.

I'd like to start, as you guys continue to work on the First Niagara deal, what are your updated thoughts on, one, the $400 million of cost saves you originally identified? And also, now how are you thinking about the revenue synergies which Don, I think, you pegged at around $300 million originally?

Sure. As far as the cost savings, we had shared an original target of $400 million. And we've been talking about since that deal was announced that we are expecting and setting an internal target in excess of that $400 million. And over the last several months we gained even greater confidence in our ability to achieve that, so -- that internal target. We are very focused on driving to that level. And again, have greater confidence in being able to achieve that.

We are also even more excited about the revenue synergies. As we've met with some of the bankers from the First Niagara system and see their excitement about a number of the product capabilities and offerings that we'd be able to provide, again gives us additional confidence in our ability to achieve that kind of $300 million incremental revenues from revenue synergies. And as we've said before, that won't be immediate. It will take some time to build that out. But we have greater confidence in our ability to achieve that as well.

Okay. That's very helpful. Just one other one. Don, on the fee revenue, if we look at the updated guidance. The first half of this year is trailing where you were last year and the comps get a little bit more difficult in the second half.

What's giving you the confidence at this stage that you will see that pick up in the second half, which you really need even get to the low end of the new guidance? Thanks.

Really, the biggest variable there is our investment banking debt placement fees. And if we look at our current pipeline, we're seeing some strength there that we haven't in the first two quarters. And it gives us greater confidence we'll be able to grow that beyond the first half of this year and get some growth compared to the prior year as well.

Okay. Thanks for all the color.

Thank you.

Next go to John Pancari with Evercore. Please go ahead.

Good morning.

Morning.

I just wanted to see if I could get some color on the C&I growth in the quarter? It came in particularly solid. And I wanted to see where you're seeing the bulk of the growth? Is it larger corporate versus mid-market? And then also what your outlook is there? Should it stay at this relatively robust level? Thanks.

As far as our commercial loan growth, it was again led by our corporate bank. We also had some strong growth in our community bank as far as the commercial lending as well. So we are seeing both parts of the franchise contribute.

We're not seeing it over-weighted in any industry and we're not seeing it over-weighted by any geography. So it's been fairly consistent throughout the overall market. Our guidance is for mid single-digit loan growth overall and it being -- continue to be led by commercial. So we would expect to see ongoing strength in the commercial category.

And related to that, any areas that are -- is it getting overheated? Or that you're intentionally backing away from, just given the competitive pressures? We're hearing a lot about CRE at some of your competitors. Thanks.

John, that's a great question. And we actually started to back off certain markets in the commercial real estate space almost two years ago because we were seeing some higher levels of prices and lower cap rates than what we'd feel comfortable with. And so we started to change that well back several quarters ago. Bill, anything else you would add to that?

Yes. The only thing I would add is that consistent with our approach, we've been focusing on owners of real estate and as opposed to peer developers of real estate for a long period of time now. And our customers are being more discrete in where they're investing. And you can even see on our construction numbers, those are smaller than they were many years ago.

Okay. Got it. One last question, if I could. Your deposit pricing, it seems to have edged up a little bit over the past couple of quarters. Just wanted to get how you're thinking about that. Is there anything else that's influencing it? Could it continue? Thanks.

The biggest impact there is really some growth we've seen in some of our consumer retail CD growth rates. And so you're seeing that go from what was a portfolio that was shrinking to a portfolio that's been growing. We do believe that having a strong retail core funded bank is important for us. But we'll continue to reassess programs going forward in that area.

Okay. Thanks, Don. Appreciate it.

Thank you.

Next question is from Matt O'Connor with Deutsche Bank. Please go ahead.

Good morning.

Good morning, Matt.

I was hoping you guys could elaborate a little bit on the drop in NIM outside of liquidity? And then what gives you the confidence in growing the standalone net interest income dollars in the back half of the year versus the first half? Obviously it's in some ways a moot point since you'll be combining with First Niagara, but you did mention you expect net II dollars to increase on a standalone basis. Just any more visibility and clarity on what's driving that after a bigger drop in NIM this quarter?

Matt, as far as the net interest income and margin there's a couple of factors that impacted it outside of the liquidity. So as we've talked before, 7 basis points is related to the increased liquidity level, which really didn't drive any net interest income from it. So that was purely a balance sheet component.

The rest of it was about 5 basis points. Typically in the second quarter we would see an increase in loan fees. And this quarter we actually saw it decline. So that swing from what our original expectations would have been to what we actually realized cost us about 3 basis points, or about $5 million in the quarter compared to what we would have expected going into the quarter.

And then beyond that we had two other components that impacted that. One was the full-quarter impact of the nonaccrual loans related to the oil and gas. And then a third piece really was the reinvestment in our investment portfolio, that the securities that we were buying had an average yield of about 1.9% compared to, say, 20 or 30 basis points higher than that that would have been our expectation. That probably cost us an additional basis point during the quarter. So those are the primary factors.

As far as the growth going forward, while we're not counting on recouping the loan fees that we didn't realize in the current quarter, we would expect to see some normal trends as far as seasonal activity and continued strong loan growth that we had been able to produce so far this year.

Okay, that's helpful. And then just separately with respect to the timing and the cost saves, you mentioned that most of them, or the majority of them, would come in 2017. Should we think about -- how should we think about the ramp in terms of throughout the year? My guess is a lot of them come after the systems conversions. But what would be the timing of, say, early versus the latter part of the year on the cost save recognition?

I would suggest that we'll see some cost saves occur post the conversion, which we talked about being in the fourth quarter. But the majority of those cost saves would be phased in throughout 2017 so that in the second half of the year we'd have the majority of those cost saves in place. And should be at a full run rate by the end of the year.

Okay. Thank you.

The next question's from Scott Siefers with Sandler O'Neill. Please go ahead.

Morning, guys. Just on the cost savings, obviously one of the higher profile disclosures recently was just the agreement to keep more jobs in New York. Wonder if -- and obviously you've reiterated the cost savings expectations. You have the higher internal target, but I was just hoping you could provide a little color on if there are going to be more jobs than you would have anticipated originally in New York, for example? Where do you make up the negative delta that you would have expected originally, whether it's just sort of the nature of FNFG's cost base, i.e., just certain switches you can kind of turn off and the costs go away? Or how does that work out in your guys' minds?

Scott, this is Beth. And I will tell you that it is consistent with the way we have been planning for both our internal targets, as well as you've heard us discuss our confidence about being able to meet the cost synergies. Some piece of how we have structured bringing these two companies together is around the notion that we can leverage what is an attractive, well skilled, low-cost workforce in Buffalo and in Western New York.

We are looking at -- we indicated enforcing some functions or work that is done elsewhere, not necessarily just within First Niagara but within broader KeyCorp, and that work could be moved to Buffalo and utilize, as I said, that attractive low-cost talent base. We've also looked at some of our operations network within Key and will consolidate those into Western New York and bring down costs or jobs elsewhere within Key.

And then the biggest driver over time for the job number is what we talked about was the fact that they have residential mortgage from origination through servicing as well as the indirect auto business, both of which -- one was a business we were trying to stand up within Key and one that is new to Key and that we will build on those businesses within Western New York as we scaled on the cost of our broader franchise, which we expect will create opportunities for many folks in Western New York to support that.

And the corresponding revenue that we would expect to gain as we introduce that to the broader Key franchise. Then there will be some leveraging of the call center capabilities.

So as we look at it, again it is a portfolio of businesses between Key and First Niagara. And there were some opportunities to really leverage Western New York. But consistent with how we thought of our expense synergies, we get there in a very, very solid path through the ability to look at in-sourcing growth, and as we look at the mix of the $400 million, and Don will have some thoughts to add on this as well, a big, big driver of that is vendor savings.

There is the outsourced technology environment at First Niagara is a huge driver of the $400 million. And then as we look at additional outsourcing to bring that work back in, we really are being able to get a huge piece of that [done] through exiting third-party relationships.

No, I would agree, Beth. And the only thing I would add is that part of the difference between our external target of $400 million and our internal target, a large portion of that is related to this third-party vendor cost that Beth had talked about. And we believe that should be a true savings for us.

Okay. That's perfect. Thank you for the color.

Thanks, Scott.

Next question from Ken Zerbe with Morgan Stanley.

Thanks. Good morning. So quick question. On page 14 you mentioned right at the bottom the incremental amortization expense of $30 million related to First Niagara. Easy question, which is I assume that is annual amortization expense.

But the other question is, on a short-term basis, right, so over the next five months of this year, is it possible that the higher amortization expense actually acts as sort of just an outright negative on earnings before you have the opportunity to really meaningfully start to reduce First Niagara's core expenses? Or are other expense savings you plan to do very, very short term that might offset the $30 million of amortization? Thanks.

Ken, as far as the $30 million of amortization, we're assuming that it's on an accelerated basis, and that's the first five-month impact from that only. It will be incremental expense. And to your point, that will be a drag on the initial earnings compared to what we would expect after the benefit of the realization of the cost saves. And so that was one piece that we wanted to make sure we made clear.

Okay. Great. Thank you.

Thank you.

And we'll go to Ken Usdin with Jefferies. Please go ahead.

Thanks. Good morning. Don, I was wondering if I could ask you a little bit more about the expense side. This quarter the other expense line at $104 million core was much higher than kind of historical run rates. Can you help us understand what the real estate side was and what you'd expect that to look like on a more normal basis?

Again, on that item you're right. The majority of the increase really related to that. We had a $7 million or $8 million increase in other expense associated with what I would consider to be grossing up the revenue and expenses associated with certain partnerships we have in light tech investments.

That was highly unusual, and we would expect a normal recurring level to be in the $1 million to $2 million a quarter as opposed to $7 million to $8 million. So that did inflate that expense category and is why we're showing a significant increase there.

Okay. And then just far as the back half, you normally do have -- or you had the last couple of years pension charges in the third and fourth quarter. Do you expect that to recur again, or is that now in the past?

Well, we do have that risk. But our outlook right now would suggest that there is an exposure for that, maybe in the fourth quarter as opposed to the third quarter right now. One of the other benefits we expect is that when we can merge the two pension plans from First Niagara and from Key that would minimize that risk prospectively. And so we never want to say one and done, but hopefully this would be a period where we might have an expense and then see that not recur in the future periods.

Okay. And if I could, just one quick one on credit. You had mentioned in the guidance that you expect the allowance to be stable with the last quarter. The allowance actually built up as a percentage of loans this quarter. It looks like you moved a little from unfunded into the over provision.

I'm just wondering, the credit looks great underneath the surface. So from here is it more just about reserving a bit for loan growth, or is there anything underneath the surface in credit that we should be thinking about?

Nothing underneath the surface. But you're right that we did see some migration out of the reserve for unfunded loans into the allowance. And those two kind of worked hand in hand as far as loans would fund up that were previously commitments, that you might see a transfer from the unfunded loan commitment over to the overall allowance.

And I would also say that our judgmental portion of the reserve also increased this quarter. And so we feel very comfortable with the level of reserve we have and do believe that prospectively the provision will slightly exceed the net charge-offs to make sure we continue to provide for loan growth.

Okay. Thanks a lot, Don.

Thank you.

Our next question's from Matt Burnell with Wells Fargo Securities. Please go ahead.

Good morning. Thanks for taking my question. Don, first a question for you. I wanted to follow up on, I guess, Bill's earlier commentary about the construction numbers in the CRE portfolio. Overall CRE numbers were up about 10%, 11% annualized quarter over quarter with 30% decline year over year in the construction portfolio.

Has that kind of reached a bottom as to where you want that to be, ex FNFG? And how should we think about commercial real estate growth going forward?

As Bill noted, where we're seeing that growth is more in income producing properties as opposed to development type of lending. And so we did see some increase there, and are very comfortable with that type of an exposure and risk profile for the credits we're putting on. And you're right that next quarter we'll see a change here because of the acquisition of First Niagara. Anything else you'd add, Bill?

No. I think that covers it, Don.

Okay. And just as a follow-up. It looked like your exposure in terms of overall amounts and nonaccruals in oil and gas was stable and down a bit respectively. Can you provide any additional color in terms of how you're thinking about that portfolio and the trajectory of nonaccruals going forward? I realize it's price dependent, but any additional color you can provide would be helpful.

Sure. This is Bill Hartmann. So what we've been seeing happen is, as a couple of things going on. The borrowing base redetermination was largely complete this quarter. And we saw a little bit of a reduction, obviously as a result of adjustments to the borrowing base as a result of the redetermination.

The second thing that we are seeing is that there have been some bankruptcies in the space. The resolution of those bankruptcies are resulting in some reductions in exposure. We continue to see that as a positive going forward.

And then lastly, with prices up a little bit we are seeing the cash flows improve at some of the borrowers. And as a result of that, they are reducing some of their outstandings.

Okay. And just finally for me, Don, if I can. The merger-related charges in the quarter were a little higher than we were thinking about. I presume, however, that the overall timing of the merger-related charges will be concentrated in the second half of this year with a little bit in 2017, as you previously guided, correct?

That's correct. We had talked before about a total one-time charge of $550 million of merger-related costs. And we do believe that a significant portion of those will be in the second half of this year.

Okay. Thanks for taking my questions.

Thank you.

Next we go to Gerard Cassidy with RBC. Please go ahead.

Good morning, Beth. Good morning, Don.

Good morning.

Can you guys remind us, of the $400 million in cost savings, how does that break out by personnel, occupancy, outside vendor, systems, et cetera? And is it different post the agreement with New York than what it was prior, when you first announced the deal?

As far as the $400 million, the largest piece that we did disclose was about 40% of that was related to third-party vendors, or $160 million.

What we'd also talked about was, was that we expected to see significant opportunities from branch consolidations. And as we announced here earlier this month that we expected to consolidate approximately 70 branches of First Niagara and a little over 30 of Key. And so that is about 25% incremental consolidation related to that. So that will also drive a significant portion.

But beyond that, we really haven't provided a lot of color as far as how much is personnel-related. I would say that with our discussions here and announcement as far as the New York staffing plans that I don't know it's changed what our initial plans have been significantly.

Again, we are looking for a lot of opportunity from the third-party vendor saves. And it's just an issue as to where the work is being performed as opposed to whether or not it's changed the overall plan.

I see. And I'm sorry, the third-party vendor, that did increase now versus the original $400 million when you guys first outlined those cost savings?

What we had talked about is our internal target is higher than the $400 million. And a big portion of that increase is related to the third-party vendors as opposed to other categories.

I see. And then just to go back, Don, to your comment about liquidity. Your margin obviously was impacted, as you pointed out, in the quarter by the increase in liquidity. But I thought you said that we should expect your liquidity levels to go back to the way they were in the first quarter. If that's true, should the margin then benefit from the lower liquidity levels that you expect going forward?

The margin should benefit from lower liquidity levels. Now at the same time, we're going to be adding First Niagara on top of our balance sheet and margin impacts. So there will be some noise we'll have to walk you through next quarter as to how they all combine and what the impact is. But we should see a benefit to margin, not a huge change from net interest income, but a benefit to margin as those liquidity levels return to more normal levels.

Thank you.

Thank you.

Next we go to Marty Mosby with Vining Sparks. Please go ahead.

Thanks. Don, I wanted to ask you a little bit about the compression you saw on earning asset yields. When you look at the core portfolios of the loans and securities, they were only down a couple basis points. When you look at the trading account and you look at the loans held for sale, trading account was down over 100 basis points and loans held for sale were down 80 basis points.

So was there some noise or activity in those portfolios, because that's what drove a lot of the earning asset yield compression, was in those two smaller accounts?

One, the loans held for sale also were impacted by the fact it was a lower level of loans held for sale during the quarter than what we had in the previous quarter. So that was a bigger driver. The trading account dropped by about $1 million as far as net interest income. And that really wasn't a huge driver to the overall net interest income, but there was a different mix of those assets than -- in the first quarter than what we had for the second quarter.

The biggest driver there, Marty, really is, if you look at the next line below that which is our short-term investments, and it's up to $5.6 billion. And that's primarily our account at the Fed. And that's up by $2.1 billion from the previous quarter and up by $2.3 billion over the previous year. And that $2 billion-plus equated to a 7 basis point reduction in our margin. So it's just a ballooning up of the balance sheet related to that.

Yes. I was excluding the extra liquidity. When you look at the quarter, there's a couple things that you're doing in preparation for bringing First Niagara on. You suspended your share repurchase, which you get the start back. You've raised debt. And now you've increased liquidity.

On my estimate, it's probably a $0.01 or $0.02 in bottom-line impact that's just kind of sitting there waiting to get utilized as you kind of move over into the next stage, which is post the closing of the acquisition.

A couple things there. You're right, we did raise debt and that will help with the funding costs -- our funding of the First Niagara acquisition. That was anticipated as part of the cost of First Niagara. And so we did expect that to be incurred in our position for that.

Then we're also glad to start our share buyback program again. And that will be helpful to our earnings per share and to continue to support our shareholders from that perspective.

And consistent with our guidance all year, we have been positioning the Company, the balance sheet, our clients for our fourth-quarter close. And so right after (technical difficulties) received our CCAR results. Shortly thereafter was our approval from the Federal Reserve. So yes, a lot of these were conscious choices about timing to be positioned for First Niagara.

What I was really getting at is that there's a temporary pressure on earnings the quarter before you actually get the benefit. So there's kind of a timing here that you have to make all those choices, knowing that you're going to get the benefit once the acquisition comes in.

No, you're absolutely right.

Thanks.

Thank you.

And we'll go to Mike Mayo with CLSA. Please go ahead.

Hi. Just a question on slide 4. Pretty straightforward. Your target, I think it's unchanged, right? The ROTCE 200 basis points higher and the cash efficiency ratio 300 basis points higher. Is that correct, it's unchanged?

That's correct.

And so what is the specific target? Higher than what? Higher than 2015, higher than the first half of 2016, higher than the second quarter 2016? What's the comparison? So what is the actual numerical target?

For both of those ratios it's the incremental benefit from the First Niagara transaction compared to Key on a standalone basis. So it would be compared to where our projections would show us on a standalone basis versus where we would be with First Niagara.

Now, what we had talked about before was that if rates did not improve, Key on a standalone basis for the efficiency ratio would drive down to the low 60%s. And with the impact of First Niagara it will be in the high 50%s. And so that, again, is without interest rates. If interest rates did come through, it would again have additional benefit beyond that.

And the ROTCE?

We haven't disclosed what our targeted levels are there. Our ROTCE is right now in that 9% level. And so we would hope to continue to build that prospectively and show an incremental benefit from the First Niagara transaction of that 200 basis point range we talked about.

I mean, for the investors on the outside, it's nice to have something to hold management accountable to. And so let's assume there's a debate going on. Some people like the acquisition. Some don't and will say, all right, in the end we'll look at the results. It would be nice to have some sort of [bogey] that we could all look at together.

Is there any more specifics you can give us, let's just say, on the ROTCE? We can't see what Key is likely to do on a standalone basis based on your projections. But it would be helpful, any other color you could give would be great.

Let us go ahead and reflect on that and see what kind of additional detail we can provide. I think we did provide more detail as it relates to the efficiency ratio. But part of that return on tangible common equity, too, will be impacted by some of the mark-to-market on the balance sheet and other purchase accounting adjustments. So we want to make sure we can clarify what component relates to each of those pieces. Let us do that for you, Mike, and we'll get back to you.

All right. And then a related question. So there's no change in your targets. We hear you saying that the cost savings, you feel good. The revenue synergies feel good. But since October 30 of last year when you announced the deal, the expectation for rate increases really has come down, and that would hurt First Niagara which was somewhat asset sensitive. So why do you still feel okay about your targets -- the same feeling about your target, even though the outlook for First Niagara wouldn't be as good?

One, First Niagara was asset sensitive, but as we looked at running their information through our models, their asset sensitivity wasn't much outside of where we are today and where we were back in October.

We also took a look at this transaction for if rate increases did occur and also if rate increases did not occur. And we still saw that kind of incremental lift for what we saw for the combined Company compared to Key on a standalone basis.

That's why we think there truly is benefit from this. And we're very confident in our ability to achieve those incremental improvements we talked about. Beth, anything you want to add?

Yes, Mike. The other thing I would tell you, in a lower and slower environment which is I think the consensus of the macro environment that we find ourselves in, I do think it's an attractive proposition to be able to extract cost synergies. And then the confidence for one million new clients, the resulting revenue opportunities. I believe that it is a value proposition of the merger is solid and it creates a lever in an environment where headwinds and levers are hard to come by.

All right. Thank you.

Thank you.

(Operator Instructions).

We'll go to David Long with Raymond James. Please go ahead.

Good morning, everyone.

Good morning.

You guys mentioned that short-term inflows from commercial clients impacted your deposit growth in the quarter and maybe had an impact on the NIM. Related to that, what are you expecting on the runoff there, the duration? And then maybe more importantly, what are you hearing from clients, your commercial clients, and what drove that short-term inflow in deposits?

A big chunk of that really was coming from some of our escrow deposits that we have with our commercial servicing business and also some other escrow-related deposits we have with other commercial clients. Some of that is seasonal related, as you would see some of the real estate taxes and other things that we build up throughout the first half of the year and pay down. And so we would expect to see some of those go down.

But we also had several situations where there'd be prepayments in the commercial mortgage servicing area that had cash idle for weeks at a time, and that resulted in some over -- or outsized increases in those deposit balances.

As far as our commercial customers, we are still seeing and hearing from them that they continue to be fairly cautious. And so we believe they continue to park liquidity with the expectation that they will be using that at some point in time. But really not in a mode to significantly change their overall position as far as investment. We are seeing a little bit of additional build there as well.

Great. Thanks.

Thank you.

Next we go to David Eads with UBS. Please go ahead.

Hello.

Good morning.

First, following up on some of this commentary about preparing for First Niagara to come over. Has there been any change to the strategy for the securities book? And also, in both legacy Key book and then the expectations for restructuring the First Niagara book once it comes over, given the lower rates?

What we had talked to before, at the time of the acquisition is, is that First Niagara has about $3.5 billion worth of credit-oriented securities in different asset classes. And First Niagara has not been required to maintain the LCR compliance. And so in order to make sure that they are LCR compliant as part of Key, our plans are to shift out that $3.5 billion of credit-oriented securities and have their investment portfolio look more like legacy Key.

And so that process would take place throughout the third quarter, and we believe that we would be in a good position at that point in time. As far as Key, we have been continuing to reassess our overall strategy as far as the duration of the portfolio, given these lower rates and the timing of certain purchases. But the composition and nature of that portfolio really hasn't changed over the last couple of quarters.

And with the reinvestment of the First Niagara credit-oriented one, you'd still look to reinvest that kind of similar duration to the current portfolio?

That's correct.

All right. Thanks.

Thank you.

We'll go to Kevin Barker with Piper Jaffray. Please go ahead.

Thank you. As we transition into 4Q and then into the first half of next year, do you expect loan growth to slow down on a consolidated basis as you let some of the First Niagara portfolios run off that do not fit the profile that you would like for Key? And would you continue to expect interest bearing deposits to increase to meet LCR requirements post First Niagara acquisition?

Kevin, maybe first as far as the LCR and the deposit shifts, that we are in a very good position from an LCR perspective for both Key and the combination with First Niagara. We do not believe that we are going to see an ongoing shift as far as the overall deposit categories. We do believe over time, and especially as rates start to pick up, that we will see some continued growth in timed deposits compared to money market deposits. But we don't believe that will be meaningful.

As far as the loan growth, we've been very pleased with the portfolio that First Niagara has. And we've been continuing to work with their team and making sure that we are in position post our conversion time period. And do not see any significant change in the overall mix composition or any sizable change in the overall growth rates related to that. Bill, anything else you want to add to that?

I would just add that as part of our due diligence process, we spend a significant amount of time looking at the portfolios, looking at their underwriting standards, and looking at their mix of clients. And that was part of the attractiveness that we found in First Niagara. So I would not expect, to use your phrase of runoff in the portfolio, due to a change in strategy.

Thank you.

Our final question will be from Geoffrey Elliott with Autonomous Research. Please go ahead.

Thank you for taking the question. Could you give a bit more color on the change in the outlook on noninterest income? What's behind that?

The only change we really have there is that the second quarter's fee income reflected a lower level of capital markets related revenue than what we would have expected coming into the quarter. And as a result of that and the year-to-date results, we've adjusted the outlook to reflect that. If you look at the second half of this year's outlook for Key, we would say that it's very consistent with what we had initially assumed. And this is more just to reflect the impact of the actual results to date.

Why do you think the second quarter was weaker than you'd been expecting, given the, I guess, in general markets recovered? If I look at the S&P it's higher now than it was in April when you gave the last outlook? What was more difficult?

I would say where we saw some weakness compared to normal, expected periods would be merger and acquisition advisory revenues and also IPO levels were weaker, especially earlier in the second quarter. So we did see some reductions into that space compared to what our expectations would have had coming into the quarter.

If I can just squeeze a very last quick clarification in. You mentioned $7 million to $8 million of real estate expenses, kind of one-time. Was the gains number that offset that, was that $7 million to $8 million as well or was that slightly different?

That's correct. It was in the other income category. And so we did see other income impacted for that $7 million or $8 million and other expense impacted by the same dollar amount.

Great. Thank you very much.

Thank you.

I will turn it back to the Company for any closing comments.

Thank you, operator. Again, we thank you for taking time from your schedule to participate in our call today. If you have any follow-up questions, you can direct them to our investor relations team at 216-689-4221. That concludes our remarks. And again thank you.