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Circling Back On KeyCorp After Q4 Earnings; Maintaining Our Fair Value Estimate of $2Circling Back On KeyCorp After Q4 Earnings; Maintaining Our Fair Value Estimate of $24 Eric Compton Strategist Business Strategy and Outlook | by Eric Compton Updated Feb 17, 2023 KeyCorp is a mid-sized U.S. regional bank. The firm has the largest relative exposure to investment banking-related fees among the regional banks under our coverage, is investing in a unique digitally focused retail business (Laurel Road), and has an odd geographic mix, as Ohio, New York, and Washington state are its three largest deposit markets. KeyCorp was hurt during the financial crisis largely because of its ventures into higher-risk commercial real estate lending in out-of-footprint states. Since the crisis, KeyCorp has wound down most of its construction-related commercial real estate business and refocused on its core corporate banking operations and capital markets services. With increasing credit quality and declining credit-related costs, along with significant operational improvements, KeyCorp has returned to healthy profitability. The bank's First Niagara acquisition back in 2016 has also helped improve the bank's operating efficiency and scale. The acquisition improved the bank's deposits per branch and average metropolitan statistical area market share. KeyCorp also gained access to some key new product sets, most notably residential mortgages, which remains a key growth driver for the bank today. And ultimately the acquisition gave the bank some much needed scale, helping to improve operating efficiency. KeyCorp is also a bit special, with its latest investments into more technologically forward endeavors, including the acquisitions of HelloWallet, Laurel Road, AQN Strategies, XUP Payments, and GradFin. Laurel Road is a key growth engine for the bank today, using a digital national platform particularly focused on healthcare school graduates. KeyCorp’s noninterest income comes primarily from investment banking and asset and trust management services. While noninterest income did not grown substantially for the decade after 2007, we think that the bank has turned a corner here. We like that KeyCorp is expanding its relatively new credit card income base as well as its own mortgage and capital markets operations. Going forward, we see the bank gradually expanding its customer base and fee base over time. Economic Moat | by Eric Compton Updated Feb 17, 2023 We believe KeyCorp lacks a moat because it does not possess durable cost advantages that are consistent with our bank moat framework. While the company’s returns on tangible equity have admittedly improved and now exceed its cost of capital, we still project the bank will tend to be on the lower end of peers, and we'd like to see just a bit more improvement in operating efficiency before we potentially award the bank a narrow moat. We also worry about what happens over the next 10 years as larger banks increasingly push into the middle market. We think KeyCorp has a viable way to defend its turf, but with competition likely only increasing, KeyCorp remains on the edge for us from a moat perspective. We believe bank moats are derived primarily from two sources: cost advantages and switching costs. We see cost advantages coming from three primary factors: a low-cost deposit base, excellent operating efficiency, and conservative underwriting. Regulatory costs must also be considered. KeyCorp has historically been a less efficient operator than the best banks under our coverage, averaging an efficiency ratio in the upper 60s. We believe KeyCorp’s somewhat dispersed branch network, lower deposit market share concentrations, and focus on investment banking have played a role in this. However, the First Niagara acquisition in 2016 has been a very positive step here, and the bank is now on a path to consistent performance in the mid- to upper-50s. That said, KeyCorp maintains an efficiency ratio on the high end relative to the more moaty banks under our coverage. KeyCorp has tended to have a slightly higher cost of deposits than the other banks we cover. This is despite having a better mix of interest-bearing to non-interest-bearing deposits, as KeyCorp has historically had to pay slightly higher rates on its pool of interest-bearing deposits. We don’t see this changing and note that First Niagara had a slightly higher cost of funding than did KeyCorp, reinforcing our view that this aspect of the business will probably remain relatively average for the bank. Finally, KeyCorp has not historically been a solid underwriter, generally performing worse than peers through the past several downturns. While KeyCorp did not make it through the 2008-09 financial crisis unscathed, we believe it has been a more conservative lender since that time, having rotated out of the riskier and out-of-footprint construction loans that had hurt it in past cycles. The bank's performance during the pandemic confirms this. Although the bank has tightened up its lending since the crisis, we think the bank will perform closer to the peer median, which is admittedly an improvement, but not necessarily worthy of a moat. We do not view any of KeyCorp’s nonbanking businesses as particularly moaty. KeyCorp operates a mix of smaller nonbank operations, including wealth and trust management, investment banking, a growing credit card base, and a residential mortgage business. For each of these businesses, scale and reputation tend to matter, and while KeyCorp is competitive, we don't think it stands out enough. We view these segments as good add-on services that allow the bank to adequately provide for its clients and to diversify the bank's revenue streams, but we don’t see them as sources of durable structural advantages as of yet. KeyCorp does have a heavier focus on its capital markets offerings and using these services to complement its corporate banking operations. We believe this space fundamentally remains very competitive. Also, for the middle market where KeyCorp focuses, the deal sizes and services rendered don’t scale up as much as the large deals done by the truly dominant investment banks. We also wonder how returns will develop over the next 10 years as larger peers look to migrate more into the middle market space, where banks like KeyCorp have historically done well. KeyCorp is seeing good growth for its Laurel Road digital mortgage platform, and while we think the bank's strategy is sound here, we still view these markets as very competitive (digital banking relationships and mortgage origination). From a systemic standpoint, we believe the U.S. offers a fair but improving banking environment. Regulation has become considerably stronger since the crisis, and capital levels have never been higher, though the country still uses a complex and somewhat archaic system of regulation. Furthermore, the U.S. banking market remains relatively fragmented; KeyCorp must compete with a variety of regional and community banks as well as large money center institutions. Our outlook is positive from a macroeconomic and political standpoint. The U.S. is still the world's leading democracy, has increased GDP at a steady pace for years, and maintains the world's reserve currency, all of which contribute to banking stability. KeyCorp is not large enough to be considered a global systemically important bank and therefore avoids some of the more onerous regulatory capital requirements. KeyCorp is large enough to be subject to the Federal Reserve's stress tests because it has more than $100 billion in assets, but it only has to go through the full process every two years. The bank also avoids extra liquidity coverage and funding ratio requirements. Overall, because the bank avoids much of the extra regulation that larger peers attract, we would view the bank’s regulatory burden as slightly advantageous. While we do think KeyCorp could benefit from some additional scale, it is small enough to avoid some of the extra costs faced by its largest peers. Further requirements will be triggered if KeyCorp surpasses $250 billion in assets. Fair Value and Profit Drivers | by Eric Compton Updated Feb 17, 2023 After updating our projections with the bank's latest earnings results, we are maintaining our fair value estimate of $24 per share. Slight cuts to our net interest income and fee outlook were offset by the time value of money and slightly lower credit costs. Our fair value estimate is equivalent to 2.8 times the bank's tangible book value as of December 2022 (and 1.6 times TBV with AOCI effects removed). Our base-case scenario has rate hikes ending in the middle of 2023, followed by cuts in late 2023 and into 2024, along with anemic loan growth in 2023 followed by 4% growth in 2024. This leads to 6% growth in net interest income in 2023 and 1% growth during 2024. KeyCorp is less rate sensitive than many of its peers, leading to a bit less growth from a rising rate environment, but also less downside as rates are cut. After a difficult 2022 for fee income, we don't see much relief in 2023, where we have fees falling another 3%. Capital markets income should remain in a less than ideal spot, as should mortgage fees and wealth related fees, and the drag from removing certain deposit service fee charges is also set to have an effect in 2023. Following a mild recession toward the end of 2023, we see a nice bounce back in fees in 2024 as more cyclical items start to climb once again, leading to 5% growth in 2024 and 4% growth in 2025. Because KeyCorp has an outsize exposure to investment banking related fees, we think a return to strength for this industry will be one of the keys for KeyCorp's share to rerate higher. We see expenses only increase 1% in 2023, better than peers, as management exercises additional cost-cutting measures. We see growth normalizing to 2%-3% annually thereafter. This leads to the bank's efficiency ratio eventually declining to about 58% by the end of our forecast, just above management's target range of 54%-56%. We project credit costs will remain a bit elevated in 2023 and 2024, with our forecast calling for a minor recession in the second half of 2023, but these credit costs and the recession should be relatively mild. Overall, we expect a return on tangible common equity of roughly 14% through the cycle compared with our estimate of the bank's cost of equity of 9%. For our bull- and bear-case analysis, we attempt to model what a higher growth, higher profitability KeyCorp could look like in our bull base, and what the opposite might look like for our bear case. Under our bull case, we have net interest margins coming in 10 basis points higher than under our base case, and assume 1% higher loan and fee growth in each year of our five-year forecast. This leads to a fair value estimate of $29 per share, a terminal return on tangible equity of 14%, and an efficiency ratio of 56%. In our bear case, we assume net interest margins come in 10 basis points lower than under our base case, with loan and fee growth being 1% lower each year in our five-year forecast. While the bank is able to manage expenses a bit lower, the efficiency ratio remains stuck at 62% and the average return on tangible equity drops to 10%. Under this scenario our fair value estimate falls to $18 per share. Risk and Uncertainty | by Eric Compton Updated Feb 17, 2023 We view the macroeconomic backdrop as the primary risk to the bank. KeyCorp's profitability will largely be determined by the interest-rate cycle and the effects of credit and debt cycles, all of which are not under management’s control. In addition, the bank is subject to the Federal Reserve's stress test on a biennial basis. Depending on the results of that review, KeyCorp may be subject to capital return restrictions. If required to hold more capital, its returns on equity could be affected. The bank has performed well on the most recent tests, and we would be surprised to see issues here in the future. From an environmental, social, and governance perspective, commercial banks are expected to have strong product governance. Predatory or discriminatory lending practices are examples of poor product governance, and this can affect certain banks at times. We view most product governance and social risks as manageable and incorporate a steady level of operational expenses related to compliance and litigation in our models. Outside of the rare, headline-grabbing scandals, we don’t see social risks as having a material effect on our valuation. Banks also lend to certain sectors which can come under more scrutiny at times, like gun manufacturers, or energy, for example. Commercials banks don’t directly have a large environmental footprint, and governance practices are in line with most companies. We assign our U.S. regional banks a Morningstar Medium Uncertainty Rating. Capital Allocation | by Eric Compton Updated Feb 17, 2023 We give KeyCorp a Standard capital allocation rating. In our opinion, the company’s balance sheet is sound, its capital investment decisions are standard, and its capital return strategy is appropriate. KeyCorp is roughly in line with management's targeted common equity Tier 1 ratio of 9.0%-9.5%, and we view the current goal as appropriate. We view the company's capital investments as standard. KeyCorp had its issues during the financial crisis of 2008 with over exposure to certain CRE sectors, however we think the bank has improved its capital allocation since. Not only has the bank greatly improved the risk it takes with its capital, it has undergone value accretive acquisitions as well, notably the First Niagara acquisition which we think helped the bank gain critical scale. The bank has also been a notable investor in digital efforts, notably with its Laurel Road platform, GradFin, and building out its payments offerings. Overall, we think the bank has made much improved capital allocation decisions since 2008. We assess the company’s capital return strategy as appropriate. KeyCorp, like most banks, targets a payout ratio for dividends, uses some of its earning to invest back into growth, and any extra capital can be returned to shareholders via repurchases. Now retired CEO Beth Mooney took the helm in 2011 and focused the bank’s strategy on its core corporate banking and capital markets activity with an eye toward cutting costs and improving operating efficiency. Under Mooney's watch, the bank underwent an arguably transformative acquisition when it acquired First Niagara. The acquisition has largely met or exceeded its original targets and has durably improved overall performance for the bank. While the firm paid a decent premium for what was considered a riskier acquisition given the large size of First Niagara in comparison with KeyCorp, we believe the acquisition made strategic sense and results have backed up the decision. Mooney should be given credit for this. The bank has also undergone an increased focus on its retail operations, as well as improving its internal technological capabilities, with the acquisitions of HelloWallet, Laurel Road, AQN Strategies, and XUP Payments. Mooney retired in May 2020, and she was succeeded by Chris Gorman, who has been with the bank since 1998 in multiple leadership roles. Most recently he was president of banking, where he oversaw consumer, commercial, and institutional banking. Gorman also headed up the integration efforts between KeyCorp and First Niagara. Thus far, Gorman has pushed KeyCorp's digital efforts even further with the national launch of Laurel Road and other bolt-on acquisitions. We like the direction Gorman has steered the bank thus far. |
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