Sometimes you find a relative valuation situation that’s a head-scratcher, and I think that’s the case with KeyCorp (KEY). I don’t exactly love this bank from an operational standpoint, but management has made a lot of good moves over the years – cutting the efficiency ratio from the high-60%’s to the high-to-mid-50%’s, diversifying/growing the consumer lending business, adding digital platforms – but doesn’t seem to get full credit for it. True, the bank has outperformed the sector over the last five years (with strong outperformance over the last year), but it still looks curiously under-valued.
A Largely In-Line Quarter Won’t Get Anybody Excited
It’s certainly easier to make a “this stock is too cheap” call on the back of a much stronger than expected earnings report, but KeyCorp didn’t produce that in the fourth quarter. It was basically an in-line, okay quarter, though with a little softness at the pre-provision profit line and a final core tally that was maybe a penny shy of the average sell-side estimate.
Revenue declined 1% yoy and rose slightly on a qoq basis, missing expectations by about 1%. Net interest income was slightly better than expected, falling 2% yoy and rising almost 1% qoq, with good earning asset growth (up almost 5% yoy and more than 1% qoq) and slightly better net interest margin (down 18bp yoy and 2bp as reported). Fee income was disappointing, rising 1% yoy and more than 2% qoq but missing by about 2%, due to weaker than expected investment banking results (down 3% yoy, up 3% qoq and 5% short). Trust revenue also looked light to me (down 1% yoy and up 2% qoq) in a quarter that was pretty good for many banks with substantial trust operations.
Operating expenses dropped more than 1% yoy on a core basis (up about 2% qoq), more or less in line with expectations in absolute terms, but a little worse in terms of efficiency ratio given the lower revenue base. Core efficiency ratio is still in the high 50%’s, and the cash ER was not only up 130bp qoq (up is bad), but above management’s 54% to 56% target at 57.3%. Pre-provision profits were basically flat on a yoy basis and down slightly on a sequential basis.
Good Loan Growth In A Quarter Where That’s Rare
Like M&T Bank (MTB), KeyCorp is one of the relatively few large banks to report so far that had better-than-expected loan growth. Loans rose about 5% yoy on an average balance basis (up close to 2% qoq), beating expectations by about half a point (hey, it’s not a big beat, but any beat is rare this quarter…).
C&I lending was stagnant, and other banks with relatively strong middle-market lending operations (I’m thinking of banks like Comerica (CMA) and PNC Financial (PNC) here) also had lackluster quarters, so Key is not so unusual there. CRE lending was good, up more than 2% qoq, as was construction, but consumer lending was the real star. Consumer lending (mortgages, home equity and other) rose more than 11% yoy and more than 5% qoq. Expanding the consumer lending business has been a management strategy/goal for some time, and I’d say they’re doing well entering 2020 with third quarter growth (up 6%) accelerating in the fourth quarter.
Key isn’t immune to spread pressures, though, even though consumer loans on average yield more. Average loan yields declined 16bp yoy and 20bp qoq.
Deposits rose more than 4% yoy and 5% qoq, though non-interest-bearing deposits dropped a surprising 8% yoy (and rose 12% qoq). A decline in NIB deposits was expected, but not quite this much. Interest-bearing deposits rose 8bp yoy and fell 13bp qoq, with overall deposit costs rising 7bp yoy and falling 11bp qoq to 0.71%. With a loan/deposit ratio of only 83%, KeyCorp could arguably afford to be more aggressive with deposit pricing as a means of offsetting loan yield pressure.
Credit looks okay. KeyCorp took a charge related to fraud, but non-performing loan balances declined about 1% qoq and the non-performing asset ratio is stable. Charge-offs were higher than expected, though.
Decent Guidance And Some Opportunities To Outperform
Management’s guidance for 2020 was slightly better than expected, but not enough to meaningfully move sentiment – just a few pennies of upside to the pre-existing average sell-side estimate for 2020. While expenses are forecast to be “stable”, it looks like the efficiency ratio is going to remain above the long-term target. On the positive side, loan growth looks a little stronger than expected with management looking for mid-single-digit growth, and management is looking for low single-digit net interest income growth for year where many banks are expecting contraction. Fee income growth is expected to continue at a mid-single-digit rate.
KeyCorp is planning to launch a full digital mortgage program in 2020, and the bank is only just getting started with its Laurel Road acquisition – a digital lending platform targeting young professionals (doctors, dentists, and lawyers mostly, at this point) and offering student loan refis and mortgage products. Management is looking to expand its offerings on this platform, and could well use it as a platform for growing C&I and CRE lending in the future – handling doctors’ and dentists’ school loans and also lending them money for equipment, office mortgages, and so on.
One thing management has been consistent on lately is its lack of interest in whole bank M&A. Although I think there are a lot of areas that KeyCorp could shore up with a few select community bank deals, management thinks they don’t need to boost the platform. To their credit, they were able to significantly reduce the branch count in Indianapolis (to name one market) without any real attrition in deposits, so maybe they don’t need to buy scale. Likewise, while KeyCorp gets criticized for its far-flung operating footprint and generally weak deposits per branch, the efficiency ratio isn’t bad.
With above-average loan growth and past hedging moves, KeyCorp is in a better than average position with respect to spread revenue in 2020 and positive operating leverage should be possible. That, in turn, leaves KeyCorp positioned for above-average pre-provision profit growth in 2020 and 2021. Looking at things a little more broadly, KeyCorp has made good progress derisking its balance sheet while also expanding its consumer lending operations – not something that’s necessarily easy to do simultaneously.
My modeling assumptions for KeyCorp work out to a medium-term core earnings growth rate in the low single-digits and a longer-term growth rate likewise in the “high low single-digits”. Between discounted core earnings, P/E, and an ROTCE-driven P/TBV valuation approach, I believe fair value is in the low $20 ($21.50 to $22.50).
The Bottom Line
KeyCorp’s fourth quarter wasn’t really the sort of quarter that supports a table-pounding buy, and there are legitimate criticisms that can be made about this bank. I’d also note the shares haven’t done much since my last update in late November. Still, it looks like the market discounts a lot of what the bank has accomplished and the prospect of better-than-average profit growth in the coming year or two. With that, I think this is a name to consider.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.