KeyCorp (NYSE: KEY) reported earnings of $0.17 per share in the second quarter of 2020, up 36% on a linked-quarter basis. Strong growth in mortgage banking revenues and an increase in loans drove the earnings recovery in the last quarter. Earnings will likely continue to improve in the year ahead because the net interest margin will likely increase on the back of a decline in deposit cost and a reduction in liquidity. Moreover, continued loan growth will support earnings. On the other hand, elevated provision expense and lower mortgage banking revenue will likely pressurize net income in the remainder of the year. For the full year, I’m expecting earnings to decline by 38% year over year to $1.0 per share. The June 2021 target price suggests a high upside from the current market price; hence, I’m bullish on KEY for a holding period of one year. However, I’m expecting KEY’s elevated risk level to keep the stock price subdued in the next two to three months. As a result, I’m adopting a neutral rating for the near term.
Lower Deposit Cost, Deployment of Excess Liquidity to Expand the Margin
KEY’s net interest margin, or NIM, declined by 14bps in the second quarter compared to the first quarter of the year. As mentioned in the second quarter’s investor presentation, the NIM compression was attributable to elevated liquidity, lower interest rates, and the Paycheck Protection Program, PPP. I’m expecting NIM to improve in the year ahead because excess liquidity will likely decline as the economy gradually recovers from the shelter-in-place orders. Furthermore, the company will have an opportunity to lower its deposit cost in the remainder of the year through an improvement in the deposit mix and maturities of high-costing deposits. The management mentioned in the second quarter’s conference call that it expects to lower the deposit cost by 15bps in the third quarter.
Moreover, as mentioned in the presentation, KEY has a total hedge portfolio of $34.2 billion, which will likely protect the average yield on earning assets from negative interest rates or a further rate decline. As mentioned in the presentation, the management expects modest NIM improvement in the third quarter. Considering the factors mentioned above and management’s guidance, I’m expecting NIM to improve by 2bps in the third quarter. The following table shows my estimates for yield, cost, and NIM.
Loan Growth to Drive Net Interest Income
KEY’s loans increased by 11% in the first half of the year due to the high demand for relief loans, including PPP. I’m expecting loan growth to decelerate in the year ahead but remain positive. Consumer mortgages will likely continue to grow due to low interest rates. The management mentioned in the conference call that the consumer mortgage pipeline was at a record level. On the other hand, commercial loans will likely decline due to the uncertainties related to the COVID-19 pandemic and the upcoming presidential elections. Moreover, the management expects around 80% of the $8 billion PPP loans to get forgiven in the fourth quarter, which will further pressurize loans. Considering these factors, I’m expecting KEY to end the year with a loan balance of $106.6 billion, up 2% from the end of June, and up 13.7% from the end of last year. The following table shows my estimates for loans and other balance sheet items.
Loan Growth and Migration Within Portfolio to Drive Provision Expense
KEY reported a provision expense of $482 million in the second quarter, up 34% from the first quarter of 2020. The substantial loan loss reserve built in the first half of the year will likely cover the pandemic-driven impairments in the year ahead without a need for another sizable reserve build. As a result, I’m expecting the provision expense to decline in the year ahead compared to the first half. However, I’m expecting the provision expense to remain above normal in the year ahead. As discussed in the conference call, the following three factors will determine the provisioning requirement:
- Loan growth. The management expects loan growth to lead to a provision expense of $80 million to $100 million, as mentioned in the conference call.
- Changes in economic forecasts can impact the provisions. I’m expecting the economic outlook to remain stable; hence, I’m not expecting this component to contribute much to the provision expense in the year ahead.
- The migration of portfolios and change in their credit quality can impact the provisioning.
I’m expecting loan growth and migration of portfolios towards worse than expected credit quality categories to drive provision expense in the year ahead. The COVID-19-sensitive industries will likely cause the most problems compared to other loan segments. According to details given in the presentation, COVID-19-sensitive industries, including education and hotels, made up 9% of total loans at the end of the last quarter. Additionally, the oil and gas segment made up 2.2%, leveraged lending made up 1.8%, and consumer credit cards made up 1% of total loans. Altogether, the vulnerable loan segments made up 14% of total loans.
Considering these factors, I’m expecting KEY to report a provision expense of $1.4 billion in 2020, up from $445 million in 2019.
Expecting Earnings of $1.0 per Share in 2020
The NIM expansion and loan growth will likely help earnings recover in the year ahead from the dip in the first half of the year. Further, a sequential decline in provision expense will likely help earnings increase in the second half compared to the first half. However, the provision expense will likely increase on a year-over-year basis in the second half of 2020, which will keep net income lower than last year’s level. Moreover, the non-interest income will likely decline in the year ahead after remaining elevated in the second quarter. Low interest rates triggered mortgage banking revenue in the second quarter, which will naturally decline in the coming quarters. Overall, I’m expecting earnings in the second half of the year to be 146% higher than the first half of 2020, and 15% lower than the second half of 2019. For the full year, I’m expecting earnings to decline by 38% year over year to $1.0 per share. The following table shows my income statement estimates.
Bullish for a One-Year Holding Period
KEY has traded at an average price-to-tangible-book ratio, P/TB, of 1.36 in the past, as shown below.
Multiplying this average P/TB ratio with the June 2021 forecast tangible book value per share of $13.8 gives a target price of $18.8 for the mid of next year. The price target implies a 56% upside from KEY’s August 3 closing price. The following table shows the sensitivity of the target price to the P/TB multiple.
Apart from the price upside, KEY is also offering an attractive dividend yield of 6%, assuming the company maintains its quarterly dividend at the current level of $0.185 per share. There is little threat of a dividend cut because the earnings and dividend estimates suggest a payout ratio of 74%, which is manageable. Due to the high upside and attractive dividend yield, I’m bullish on KEY for a holding period of one year.
Risks to Restrain the Stock Price in the Near Term
Compared to the one-year outlook, I’m less bullish on the stock price in the near term of two to three months because of the elevated risk level. The uncertainties regarding the severity and duration of the pandemic pose threats to earnings and valuation. If the pandemic lasts longer than expected, then provision expense can exceed its estimate. The high exposure to vulnerable loan segments, including education, hotels, oil and gas, and credit cards, exacerbates the riskiness. In my opinion, the stock will remain subdued in the near term due to the risks; therefore, I’m adopting a neutral rating on KEY.
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.
Additional disclosure: Disclaimer: This article is not financial advice. Investors are expected to conduct their own due diligence, and consider their investment objectives and constraints before investing in the stock(s) mentioned in the article.