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Morningstar | KeyCorp Comes Through in 2Q Results With Better Fee Growth; Asset Sensitivity Also Quite Low

After a tough first quarter, no-moat-rated KeyCorp largely accomplished what it had to in second-quarter results. Management essentially maintained all guidance, while admitting that it will likely come in on the low end of the revenue ranges, but it believes it can do the same for expenses. It is a good sign that KeyCorp will be able to manage the expense base in the face of a more difficult revenue backdrop. KeyCorp also made a nice comeback on the fee income front, with noninterest income up 16% compared with the first quarter of 2019. Roughly one week ago, KeyCorp also announced the discovery of fraudulent activity by a client that could result in up to a $90 million charge net of tax (although it could come in lower than this). The bank emphasized it appears to be an isolated incident and it is reviewing how it occurred and taking measures to recover losses. After incorporating the latest results, which we found largely encouraging and supportive of our current thesis on KeyCorp, we are maintaining our fair value estimate of $21 per share. The bank hit a return on tangible equity of 15% in the quarter, and we see no reason why this can’t move higher given the muted rate sensitivity KeyCorp has put in place, when combined with decent loan growth, a return to fee income growth, and continued expense control. As such, we still think there is a valuation gap that could close for the stock, although the stock is now approaching 7-8 month highs as it has not consistently broken $18 per share since before December 2018, therefore the gap is closing.

This was a “prove it” moment for KeyCorp, and the bank largely came through. Fee income saw strength in multiple areas, including a $53 million swing in investment banking fees (a nearly 50% swing and an all-time quarterly high), nearly 11% growth for card and payment income compared with the first quarter, and the bank’s mortgage related fees are also finally growing. Excluding notable items, fee income was roughly on level with what was seen in second-quarter 2018, when the bank was hitting a return on tangible equity of 16.7%. Management commented that it believes mortgage related revenue can go even higher, and it is also working on integrating their own mortgage originating capabilities with Laurel Road. Management also believes the pipeline remains strong within I-banking, so we wouldn’t be surprised to see further growth there, as well.

Net interest income was roughly flat both quarter over quarter and year over year. KeyCorp has instituted one of the largest hedging programs we have seen among the banks under our coverage, and as a result, the bank seems to be very well insulated in the event of any rate cuts. In fact, management estimates that a 100-basis-point parallel move in rates would affect net interest income less than 1%. This is the lowest sensitivity we have seen so far. If the bank can roughly maintain net interest margins and get continued loan growth, there is no reason net interest income couldn’t grow, although we calculate that the bank will need some balance sheet growth to meet the low end of its net interest income guidance. To that end, average loans were up 2.4% year over year, with C&I loans, auto loans, and loans from Laurel Road driving the growth. The bank continues to stay conservative within the CRE space, where loans declined.

Adjusted noninterest expenses were roughly flat year over year. The bank has now acted on essentially all of the expense savings to be had from its latest $200 million efficiency initiative, although since some of the savings occurred later in the quarter they are not fully present within the current quarter run rate just yet. As such we would expect additional savings to come through in third-quarter results as well as the roll off of one time efficiency initiative charges.

Credit remains sound with delinquencies and charge-offs remaining range bound. The bank remains on a charge-off run rate that is well below its targeted range. We believe that credit costs are at a cyclical low and are likely to increase over the next three to five years.