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Morningstar | KeyCorp's Tough 1Q Raises Concerns About Revenue Growth

No-moat-rated KeyCorp faced a tough first quarter, as revenue softness raises concerns about 2019 guidance. Fee income was hit hard, declining 10.8% year over year amid a continued challenging environment in the investment banking business. While there can be substantial variation in quarterly investment banking revenue, we were disheartened to see year-over-year declines in several other noninterest income line items as well. The result was flat earnings per share at $0.38. After updating our model to reflect a more conservative revenue growth, we are reducing our fair value estimate to $21 per share from $22. KeyCorp’s performance is still not that bad, as returns on tangible were still close to levels seen in the first quarter of 2018, despite much worse headwinds. If the bank can maintain expense discipline, prove that this quarter was just an unusually bad one, and bounce back to get close to the guidance levels that management maintained, we think there is still a valuation gap that could close. In the meantime, this year will be a crucial "prove it" moment for the bank.

Noninterest income was the clear laggard, as nearly every line item saw year-over-year declines. Management reiterated overall guidance and said it expects a double-digit rebound in fee income growth in the second quarter compared with the first. It is worth noting that some peers did not experience nearly the same investment banking headwinds that KeyCorp did, and larger peers (like JPMorgan) are re-emphasizing a focus on winning new middle-market business. It will be crucial for KeyCorp to prove that it can maintain steady growth and profitability for this segment. Currently, we think KeyCorp will see a rebound, but it will still be tough for the bank to hit full-year guidance.

The bank’s net interest income was not much better. Net interest margins declined 2 basis points year over year, as purchase accounting accretion and rising deposit costs worked against the bank. We anticipate that deposit costs still have room to rise, and net interest margins will likely face continued pressure, being flat to down over the next five years. Average loans grew at a reasonable pace, up 3% year over year. Management outlined a number of items that should work in the bank’s favor for the rest of the year in relation to net interest income, and again we expect some rebound here, getting the bank back on track to just missing the low end of guidance. While KeyCorp has room for balance sheet growth this year, we think that increasing deposit costs will make it challenging for the bank to meet its interest income targets.

The bright spot on KeyCorp’s income statement was noninterest expenses, which declined 4.3% year over year. This was due to lower salary expense (partially offset by higher severance costs), lower FDIC assessment costs, and lower marketing costs. KeyCorp still has roughly $100 million left in expense savings to be had from its latest efficiency initiative, and the bank will have to rely on this to get close to its full-year efficiency goals. While we like to see cost savings, we think that marketing and personnel are two important areas of investment for a bank, and as competition heats up, it will be interesting to see how the expense base and overall revenue growth respond.

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

For our recent analysis of bank M&A opportunities, please see our March Select presentation, "The Fellowship of the Banks: U.S. Banks Merging for Size, Scale, and Scope."