2023-10-27 21:17:01 ET
Summary
- Regional banks, including KeyCorp, are facing challenges in the current economic landscape, with declining profits and the need to retain depositors.
- KeyCorp's recent earnings reveal both challenges and opportunities, with a focus on optimizing its balance sheet and maintaining solid credit quality.
- The stock is trading at deep value and offers an 8% yield, but caution is advised due to uncertainty in the market and the impact of interest rates.
Introduction
We are at a very tricky point in the economic cycle. A lot of high-quality companies are trading at attractive prices. This includes industrial stocks, real estate, utilities, consumer staples, and banks - among others.
The problem is finding a bottom, as some fantastic companies could easily continue to decline if the Fed is forced to keep rates elevated.
KeyCorp ( KEY ) is one of these companies. This 8%-yielding bank is currently in the biggest downtrend since the Great Financial Crisis, as it trades 62% below its high, excluding dividends.
On top of the usual cyclical headwinds like a weakening consumer and slower manufacturing output (expectations), banks are struggling with deposit outflows caused by elevated rates and huge unrealized losses.
In general, banks are a tough place to be for long-term investors, as the risk/reward is poor.
KEY is still down 51% from pre-Great Financial Crisis levels, which includes dividends! The Regional Banking ETF ( KRE ) is up just 25%.
The good news is that regional banks make for great recovery plays. In 2020, I bought banks, and I'm looking to do it again, this time potentially using KEY.
A little more than a month ago, I wrote that regional banks are dealing with real estate woes. Since then, KEY is down another 6%.
So, before I update my KEY thesis using its recently announced earnings, let's start with the bigger picture.
The Challenges Of Regional Banks
Some banks are doing better than others. Stronger regional banks, like PNC Financial ( PNC ), are often banks with well-diversified exposure instead of a strong focus on lending.
I believe that the current crisis will result in an accelerating transformation in the banking sector. Not only are smaller, failing banks being swallowed by the big guys, but a lot of banks need to find a strategy that suits them better for what is set to be a very uncertain future.
A few days ago, the Wall Street Journal focused on this issue and an increasing trend of banks that look to downsize. One of them is KeyCorp.
Wall Street Journal
According to the article, regional banks have faced a challenging third quarter, marked by declining profits, as they grapple with the need to retain depositors.
KeyCorp, Citizens Financial ( CFG ), and Truist Financial ( TFC ) reported double-digit profit drops, with KeyCorp even announcing plans to become a "smaller, simpler company." PNC Financial disclosed layoffs, while Truist and Citizens scaled back various businesses to improve their financial health.
As I already briefly mentioned, in contrast to regional banks, megabanks like JPMorgan Chase ( JPM ), Bank of America ( BAC ), Wells Fargo ( WFC ), and Citigroup ( C ) have faced fewer deposit-related challenges due to their diversified business operations, including trading, investment banking, and wealth management.
As we can see below, regional banks haven't underperformed the banking sector by a margin this big since the Great Financial Crisis.
In response to these challenges, smaller regional banks have started merging.
According to the Wall Street Journal, during the third quarter alone, 34 bank deals were announced with a collective value of nearly $3 billion.
This contrasts with the first and second quarters, which saw deals worth around $630 million. While regional banks are making less money, they have maintained relatively stable deposit levels.
Regional banks that used to pay minimal interest on deposits now have to compete with alternative investments like treasuries, which can yield up to 5%.
As a result, the average interest rate offered on deposits by major regional banks rose to around 2% or higher in the third quarter from negligible rates a year earlier.
What's Up With KeyCorp?
As the Wall Street Journal mentioned, KEY was among the biggest losers in 3Q23 (so far).
Net income from continuing operations for the quarter was $0.29 per common share, which represents an increase of $0.02 from the previous quarter but a significant decrease of $0.26 from the same quarter last year.
That's a 47.3% year-over-year decline!
KeyCorp
One of the main factors contributing to the earnings decline was a significant reduction in net interest income ("NII").
NII decreased by 23% from the year-ago period. This decline was driven by higher interest-bearing deposit costs and a (related) shift in the funding mix to higher-cost deposits and borrowings.
The bank also faced headwinds from its short-dated treasuries and swaps, which reduced NII and net interest margin.
The company's swap portfolio and short-dated treasuries reduced NII by $370 million and lowered the net interest margin by 80 basis points during the quarter.
As a result, these financial instruments had a significant negative impact on the earnings.
KeyCorp
The good news is that KeyCorp sees a clear opportunity in its balance sheet positioning, which has been a near-term drag on earnings.
Based on the forward curve, the bank projects an annualized net interest income benefit of approximately $1 billion from the maturities of its short-term treasuries and swaps by the first quarter of 2025.
KeyCorp
Key also expects its common equity Tier 1 ratio to remain above the targeted range of 9% to 9.5% and will focus on building capital in advance of newly proposed capital rules.
KeyCorp
Speaking of capital and in light of the aforementioned re-sizing comments, average loans for the quarter were $117.6 billion, reflecting a 3% increase from the year-ago period but a 3% decrease from the previous quarter.
KeyCorp
This decline in average loans was primarily due to a reduction in C&I (Commercial and Industrial) balances, which were down almost 4% from the prior quarter.
This reduction is part of KeyCorp's balance sheet optimization strategy, which focuses on prioritizing full relationships and de-emphasizing credit-only and non-relationship businesses in preparation for Basel III regulations.
The reduction in loans also contributed to a decline in risk-weighted assets ("RWAs"), which accounted for roughly half of the RWA decline in the quarter. Key's optimization efforts allowed them to apply more attractive capital treatment to existing portfolios while minimizing the impact on net interest income.
In its outlook for the fourth quarter, Key anticipates average loans to be down 1% to 3%, continuing its balance sheet optimization and recycling capital to support relationship clients.
So, what about deposits?
After all, you now can get a 4% yield by investing in the JPMorgan Ultra-Short Income ETF ( JPST ). The 10-year government bond is at 5%.
Average deposits in the third quarter reached $144.8 billion, remaining relatively stable from the year-ago period and increasing by nearly $2 billion from the previous quarter.
KeyCorp
This (somewhat unexpected) growth in average deposit balances was driven by increases in both consumer and commercial deposit balances.
The bank has improved the quality of its funding mix by growing core relationship balances and reducing wholesale and brokered deposits. Brokered deposits decreased by $2.6 billion on average during the quarter.
In the fourth quarter, average deposits are expected to remain relatively stable.
Credit Quality & Valuation
With regard to credit quality, net charge-offs in the third quarter were reported at $71 million or 24 basis points of average loans.
This number is below the company's expected over-the-cycle targeted range of 40 to 50 basis points.
KeyCorp
Furthermore, KEY reported a provision for credit losses of $81 million for the third quarter. This provision is set aside to cover potential future credit losses and is a standard practice in the banking industry.
The allowance for credit losses to period-end loans increased from 1.49% to 1.54%.
Overall, these numbers suggest that the bank's credit quality remains solid and that it is adequately prepared to handle any credit challenges.
KEY is trading at 1.2x its tangible book, which is a valuation that starts to indicate deep value. Also, unlike the 2016 and 2020 downtrends, the tangible book value has come down to $8 billion from more than $12 billion in 2021.
Furthermore, the stock is trading at less than 8x earnings. This is similar to levels seen in 2010 and the 2020 bottom.
This year, EPS is expected to decline by 40% after a 27% decline in 2022.
FAST Graphs
If the company is able to grow earnings again next year, it could bottom at a similar valuation compared to prior cycles. Historically speaking, a return to a normalized valuation of 12.2x earnings could result in >20% annual returns.
This was the case between 2010 and 2018. Technically speaking, it could be the case in the next years as well.
So, the company has an 8% yield. It's re-sizing and still benefitting from strong credit fundamentals.
I'm starting to like the risk/reward.
However, there's still so much uncertainty in the market. KEY could easily decline another 15% to 20% if the Fed is forced to keep rates elevated through 2024. In that case, an earnings rebound is unlikely.
In other words, despite a favorable risk/reward, I urge investors to be really careful here. Know what you're dealing with and assess whether or not banks are right for you.
If I hadn't invested so much in cyclical stocks in the past few weeks, I would likely be a gradual buyer. If the stock keeps dropping, I would average down.
Depending on my cash flows in the next few months and quarters, I may initiate a position in KEY in early 2024.
The stock gets a Buy rating. A highly speculative Buy rating.
Takeaway
Regional banks, like KEY, are grappling with a changing landscape. Smaller banks are merging as they face declining profits and the need to retain depositors in the face of alternative investments. This transformation could result in a stronger banking sector.
As for KEY, their recent earnings reveal both challenges and opportunities. The bank is working to optimize its balance sheet, which should benefit earnings in the long term. Additionally, its credit quality remains solid, and the stock is trading at deep value, offering an 8% yield.
However, the market remains uncertain, and KEY's fate is tied to interest rates. While there's potential for strong returns, caution is key.
Investing in KEY might be speculative, but it's worth considering as part of a diversified (trading) portfolio.
For further details see:
KeyCorp: 8% Yield And A Path To 20% Annual Returns (Rating Upgrade)