2023-08-11 12:30:52 ET
Summary
- Silicon Valley Bank collapsed earlier this year, causing a banking crisis and sending most regional bank stocks into the gutter.
- KeyCorp's financial performance has been spotty, with declining net income and missed earnings estimates.
- Despite the challenges, KeyCorp remains well-capitalized and has the potential for improved results in the medium term.
- The risks to KEY's future net income are very real, but ultimately won't affect the dividend given the strong coverage ratio.
Unless you've been living under a rock for the last 6 months, you're probably well aware that in March of this year, we experienced a banking crisis, unlike anything that's occurred since 2008.
In the span of a few short days, Silicon Valley Bank ( SIVBQ ) (SIVB), a storied and well-respected bank that was in the top 20 U.S. banking institutions by assets, collapsed, as depositors withdrew billions in cash as fears of a bank run self-perpetuated.
The bank had grown its assets considerably throughout the 2021 VC boom, and faced with a glut of new deposits, executives decided to allocate this new cash to a massive position in U.S. treasury bonds, that they then placed on their "held to maturity" book.
As the Fed Funds rate rose throughout 2022 to combat historic inflation, SIVB began taking big losses on this position that ate into the firm's capital cushion. Eventually word got out, and a bank run forced SIVB into FDIC custody. A few more banks collapsed due to contagion fears, (Signature, First Republic), which sent the stocks of other regional banks into the gutter.
Today, despite the distinct lack of a continued nationwide bank run, many regional bank stocks are still trading at rock-bottom prices and are paying record dividend yields.
In this article, we're going to take a look at KeyCorp ( KEY ), to determine whether or not this big regional player is a safe bet, or a dangerous/risky proposition.
Financial Results
As always, let's begin with the financials.
And, honestly, we wish we had better news.
Looking more closely at some of the company's recent earnings reports, it's clear that performance has been spotty:
Sure, revenue has been steady at around ~$1.8 billion per quarter, but KEY has had a penchant for missing EPS and revenue estimates for several of the last few periods. It's tempting to say that much of this can be attributed to a rowdy H1 of 2023, but blips were showing up in 2022, as well as Q1 of 2023, before the Silicon Valley Bank crisis really had time to affect performance.
These misses coincide with a massive drop in net income since profits peaked in late 2021:
On a quarterly basis, income has declined from highs of more than $700 million to just $287 million in the most recent quarter.
Clearly, rising interest rates have not been good for KEY. While banks often have an opportunity to grow net interest margins as base rates rise, KEY hasn't materially grown net interest income at all over this period. In fact, NII declined, dropping below $1 billion in the most recent quarter for the first time since the pandemic:
This underperformance has led to a drop in the stock price, which was only exacerbated by the aforementioned SIVB crisis:
All of that said, there are a few positive notes to mention.
First off, net income trends are bad, but less worrisome than feared.
While net income has fallen since the start of 2022, zooming out, it appears that the net income issues of the last 6 quarters are more of a retracement from a period of overearning, rather than a period of secular weakness:
Sure, some banks have fared better, but KEY is by no means in dire straits.
Additionally, the bank remains in a solid position liquidity-wise.
KEY has $145 billion in deposits, and nearly $200 billion in total assets, including $111 billion in loans & $63 billion in investments. All told, the company's CET ratio remains healthy at >9%:
Earnings Presentation
Finally, KEY expects nearly $900 million in annualized accretive swap transactions to mature in the coming ~6 quarters, which should boost net income and EPS substantially going forward:
So, while earnings have suffered and NII hasn't benefitted from a rising rate environment, the bank remains well capitalized and has some reasons to expect improved results in the medium term.
Dividend Coverage
That's great to hear, but the question we're looking to answer today is whether or not the dividend is safe.
Let's start with the coverage ratio.
Here's a chart of net income vs. dividends paid for KEY over the last several quarters. As some may notice, the quarterly coverage ratio is deteriorating, and in Q2 2023, net income was 287 million, while dividends paid out were 228 million:
This is less concerning than it first appears. First off, the bank has ample retained earnings/cash it can use to pay future dividends, even if net income continues to drop. Secondly, we're expecting net income tailwinds in the form of the swap transactions we mentioned earlier. Finally, zooming out, KEY still retains an annual payout ratio of only 54%, which is well within "safe" limits.
If the ratio was higher, near 80%, then there would be more cause for alarm.
So, for the time being, it looks like KEY can support the dividend.
Risks
But what about larger business risks?
Right now, there are three risks that we think the market believes may cause a dividend cut.
1.) CRE Exposure
2.) Higher Capital Ratios
3.) Lack of competitiveness with TBTF Banks
Let's address each of these in order.
First, many believe that Commercial Real Estate is set for an unwind, as many companies are still having trouble getting workers to come back into the office. This has led to vacancies and a serious overhang for the Office CRE market.
Thankfully, KEY has incredibly low exposure to office real estate, with loans to the sector totaling less than 1% of outstanding exposure:
We don't think this narrative should affect KEY in any material way.
Second, regulators have come out and threatened that they may increase mandated capital ratios for banks with more than $100 billion in assets, a size threshold above which KEY sits.
This would have three main impacts on profitability, according to BCG :
1.) Recent commentary by the Fed suggests that banks will need to further increase their total loss-absorbing capacity, leading to increased funding costs.
2.) New rules requiring recognition of unrealized losses of available-for-sale securities will temper risk-taking and dent returns in investment portfolios.
3.) Risk management capabilities will need to be upgraded, especially for regional banks, causing staffing levels and costs to rise.
While we think the impact will be material, KEY already retains a 9.5% CET ratio, and thus a move to the low teens would likely impact the bank less than competitors. Plus, KEY would have until 2028 to implement the necessary changes.
Finally, the largest risk in our mind is the potential for banks like KEY to become less attractive to depositors and investors than larger, TBTF banks.
The reasons are twofold. First, the Fed didn't resolve anything when they fully rescued SIVB. Would banks in the future be allowed to take unlimited risk with customer deposits and essentially become big macro hedge funds, backstopped by public funds? Or would depositors be on the hook for doing due diligence for every bank account that they open? There are no easy answers.
As it stands, depositors are likely going to feel safer sticking with the too-big-to-fail institutions, like JPMorgan Chase ( JPM ), Citi ( C ), Bank of America ( BAC ), or Wells Fargo ( WFC ). This could eat into the deposit bases of smaller banks like KEY, which could lead to lessened profitability.
Second, should the new regulations come into place, regional banks would essentially become less profitable versions of the big banks. Increased capital ratios and compliance costs, without the wealth management, IB, or trading arms that provide natural hedges in all market types and extra profits for shareholders.
Sure, this doesn't impact the ability of KEY to pay its dividend, but it could hamper additional capital appreciation of a KEY position going forward.
Final Thoughts
In short, we think KEY's dividend is safe, despite the recent trough in net income.
The company sports a steady capital base, solid business practices, and a strong future income catalyst that has us confident in the safety of the dividend.
The main risks are all regulatory in nature, including the murkiness introduced by the Fed when they rescued SIVB depositors. That said, we think that with a payout ratio near 50%, that future compliance costs and capital requirements shouldn't cut into profits enough to endanger the dividend.
The profile for capital appreciation in KEY stock isn't robust, but as an income play, we think you could do a lot worse than a position in this regional bank.
For further details see:
KeyCorp: Is The Juicy 7% Dividend Safe?