2023-12-20 02:55:30 ET
Summary
- KeyCorp became my third-largest bank holding at some point during the second-quarter after the liquidity crisis in the U.S. financial system necessitated emergency action from the Fed.
- KeyCorp can be expected to achieve weaker net interest income/margins in FY 2024 due to weakening sector fundamentals.
- Shares of the regional lender have revalued sharply upwards in recent months.
- While shares are no longer a buy, in my opinion, they are a hold due to the bank's strong dividend.
KeyCorp ( KEY ) at some point during 2023 became my third-largest bank holding, following the massive liquidity crisis that unfolded in the U.S. financial system after a number of regional lenders started to tumble. The crisis was kicked into gear by the failure of Silicon Valley Bank which invested heavily in fixed income assets whose values came under pressure during the Federal Reserve’s tightening cycle. I believe KeyCorp is still worth holding as a dividend investment, given its solid 6% dividend yield, but I expect weakening sector fundamentals to translate to lower bank profitability going forward, now that the Federal Reserve is loosening up on interest rates. Since a major revaluation has taken place for shares of KeyCorp in the last couple of months, I am changing my rating to hold!
Previous rating
I rated shares of KeyCorp a buy ahead of the bank’s third-quarter earnings because the lender was still trading at a discount to book value, generated strong income, and had upside revaluation potential: I Am Adding This 8.1% Yielding Regional Bank Gem Ahead Of Q3 . The coming change in the interest rate landscape, however, will diminish KeyCorp’s net interest margin picture, and considering that shares are now already trading at a material premium to book value, I have scaled back my position in the regional lender by 50% and plan to sell the rest this week. I rate KeyCorp a hold, however, due to the fact that the bank has a low payout ratio and delivers strong quarterly dividend income for investors.
Deteriorating net interest margin picture + premium valuation make KeyCorp unattractive as a new stock purchase
The Federal Reserve guided for a major change in the 2024 interest rate landscape last week when it signaled that the period of high interest rates is all but over. The change in interest rates is likely to trigger a reevaluation of banks’ earnings potential going forward, especially because net interest margins have already started to contract.
KeyCorp’s net interest margin and yield trends are negative, as one would expect in a market where interest rates have topped out. KeyCorp generated $923M in net interest income in the third quarter, showing a steep decline of 23% year over year. The lender’s net interest margin also consistently declined in each of the last four quarters, indicating that banks' NIMs are on a cyclical downward trajectory.
KeyCorp’s own guidance for the fourth quarter projects stable net interest income on a quarter-over-quarter basis, but the bank’s net interest margin is set for a further slide as the Federal Reserve gets ready to reverse its 2022/2023 interest rate increases in 2024.
The immediate implication for KeyCorp is one of lower profitability in the short to medium term. On the other side, KeyCorp's loans could be primed for incremental growth as consumers are more open to buying things with debt when it is less expensive. Loan volume growth is therefore a growth catalyst that I see for KeyCorp in the long term, especially if the U.S. economy avoids a recession.
KeyCorp's average loan balance in the third-quarter declined 3% as clients continued to suffer from the high cost of debt. These effects would likely slowly wear off as FY 2024 progresses and banks pass on the Fed's rate cuts to their customer bases.
Huge revaluation makes KeyCorp a hold
I recommended KeyCorp in part because of the lender's high dividend income that the shares generated for investors and because of its unreasonably low valuation based off of book value, especially throughout the second and third quarters of FY 2023. Shares of KeyCorp are currently trading at a 22% premium to book value as opposed to much lower P/B ratios throughout 2023.
While other banks have already fully revalued to their pre-crisis valuations, KeyCorp is not there yet, but the premium to book value materially exceeds the P/B average of 1.06X. Since I see an unfavorable investment proposition for banks, large and small, in a falling-rate market, I have taken profits and plan to liquidate my position by the end of the week.
The 6% yield is well-supported
One reason to hold on to shares of KeyCorp is that the regional lender is paying a well-supported 6% dividend yield and the bank may very well increase its dividend in FY 2024. KeyCorp pays out about 66% of its earnings, which is higher than the sector median of 36%, but the dividend appears to be well-supported and has the potential to grow in the long term.
Risks with KeyCorp
I don’t see a real scenario in which KeyCorp could achieve significantly higher earnings in the short term. With the federal fund rate set to drop in 2024, KeyCorp faces a weaker net interest income and margin picture that should translate to lower bank profitability as well. However, if the bank were to see a dramatic restart of its loan business (loan originations tend to increase as interest rates fall) in a strong U.S. economy, then my thoughts on KeyCorp could be wrong and shares could have a revaluation catalyst.
Final thoughts
I am not chiefly a dividend investor so owning KeyCorp for purposes of generating recurring quarterly income is not one of my priorities. However, I do see the value of KeyCorp and its 6% yield for those investors who want to build a diversified portfolio of dividend-paying stocks. Given the reasonable payout ratio of KeyCorp, I believe the dividend is protected by the bank’s earnings power. I personally have made the decision to reduce my position by 50% and will sell the rest this week as the net interest margin situation should be expected to deteriorate as the Federal Reserve pulls off a pivot in 2024. Shares now also trade at a premium to book value, so the risk profile is no longer as attractive as it was directly after the financial crisis erupted in March!
For further details see:
KeyCorp: Solid 6% Yield, But Risks Are Growing (Rating Downgrade)