Up 35%, Yielding 6.2% – How Cheap Is KeyCorp? (NYSE:KEY)

Introduction

It’s time to talk about a very tricky topic in this economic environment: banks.

On October 27, I wrote my most recent article covering one of the Midwest’s largest regional banks, KeyCorp (NYSE:KEY), using the title “KeyCorp: 8% Yield And A Path To 20% Annual Returns.”

Since then, KEY shares have returned 33%, including the dividend, beating the already impressive 16% return of the S&P 500 by a wide margin.

In this article, I’ll update my thesis using the company’s just-released quarterly numbers and comments, which show that despite headwinds, the bank is making progress.

It also helps that other banks continue to report stellar numbers, which is what I will cover first in this article.

So, let’s get right to it!

What To Make Of Recent Earnings?

As most readers will be aware, earnings season started last week, with the numbers of some of America’s largest banks.

According to the Wall Street Journal, JPMorgan (JPM), Bank of America (BAC), Wells Fargo (WFC), and Citigroup (C) earned $104 billion in 2023, 11% more than in 2022.

According to the article, contrary to predictions, the U.S. economy remained resilient despite the Federal Reserve’s aggressive rate increases, ongoing wars, and a regional banking crisis in the first half of the year.

However, despite the impressive earnings, the four banks faced challenges, with one-time charges affecting quarterly profits.

• Citigroup reported a $1.8 billion loss in the fourth quarter and announced plans to cut 20,000 jobs.
• Wells Fargo and Bank of America shares experienced declines, while JPMorgan’s slipped slightly, and Citigroup saw a modest rise.

Moreover, the banks collectively charged off $6.6 billion in loans in the fourth quarter, double the amount from the previous year. Loan losses, particularly in the commercial real estate sector, posed challenges.

It also doesn’t help that headlines like the one below are surfacing at an increasing pace, which indicates that loan quality will be an even bigger issue in 2024 than in 2023.

Furthermore, going back to the Wall Street Journal article, Americans struggled with increasing monthly car payments, leading to higher auto delinquencies.

Nonetheless, while acknowledging rising loan losses, bank executives remained confident in consumer strength, attributing it to a robust labor market.

During earnings calls, wage gains surpassing inflation and strong average deposit balances per customer were highlighted. However, signs of strain emerged as consumers faced higher interest rates and depleted pandemic savings, which I expect to worsen in 2024 unless the Fed manages to achieve a “soft landing.”

Now, let’s take a closer look at KeyCorp, which is a regional bank with a bigger focus on the lending business.

What To Make Of KeyCorp’s Numbers?

In the fourth quarter, KeyCorp reported a net income from continuing operations of $0.03 per common share, marking a significant decline of $0.26 from the prior quarter and $0.35 from the previous year.

The Cleveland-based bank noted that this decrease was due to the impact of three specific items, totaling $0.22 per share.

These items included:

• A substantial $190 million from an FDIC special assessment.
• $67 million from an efficiency-related expense.
• An $18 million pension settlement charge.

Despite the challenges in net income, the company witnessed stability in the net interest income line during the fourth quarter.

Notably, there was a six basis point increase in the net interest margin compared to the third quarter.

During the earnings call, the bank’s management highlighted the positive impact of swap and treasury portfolios on this margin. However, it was also noted that fees experienced a 5% sequential decline, which aligns with prior guidance.

Furthermore, a notable factor affecting net interest income and margin was the impact of short-dated treasuries and swaps, resulting in a substantial reduction of $345 million in net interest income for the quarter.

With that in mind, the average loans for the quarter came in at $114 billion, reflecting a 3% decline from both the year-ago period and the prior quarter.

This reduction was primarily driven by a 4% decrease in C&I balances, aligning with the company’s planned balance sheet optimization efforts, as it focuses on credit quality over loan growth.

During its earnings call, it was emphasized that the focus was on prioritizing full relationships and de-emphasizing credit-only and nonrelationship business.

Additionally, risk-weighted assets (“RWA”) decreased by $4 billion in the fourth quarter and approximately $14 billion throughout 2023.

The majority of this decline was attributed to lower loan balances, with expectations of modest RWA reductions in the first half of 2024.

Another major topic is deposits. Especially when banks started to default, it was feared that it would trigger a massive wave of deposit withdrawals from fearful clients, causing a wave of liquidity issues.

Hence, it’s good news that despite market volatility, the company reported a positive growth trend in period-end deposits, with a year-over-year increase of $3 billion.

Noteworthy was the 4% sequential growth in commercial deposits, primarily attributed to seasonal build, while consumer deposits grew by 1%.

However, this growth was offset by a $2 billion decline in broker deposits, reflecting the company’s strategic effort to improve the quality of its funding mix by emphasizing core relationship balances and reducing reliance on wholesale funding and broker deposits.

Speaking of emphasizing quality over quantity, the company reported net charge-offs of $76 million for the fourth quarter, equivalent to 26 basis points of average loans.

This represented an increase from the prior quarter’s net charge-offs of $71 million.

Criticized outstandings to period-end loans increased by 50 basis points in the quarter, driven by movements in real estate, health care, and consumer goods.

Despite these increases, management used the earnings call to express confidence in the bank’s well-positioned status concerning potential loss content, noting that over half of nonperforming loans remained current.

In general, while credit quality trends are going in the wrong direction, we are not yet seeing strong upside momentum that would indicate a wave of default.

The good news is that Key significantly increased its capital position throughout 2023, ending the fourth quarter with a common equity Tier 1 ratio of 10%, up 20 basis points from the prior quarter and 90 basis points from the year-ago period.

Going forward, the company remains focused on building capital in anticipation of newly proposed capital rules while continuing to support relationship client activity.

So, what’s next?

An Upbeat Outlook

One of the tailwinds going forward comes from net interest income as short-term swaps roll off and treasuries mature throughout 2024.

The expected benefit is approximately $500 million in total for 2024, resulting in a full amount of $900 million in the first quarter of 2025.

Moreover, the company provided a longer-term outlook.

While it had to acknowledge that there is massive uncertainty regarding the Fed’s interest rate path, its expectations for 2024 include a 5% to 7% decrease in average loans, stable period-end loans, and flat to a 2% decrease in average deposits.

Net interest income is anticipated to be down 2% to 5%, which mostly reflects the lower fourth-quarter exit rate relative to the first half of 2023.

Noninterest income is expected to increase by 5% or better, with stability in noninterest expenses at about $4.4 billion.

Furthermore, the company aims for moderate positive operating leverage in 2024, driven by meaningful expansion in the second half of the year, outpacing tough comparisons in the first half.

Also, credit quality is expected to remain strong, with net charge-offs modestly increasing to the 30 to 40 basis point range.

The net interest margin is projected to improve meaningfully to the 2.40% to 2.50% range by the end of 2024, putting the company on a strong trajectory entering 2025.

Going beyond its interest-focused business, the company also highlighted leading positions and growth opportunities in capital markets, payments, and wealth management, emphasizing consistent investment in these fee-based businesses.

So, what does this mean for the valuation?

Valuation

After rallying 35% in recent months, KEY still appears to be cheap.

That is mainly caused by two issues:

• The bank is still trading way below its highs.
• Analysts expect a consistent earnings recovery.

Using the data in the chart below:

• KEY trades at a blended P/E ratio of 11.6x.
• Its long-term normalized valuation is 12.2x.
• After two years of double-digit earnings contraction, analysts expect 5% EPS growth in 2024, followed by roughly 38% in each of the following two years.

Technically speaking, this should provide a path to $28 per share, which is the bank’s 2022 high and more than 110% above the current price.

It also has a $0.205 per share per quarter dividend, translating to a 6.2% yield.

Over the past five years, this dividend has grown by 7.7% per year, currently protected by a 68% 2024E payout ratio.

The current consensus price target is $15.80, which is 20% above the current price.

With everything said so far, I believe that KEY is undervalued on a long-term basis. I have little doubt that if I were to buy KEY shares now, I would generate a profit over the next ten years.

However, as much as I like the bank’s outlook, I will not make the case that the bank will double soon.

Economic headwinds are too severe, which is why the same analysts who predict a strong earnings recovery aren’t giving the stock a price target above $16 (on average).

Furthermore, what worries me is that sticky inflation could force central banks to keep rates higher for longer, potentially until severe economic weakness pressures inflation. That’s not bullish and bad news for banks, as it would hurt credit quality and potentially pressure deposits if risk-free alternatives remain attractive.

In my prior article, I gave the stock a Buy rating due to its long-term potential.

As I’m bullish on its longer-term future, I will stick to that.

However, this is by no means a high-conviction rating. This year could potentially get messy for banks, which is why I keep dry powder to eventually boost my bank holdings.

Please keep that in mind.

In general, I urge investors to assess if bank investments are right for them, as elevated volatility and cyclical risks sometimes make juicy yields unattractive from a risk/reward perspective.