KeyBank’s Digital Efforts Driving Returns

KeyCorp (KEY) has been on our Dividend Growth List since October 15th, 2018 and is down 9% since then. That is also 6.2% worse than the return on the  iShares Russell 1000 Value Index (IWD), which we use as the benchmark. Our list highlights a consensus price target of $19.62 and a potential return of 20% after taking into account the 3.4% dividend. We are a bit more cautious on the upside in the short-term but still think 10% is ‘very likely’ in the next 6-12 months. 

Investment Thesis

The U.S. regional banking sector was under pressure in 2018 even though the rising interest rate environment usually has a positive impact on overall banking performance. Regional banks are trading at a forward PE of ~10.0x, which is below that of the S&P 500, with a  forward PE of ~15.5x. We believe KeyBank (KEY) will be one of outperformers on the back of its momentum in 2018 driven by digitalization, middle-market focus and strong revenue growth particularly in fee-based segments.

The bank is an interesting dividend play by increasing dividends(current yield~3.75%) and share repurchases($1.2B or 6% of market cap ) that results in a 10% yield in fiscal 2018. It offers a leading commercial and investment banking platform with diversified and longer-term relationship-based revenues generated from different sources, especially from the middle market. By simplifying and digitizing the IT ecosystem and offering a best-in-class customer experience the bank will drive lower efficiency ratios and improve operating leverage in FY 19.  

Business Overview

Source: Investor Presentation, October 2018

The bank is going through a transformation and is a completely different company than it was 5 years ago. According to the figure above, the company has improved cash efficiency ratios from 68% in 2011 to 56% in Q4 18 and it has improved Return on Total Capital Employed – ROTCE – from 10% in 2011 to 17% in Q4 18.

Dividends have increased from $0.10 in 2011 to $0.565 in 2018 – a CAGR of 28% since 2011. The company also returned capital to shareholders with common share repurchases of $3.2 billion since 2012. The share price outperformed its peers with an increase of 125% vs 110% for peer group median return since 2011. These facts point out how successful the transformation has been thus far, and the bank is on the right path to continue with its business growth trajectory and shareholder value creation in the near future.

Source: Investor Presentation, October 2018

The main competitive advantage and the reason for outperformance compared to peers results from offering a full set of products & solutions to targeted clients in the middle market. The bank has a strong traditional banking division combined with investment banking solutions. Both segments achieved a double-digit growth rate over the past several years.

Middle market customers tend to choose KeyBank over some competitors because they prefer to have a complete bundle of offerings at one bank. The bank also puts great emphasis on having a strong relationship with clients and a sticky customer base.

For example, the customer might execute one M&A transaction with the investment banking division but usually decides to do even more transactions over the next several years. The sticky customer base also offers great cross-sell and upsell opportunities as the bank might offer customers its broad traditional banking products like wealth management or commercial loans. It can even offer other Investment banking products like equity issuance advisory or derivatives & FX solutions, enabling customers to hedge certain interest rate or FX related risks.

Digital solutions like Financial Wellness and Hellowallet make the whole process of consumer penetration easier as it drives increased consumer engagement and leads to a deepening of the customer based relationship.

Source: Investor Presentation, October 2018

The company acquired personal finance software Hello Wallet from Morningstar Inc. a year ago. It is a simplified digital solution so customers can track their saving and spending habits in real time. Financial Wellness is a digital-led experience that provides them with a financial score and advises customers on how to plan and achieve their desired retirement goals or savings goals so they can improve their financial well-being.

This product has a strong growth opportunity as it offers customers a user-friendly interface to get access to KeyBank’s solutions that solve their daily problems or needs. For example, a customer might want to take out a student or car loan, or check on their progress towards reaching their retirement goals. It is especially helpful for a small-business as it gives them a solution to schedule payments to vendors and provides available funds to cover short term working capital requirements.

Source: Investor Presentation, October 2018

Expense Reductions and Tech Partners

The bank has set an ambitious plan to reduce expenses and drive operational efficiency and effectiveness over the long run. The key solution to achieve these targets is digitizing the business operations to build enduring customer relationships.

The bank has important strategic partnerships with tech giants like Google, Oracle, and Mastercard that enables it to increase the addressable market through partner channels, bring in new capabilities, quicken the product to market timeline, and simplify and modernize customer offerings.

For example, KeyBank was the first bank in the U.S. to use the Oracle banking platform leading to better insights into the bank’s client relationships. That has highly improved operational efficiency and profitability in the commercial banking segment. The strategic plan to modernize the technological ecosystem of the bank will also enhance product innovation and incorporate advanced IT capabilities like artificial intelligence in its commercial and investment banking pipeline.

M&A Activities

The company also looks at M&A activities as an important growth engine to drive further digital transformation. KeyBank acquired First Niagara in a cash and stock deal worth $4.2 billion back in 2015. The main goal of the merger was increasing the number of clients by offering them a broader set of product features and functionalities. Other goals were market penetration of new segments like commercial real estate business and to increase operational leverage over the long term.

The successful integration of First Niagara transaction has contributed to a 700 bps points improvement in ROTCE and as well as improved cash efficiency ratio in 2018. KeyBank plans to take a breather from large acquisitions in the near term, but the potential for smaller investments is still possible, such as the company’s acquisition of smaller fintech or tech companies like HelloWallet that enhance customers digital experience and improve operational efficiency.

Market Dynamics

The bank operates in a highly competitive market against both smaller private companies, and larger banks. The biggest banks like J.P Morgan (JPM) or Goldman Sachs (GS) have significantly higher financial resources to spend on marketing activities and capture the growth opportunity of the digital transformation of the entire banking system.

In the eyes of the CEO Beth Mooney, the operating environment in FY 19 will remain bullish as there are no signs of a recession at the moment. KeyBank’s customers are healthy and continue to increase their banking and business activities. The U.S. macroeconomic and business environment is still healthy with key tailwinds like rising rates, strong economic growth, and softer banking regulations.

Regional banks are well-positioned to increase net interest spreads in this environment. However, steepening of the yield curve is essential.   

Source: Bondsupermart, January 2019

According to the figure above, we can spot see how the yield curve flattened over the last year. We expect the yield curve to steepen in the near future as long rates rise – that would be a bullish catalyst that could trigger stock price increases for the regional banks.

As for the regulatory environment, The FED announced a set of proposed rules in October 2018, that would lower regulations for smaller banks, exempt them from liquidity coverage ratios, and reduce the frequency of stress tests. Banks with $100-$250 billion in assets would experience the biggest relief and could invest excess capital into higher yielding asset classes.

Source: Investor Presentation, October 2018

The bank is trying to maintain a neutral risk profile and puts more emphasis on operational growth to make its business model more resilient in the case of a financial crisis. However, it started to be slightly biased towards a rising rate environment by terminating $5B of discretionary hedges or interest rate swaps that were scheduled to mature in 2019. The decision was based upon an internal positive outlook of a further federal fund rates increase compared to the implied forward curve in the market at that time. If the decision ends up being correct the bank’s net interest income will rise and provide an extra boost to earnings in FY 19. Management estimates with each 25 bps increase in the FED funds rate the bank can earn $4-8 million in additional net interest income per quarter.

Q4 18 Results

Source: Earnings Release, January 2019

CEO Beth Mooney stated:

Key’s fourth quarter results marked a strong finish to a successful year for our company, as we continued to grow, invest for our future, and deliver on our financial commitments. We achieved our sixth consecutive year of positive operating leverage, with a record $6.4 billion of total revenue and all-time highs in several of our fee-based businesses, including investment banking and debt placement fees. Our expenses remain well-managed, as we maintain our focus on efficiency, while continuing to invest in our businesses. We remain committed to reducing expenses in 2019 and achieving our $200 million cost savings target.

Source: Earnings Release, January 2019

The bank reported total GAAP revenues of $1,653 million in Q4 18, compared to $1,608 million in Q4 17, beating the analyst estimates of $1,640 million. Both net interest margin and return on average tangible common equity increased 7bps Y/Y to 3.16% and 1005 bps Y/Y to 16.40%, respectively. Strong Q4 results clearly reflect a positive business performance as both fee-based and spread businesses achieved single-digit growth. A capital markets platform with investment banking and debt displacement fees achieved a new record level in 2018. The bank managed to lower overall expenses and nonperforming loans declined by $103 million Q/Q. Pensions settlements contributed to a $0.03 lower EPS and to a major increase in the other expenses in Q4 18. The bank has repurchased $1.1 billion of common stocks throughout 2018 and reported an equity Tier 1 ratio at 9.92%. The company reported Q4 18 GAAP net profit and GAAP diluted EPS to common shareholders of $461.6 million and $0.45, respectively, slightly lower than the analysts’ consensus EPS estimate of $0.47 and up 165% compared to Q4 17 numbers.

The bank has acquired Laurel Road on January 16, 2019 – the company built a student loan refinancing platform and later expanded its offering into mortgages. The president of banking at KeyBank, Mr. Chris Gorman is highly optimistic about the acquisition, as it will help the bank to penetrate the millennials market segment. KeyBank can incorporate technical capabilities of the platform in its other commercial loans offerings as well. This is a great example of the types of fintech acquisitions we expect the bank to continue focusing on to further drive its strategy of digitizing the enterprise.

Source: Investor Presentation, October 2018

According to the figure above the company expects top-line total revenues of $6.7 billion and cash efficiency ratio target in the range of 54 – 56% in FY 19. The analyst consensus estimate for FY 19 is GAAP revenue and GAAP EPS of $6,632 million and $1.91, respectively.

Valuation

Source: Data derived from Reuters & Finance Yahoo, as of 01/22/2019 at 4.00 PM EST

Shares are now trading at a slight discount to peers at forward P/E and P/Tangible Book multiple of ~9.17 and 1.53x, respectively. KeyBank is also offering the highest Dividend Yield of 3.34% vs 2.94% of the peer group. We believe that the market hasn’t fully priced in the ongoing business transformation and strong operational performance in FY 18. In our opinion, the current price doesn’t reflect the firm’s intrinsic value and we expect forward PE and P/Tangible Book value to return to the bank’s historical trading multiples of 11.0 and 1.7, respectively. That makes a ~10% upside potential with our target price of $18.50 compared to analysts’ 12-month target estimate of $19.78.

Risks

The bank is highly exposed to commercial real estate markets, and a potential correction in these particular markets could negatively affect business performance. Any negative changes in the regulatory requirements or newly imposed capital or liquidity requirements imposed by the Dodd-Frank Act, could negatively impact organic growth or limit potential acquisitions in the future. Apart from the general U.S. macro risks, the key challenging risk at the moment is a potential yield curve inversion. That would decrease the bank’s net interest spread and might even cause a recession in the U.S. Given the higher number of smaller acquisitions in the Tech space, a non-successful integration of the acquired businesses might hurt shareholders by dilution of tangible book value and net income per share.

Our Take

KeyBank is an interesting regional bank to monitor as the company is outperforming its peers over the last several quarters, however the bank is undervalued based on forward PE and P/Tangible book ratios. We believe the current management is doing an excellent job of digitizing the whole enterprise and running a business in a lower interest rate environment over the past several years. Considering the negative news about the U.S.- China trade dispute, slowing down of the global economic growth, and worries about future earnings growth, we believe the market has overreacted and shares have sold off too much.

We believe KeyBank has a healthy customer base and will achieve its strategic objectives due to more robust economic growth and benefits from regulatory changes in fiscal 2019.  We expect the share price to increase at least 10% to the price target of $18.50 over the next 12 months. Key risks to our investment thesis are the potential negative macroeconomic and credit quality factors, competitive dynamics and non-successful integration of acquired companies.

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Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in KEY over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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