Description

We believe KEY stock has the potential to appreciate ~50% over the next 12-18 months. KEY trades at 8x our 2017 earnings estimate and at a significant discount to its peers. We believe it is likely that KEY will increase profitability to at or above peer levels and that this should afford KEY a peer multiple.  We also believe it is possible that the banking sector experiences a rebound from current trough multiples over time. We believe that downside in KEY is protected due to its reasonable price to tangible book value (P/TBV), robust capital levels, and 3% dividend yield.

Note: all information in this write-up is presented pro forma for the acquisition of First Niagara Financial Group (FNFG), expected to close on August 1, 2016.

OVERVIEW

KEY is the 13^th largest US commercial banks, with $135bn in assets and $100bn in deposits. KEY is headquartered in Cleveland, OH and its Eastern branch footprint (representing ~80% of deposits), spans the Mid-Atlantic and Northeast, ranging from South Bend, IN to Portland, ME. KEY also has a presence in certain Western markets (CO, ID, OR, WA, AK), which represent the remaining ~20% of deposits.

PNL DISCUSSION

Below we outline the trailing twelve month income statement for KEY, pro forma for its acquisition of FNFG. We also discuss each line item below. We believe this is important for readers to understand the profitability drivers for KEY, and that this pro forma TTM data represents a solid baseline from which to project our forward earnings estimates.

KEY generated a total of ~$5.7bn in net revenue in the trailing twelve months. As a bank, KEY utilizes its customers’ deposits to invest in loans and securities to generate investment income. Net investment income (NII) represents ~2/3 of KEYs total net revenues (~$3.4bn TTM). 

KEY’s  loan book generates ~ 85% of KEYs NII. ~70% of KEYs loans are commercial (70% loans to businesses v 30% commercial real estate), and ~30% are residential loans (primarily mortgages). KEYs loans have an average yield of ~3.8%.  KEY’s investment portfolio generates the remaining ~15% of NII, with an average yield of ~2.3%.

The remaining ~1/3 of KEYs total net revenues (~$2.2bn TTM) consists of non-interest income (fee income). The main components of KEYs fee income are trust and investment services, service charges on deposit accounts, investment banking and capital markets, corporate services and cards and payment income.

KEYs operating expenses (~$3.9bn TTM) are largely fixed in nature and consist primarily of personnel expenses and net occupancy costs. Importantly, KEY is targeting $400mm reduction to these expenses as a result of the FNFG acquisition.

KEY incurred provision expense of ~$0.3bn TTM. This equates to ~35bps of loans. As with the entire banking sector, KEYs provisions are low relative to historical standards. Loans made in the wake of the global financial crisis were made selectively, by fewer players, and as such are of relatively high quality.  As KEY continues to originate loans in an increasingly competitive environment, it is logical that provision expense will increase. KEY management is targeting 40-60bps of provisions to loans through the cycle.

After subtracting taxes and preferred stock dividends, and adjusting the share count for the FNFG acquisition, KEY earned ~$1.00 per share in pro forma EPS in the trailing twelve months.

FORWARD PNL ESTIMATES

Below please find a table with the above TTM data for KEY, with an added column with our forward projections for 2017. By our estimates, in 2017, pro forma for FNFG synergies, KEY will be able to increase earnings by 40% from TTM levels to ~$1.40 per share.

Our main assumptions are outlined above. The main delta between the $1.00 TTM earnings and $1.40 in earnings is the $400mm of cost savings expected from the FNFG acquisition (~0.30 per shr AT).  This is one of the things that we like most about KEY relative to other banks. We believe that most banks are reliant on a steeper yield curve to grow earnings (and in many cases simply to meet consensus estimates). This is something that is largely outside of the control of bank management teams. However, the majority of the earnings growth at KEY is a function of management delivering on their commitment to reduce costs. To us, this is what makes the KEY story attractive versus other banks.

Also, we note that KEY has identified “meaningful” revenue synergies from the FNFG transaction. We do not include any of those synergies in our projections, however we believe that achieving $200mm in revenue synergies could add nearly $0.10 to our EPS estimates.

COST SAVINGS

The FNFG cost savings represent the bulk of the earnings growth for KEY. As such, we believe it is imperative to drill down further to try to get comfortable with management’s guidance. There are a several reasons why we are comfortable with management’s guidance, as we outline below.

First, see management’s commentary on cost savings in their most recent conference call:

Beth Mooney (KEY CEO): “I have commented before about the cultural fit between Key and First Niagara, and that continues to be evident in the way our two teams are working together. We have made significant progress in developing detailed business plans and our target environment, including talent assessment and selection. As we move forward, I'm even more confident in achieving our cost savings and revenue synergies, and ultimately delivering on our commitments for value creation for our shareholders.” (Seeking Alpha)

While we don’t like taking any management team at face value, we do give credence to a management team having increasing confidence in a synergy plan after having more time in the field. We believe that management has been conservative in their targets, and there is a strong probability that management will be increasingly confident in their outlook on expense savings in their Q2 earnings call on July 26^th.

Second, one of the critical elements for achieving synergies in bank M&A is the degree of overlap in the branch network of the two banks. FNFG has >30% of their branches within a two-mile radius of a KEY branch, which should aid in cost reduction efforts. The $400mm cost savings identified is ~40% of FNFG’s expense base, which we believe is a reasonable sanity check to the >30% branch overlap, when including corporate overhead expense savings and third party vendor savings.

Third, on a standalone basis, KEY has a higher than average efficiency ratio compared to other regional banks. (defined as noninterest expense / net revenues) To us, this means that there is potentially an opportunity, even absent FNFG, for KEY to reduce expenses. KEYs core efficiency ratio averaged 65% over the trailing twelve months, versus ~60% for peers. Importantly, management’s efficiency ratio target before the FNFG acquisition was <60%. Each 1% decrease in KEYs standalone efficiency ratio (excluding FNFG) is $0.04 in EPS… Therefore, if management achieves half of their own internal standalone target, our estimates could be $0.10 higher, all else equal.

VALUATION

We look KEYs valuation two different ways: KEY versus peers, and banks versus the broader market.

KEY v Peers: Based on our analysis, peer banks trade at ~11x 2017E EPS. We believe that as a result of the profitability improvement that KEY is likely to experience, KEY should trade at the peer multiple. In this case, assuming our projections are accurate, KEY stock would be worth ~$15.50, or approximately 35% upside from current levels.

Banks v Market: The historical pre-GFC median forward relative multiple of banks to the S&P 500 was ~75%. Currently, the banks are trading at ~67% of the S&P forward multiple. If the banks recapture the excess discount versus historical multiples, the group would trade at ~12.5x earnings. Applying that peer multiple to our KEY projections would result in a stock worth $17.50, or approximately 50% upside from current levels.

Note that it is not our base case that the banking sector recaptures their historical relative multiple. However, we can certainly envision a scenario where that is the case. In our view, the banks have significantly de-risked since the GFC and therefore we believe that earnings quality has improved. Higher quality/more stable earnings should lead to a higher multiple, all else equal. If and when the market, which is thirsty for yield, recognizes that the earnings yield on banks is attractive, earnings have been de-risked, and payout ratios are high, we believe it is not inconceivable to think that banks could not only recapture the lost discount to the market, but possibly trade at a smaller discount than historical… much crazier things have happened, in our view!

DOWNSIDE CASE

While its fun to think about the upside case, we believe any decent investor has to spend twice as much time thinking about the downside risk.

We view the main risks in KEY as sector-related. In our opinion, there are two broad risks that all banks must contend with, and KEY is no exception. The first is an adverse credit cycle, and the second is an unfavorable interest rate backdrop.

As we discussed above, what we like about KEY is that much of our upside to numbers comes from delivering on expense savings, which should be basic blocking and tackling for a competent management team. Therefore, assuming KEY delivers on their expense savings, there is great deal of earnings cushion to deal with these two broader issues, if and when they arise.

Below we attempt to sensitize KEYs financial impact in the event of these risks arising.

Credit Cycle

In terms of a credit cycle, see below for a stress case on KEY’s balance sheet. In our analysis, if KEY were to experience stress in its portfolio such that losses reached their median over the past 30 years, which we estimate would equate to ~60bps for KEY (which just happens to neatly coincide with the upper-end of managements through-the-cycle guidance), we estimate that our EPS estimates would drop to $1.27 from $1.40. We believe this is a very manageable downside case for KEY.

In a severe stress, where losses returned to peak levels, we believe that KEY could still be profitable. To be clear, we believe that this severe stress case is remote, however we illustrate to show that KEY would likely be well equipped to handle such an outcome (this is why the regulators stress-test the banks, after all!).

Interest Rates

In our opinion, the more pressing risk to banks is an elongated unfavorable interest rate cycle. Given that banks lending and investing is tied to the level of interest rates, lower rates for longer generally have a negative impact on banks’ profitability. The main risks to KEY are the re-pricing of the loan portfolio downward, and the reinvestment risk on KEYs securities portfolio.

KEY (and all banks) are at risk of new loans and investment securities being priced lower than the loans that are maturing. Additionally, variable rate loans and securities will fluctuate based on benchmark rates. In a more normal rate environment, banks can offset this risk through lowered funding costs. However, in this environment, deposit costs are already near zero (they are 13bps for KEY currently), so the offsets going forward are limited to wholesale funding, which is a much smaller portion of KEYs balance sheet.

In an environment where all loans re-priced downward an additional 25bps, with no offset on funding, KEYs EPS would be impacted by ~$0.15 per share. If securities were to re-price downward an additional 50bps, with no offsets, KEYs EPS would be impacted by an additional ~$0.10 per share.

It is important to note that 1) this impact would not happen all at once (loan/securities maturities are staggered, not all variable), and 2) we have been in a low interest rate environment for some time now, and banks have been managing through this environment for an extended period.

Downside Summary

In summary, we believe that downside risks to KEY are manageable. We feel comfortable that any hit to earnings from either an adverse credit cycle or the perpetuation/exacerbation of the current low interest rate environment, can be managed through, and that there is ample embedded profitability from the realization of the cost savings from the FNFG integration to weather the storm. Additionally, in an adverse interest rate environment, it is quite possible that further M&A could provide an avenue for growth to offset profitability challenges for the sector.

Additionally, KEY trades at only a slight premium to our estimate of its pro forma tangible book value of $11.35 (2017E), has a 10% CET1 regulatory capital ratio, and offers a 3.0% dividend yield, all of which we believe offer some downside protection under relatively normal circumstances.

CONCLUSION

We believe KEY stock has the potential to appreciate ~50% over the next 12-18 months, as KEY will increase profitability to at or above peer levels and earn a peer multiple.  We also believe it is possible that the banking sector experiences a rebound from current trough multiples over time. We believe that downside in KEY is protected due to its reasonable price to tangible book value (P/TBV), robust capital levels, and 3% dividend yield.

CATALYSTS

·         FNFG deal closes, management provides further update on integration

·         KEY delivers on their expense saving initiatives

·         Banking sector experiences stable profitability, benign credit cycle continues, and interest rates stabilize

OTHER NOTES

·         CEO and directors purchased ~165,000 shares of KEY stock in the open market since the beginning of 2016

·         KEY received regulatory approval for the FNFG deal and expected close date is Aug 1, 2016 (versus original expectation of Q3 2016)

DISCLAIMER

The author of this posting and related persons or entities ("Author") currently holds a long position in the securities mentioned above. The Author makes no representation that it will continue to hold positions in these securities. The Author is likely to buy or sell long or short securities of this issuer and makes no representation or undertaking that Author will inform Value Investors Club, the reader or anyone else prior to or after making such transactions. While the Author has tried to present facts it believes are accurate, the Author makes no representation as to the accuracy or completeness of any information contained in this note. The views expressed in this note are the only the opinion of the Author.  The reader agrees not to invest based on this note and to perform his or her own due diligence and research before taking a position in securities of this issuer. Reader agrees to hold Author harmless and hereby waives any causes of action against Author related to the above note.

Catalyst

see above