KeyCorp (NYSE:KEY) Q1 2023 Earnings Call Transcript April 20, 2023
KeyCorp misses on earnings expectations. Reported EPS is $0.3 EPS, expectations were $0.44.
Operator Ladies and gentlemen, good morning, and welcome to KeyCorp’s First Quarter 2023 Earnings Conference Call. As a reminder, this conference is being recorded.I would now like to turn the conference over to the Chairman and CEO, Chris Gorman. Please go ahead.Chris Gorman Well, good morning, and thank you for joining us for KeyCorp’s First Quarter 2023 Earnings Conference Call. Joining me on the call today are Clark Khayat, our Chief Financial Officer; Don Kimble, our Vice Chairman and Chief Administrative Officer; and Mark Midkiff, our Chief Risk Officer.On slide 2, you will find our statement on forward-looking disclosure and non-GAAP financial measures. It covers our presentation materials and comments as well as the question-and-answer segment of our call.I am now moving to slide 3.
Before I comment on our quarterly results, I want to touch on three areas that I know have been top of mind for investors, namely deposits, capital and credit quality. Key has significantly strengthened each of these areas over the last decade. We have de-risked our business and built a differentiated franchise that is well positioned for all business conditions, including the current environment.Key’s relationship-based business model provides us with strong granular deposit base and with attractive lending and fee-based opportunities. Our long-term standing strategic commitment to primacy that is serving as our client’s primary bank continues to serve us well.Over 60% of our deposit balances are from consumers, wealth clients, small businesses and escrow accounts.
Over 80% of our commercial balances are core operating accounts. The diversity of our deposits extends across client type, account size, industry and geography.Our deposits come from 3.5 million retail, small business private banking and commercial customers with 56% covered by FDIC insurance and an additional 10% of balances that are collateralized.In the first quarter, our period-end deposits remained stable and balances from March 31 to present remain relatively unchanged. With respect to capital, Key’s position remains strong with a common equity Tier 1 ratio of 9.1%. This positions us well to execute against our capital priorities, including supporting our clients.We are also aware of the heightened focus on accumulated other comprehensive income, AOCI.
AOCI improved this quarter by 13%, which drove a 20 basis point improvement in our tangible common equity to tangible asset ratio. Our capital position will benefit from the expected $2 billion improvement and AOCI by 12/31/24.Credit quality remains strong, once again reflecting our proactive and intentional de-risking over the past decade. In our consumer bank, we serve a wide range of clients. Our weighted average FICO score at origination is above 770.In our commercial bank, 82% of our credit exposure is to relationship clients and 56% of our C&I portfolio is investment grade. We have built a strong originate-to-distribute model that strengthens our risk management and allows us to offer our clients a wide range of on and off-balance sheet financing options.
In the first quarter, we raised $26 billion for our clients.Another area getting attention is commercial real estate. Our largest exposure is multifamily, including a growing affordable housing segment. There exists a significant shortage of available housing broadly and affordable housing specifically in the United States today. As such, affordable housing will continue to receive bipartisan government support.Importantly, we have limited exposure to high-risk areas such as office, lodging and retail. We also have unique insights into commercial real estate through our third-party commercial loan servicing business. Not only is this a great business with over $630 billion of servicing assets, but the business provides us with unique insight into the markets, which vary greatly by asset type and geography.Each of these three areas that I’ve covered; deposits, capital and credit quality provide a foundation and support the long-term earnings power of our company.
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With that as a backdrop, let me move to slide 4 and touch on a few quarterly highlights before I turn it over to Clark to cover the quarter in detail. This morning, we reported earnings of $275 million or $0.30 per common share. Our results included $126 million or $0.14 per share as a result of both our increase in allowance for credit losses and the expense actions we previously announced. The build in our allowance for credit losses is principally model-driven and reflective of a greater range of outcomes as we look ahead.Our strong credit quality and guidance for net charge-offs, however, remain unchanged. Our expense actions this quarter were part of a company-wide effort to improve efficiency and support reinvestment back into our business.
We completed actions this quarter, which represented over 4% of our expense base or $200 million in annualized benefit. This will allow us to hold non-interest expense relatively flat in spite of persistent inflation. Our results this quarter were driven by year-over-year growth in both our consumer and commercial businesses.In our consumer business, we grew new households at a pace supporting our Investor Day target. Our commercial businesses also continued to add and expand relationships. Recent market disruption has provided us with further opportunity to acquire clients and opportunistically add high-quality bankers to the platform.Net interest income declined from the fourth quarter, reflecting higher interest-bearing deposit costs and a shift in funding mix.
Net interest income was also negatively impacted by our received fixed rate swaps, which are used to hedge our floating rate portfolio. Swaps and treasuries reduced net interest income by $317 million this quarter and lowered our net interest margin by 72 basis points.Given the short duration of our swaps and treasuries and the meaningful repricing opportunity, we will see significant benefit to our net interest income beginning late this year and extending into 2024 and beyond. We have continued to take actions to lock in the net interest income benefit going forward. Clark will cover our interest rate positioning in detail during his presentation.Our fee based businesses in the first quarter showed several areas of strength, but overall reflected expected weakness in capital markets.
Although the market remains challenging, we did experience a record first quarter in our M&A advisory business.While we do not anticipate a significant pickup in our capital markets business in the first half of the year, we continue to expect deal activity to pick up sometime in the second half.As I pointed out on the prior slide, credit quality remained strong this quarter, with net charge-offs as a percentage of average loans of 15 basis points. Our credit losses remain near historic lows and we remain confident in the way we have positioned our portfolio consistent with our moderate risk profile.Despite the market disruption, we have not lost focus on driving our targeted scaled strategy and investing in points of differentiation. In our Wealth business, for example, which currently has 54 billion in assets under management, we are bringing the power and capabilities of our private bank to better serve mass affluent client through our retail channel.Our Laurel Road business is expanding to serve the distinct needs of healthcare professionals through hospital system partnerships.
In our commercial businesses we are empowering our relationship managers with a comprehensive suite of pools to enhance productivity and to better support our clients. I remain confident and key in the long term outlook for our business.We have durable relationship based businesses that will continue to serve our clients our prospects and deliver value to our shareholders. Lastly, I would like to thank our 18,000 employees for what they do each and every day to serve our clients.With that, I’ll turn it over to Clark to provide more details on the results of the quarter and our 2023 outlook. Clark?Clark Khayat Thanks, Chris, and good morning. I’m now on slide six. For the first quarter, net income from continuing operations was $0.30 per common share, down $0.08 from the prior quarter and down $0.15 from last year, driven in part by two notable items.We incurred $64 million of restructuring expense or $0.06 per share, which included $36 million of severance and other related costs and $28 million of corporate real estate related rationalization and other contract terminations or renegotiations.Our results also included $94 million of additional provision expense in excess of charge-offs or $0.08 per share as we continue to build our reserves, reflecting a more cautious economic outlook and view on home prices.Turning to slide seven.
Average loans for the quarter were $119.8 billion, up 16% from the year ago period and up 2% from the prior quarter, as we continue to support relationship clients.Commercial loans increased 15% from the year ago quarter. Relative to the same period, consumer loans increased 16%, reflecting growth in consumer mortgage. Compared with the fourth quarter of 2022, commercial loans grew 3%. Our commercial growth continues to reflect the strength in our targeted industry verticals and support for our relationship clients.Continuing on to slide eight. Average deposits totaled $143.4 billion for the first quarter of 2023, down 5% from the year ago period and down $2.3 billion or 2% compared to the prior quarter. Year-over-year, we saw declines in retail deposits, driven by elevated spend due to inflation, normalization from pandemic levels and changing client behavior due to higher rates.Commercial balances, which included $6 billion of brokered deposits remained relatively flat.
The decrease in deposits from the prior quarter reflects a continuation of these same trends. Interest-bearing deposit costs increased 62 basis points from the prior quarter and our cumulative deposit beta was 29% since the Fed began raising interest rates in March 2022. Our outlook for 2023 now assumes a cumulative deposit beta peaking in the low 40s.Turning to slide 9. We wanted to provide incremental detail on the granularity and composition of our $143 billion deposit portfolio. At the end of the first quarter, approximately 54% of our deposits came from consumer, wealth and small business clients. An incremental 6% of deposits are from low-cost, stable escrow balances. The remaining approximately 40% of our deposits comes from our large corporate and middle market commercial clients.Over 80% of commercial segment deposit balances are from core operating accounts.
Our total deposit — of our total deposits, 56% are covered by FDIC insurance, while an additional 10% are collateralized. We maintain access to enough liquidity to cover over 150% of uninsured and uncollateralized deposits.The quality of our deposit base derives from the strength of our relationship-based strategy, which is benefited key both from a balanced stability and cost perspective. At period end, our loan-to-deposit ratio was 84%.Now moving to slide 10. Taxable equivalent net interest income was $1.1 billion for the first quarter compared with $1 billion in the year ago quarter and $1.2 billion in the prior quarter. Our net interest margin was 2.47% for the first quarter compared to 2.46% for the same period last year and 2.73% for the prior quarter.Year-over-year, net interest income and the net interest margin benefited from higher earning asset balances and higher interest rates, partly offset by higher interest-bearing deposit costs and a shift in funding mix.Relative to Q4, our net interest margin was negatively impacted by 22 basis points related to higher interest-bearing deposit costs and 22 basis points from a change in funding mix and liquidity and loan fees, partly offset by 18 basis points related to higher interest rates and earning asset growth.As Chris noted earlier, our swap portfolio and short-dated treasuries reduced net interest margin by 72 basis points in the quarter.
Additionally, the net interest income was lower, reflecting two fewer days in the quarter.Turning to slide 11. As previously mentioned, Key stands to benefit significantly from the maturity of our short-dated swap book in treasuries. This opportunity is consistent with the $1 billion of upside we’ve been talking about over the last few quarters. While we recently offered more detail on the swaps and treasuries by quarter and interest rate, we thought it would be valuable to include a view on the realization of that potential value in both timing and amount.The chart on slide 11 shows this with the forward curve. We do not include — we do include the value should short-term rates remain at current levels in a higher prolonger scenario as well.
We have also gotten questions about how we plan to lock in this value. As we’ve shared, we’ve taken a measured but opportunistic approach to adding hedges to address this potential. The analysis on slide 11 reflects the additional hedging activity we’ve undertaken beginning in Q4 and since. The point here is to provide one more level of depth to clarify the timing and magnitude of this opportunity. As this demonstrates, we continue to see significant future value in NII as these swaps and treasuries mature.Moving to slide 12. Non-interest income was $688 million in the first quarter of 2023 compared to $676 million for the year ago period and $671 million in the fourth quarter. The decline in non-interest income from the year ago period reflects a $24 million decline in service charges on deposit accounts due to changes in our NSF/OD fee structure that we previously discussed and implemented in September and lower account analysis fees related to interest rates.Additionally, investment banking and debt placement fees declined $18 million, reflecting lower syndication fees, partly offset by an increase in advisory fees, while corporate services income declined $15 million, reflecting lower loan fees and market-related adjustments in the prior period.The decline in non-interest income from the fourth quarter reflects a $27 million decline in investment banking and debt placement, driven by lower advisory and syndication fees.
Recall that Q1 is historically the low point for investment banking activity in the year.Other income decreased by $20 million driven by Visa litigation assessment and market-related adjustments. Additionally, corporate services income decreased by $13 million, reflecting lower derivative volumes.Moving on to slide 13. Total non-interest expense for the quarter was $1.18 billion, up $106 million from the year ago period and up $20 million from last quarter, inclusive of $64 million of restructuring charges related to actions we completed this quarter to take out $200 million in annualized costs.As we shared on the Q4 call, we took these steps proactively to support investment in our business in the face of continued inflation. Compared with the year ago quarter and in addition to restructuring charges, personnel expense increased, reflecting an increase in salaries and headcount, partly offset by lower incentive compensation.Compared to the prior quarter, and in addition to restructuring, business services and professional fees declined $15 million in marketing expense declined $10 million.
Additionally, other expense increased in the first quarter by $9 million reflecting an increase in the base FDIC assessment rate.Moving now to slide 14. Overall, credit quality remains strong. For the first quarter, net charge-offs were $45 million or 15 basis points of average loans, which remain near historically low levels. Our provision for credit losses was $139 million for the first quarter, which, as we pointed out, exceeded net charge-offs by $94 million.30 to 89-day delinquencies to period-end loans were down one basis point to 14 basis points, while 90-plus day delinquencies remain stable. The excess provision increases our allowance for credit losses, reflecting a more cautious model-driven assumptions. Despite the increase in the allowance, our outlook for net charge-offs in 2023 of 25 to 30 basis points remains unchanged and well below our through-the-cycle levels of 40 to 60 basis points.Moving to slide 15.
With regard to commercial real estate in particular, Key’s exposure is well controlled and credit quality remains strong. Over the past decade, we meaningfully repositioned our commercial real estate book by sharply reducing our exposure to construction and homebuilders and reducing the level of commercial real estate loans in our book. We focus on relationship lending with select owners and operators.Our improved risk profile has been demonstrated in Key’s most recent stress test results where projected losses in our commercial real estate book stands at 8.2% compared to 11.5% for peers.Now on to slide 16. Our liquidity position is strong, our period-end cash balances at the Federal Reserve stood at $8 billion, and we maintain flexibility with significant levels of unused borrowing capacity from additional sources.
We would expect to maintain higher cash balances until the market stabilizes. Our levels of additional available liquidity have not changed materially since the end of the quarter.On to slide 17. We ended the first quarter with common equity Tier 1 ratio of 9.1% within our targeted range of 9% to 9.5%. This provides us with sufficient capacity to continue to support our relationship customers and their needs.We completed $38 million of open market share repurchases in the first quarter related to our employee compensation plan. Given market conditions, we do not expect to engage in material share repurchases in the near-term.We will continue to focus our capital in supporting relationship client activity and paying dividends. Over the last six weeks, there’s been significant discussion of AOCI and its potential inclusion in CET1 capital levels for Category 4 banks.
We’ve historically chosen to put most of our portfolio purchases and available for sale. And given the recent market rise in rates, we saw significant increases in the negative mark. As time passes and if rates have come down, we’ve seen our AOCI mark decrease by 13% and from $6.3 billion at 12/31 to $5.5 billion at 3/31.We share on Slide 16, the expected reduction in the AOC mark from 3/31 to the end of this year and the end of 2024. Over that time frame, the AOC mark declined by approximately 40%. And while this analysis assumes the forward curve, it’s important to note that 90% of the value is for maturities and cash flows that is not rate dependent.Although we have no unique insight into the path of potential regulatory changes, as we’ve seen historically when bank capital regulations have changed, they carry with them comment periods in a reasonable phase-in time frame.
Our view is that for any new requirements, our reduction in AOCI mark and more significantly, our earnings would allow us to organically accrete capital to required levels over the necessary period.Slide 18 updates our full year 2023 outlook. The guidance is relative to our full year 2022 results. We expect average loans to grow between 6% and 9%. Importantly, most of this growth has already occurred relative to 2022, so we don’t expect material loan balance growth. We’ll continue to support relationship clients by recycling capital throughout the year.We expect average deposits to be flat to down 2%. Net interest income is now expected to decline by 1% to 3% driven by higher interest-bearing deposit costs and a continued shift in funding mix.
Our guidance is based on the forward curve, assuming a Fed funds rate peaking at 5.1% and in the third quarter and starting to decline in the fourth quarter. These interest rate assumptions, along with our expectations for customer behavior and the competitive pricing environment are very fluid and will continue to impact our outlook, prospectively.Non-interest income guidance is unchanged. We continue to expect it to be down 1% to 3%, reflecting the implementation of our new NSF OD fee structure last year and continued challenging capital markets activity, at least in the first half. Our non-interest expense outlook is also unchanged. We expect it to be relatively stable, driven in part by the actions we took last quarter to accelerate cost savings, which includes the impact of the $64 million in restructuring charge.For the year, we continue to expect credit quality to remain strong and net charge-offs to be in the 25 to 30 basis point range, well below our over-the-cycle range of 40 to 60 basis points.
Our guidance for our GAAP tax rate is now 20% to 21%. We feel confident in the foundation of our business, the relationship-driven value of our deposit book, the durability of our balance franchise and our improved risk profile. Despite near-term headwinds, we continue to be focused on execution in 2023 and the strong long-term earnings power of our company.With that, I’ll now turn the call back to the operator for instructions on the Q&A portion of the call. Operator?
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Question-and-Answer Session Operator Thank you. [Operator Instructions]
We go to the line of Ebrahim Poonawala with Bank of America. Please go ahead.Ebrahim Poonawala Good morning.Chris Gorman Good morning, Ebrahim. How are you?Ebrahim Poonawala So maybe just starting on deposits.
We’ve obviously gone from mid- to high 20s beta to 30s, now low 40s. I guess, Chris Clark, give us a sense of just in terms of your comfort level that this high — if the forward curve or at least if the Fed is done with one more hike, why the low 40s beta should be the right number in terms of your confidence level and just a rigor of the analysis that went behind that assumption?Chris Gorman Sure. We’ll get into that analysis in just a second. But there’s no question that we early were surprised at how low the betas were and as of late, we’ve been surprised at the steepness of the curve. So your question is a good one.Before I turn it over to Clark, let me just give you a little bit of context on our deposit base. Our total cost of deposits as is in the deck there is 99 basis points.
Our cost of interest bearing deposits are 1.36. As we mentioned, our cumulative beta is 29. And as you just brought up, we now expect betas to peak in the low 40s. But I just want to talk a little bit about the composition of our deposit base. We are a business that’s more heavily canted to commercial than retail. And if you think about those deposits, these are people that we’ve helped through many cycles. Most recently, we’ve helped through PPP.Over 80% of these accounts are operating accounts. And so when people talk about what’s insured, what’s not insured, I think one thing that some people miss is if you’re running a $200 million or $300 million or $400 million business and we have the operating account those deposits aren’t going to go anywhere because it’s a living, breathing thing.
And so I just — I thought I would just give you that context because when we think about deposits, we always bifurcate it by category. But getting back to your question, Clark, give us the rigor behind the 40 — low 40s and our confidence in same.Clark Khayat Yeah. So I’d start, I think, with balances, Ebrahim. I think we feel very good about where our balances sit today relative to where they have been relative to the market we’re in and relative to competitors. So it starts with balances and then you get to pricing — as we’ve talked about in the past, we’ve been more focused on retention of deposits than acquisition of new deposits, and I think that is reflected in the beta to date.The other point since last third quarter, fourth quarter, as we’ve watched the market develop, I think we — while we would not purport to have perfect information about behavior, we have a much better view on how customers are interacting I think the commercial betas have mostly played through.
So we’ve seen those come up. Many of those, as we’ve talked about, four are indexed and others, there’s been a lot of conversation engagement with commercial clients. The consumers are always slower to move, and we believe at this point, we have a better view on how they’re behaving, the types of accounts they want and how competitors are reacting.So when we look at the low 40s number up a bit from the high 30s, we have some confidence that we can deploy beta in across the retail franchise, but also in some targeted customer sets to not only retain but potentially acquire some deposits going forward.Ebrahim Poonawala Got it. Thanks for that. And just maybe a quick one, Clark, on the slide 11, the bar chart with the NII upside from swaps and treasury roll-off.
Give us a sense of sensitivity if rates 100 basis points lower next year versus today? What does that mean for that upside that you lay out there?Clark Khayat Yeah. So what’s embedded in the chart on the page, Ebrahim is the forward curve, which is coming off. I don’t have in front of me exactly what those rates are, but they’re coming down pretty significantly over that time frame. I could follow-up with a little more sensitivity, but effectively, you can think about the forward curve in that 720 range as we talked about annualized. Maybe the right comparison is, if rates didn’t move at all and the spot rate just sort of played out you’d get back to that $1 billion number.So you see a little bit of a sensitivity between “higher for longer version” where the spot rate just sort of sticks versus the forward curve, which is coming down fairly significantly over the next seven quarters.Ebrahim Poonawala And I think in the prepared remarks, you said you were taking actions to lock that in.
