KeyCorp (NYSE:KEY) Q1 2024 Earnings Call Transcript

KeyCorp (NYSE:KEY) Q1 2024 Earnings Call Transcript April 18, 2024

KeyCorp isn’t one of the 30 most popular stocks among hedge funds at the end of the third quarter (see the details here).

Operator: Thank you, everyone, for standing by. Welcome to the 2024 First Quarter Earnings Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to Brian Mauney, KeyCorp’s Director of Investor Relations. Please go ahead.

Brian Mauney: Thank you, operator, and good morning, everyone. I’d like to thank you for joining KeyCorp’s first quarter 2024 earnings conference call. I’m here with Chris Gorman, our Chairman and Chief Executive Officer; and Clark Khayat, our Chief Financial Officer. As usual, we will reference our earnings presentation slides, which can be found in the Investor Relations section of the key.com website. In the back of the presentation, you will find our statement on forward-looking disclosures and certain financial measures, including non-GAAP measures. This covers our earnings materials as well as remarks made on this morning’s call. Actual results may differ materially from forward-looking statements and those statements speak only as of today, April 18, 2024, and will not be updated. With that, I will turn it over to Chris.

Chris Gorman: Thank you, Brian. I’m on Slide 2. This morning, we reported earnings of $183 million or $0.20 per share which incorporates $0.02 per share impact from an additional FDIC special assessment charge this quarter. I would characterize our underlying results as solid. Revenue was essentially flat sequentially despite expected first quarter seasonality as investment banking reported its best first quarter result in our company’s history. Fees were up 6% against both the prior quarter and prior year. Retail relationship households were up 2.5% year-over-year and commercial clients were up 6%. Customer deposits were up 2% year-over-year and essentially flat on a sequential basis. We continue to reduce our reliance on higher cost brokered CDs and wholesale borrowings.

Expenses remained well controlled at $1.1 billion. Nonperforming assets and credit losses remained low. Additionally, we continued to build our credit reserves this quarter. Our capital ratios, including tangible common ratios were flat to improved across the board, despite the impact of higher interest rates on the fair value of our available-for-sale securities. We ended the quarter with a common equity Tier 1 ratio of 10.3%, up 120 basis points from a year ago, representing our fastest rate of organic capital build over a 12-month period since the industry began tracking this metric. I’m also encouraged by the momentum we are seeing in areas where we have a differentiated advantage and have been investing. While only one quarter, I am encouraged by the strong broad-based results we saw in our capital markets business, across M&A, equity and debt capital markets and our commercial mortgage group.

We also are seeing broad momentum across our targeted industry verticals, such as health care, power, industrials and renewables. While I would expect to see some pullback in fees in the second quarter, our pipelines are up from a year ago and from year-end levels. Market conditions are clearly starting to normalize. We also continue to raise significant capital on behalf of our clients. In the first quarter, we raised over $22 billion, holding 12% on our balance sheet and distributing the balance in the capital markets. To this end, last month, we announced a strategic forward flow origination partnership with Blackstone. This partnership will allow us to accelerate growth and manage credit concentration risk within our differentiated commercial platform and is another example of how we are delivering best-in-class execution for our clients.

This deal also further validates our distinctive underwrite-to-distribute model, in that one of the largest private credit providers has recognized our platform for its ability to originate, soundly underwrite and service at volume with our high-quality clients. As markets evolve, we will continue to evaluate the potential for arrangements with other leading providers like this one, which allow us to offer a distinctive experience for our clients while concurrently managing our risk. Turning to Wealth Management. We recently launched Key Private Clients where we have the opportunity to penetrate a large growing mass affluent segment within our consumer base and with our commercial business owners. In this mass affluent segment, we enrolled another 6,000 households in this quarter and doubled production volumes compared to last year.

This new business has added over $2 billion of household assets in just over a year. Overall, our assets under management have now surpassed $57 billion. Before I turn it over to Clark, I want to touch briefly on credit quality. As I mentioned earlier, our nonperforming loans, net credit losses and delinquencies remain at low historical standards with credit losses below our full year 2024 and through-the-cycle targets. In the first quarter, we saw an uptick in criticized loans, which was driven by our belief which, by the way, we have held for some time now, that we will remain in a higher-for-longer environment as inflation remains sticky. With that in mind, this quarter, we performed a deep dive on over 90% of our clients that we believe would be most impacted under a higher-for-longer scenario, encompassing over 80% of our non-investment grade commercial exposures.

Performing this deep dive confirmed our view that there will be low loss content in these loans. Approximately 96% of accruing criticized commercial loans are current and 93% are current when also including non-accruing loans. Over 85% of our criticized real estate loans have recourse. I continue to feel very good about our ability to hit our net charge-off guidance of 30 to 40 basis points this year. In summary, while it’s still early in the year, we are on pace to deliver against the commitments that we detailed at the beginning of this year. Key is back to playing offense. And I remain excited about our future and our ability to generate sound profitable growth moving forward. I also want to take a moment to thank our teammates for their continued commitment to our clients and our communities.

I am very proud to share with you that for the 11th consecutive exam cycle, since the passage of the regulation in 1977, Key received an outstanding rating from the OCC for meeting or exceeding the terms of the Community Reinvestment Act. This achievement reflects our collective commitment to our purpose and an enormous amount of hard work and dedication from every teammate at Key. With that, I’ll turn it over to Clark to provide more details on the results of the quarter. Clark?

Clark Khayat: Thanks, Chris, and thank you, everyone, for joining us today. I’m now on Slide 4. For the first quarter, we reported earnings per share of $0.20, including $0.02 impact from the FDIC special assessment. This quarter’s $29 million pretax assessment represented a 15% add-on to the charge we had taken in the fourth quarter relating to the bank failures last spring. As expected, our taxable equivalent net interest income declined 4.5% sequentially within the range of down 3% to 5% that we provided in January. Noninterest income increased 6% compared to both the prior year and quarter, primarily driven by strong investment banking performance. Reported expenses were down and excluding selected items, expenses were up slightly linked quarter and essentially flat year-over-year at approximately $1.1 billion.

Provision for credit losses of $101 million was roughly flat to the fourth quarter and included $81 million of net loan charge-offs and $20 million of credit reserve build. Our common equity Tier 1 ratio increased to 10.3%, while tangible book value declined 1% sequentially, reflecting the impact of higher rates on AOCI this quarter. Moving to the balance sheet on Slide 5. Average loans declined 2.6% sequentially to $111 billion and loans ended the quarter at about $110 billion, down approximately $2.7 billion from year-end. The decline reflects the expected follow-on impacts of intentional actions we took in 2023 to reduce low-return lending-only C&I relationships and the runoff of residential mortgages and student loans as they pay down and mature.

Lower balances are also a function of lower client demand driven by the uptick in rates in the quarter and the return of capital markets activity, which moved some client assets to more attractive off-balance sheet structures. We also remain disciplined and intentional about what we’re putting on our balance sheet. We’re very active with clients and prospects and still expect new loan origination to come back throughout 2024. On Slide 6. Average deposits declined about 1.5% sequentially, in line with recent historical seasonal patterns. And within that decline, we reduced brokered deposits by roughly $1 billion. Client deposits were up 2% year-over-year. Both total and interest-bearing cost of deposits rose by 14 basis points during the quarter, primarily reflecting repricing of existing CDs and money market deposits as they come up for maturity and some continued migration out of noninterest-bearing.

When adjusted for the noninterest-bearing deposits in our hybrid commercial accounts, our percentage of noninterest-bearing to total deposits dropped from 25% to 24% linked quarter. Our cumulative interest-bearing deposit beta was just below 52% since the Fed began raising interest rates, up about 3 percentage points from last quarter. On the bottom left of the page, we split out for you our deposit mix by product type and for interest-bearing by business, including how much of our commercial book is indexed or managed to benchmark rates. We hope you’ll find this information useful as you think through potential beta sensitivities. Moving to net interest income and margin on Slide 7. Taxable equivalent net interest income was $886 million, down 4.5% from the prior quarter.

Approximately $40 million of benefit from fixed rate asset repricing, mostly from swaps and short-dated U.S. treasuries, was more than offset by lower loan volumes, higher deposit cost and deposit mix migration. Day count impact was about $7 million. Net interest margin declined by 5 basis points to 2.02% driven by higher deposit costs, lower-than-expected loans and changes in funding mix. Both our net interest income and margin continue to reflect headwinds from prior balance sheet positioning. Our short-dated swaps in U.S. treasuries reduced net interest income by $309 million and our NIM by about 70 basis points this quarter. That said, we affirm our prior commitments that our NIM bottomed in 3Q 2023 and that this first quarter of 2024 reflects the low point for net interest income.

Turning to Slide 8. Non-interest income was $647 million, up 6% quarter-over-quarter and year-over-year. Compared to the prior year, the increase was primarily driven by investment banking fees, which grew 17% to $170 million, a record first quarter. Strong performance was broad-based across products and industries. Commercial mortgage servicing fees rose 22% year-over-year, reflecting growth in servicing, special servicing and active special servicing balances. At March 31, we serviced about $660 billion of assets on behalf of third-party clients. Finally, Trust and Investment Services grew by 6% year-over-year as assets under management grew 7% to $57 billion. We’re seeing strong momentum in Key private clients as well as tailwinds from higher market levels.

Conversely, on a year-over-year basis, corporate services income declined by 9% given elevated LIBOR to SOFR related transaction activity in the first quarter a year ago. And the 5% decline in cards and payment fees reflects slowing spend volumes and lower interchange rates in credit card and merchants. On Slide 9, total non-interest expense for the quarter was $1.1 billion and included $29 million related to the FDIC special assessment increase. Excluding selected items in all periods, expenses were flat compared to a year ago and up 1.5% from fourth quarter. Personnel expenses were flat year-over-year as a 7% decline in headcount offset impact from inflation in merit and higher incentive compensation associated with our strong fee revenue results and the impact of appreciation of our stock price associated with equity awards.

Linked quarter, higher personnel costs also reflects seasonal benefits costs in addition to the factors just listed. Moving to Slide 10. Credit quality remained solid. Net charge-offs were $81 million or 29 basis points of average loans, below our target of 30 to 40 basis points for the full year 2024. Delinquencies increased just 2 basis points this quarter and non-performing loans increased 15%, but remained low at 60 basis points of period-end loans. As Chris mentioned, criticized loans increased and represented 6% of loans at quarter end. Roughly two-thirds of the increase came from our C&I portfolio with the rest primarily in commercial real estate. Our internal ratings are driven by primary repayment sources. As loans were moved to criticized, we reaffirmed our collateral coverage, reappraised properties, further engage with borrowers to understand operating pressures, if any and analyze secondary payment sources on these loans.

Based on that thorough review, we feel good about the loss content on these loans, and as Chris shared, remain comfortable with our prior loss guidance for 2024 of 30 to 40 basis points. On Slide 11, given this was a fairly unique quarter in terms of the ins and outs, we provided you with a walk of how we derived a roughly $20 million build in our credit allowance this quarter. We added roughly $117 million to account for the quarter’s credit migration, partially offset by a $98 million release to account for an improved macro outlook. Even with this quarter’s proactive deep dive, our net upgrades to downgrades ratio across the entire commercial book improved this quarter as the velocity of downgrades have slowed. As a result, our allowance for credit losses continued to build and represented 1.66% period-end loans at the end of March.

When you analyze our levels of reserves by loan type, you’ll find that we compare similarly or better versus our peers and we feel particularly well reserved in our commercial real estate, including a 3% ACL against non-owner-occupied CRE loans. Turning to Slide 12. We continue to build our capital position with CET1 of 24 basis points to 10.3% or 330 basis points above our required minimum, including our stress capital buffer. Our marked CET1 ratio, which includes unrealized AFS and pension losses, increased 13 basis points to 7.1%, and our tangible common equity to tangible assets ratio held steady, down just 2 basis points at 5.04%. This outcome despite the roughly 40 basis point increase in five-year rates during the quarter reflects work we have done over the past year to reduce our exposure to higher rates.

This includes reducing the size of our securities portfolio, reducing the portfolio duration and putting on roughly $7 billion of paid fixed swaps, while terminating about $7.5 billion of fixed cash flow swaps last fall. We’ve reduced our DVO1 by 27% over the past 12 months. Our AOCI was negative $5.3 billion at quarter end, including $4.3 billion related to AFS. As we shared with you in the past, the right side of this slide shows Key’s go-forward expected reduction in our AOCI mark based on two scenarios. The forward curve as of March 31, which assumes six rate cuts through 2025, and another scenario where rates hold at March 31 levels through the end of next year. In the forward curve scenario, the AOCI mark is expected to decline by approximately 32% by the end of 2025, which would provide approximately $1.7 billion of capital build through that time frame.

In the flat scenario, we still accrete $1.3 billion of capital driven by maturities, cash flows and time. Slide 13 provides our outlook for 2024 relative to 2023. In short, our guidance is unchanged from what we shared in January. If there’s one commitment, we think will be a little more challenging to hit, it will be ending loan balances given the impact of rate increases on client demand and our own selectivity of loans. But as we’ll show you in a minute, we don’t believe this will impact our ability to deliver on our net interest income commitments, both for the full year and the fourth quarter exit rate. On Slide 14, we updated the net interest income opportunity from swaps and short-dated treasuries maturing. As forward rates have moved higher this quarter, this cumulative opportunity has increased to $975 million from the roughly $900 million we estimated last quarter.

Of course, some of this incremental benefit will be offset by higher funding costs and a higher-for-longer environment. As of the end of the first quarter, we’ve realized a little over 30% of this opportunity to date, which is shown on the left side of the slide in the gray bars. This leaves about $650 million annualized net interest income opportunity left that we expect to capture over the next 12 months. Moving to Slide 15. We wanted to lay out for you the path of how we intend to get from the $886 million of reported net interest income this quarter to a $1 billion plus number by the end of the year. In the top walk, we’ve laid out the drivers of growth, assuming rates generally follow the forward curve and the Fed cuts twice later this year once in September and again in December.

In this scenario, we see about $120 million benefit from the swaps and U.S. Treasuries in line with what we showed you on the previous slide. We also have another roughly $1.1 billion of projected fixed rate cash flows rolling every quarter, currently yielding in the low 2% range that will get reinvested at higher rates. This offsets the immediate impact that rate cuts would have on our variable rate loans and other short-term floating rate investments. We see some modest benefit in year from lower funding costs, particularly from our index commercial deposits and wholesale funding. We’d also expect the net interest margin to improve meaningfully to the 2.4% to 2.5% range in the fourth quarter with about 75% of the improvement driven by the treasuries and swaps and the other 25% through lower funding costs.

In the bottom walk, we hold rates flat to where they are at March 31. In this scenario, we get more earning asset repricing benefit because variable rate loans and other short-term instruments do not reprice lower. That is partially offset by deposit betas continuing to creep a little higher. As we’ve said, we expect to support clients and prospects to drive high-quality loan growth throughout the year. Should loan demand remain softer than expected, we would still expect to meet our Q4 net interest income guidance in either scenario I just described. With that, I will now turn the call back to the operator for instructions for the Q&A portion of our call. Operator?

See also Bill Miller’s Latest 13 Stock Picks and 15 Best Alternatives to Dyson Airwrap.

Q&A Session

Operator: [Operator Instructions] And our first question is from the line of Ken Usdin from Jefferies. Please go ahead.

Ken Usdin: Thanks. Good morning. Clark, I’m wondering if you can kind of start where you just finished and just looking at those two scenarios on Slide 15. I hear you that it still seems like there’s a lot of ways to get to that $1 billion plus. Just wondering how you can help us understand the variance of those outcomes, maybe a way to think about how much those two cuts mean on their own or some of the other kind of moving parts that would change that? Or is it really just like a pretty narrow answer whatever the cut scenario is in terms of where that fourth quarter exit lands?

Clark Khayat: Yes. Thanks, Ken and great question. I would point you to 15 and just say, if you look at the two ends, the swap and UST roll-off, that’s a pretty predictable number. We think we’ve been good about disclosing the details there. That’s, I think, pretty straightforward math. It will be a little bit better in a no cut than in a cut scenario, as you know, but it’s within a bound range when you think about two cuts versus zero. And then on the other side, the impact from loan growth, which, again, we think is coming, but will be a little bit back-end loaded has a relatively minimum in-year impact. So the range of outcomes on loan growth, while we – we’d rather have more in year, I don’t think is a huge driver in this number.

So it really is those two pieces in the middle and the trade between how much more you get from asset repricing, net of loan yields, if there are cuts versus what the impact of funding is and those sort of work to offset each other a little bit, but in a way that we think is relatively muted for the course of the year. And then just the other point I’d make is the $886 million well on the low end for the quarter was within the guide. And obviously, when we gave you the guide for Q1, we had in mind hitting not only the full year guide, but importantly, the fourth quarter exit rate and we continue to confirm our ability to do that. Is that helpful?

Ken Usdin: Yes, it is. Thank you. And as a follow-up on that loan growth point, I’m just wondering in the prepared remarks, Chris talked about the new agreement with Blackstone. And I’m just wondering that dynamic and how that plays into the combination of loan growth, investment banking fees and kind of like what that means for how you originate versus how you distribute?

Chris Gorman: Well, good morning, Ken, so it’s a good question. Let me hit the loan growth kind of head on. We have always demonstrated an ability to grow loans. Having said that, sort of three things all have to be present for us to grow loans. One, there has to be demand. Right now, there is not a lot of loan demand out there. So that’s point one. You see it in kind of flat utilization among other things and not a lot of investment. The second thing is, it has to be in our clients’ best interest for us to, in fact, provide those loans. And you probably noticed that we raised $22 billion, but only put 12% on our balance sheet, and that’s because we can better serve our clients, whether it’s through the forward flow arrangement with Blackstone that you referenced or a variety of other markets.

And the third thing is that they have to – the loans that are available to put on our balance sheet have to fit our risk profile and they have to fit our return requirements. And right now, there’s not a lot of loans like that from our perspective. Having said that, what’s interesting about bank loans is because there’s excess capacity, the best time to make bank loans is when there’s a downturn. And our house view is, we are going to see a downturn, and that will be a great time for us to really use our balance sheet. Your question, though, the implications of your question really are broader than just the loan growth. And let me just spend a little bit of time talking about how we’re positioning Key. We think that no matter how things play out, all banks like Key are going to have to carry more capital.

And as a consequence of that, what we’re focusing on is really serving our clients through capital-light type businesses, specifically payments, which we’ve invested in for a long time, investment banking, which we referenced, our wealth business, which we think we have an opportunity to really grow, and lastly, something that we frankly haven’t capitalized on the degree that we could or should have to date, and that’s business banking. We’re a really good commercial bank. We’ve never really capitalized on the opportunity, in my opinion, to gather the deposits. That’s a business bank is a very deposit-centric business. So I just wanted to give you some insight of how we’re thinking about the business model going forward and how we continue to reposition Key.

Ken Usdin: Thank you, Chris.

Chris Gorman: Sure.

Operator: Thank you. And our next question is from John Pancari from Evercore. Please go ahead.

John Pancari: Morning.

Chris Gorman: Hi, John.

John Pancari: Just on that loan growth topic, I know you had also indicated you do expect new loan origination to pick up as you look through 2024. I mean in what areas do you think that you’re going to be able to see the better opportunities begin to emerge? I know demand is modest as you just said, in loan utilization weaker. So what areas do you see that anecdotal evidence of a pickup that could drive accelerating originations and balance sheet growth as you look through 2024?