KeyCorp (NYSE:KEY) Q4 2023 Earnings Call Transcript

KeyCorp (NYSE:KEY) Q4 2023 Earnings Call Transcript January 18, 2024

KeyCorp beats earnings expectations. Reported EPS is $0.25, expectations were $0.22. KeyCorp isn’t one of the 30 most popular stocks among hedge funds at the end of the third quarter (see the details here).

Clark Khayat – Chief Financial Officer: Vernon Patterson – Executive Vice President, Investor Relations

Operator:

[Call Starts Abruptly]: I would now like to turn the conference over to Chris Gorman, KeyCorp’s Chairman and CEO. Please go ahead.

Chris Gorman: Thank you for joining us for KeyCorp’s fourth quarter 2023 earnings conference call. Joining me on the call today are Clark Khayat, our Chief Financial Officer; and our Chief Risk Officer, Darrin Benhart, who succeeded Mark Midkiff at the beginning of this year. On Slide 2, you will find our statement on forward-looking disclosure and certain financial measures, including non-GAAP measures. These statements cover our presentation materials and comments as well as the question-and-answer segment of our call. I am now moving to Slide 3. This morning, we reported earnings of $30 million or $0.03 per share. Our results included $209 million of after-tax expenses or $0.22 per share from three items that Clark will describe in more detail later.

For the year, we reported EPS of $0.88 including $0.27 impact from similar types of expenses. Fourth quarter closes out a challenging year for the industry and for Key. While our business fundamentals remain solid throughout the year, we acknowledge that our balance sheet coming into the year was not well positioned for the rapid rise in interest rates that transpired. We took a number of necessary steps as we move through the year to enhance our balance sheet liquidity and capital position, in preparation for potential changes in capital rules, positioning ourselves to be a simpler, smaller, more profitable bank. These actions also had some near-term financial impacts. As a result, we missed our own expectations and yours. However, as we turn the page to 2024, I think it is really important to step back and recognize that Key accomplished a number of positive things last year and as a result, I am confident we have laid the groundwork as we move forward.

First and most importantly, throughout the year the tremendous work and dedication of our teammates allowed us to continue to serve and support our clients through turbulent market conditions, particularly in the first half of the year. I am very thankful and proud of our teammates as they set aside the noise affecting our industry, stepped up and continue to focus on executing on our strategic priorities and steadfastly serving our clients. Our focus on relationships continue to guide our balance sheet optimization efforts. In 2023, we reduced loans by $7 billion as we deemphasize credit-only and other non-relationship business. Despite this meaningful reduction in lending, we grew the number of relationship clients and households we serve across both our consumer and commercial businesses and grew deposits by $3 billion.

In consumer, we grew relationship households by 3%, with about two-thirds of new relationships coming from younger demographics. Relationship deposits grew by 1%. Commercial clients grew 4% and commercial balances grew 5% as a result of our continued focus on primacy. About 96% of our commercial deposits were from clients that had an operating account with Key as of December. As a result of our ability to raise relationship deposits, while reducing loans, we were able to meaningfully reduce our reliance on wholesale funding as the year progressed. We also continue to raise significant capital for the benefit of our clients, over $80 billion in 2023, leveraging our unique distribution capabilities. This proven and mature underwrite-to-distribute model is a key differentiator for us.

On expenses, we made significant headway in simplifying and streamlining our businesses. We exited certain capital intensive and non-relationship businesses such as vendor finance, as we have previously done with Indirect auto. In November, we announced a number of organizational changes, including the reorganization and consolidation of our commercial banking and payments businesses. We also realigned our real estate capital business with those of our institutional bank. By aligning product-based teams to the client facing businesses they serve, we are reducing overhead and complexity and creating a better client and prospect experience. Altogether, these actions we took in ’23 impacted 6% of our teammates. Additionally, we continue to rationalize our non-branch, non-operation center real estate footprint, which has declined by 34% over the past three years.

We do not take these decisions lightly, but the reality is, we need to make the difficult decisions today to earn the right to invest in the opportunities of tomorrow. Last year’s actions freed up over $400 million on an annualized basis that we will redeploy to deliver value for our clients and drive future growth. More broadly, these actions combined with our ongoing disciplined expense management have enabled us to hold core expenses essentially flat at $4.4 billion annually over the past two years and that is in spite of inflationary headwinds facing our industry. On the capital front, our risk-weighted assets decreased by $14 billion from the beginning of the year, exceeding our full year optimization goal of $10 billion. Concurrently, we also increased our common equity Tier 1 numerator through net capital generation.

As a result, Our CET1 ratio increased by 90 basis points to 10% at year-end, well above our targeted capital range of 9% to 9.5%. Our capital metrics, including AOCI also improved as lower interest rates and the continued pull to par over time of the unrealized losses in our investment portfolio drove over $1 billion of improvement in our AOCI over the past year. Tangible book value and tangible common equity ratios both improved meaningfully. Overall, our capital position remains strong. We are well positioned relative to our capital priorities and the currently proposed future capital requirements. In fact, we think we’re advantaged relative to other category for banks, given our underwrite-to-distribute model and the asset and capital light businesses that we have, including a scaled wealth business with $55 billion of assets under management.

Also, I want to comment on credit quality, which I believe is the most important determinant of return on tangible common equity and shareholder value over time. Credit quality remains a clear strength of key. Our credit measures reflect the derisking we have done over the past decade and our distinctive underwrite-to-distribute model. Net charge offs were 26 basis points in the fourth quarter and 21 basis points for the full year. Our NPAs, which we firmly believe have very low loss content, remain well below our historical averages. The quality of our loan portfolio continues to serve us well, with over half of our C&I loans rated as investment grade or the equivalent. Our consumer clients have a weighted average FICO score of approximately 768 at origination.

As a reminder, we have limited exposure to leverage lending, office loans and other high-risk categories. Two-thirds of our commercial real estate exposure is multifamily, of which approximately 40% is in affordable housing, which continues to be a significant and unmet need in this country. As we move to 2024, I want to provide my key takeaways from the guidance that Clark will walk you through in more detail shortly. First, we have a clearly defined net interest income opportunity moving forward as our short-term swaps and treasuries reprice, particularly in the second half of the year. Importantly, we believe this can be achieved across a range of interest rate scenarios as a result of the significant work the team has done over the past year to improve our balance sheet resiliency.

We began to see some of that work payoff this quarter as our net interest income grew slightly relative to the third quarter. Our momentum makes me confident that we saw our net interest margin bottom out in the third quarter of 2023. Secondly, we have leading positions and meaningful growth opportunities across capital markets, payments and wealth management. We have consistently invested through the cycle in these differentiated fee businesses where we have targeted scale. We continue to see good client engagement and our pipelines remain strong. Any normalization in the capital markets represents an upside opportunity for Key, not only for fees but from the balance sheet management perspective that I spoke about earlier. Thirdly, while the macroeconomic outlook remains highly uncertain, based on our current assumptions, we anticipate we will generate moderate positive operating leverage for the full year 2024.

Finally, we continue to expect that we will outperform the industry this cycle with respect to credit. Credit quality remains one of our most significant strengths. Over the next several quarters, we continue to expect to operate below our through-the-cycle net charge-off range of 40 to 60 basis points. In summary, we acknowledge 2023 was a challenging year. Difficult, but necessary decisions were made and actions were taken. But at this point, we are nearly finished with that process. Our balance sheet is now appropriately sized for the environment in which we are operating. We are better positioned for changes in interest rates up or down. Our demonstrated ability to manage and grow our deposits proves to be a strong foundation. We are now in a position where we can be more opportunistic as we turn the page to 2024.

Before I turn it over to Clark, I want to take a moment to acknowledge last week, we announced Vernon Patterson’s retirement from Key. As Head of IR, Vernon has led Key through 112 earnings releases and countless meetings with investors and other stakeholders. I am so grateful Vernon to have worked alongside you. I have tremendous appreciation Vernon for the great relationships you have throughout our industry and within our company. So thank you again, Vernon. At the same time, I am pleased to welcome Brian Mauney as our new Director of Investor Relations. With more than 25 years of experience in our industry, Brian brings a depth and variety of experience and capabilities to the role. While he has big shoes to fill, I’m very pleased that Brian has joined the team.

With that, I will turn it over to Clark to provide more details on the results for the quarter. Clark?

Clark Khayat: Thanks, Chris. I would echo your comments on Vern and a warm welcome to Brian as well. I am now on Slide 5. For the fourth quarter, net income from continuing operations was $0.03 per common share, down $0.26 from the prior quarter and down $0.35 from last year. Our results this quarter were impacted by three items totaling $0.22 per share, first, $190 million from an FDIC special assessment, second, $67 million from an efficiency related expense, and third, $18 million from a pension settlement charge, for a total of $275 million pre-tax or $209 million after tax. A breakdown of these items can be found in the last page of our slide presentation. Our fourth quarter results were generally consistent with the guidance we provided last month.

As expected, we saw stability in the non-interest income line this quarter and our net interest margin increased by 6 basis points relative to the third quarter as we began to see some early benefits from our swap and treasury portfolios. Fees declined 5% sequentially on the better end of the range we provided last month. Expense growth was primarily attributable to the three items I mentioned. Without these items, expenses would have been relatively stable compared to the third quarter. Net charge-offs as a percent of loans remained low at 26 basis points and we added $26 million to our allowance for credit losses to reflect some modest migration of the portfolio, primarily in real estate and the still uncertain macro outlook. Additionally, as Chris highlighted in his remarks, our results reflect our focus on primacy and building relationships, our improved capital position and our strong risk discipline.

Turning to Slide 6. Average loans for the quarter were $114 billion, down 3% from both the year ago period and prior quarter. The decline in average loans was primarily driven by a reduction in C&I balances, which were down 4% from the prior quarter. The reduction reflects our planned balance sheet optimization efforts, which prioritize full relationships and deemphasize credit only and non-relationship business. We reduced risk-weighted assets by $4 billion in the fourth quarter and as Chris mentioned, by approximately $14 billion in 2023. The majority of the decline in risk-weighted assets this quarter was from lower loan balances with some reduction in unused commitments also contributing. We would expect modest RWA reductions in the first half of 2024.

Turning to Slide 7, Key’s long-standing commitment to primacy continues to deliver a stable, diverse base of core deposits for funding. Despite a year of market volatility, we grew period-end deposits year-over-year by $3 billion and average deposits were relatively stable compared to the year ago period and prior quarter. On a sequential basis, commercial deposits grew 4%, which we attribute primarily to seasonal build and consumer deposits grew 1%. The increase in commercial and consumer deposits was mostly offset by a $2 billion decline in broker deposits on average as we continue to improve the quality of our funding mix by growing core relationship balances and reducing reliance on wholesale funding and broker deposits. Since the end of the first quarter, we generated almost $13 billion of liquidity by reducing loans and growing relationship deposits and reduced wholesale borrowings by $12 billion.

Our total cost of deposits was 206 basis points in the fourth quarter and our cumulative deposit beta, which includes all interest-bearing deposits, was 49% since the Fed began raising interest rates, in line with our prior guidance of approaching 50% by year-end 2023. The higher rate environment continued to impact our deposit mix as our noninterest-bearing deposits declined by 1% sequentially to 22%. Pressure on deposit pricing appears to be abating across the franchise that we expect some mix shift to continue as long as rates remain high. Turning to Slide 8. Taxable equivalent net interest income was $928 million for the fourth quarter, down 24% from the year ago period and up slightly from the prior quarter. Our net interest margin was 2.07% for the fourth quarter compared to 2.73% for the same period last year and 2.01% for the fourth quarter the prior quarter.

Year-over-year net interest income and the net interest margin reflect the impact of higher interest rates as increased cost of interest-bearing deposits and borrowings outpaced the benefit from higher year earning asset yields. Additionally, the balance sheet experienced a shift in funding mix from noninterest-bearing deposits to higher cost interest-bearing deposits. Relative to the third quarter, the increase in net interest income and net interest margin were driven by actions taken to manage key interest rate risk, elevated levels of liquidity and improved funding mix. The increase was partly offset by higher interest-bearing deposit costs, which exceeded the benefit from higher earning asset yields. While the planned reduction in loan balances adversely impacted net interest income sequentially, it benefited Key’s net interest margin.

Our net interest margin and net interest income continue to reflect the headwind from our short dated treasuries and swaps which together reduced net interest income by $345 million this quarter or by $1.4 billion for the full year and lowered our net interest margin by 77 basis points this quarter. As previously discussed during our third quarter earnings call, in October, we terminated $7.5 billion of received fixed cash flow swaps, which were scheduled to mature throughout 2024. Last quarter, we said that net interest margin would bottom and it did. Throughout 2024, we would expect continued benefit from the maturities of our short-term swaps and treasuries, especially as more mature in the back half of the year. Moving to Slide 9, non-interest income was $610 million for the fourth quarter of 2023, down $61 million from the year ago period and down $33 million from the third quarter.

The decrease in non-interest income from a year ago reflects a $36 million decline in investment banking and debt placement fees, driven by lower syndication fees and M&A advisory. Additionally, corporate services income declined $22 million driven by lower customer derivatives trading revenue. The decrease in non-interest income from the third quarter reflects a $13 million decrease in other income, primarily driven by a gain on a loan sale in the prior quarter. I’m now on Slide 10. Total non-interest expense for the quarter was $1.4 billion, up $216 million from the year-ago period and up $262 million from last quarter. As mentioned, fourth quarter results reflect $275 million of impact from FDIC assessment, efficiency related expenses and pension settlement charge.

Efficiency related expenses included $39 million related to severance and $24 million of corporate real estate rationalization and other contract termination or renegotiation cost. Excluding these items, expenses were relatively stable in the quarter and down compared to the year-ago period. We continue to proactively manage our expense base and simplify and streamline our business so we can continue to reinvest in all our businesses. Moving to Slide 11. Overall credit quality and our related outlook remains solid. For the fourth quarter, net charge-offs were $76 million or 26 basis points of average loans. This compares to $71 million in the prior quarter. Criticized outstanding to period end loans increased 50 basis points this quarter driven by movements in real estate, healthcare and consumer goods.

While nonperforming loans and criticized loans continue to move up off their historical lows, we believe Key is well positioned in terms of potential loss content. Over half of our NPLs are still current. Our provision for credit losses was $102 million for the fourth quarter, including $26 million of reserve build, and our allowance for credit losses to period-end loans increased from 1.54% to 1.60%. Turning to Slide 12, we significantly increased our capital position throughout 2023. We ended the fourth quarter with common equity Tier 1 ratio of 10%, up 20 basis points from the prior quarter and up 90 basis points from the year-ago period. We remain focused on building capital in advance of newly proposed capital rules, while continuing to support relationship client activity and the return of capital.

As such, we expect to stay above our current targeted range of 9% to 9.5% and do not expect to be buying back our stock in the near-term. Our AOCI position improved by $1.4 billion this quarter. The right side of this slide shows Key’s go-forward expected reduction in our AOCR mark based on two scenarios. The forward curve is December 31st, which assumes 6 FOMC rate cuts in 2024 and another scenario where rates remain at their current levels. In the forward curve scenario, the AOCI mark is expected to decline by approximately 24% by the end of 2024 and 34% by the end of 2025, which would provide approximately $1.8 billion of capital build through that time frame. In the flat rate scenario, we still achieved 90% of that benefit between now and year-end 2025.

Said differently, we still accrete $1.6 billion of capital rates remained flat to current levels, driven by maturities, cash flow and time. Slide 13 provides our outlook for 2024 relative to 2023. Given uncertainty regarding eventual timing and extent of Fed interest rate cuts in 2024, our guidance reflects outputs from a few potential scenarios ranging from the December 31st forward curve, which assumes 625 basis point cuts over the course of 2024, starting with an initial cut in March to a scenario more closely aligned with the Fed’s dot plots, which currently assumes three rate cuts. We expect average loans to be down 5% to 7%, mostly reflecting the actions we have already taken over the course of 2023. In other words, the vast majority of the decline in average loans is a function of our reductions in 2023 and are reflected in our year-end balance.

We expect period-end loans at the end of 2024 to be relatively stable compared to the end of 2023, with some decline in the first half of the year, offset by growth expected in the second half of 2024. We expect average deposits to be flat to down 2%. Net interest income is expected to be down 2% to 5%, mostly reflecting the lower fourth quarter exit rate relative for the first half of 2023. This equates to net interest income in 2024 that is up low-single-digits relative to our annualized fourth quarter exit rate. I’ll provide more color on our net interest income outlook shortly. We expect non-interest income to be up 5% or better with upside if capital market activity normalizes and market levels and GDP trends remain constructive. Non-interest expense should be relatively stable at about $4.4 billion as we realize the benefits from our 2023 efficiency actions.

We will continue to tightly manage our cost base, including executing on additional opportunities to simplify and streamline our organization. At the same time, we will continue to protect and invest in our franchise, including most importantly our people. As Chris mentioned, our guidance suggests moderate positive operating leverage in 2024, driven by meaningful expansion in the second half of the year outpacing tough comparisons in the first half. For the year, we expect credit quality to remain strong and net charge-offs to continue to modestly increase to the 30 to 40 basis point range, still well below our over-the-cycle range of 40 to 60 basis points. Our guidance for our GAAP tax rate is approximately 20%. Turning to Slide 14. Given heightened investor focus on this topic, we wanted to provide a little more granularity than we have in the past, about the pacing of our net interest income opportunity as we move through 2024.

Hopefully by now you’re familiar with our well-defined net interest income tailwind as the impact of our short-term swaps roll-off and treasuries mature, especially in the back half of 2024. The ultimate opportunity remains largely unchanged at approximately $900 million. As a reminder, the benefit increases each quarter as more of the swaps roll off and treasuries mature, culminating in the full amount in the first quarter of 2025. So, this all builds quarter by quarter since the initial set of swaps came off the books in the first quarter of 2023. As we turn the page on 2023, we are nearing the halfway point of this journey. Since we’re now through three full quarters, we’re sharing a three-part view. First, on the left in light gray are the three quarters of benefit we’ve already realized.

In total for 2023, that was approximately $85 million of additional income. The next four bars show the progression through 2024. As you see the value builds from each quarter’s tranche and accrues in the following quarter. Each bar represents the value for the quarter. In other words, in 1Q ’24, we expect to realize $78 million of additional net interest versus 1Q ’23 from these positions. For 2024, we estimate the benefit to ultimately $500 million in total, which is the sum of the four quarterly bars. This would represent an increase of more than $400 million over the benefit received in 2023, which as previously mentioned was approximately $85 million. The final bar to the far right, which has been the main focus of this discussion over the last year or so is the first quarter 2025 number.

This shows the benefit currently estimated for the quarter at approximately $220 million for essentially the entire swap and short-term treasury portfolios rolling off. Again, this is incremental to 1Q ’23 and represents an annualized value of approximately $900 million. We believe the reinvestment of these fixed rate assets and swaps represents an outsize the opportunity for Key relative to our peers, but it’s also important to remember that this is just one component that drives our net interest income outlook. On Slide 15, we provide other key inputs and assumptions driving our NII outlook, deposit betas, balances and mix, loan growth as well as seasonal factors. Putting this all together, we expect our first quarter NII to be down 3% to 5% from the fourth quarter.

From there, we expect to grow and start to accelerate in second half of the year as the pace of swaps and U.S. Treasury maturities pick up meaningfully at nearly $5 billion in aggregate per quarter. From the fourth quarter of 2023 to the fourth quarter of 2024, we expect our quarterly net interest income to grow 10% plus and exit the year north of $1 billion. We would also expect the net interest margin to improve meaningfully to the 2.40% to 2.50% range by the end of 2024. This will put us on a strong trajectory as we enter 2025. With that, I will now turn the call back to the operator for instructions for the Q&A portion of our call. Operator?

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Q&A Session

Operator: [Operator Instructions] Our first question will come from Peter Winter with D.A. Davidson.

Peter Winter: Clark, a lot of good color on the net interest income with those slides. But can you just go into a little bit more detail about the moving parts to the net interest income opportunity and maybe some other factors that impacts your outlook. And then secondly, if you could talk about the quarterly NII progression, you gave us the first quarter down 3%, but clearly, it’s going to be a pretty meaningful uptick in the second half of the year?

Clark Khayat: Sure. Thanks, Peter, and appreciate the question. I know this is a point of interest. So let me provide a little bit of context to the guide and the trajectory and hopefully it will be helpful. I think first maybe just start with the puts and takes, which I think is the nature of your question there. And I’m going to just categorize sort of the big movers. I think, one, loan balances, which again we guided kind of down 5% to 7% for the year. Asset yields, I’m going to separate those from the swaps and treasuries, because I just want to identify those separately. Deposit balances, deposit pricing and funding costs and then the swaps and treasury portfolio. So, if you think about those as kind of five key levers on the guide.

If I go full-year ’23 to full-year ’24, which we’ve said down 2% to 5%. The headwinds there are going to be the loan book, so down 5% to 7%. Obviously, that’s going to impact NII, deposits flat to down is a little bit of drag. Earning asset yields will drop year-over-year as rates get cut. And then deposit and funding costs will be up for the year as that fourth quarter kind of annualized number rolls through. So those are the headwinds. What we have coming our way is the swaps in the treasury portfolio as they mature throughout the year. And then a better funding mix as we move through and become more and more reliant on deposits as we have this year. So that sort of dimensionalizes what that year-over-year look shakes out to be. If you take the fourth quarter of ’23 annualized and you compare that to the full-year ’24, we’re guiding up low-single-digits there.

The biggest difference being that that funding cost, that really is pretty flat from fourth quarter through 2024, which it was not the case if you did the year-over-year comparison. And you still get the benefits of swaps and treasuries coming in during the year and a better funding mix. So you start to see that down 2% to 5%, flip to up low-single-digits. We talked a little bit about the first quarter being down, but let me just go fourth quarter to fourth quarter, so I think that exit piece is important. You’re going to have deposits down a bit and earning asset that yields down a bit going from fourth quarter of ’23 to fourth quarter of ’24, but you get a nice pickup in the quarterly swap and treasury portfolio. Our overall funding cost should be down in that quarter as rates have been cut throughout the year.

And then again, you still have some benefits of funding mix. And all that together, we think is 10% plus quarter-to-quarter NII growth. So we think that’s a nice pickup kind of end of year to end of year. And then as you roll into 2025, you have that last $5 billion tranche of treasuries and swaps maturing in the fourth quarter that accrues to the first quarter of ’25. So we start to hit the ground running really nicely with a very steep trajectory as we enter ‘25. So I’ll stop there. That was a lot of stuff, but just trying to give you the components that are moving around.

Peter Winter: And just what are you expecting or assuming in terms of the forward curve and the timing of the rate cuts?

Clark Khayat: So, our guide of 2% to 5% kind of incorporates a couple of different views, kind of the range being the current forward down 6% with the first cut in March, incorporating the lesser cuts on the three Fed dot plots. I think our general view is more aligned to four cuts with the first one middle of the year. But we’re trying to provide guidance that I think incorporates all that. And as you know, when those cuts occur and the magnitude of that will roll through to how we manage our deposit pricing obviously.

Peter Winter: And then, Vern, congratulations on the announcement. It’s just been a pure pleasure working with you and the investment community will be missing you.

Vernon Patterson: Thank you, Peter.

Operator: Next, we go to the line of Scott Siefers with Piper Sandler.

Scott Siefers: Thanks for all the moving pieces in the NII color. I guess, Clark, you’ve discussed the 3% sort of normalized margin, I know we get sort of one final uplift between fourth quarter of next year and first part of 2025. So, I think the way you’ve guided to fourth quarter of next year gets you a lot of the way there, but certainly still some room left over. Is the 3% normalized margin kind of still where you’re bogeying and what has to happen to get us to that sort of range?

Clark Khayat: Yes. Thanks, Scott. So, if you just go back and we’ve talked a little bit about this and it’s overly simplistic to be clear. But if we took second, third and fourth quarter of ’23 and put the impact of swaps and treasuries back in the margin, we’d be 281 to284 in those quarters, which we think is pretty reflective of what we’ve got right now and that’s with this sort of oddly longstanding downward sloping yield curve. So, I think that range as we get into ’25 feels like achievable and I think getting to that longer term three, probably needs us to have a more traditional upward slipping yield curve just that tends to accrue a little bit to all of our benefit on NIM. But I do think that 280 plus is pretty reflective of the underlying core ability of the business as it stands today.

Scott Siefers: And then either Clark or Chris, just the fee guidance, feels like you’re approaching with an abundance of conservatism regarding the capital markets outlook. Just curious if you could maybe put a finer point on what sort of recovery you are, presuming what kind of upward leverage there might be if things do normalize?