KeyCorp (KEY) Earnings Call Transcript & Summary

Good afternoon, everyone. This is Gerard Cassidy. We're kicking off the afternoon presentations with KeyCorp. Joining us from KeyCorp is Don Kimble, Chief Financial Officer. Also on the call with Don is Vern Patterson, the Head of Investor Relations. As many of you know, KeyCorp's headquartered in Cleveland, Ohio. It has a market cap today of approximately $12 billion, assets of $145 billion. The total deposits of the organization approached $112 billion, and their loan portfolio is approximately $95 billion. Last year, the company achieved an ROA of 132 basis points and an ROE of just over 12%. Don, thank you very much for joining us. Vern, thank you for joining us.

Well, Gerard, thank you for having us participate in the conference this way. It was a unique way to hold a conference, but very practical. And we appreciate the efforts to make sure that we could have this opportunity. Thank you very much.

You're very welcome. In view of the current environments, Don, maybe you can share with us your thoughts around this unprecedented decline in the 10-year treasury rate and the entire yield curve, of course, coming down. How this may or has already impacted your business, your balance sheet, the income statement? I'll turn it over to you.

Well, great, Gerard, and thank you for that. And as we were heading into March, I would say that the business was going very well. And if you look at the loans, deposits, net interest income, margin, fees and expenses, they were all trading very much in line with what we would have expected. And customer sentiment was supporting strong pipelines and continued progress toward our objectives. And I would say that as we sit today, we still see -- while the customer is a little more cautious and trying to figure out exactly what's going on in the market, I would still say that it tends to be, generally, probably, more biased than what we're seeing as far as market reaction at this point in time. As far as the 10-year treasury, first, the immediate impact would be on net interest income and margin overall. And as we take a look at that, as you're aware, we've continued to position Key to relatively neutral from an asset sensitivity perspective. We really started doing that about 1.5 years ago. And as we looked into the third quarter, fourth quarter of 2018 and started to increase our swap and other hedging activities to position us to be even more neutral. We've disclosed in our 10-K that we have a fairly neutral position as well and show what that for 150 basis point decline in rates over a 12-month period, it's about a 2.5% negative adjustment to net interest income. And so just to keep that as a point of reference. Sometimes when the markets have this kind of reaction, we do see some immediate impact in some of our capital markets-related revenues. And I would say that we're starting to see some of those transactions get pushed out of the first quarter and the second quarter just because of the volatility. But even with that being said, we're still seeing levels for our investment banking and debt placement fees that are up year-over-year. And more in line with where a normal quarter, first quarter might be reflecting some of the seasonality. And so we would expect to have a good quarter, even though we were expecting to be stronger with our expectation and pipelines. Another impact because of the low interest rates is just on residential mortgage. We're continuing to see record origination levels for us this quarter and strong pipelines there as well. And so we would expect to see some growth in that activity. That is partially offset, though, because of some MSR impairments that will occur as a result of the low rates as well. But if you look at the rest of our income statement and balance sheet, I would say, it's pretty much as expected, showing the normal seasonality, reflecting some of the impacts from lower day count and changes from fourth quarter to first quarter, which also includes some of the seasonal expense trends that we have, too. As you remember that some of our employee benefits and employee taxes end up resulting in about a $30 million seasonal increase in the first quarter. And all of that was reflected in our outlook that we provided for this year.

Don, coming back to the residential mortgage business. Obviously, you grew that business with the acquisition of First Niagara. And it's still is growing. Are you seeing -- we're hearing from other participants in that residential mortgage business because demand is so high, and pipelines are so full that there's a widening of the spreads actually going on because the industry just can't handle the demand. Are you seeing anything like that in your organization?

No. We are seeing a gain of sales expanding and just for that very reason. That the consumer is still benefiting because rates are lower and they're seeing a nice decline in the rates. But that -- given that increase, refinance activity, spreads are widening and providing greater opportunity for gain on sale.

Very good. You mentioned how -- about 1.5 years ago, you started to neutralize the balance sheet. You've been clear about that. As we sit here today, is there anything that you can do to reduce the sensitivity further? Or is it just too expensive, and it doesn't make sense to put on additional derivatives or other types of products to neutralize the balance sheet even further?

It's a challenge right now as far as further steps. We'll continue to position the company so that we're fairly neutral positioned. But as we take a look at whether we put on hedges or floors or other transactions, we're also considering what our internal estimates or projections are as far as rates. And if you look at the forward curve, even after this 50 basis point decline that the Fed put in on an emergency basis, forward curve is still anticipating further rate declines, and those great declines would be greater than what we would expect. And so our hedging approaches and strategies, we'll probably be a little bit more muted until we start seeing the market and our outlook more converge on what we should do.

And when you talk to customers, or when Chris and Beth are out with your customers, what are they seeing in terms of the current environment? We all know about the coronavirus and the spread of it around the United States. Are your customers feeling pretty comfortable of where they are today?

Yes. I would say that the impact of the coronavirus and the activities over the last week are probably more recent than what some of my feedback would include. But I would say up and through that time, customers, again, tended to be relatively positive. I would say that the more recent events would suggest that there is some pause and caution, and we're seeing that come through as far as the markets. But I would say that it's still early stages, but we'll continue to monitor where that customer sentiment goes. But near term, I would say that the markets have reacted a lot more abruptly than what our customers would have been telling us in advance of this.

No doubt. And speaking about markets and changes. Obviously, the price of oil in the last 24 to 48 hours has been quite volatile, plunging, of course, yesterday. I know you're not a big energy lender. Can you share with us any thoughts that you guys are seeing with your energy customers?

Yes. No, you're right, Gerard, that our energy outstandings are fairly modest, a little over $2 billion or about 3% of the total portfolio. It tends to be more of a reserve-based type of portfolio. So we tend to be more upstream than downstream services. So it is something we watch very closely. I would say about half of it is oil and the other half is gas-related or liquefied gas as well. So gas has actually performed quite well in the last couple of days. So we'll continue to monitor this, but it isn't a large portion of the portfolio. And during the last downturn that we would have seen in 2015 and '16, I think our portfolio held up pretty well, and we'd expect to continue to do so this year as well.

Good. Obviously, it's that time of year where you and your peers are preparing for CCAR. Can you share with us -- I know you can't tell us what you're actually going to ask for, I don't mean to ask that question. But can you just share with us, with this interest rate environment, how that may change the way you guys approach CCAR?

Yes. That -- we'll continue to watch that. But the -- interesting that the scenarios that the Fed has provided would've done well in advance of many of these rate changes. And so there may be an inconsistency there. And so we'll have to evaluate how that all plays through. But, anyway, as we think about our capital plan and our overall approach that, one, we want to continue to be able to support our organic growth. We want to manage within our capital targets. And so we've established a common equity Tier 1 target of 9% to 9.5%. And we were at around a 9.43% or so at the end of the year. So we're kind of within that range, and we'll continue to work through that. After supporting organic growth, we would want to make sure we continue to maintain a strong common dividend. And so we would expect to continue to support the dividend and maintain that going forward. And then and the last variable would be to return whatever the excess is there to our shareholders in the form of share buybacks. And so I think it's important to note that we don't hold back for any type of war-chest or M&A strategy, but we do want to use that capital to make sure that's there to support the business and the growth that we would be expecting.

Speaking of capital, what's interesting for yourselves, but in the industry as well, many of the banks have reached their targeted level of the CET1 ratio, and that would imply that the return of capital that exceeds earnings, in some cases, 120%, 130% of earnings. Those days are behind us, which is -- which are fine, or is fine. The question is, what do you think, annually, just from an organic growth basis, how much does Key need of its earnings to support organic growth? Is it 25%, 30%? What's a comfortable area you think that you need to take every year just to support your organic growth?

Yes. I think you're in the right ZIP code there, depending upon what kind of balance sheet we would be expecting. But probably in slower growth balance sheet, for the time periods, you're looking at a 25% retention for supporting the growth and probably -- and more rapid expansion. You're probably in that 35% to maybe even 40% retention. And so I think it more depends on what we would be expecting as far as the driver of the balance sheet growth.

Very good. One of the hallmarks that Beth had achieved as CEO of KeyCorp is your focus on expenses and expense leverage. And we don't know what this year is going to bring on interest rates and revenues for the industry, or even for Key with any great deal of confidence because of what's happening. Can you share with us the levers that you still may have at your disposal to reduce expenses if you need to do that as the year progresses?

Well, that's great. And we -- as we've been talking for a number of years to really try to focus on driving positive operating leverage. And ensure that the revenue growth is at a faster pace than the expenses. And we've been able to target that by showing revenue growth and having our expenses remain relatively stable. And for us to do that, and still invest back in the business, we do have to pull a lever on greater efficiencies and cost savings. Some of the things we'll continue to look at from that perspective is that our branch counts have been coming down over the last several years. Last year, our branch count dropped by about 5% of total branches. And we've said that we normally would see about a 2%, 3% kind of decline in branches. And that really is just because of the customer base is changing their expectations as to how they use the branch and are able to do much more self-service through the digital online channels for us. And so that we do believe we'll continue to create a source of additional expense reductions for us. Beyond that, we've continued to invest in modernizing our infrastructure, which allows us to gain additional operational efficiencies from having a much more straight-through type of processing, whether it's in supporting our private bank. A couple of years ago, our commercial loan servicing or some of the retail areas that we've been going through. We'll realize expense savings from those efforts as well. And the last piece really is just continuing to make sure that we can manage our third-party vendor costs and other staffing areas to make sure that we are getting as efficient and as effective as we can be with each of those spends as well.

Very good. And as we used to do when there is an in-person fireside chat, like we're having, we'd ask questions from the audience. And for people that may want to ask questions, again, you can do it through the webcasting, the box on the lower left-hand corner. Please forward your questions if you have any. Don, coming back to technology and what you guys have been doing, the Laurel Road acquisition, Chris mentioned on your fourth quarter call, you've been very pleased with how that is going. Can you share with us -- can that help also with the expenses as you maybe generate more business through that digital channel, so to speak, rather than having physical people in branches and making those types of loans?

We do think it can help in that area as well that as we see any loan or product origination, it is much cheaper for us to be able to fulfill that in a digital channel than it is person-to-person. And so we want to have that capability throughout the organization. And so there will be expense savings from those types of programs. But more importantly, I think, where Laurel Road will help us is that, we do have a strategy of being a relationship bank, and we do believe that through Laurel Road, we can really jump-start our ability to originate and service and maintain and grow relationships in a digital environment. And so we're learning not only just from the technology platform, but also from how that business works and how we can leverage that throughout the rest of the company and are very excited about the prospects from that side.

And speaking of technology in general, the very large banks always beat their chests about the tens of billions of dollars they spend each year in technology. And we recognize that those banks have to spend more because they're much larger organizations with global footprints. Can you share with us about your technology spending? How comfortable you're with it? Where has it kind of been directed at?

Sure, that. We've talked before about our technology spend in total about $700 million to $800 million a year, and about $200 million of that is on development of new products and services and capabilities through our technology area. About half of that really is for new business initiatives. And much of that is aimed at digital capabilities and origination. And so where we think we can compete is with this concept that we've teed up a little over a year ago at our Investor Day, which is targeted scale. And we're not going to be able to be a global institution, like some of the largest players are, and therefore, don't have the complexity that they will have. But what we want to do is make sure that we understand who our customer is, and how we can best serve them and make sure that we're making investments in technology or other capabilities that can address their needs and allow us to grow and expand those relationships. And so we think by keeping very focused on that targeted customer base, it will allow us to have sufficient resources and invest with the kind of pace to remain relevant and competitive and show strong performance as a result of that.

Very good. Circling back to your capital comment about being in that range between 9% and 9.5%. I think you said, you're at 9.4% for CET1 ratio. Any thoughts or comments on -- we finally received the finalization of the stress capital buffer, regulatory stuff. Can you share with us what you thought of it? And is there anything on the horizon that you're keeping an eye on for with the regulators?

Yes. I would say, as far as the stress capital buffer that it was consistent with what we would have expected as far as the release and their quantification of how it would work. And so that's good. And I would say that our initial interpretation of the ruling could give us additional flexibility in so far as the timing of capital actions as long as we remain within that capital buffer type of constraints. And so that, to me, could be a real positive for us. But up until now, it's been very set as far as the quarterly capital actions. And then unless you go back and resubmit a plan, it's difficult to get changes to that plan. And I think this could provide a little bit more flexibility there. So overall, excited about it. I think that it makes a lot of sense, and it's consistent with what we would have expected going into it. As far as other compliance regulatory actions that I would expect to continue to see the appropriate focus coming from the regulators as far as the safety and soundness. And we continue to see activity that would increase the attention around this space. And so we think that we're well prepared, and we'll continue to address concerns as they are presented there. So not fearful of anything significant changing, but it's something we'll keep our eyes on.

Very good. Generally speaking, KeyCorp is a company that has evolved over time. Can you share with us how you've seen that evolution? And what do you think sets you guys apart today from some of your peers?

Good. And one, as far as what's happened for Key. One is that I think the strategy is different for Key than it used to be. If you think about Key today, we are, again, very relationship-focused. I would say, historically, Key's reputation may have been one more of a deal-focused or transaction-focused. And that may sound like it's subtle, a small difference, but it means a lot as far as how the company is positioned and how we view success. And so I would say that's the first major difference. Second is that it's a completely different organization from a risk culture perspective that I would say that the risk profile of Key is significantly different than what it was 10 and 15 years ago. And we have intentionally managed out some higher risk portfolios. We've intentionally maintained discipline and rigor around our underwriting process and our credit monitoring process. And we think that will pay dividends for us through the cycle. And so we're excited about that. And the third thing is, I believe that Key has developed a much more intense focus on setting targets and delivering those. And so I think our execution has been much stronger than what it used to be. And I would say that's allowed us to make commitments as far as expense targets, as far as our integration with First Niagara. And not only deliver on them but oftentimes exceed. And I think each of those 3 have been a reflection of the leadership that Beth has provided over her 10 years, and that we're seeing continue with Chris going forward as that transition occurs. And it's been good to be part of that and see the evolution and growth of Key in all 3 of those fronts. And I think that's what will help us differentiate our performance going forward. This is it -- I think that we will show that, that rigor and commitment that maybe some of our peers won't be able to deliver against.

And speaking of targets and objectives, can you share with us what particular objectives, do you need to meet in order to achieve your long-term return on common tangible equity target of 16% to 19%?

That's an interesting question, especially with this lower rate environment, Gerard. Because as you know with the rates being down as low as they are, the investment portfolio valuation goes up and so does our capital. So that's the bigger challenge is. And as that plays through, I think we'll see that normalize. But I think, again, gets back to this objective that we have of delivering revenue growth and maintaining a relatively stable expenses and showing that improvement in the overall operating performance. We'll continue to drive on an organic basis that return on tangible common equity. But I would say that in 2019, if you would have just kept the mark on the investment portfolio, the same as what it was at the beginning of the year, throughout the year, we would have been in a ROTCE level that we've been right within our targeted range. And so it was more of the market conditions that drove the capital levels up that created the pressure as far as our ability to achieve that return target.

You bring up an interesting point, Don, is under what circumstances does it make sense to take some of those unrealized gains, especially in this bond environment? I know you'd give up some higher income, but is there any circumstance that you could think of that would prompt you to maybe to consider taking some of those gains?

Well, I would say that the challenge is that unless you are seeing the liquidity levels come down. So if you would have strong loan growth and have a need for sourcing that loan growth, it's tough for us to sell the securities and reinvest them at lower yields going forward. And so that's not something that I would favor doing, but it's something that we'll continue to look at as far as what's the risk profile of the assets. And the liquidity value that it provides and see if there might be opportunities down the road for us to reposition the portfolio from either an interest rate risk perspective or from a future cash flow perspective.

You touched on a moment ago about the transition from Beth to Chris, how is that going? Obviously, Beth officially steps down in May, if I recall correctly. And maybe any updates or color on that transition between the 2 of them.

Great. And the transition continues to go very well, that both Beth and Chris are still actively involved in the business. And you're starting to see subtle changes of Chris taking the leadership of certain meetings for the executive team, and Beth starting to step back a little bit on those. But it's been very well coordinated, both internally and externally. And I think both are pleased with how the transition is going. And, I would say, the company is as well, that it's great to be able to have Chris promoted and continue to maintain the strategy, the focus of the organization, and keep the company head in the same direction, which we're all excited about.

Very good. You mentioned, as we do as investors through the cycle, how will banks perform, in particular, Key. Again, you guys have talked about this in the past. How should we measure it as investors of a through the cycle successful bank. What are some of the metrics that you guys have your fingers on to measure that success?

Well, a couple of things that we would take a look at. One is the ability to generate positive operating leverage throughout the cycle. And what you've seen from Key is 7 consecutive years of positive operating leverage. And so I think that's something important for us to continue to maintain strong returns. Doesn't mean that we have to have the highest ROE in our peer group, but higher consistent returns for the company and something that's going to be important for us. I think a strong return of capital for our shareholders, both in the form of share price appreciation along with common dividend support. But as we look at a top performer, we look at other stakeholders as well as far as how does Key support the community, how does Key support the customers and our employees? And also, how are we managing things from a risk management and a regulatory perspective? And so we're looking at all 5 stakeholders as far as the shareholder, the customer, the community, the employee and also the regulators. And we want to be viewed as a top-performing company across the board with all 5 factors, which is critical for us.

We're running out of time. We've got a couple of minutes until you're done. This question, you've got an advantage over investors since you're inside the bank, of course. And if you were sitting in the audience as an institutional investor, with your knowledge as CFO, what kind of questions would you be asking bank management teams today?

Boy, that's a great question because I don't want to give them too good of a question because you've actually ask me that question. So I would just want to make sure -- and you alluded to this earlier, Gerard, is how do you feel your company is going to be differentiated compared to other banks. And I think too often that there's 2 things that would occur: one is, is that they lump all banks together; or two, they'll look at the past performance of the bank through a downturn and assume that, that continues to be a risk. And so I think that's the challenge. And I think that's where investors will be able to differentiate their performances to better understand and maybe you could get a look below the covers, so to speak, to see who can truly differentiate through the next cycle.

Well, that's great. We've run out of time. And I want to really thank you. It's been a privilege to have you and Vern here. And I really appreciate you guys joining us today. And we will be talking to you, obviously, on the earnings call. So thank you, again.

Well, thank you, Gerard, for hosting the conference, and very much appreciate the opportunity to participate. Thanks, again.

You're welcome.