KeyCorp (KEY) Earnings Call Transcript & Summary

Moving right along, very pleased to have KeyCorp with us this afternoon. Before we jump into KeyCorp, just some housekeeping. On the left-hand side of your screen are some audience response questions where you can respond, click on an answer. You click next on the top of the screen for the next question. It's about 4 questions, and time permitting, we'll go through the answers at the end, same way we've done in prior years. [Operator Instructions] Next up from KeyCorp, very pleased to have Chris Gorman, Chairman and CEO; and Don Kimble, Vice Chairman and Chief Financier. And with that, let me turn it over to Chris.

Well, thank you, Jason. We appreciate the opportunity to be part of your virtual conference this year, and we certainly look forward to being back in person at some future events. As Jason mentioned, Don Kimble, our Chief Financial Officer, is here with me today, and he'll participate in the Q&A. On Slide 2 is our statement on forward-looking disclosures and non-GAAP financial measures. It covers our presentation as well as the Q&A that follows our formal remarks. I am now turning to Slide 3. Throughout the pandemic, we have continued to maintain strong operational effectiveness, which has allowed us to proactively support our teammates as well as reach out to our clients and provide them with capital and advice. I am especially pleased with the performance of our team and the collaboration across our company. One great example of our performance is the Paycheck Protection Program. This was a time that our clients really needed us. And when it mattered most, our team did their best work through a highly focused and coordinated support effort including technology and specifically, RPA, Robotic Process Automation, we were able to achieve one of the highest approval rates with 90% of requests completed in the first wave and over 40,000 applications processed in total. We were competing with regional banks as well as the largest banks in the world, and we clearly demonstrated our ability to deliver for our clients. This was a time when, frankly, many banks struggled. There are learnings from PPP that will further strengthen our competitive position going forward. In addition to managing through the current crisis, we are also focused on making the right long-term decisions for our business. I often refer to this as our dual mandate. On the right-hand side of the slide, we have identified our priorities for driving future growth. We have built a company that is strong, resilient and well positioned. It all starts with our distinctive relationship-based strategy. We have built scale in a very targeted way by knowing who we want to do business with, how we win in the marketplace. A key element of our strategy is to maintain our moderate risk profile. This is an area where we have made significant progress since the financial crisis and I'm going to spend more time on risk and credit quality later in my presentation. We are continuing to advance the pace of digitalization across our company. The current crisis has greatly accelerated our transformation probably as much as 5 years. One data point. Over the last few months, we have seen a 3x increase in first-time digital deposits with a number of customers using our digital capabilities for the very first time. We have also seen a 50% year-over-year increase in digital sales. Clearly, this is an area of growing importance to our clients. And as such, we will continue to make investments. We will also maintain the energy we have around serving our relationship clients, both commercial and consumer. On the consumer side, we made a leadership change as we continue to position the business for future success. I'm also very excited about our new growth engines, specifically Laurel Road and consumer mortgage. We will continue to invest in these businesses and support them to drive continued growth. On the commercial side, it is really more about continuing to do what we do well. Over the years, we have built a leading commercial investment bank focused on middle market clients in our 7 industry verticals. We are able to offer clients actionable advice and solutions, along with a full complement of products and services. Expense management also remains an area of focus. We will continue to foster a culture of continuous improvement, balancing cost savings and the right investments in technology and talent. The current environment provides expense saving opportunities such as occupancy, branch network expense, and importantly, continuing to leverage technology throughout our entire organization. We are also disciplined in the way we manage and deploy our capital, focusing both on the return on and the return of capital. And importantly, we remain committed to achieving our long-term targets listed on the bottom of this slide. The way we have positioned the company will benefit us through the crisis and position us for success as we go forward. I'm now moving to Slide 4. As I said, we have significantly reduced our risk profile over the past decade by focusing on relationships and being very targeted in who we do business with across our consumer and our commercial businesses. The composition of our loan portfolio and focus on credit quality positions us well as we move through this period of slower growth and significant economic uncertainty. As you can see from the slide, our loan portfolio is approximately 3/4 commercial, 1/4 quarter consumer. Our commercial portfolio is focused on middle market and institutional clients in our 7 industry verticals, where we have experienced bankers and industry expertise. We can offer those clients both on- and off-balance sheet financing solutions. Over the last 12 months, we have placed with others approximately 85% of the capital raised for the benefit of our clients. Importantly, around 50% of our C&I portfolio is investment grade. Clearly, a distinguishing characteristic relative to many of our peers. Our consumer business targets super prime clients, where we benefit from a local presence and a strong digital offering. As I mentioned, we have 2 significant growth opportunities within our consumer portfolio, Laurel Road and our consumer mortgage business. The second quarter was a testament to the opportunity those businesses provide to us with record mortgage originations of over $2 billion and continued strength in Laurel Road loan production. I'm now moving to Slide 5. This slide highlights 2 important metrics around supporting our clients and maintaining our credit quality. Importantly, the slide further depicts Key's relative performance to our peers. We recognize that there remain many unknowns in this environment, and our industry continues to face challenges as we deal with disruption caused by COVID-19. However, our credit quality measures overall have continued to perform well, and credit migration has been consistent with or in some cases, better than we had projected. As of June 30, loans subject to forbearance were about 2% based on the number of clients in both commercial and consumer businesses, and this represents approximately 4% of commercial loan balances and just over 5% of consumer loan balances. As you can see, we compare favorably to our peer group. To date, we have received a modest number of second round requests. We have also been tracking favorably to our peer group with respect to our percentage of criticized loans. At the end of the second quarter, we were the lowest in our peer group that we could readily identify through external disclosures. When -- as we look at that measure. We believe our strong underwriting and focus on high-quality relationship business in both our consumer and commercial segments support these results and underscore the true change in our risk profile since the financial crisis. We feel well-positioned as we move through this challenging economic environment. I'm now turning to Slide 6. As I said, the current crisis has greatly accelerated our digital transformation, and we continue to make smart, targeted investments to digitally transform our company and to drive both growth and efficiency. Today, roughly 1/2 of our annual technology development spend is devoted to new business capabilities and client-facing digital enhancements. Clients of all sizes are demanding seamless, data-driven, well-designed experiences, and we are investing in a targeted way to meet their needs. Over the past few years, we have introduced new client portals for each client segment, featuring a better user experience and a higher level of self-service capabilities. We are also leveraging software and data more broadly to advance our business. We are modernizing our core systems, creating intuitive employee tools, developing straight through end-to-end processes and expanding our cloud infrastructure. This drives efficiency and also allows our employees to spend more time doing value-added work like spending time with our clients. Our approach is yielding results. As you can see on the slide, our increase in digital deposits both in absolute terms and as a percentage of total deposits. From a digital perspective, we remain focused on our targeted relationship strategies. This is not a digital deposit gathering mechanism. We are not out there chasing expensive funding, but rather following a targeted approach with our relationship, clients and prospects. Targeted scale is something that we've talked about a lot here at Key over the last several years, and the healthcare industry is a great example. With our acquisition in April of 2019 of Laurel Road, a born-digital company, we are able to serve our healthcare clients in a robust and differentiated way. Our acquisition of Laurel Road has exceeded our expectations with originations of over $3 billion since closing. The quality of our originations continue to be very high. The average FICO scores of over 790 in the most recent quarter. Affinity partnerships have also grown significantly post-acquisition. By targeting medical professionals, we are adding high-quality clients with the ability to expand those relationships going forward. We are also integrating Laurel Road's capabilities into other parts of Key. Laurel Road's engineering team have successfully built end-to-end cloud-based home lending software that will enhance the client experience and reduce origination and servicing costs for both consumer mortgage and home equity. Laurel Road is another example of our ability to buy entrepreneurial companies, integrate them and successfully leverage their expertise across our entire enterprise. I'm now moving to Slide 7. One of the strengths of our companies -- of our company is our disciplined way that we manage capital. At the end of the second quarter, our common equity Tier 1 ratio was 9.1%, which falls within our targeted range of 9% to 9.5%. We believe that operating within our targeted range provides us with the sufficient capital to support our customers to support our businesses while concurrently allowing us to continue to return capital to our shareholders. On the bottom of the slide, you can see that we have returned a large portion of our earnings to our shareholders in the form of dividends with a 7-year compound annual average growth rate of 19%. Disciplined capital management will continue to be a focus. Our stated capital priorities are as follows: first is to support our business' organic growth; the second is dividends; and the third is share repurchases. In July, our Board of Directors approved a third quarter common stock dividend of $0.185 a share, which was consistent with our second quarter dividend level. We remain committed to maintaining a strong level of capital and returning capital to our shareholders. As we look forward, we believe that our capital and earnings outlook will continue to be support ongoing dividends, subject, of course, to the approval of our Board of Directors. I'm now turning to Slide 8. I will close my formal comments by restating my confidence in our team, our competitive positioning and our ability to achieve our long-term financial targets. We remain committed to the following: first, maintaining our moderate risk profile and proactively managing credit risk; secondly, we are committed to growing organically by focusing on targeted clients and prospects; third, we remain committed to continuous improvement, while concurrently investing in our business. Digital will clearly be a big part of that investment. And finally, we will remain focused on both the return on and the return of capital. With that, I'd be happy to open up for questions and take it from there.

Chris, I appreciate that. I guess I'll ask the first question actually from the audience. But -- and before I ask the audience question, just a reminder for those investors listening in, you can submit questions in the upper left hand part of your screen. Also please participate in the audience response polling questions. If we don't get to them during this session, we will publish results on -- this evening. But the first investor question goes, Chris, your presentation kind of reiterated your long-term targets, but didn't include any third quarter earnings guidance, would you want to update that? Or how are you and Don thinking about that?

The way we're thinking about the third quarter. First of all, thank you for the question. The way we think about the third quarter, our guidance is unchanged from that which we talked about at the end of the second quarter. The balance sheet remaining relatively flat will increase a bit in terms of our net interest margin. Our noninterest income will be down on a linked-quarter basis.

Just to highlight that, I would say that what we're seeing is strong deposit growth, a little bit stronger than what we would have expected, which is putting a little pressure on the net interest margin, but revenue trends continue to be fairly consistent with what we would have expected. Fee income is a little stronger for some of the fee categories that we had seen growth in before, with probably mortgage coming in a little higher than what we would have expected. And also some of the cards and payments-related revenues. Offsetting that though is that some of the cards and payments-related revenues are also driving a little bit higher levels of expense, but Chris is right that in total, we feel comfortable with what the guidance range implies and you'll see a little bit of variability from line item to line item.

Helpful. I say -- and maybe just delve into a bunch of the stuff that was talked about so far and maybe a bit more in terms of just credit quality and where are you seeing deterioration of the portfolio? And what are you seeing in terms of credit migration?

Sure. So we've identified certain areas, Jason, where we've talked about before, where there's the most pressure. Obviously, things like hospitality is where you would see the greatest amount of pressure. Retail has some pressure, but for us, that's a very small portfolio, and we've also identified oil and gas. We have about a $2.4 billion portfolio there that we've identified as being a portfolio that we have our eyes on. What we always think about, whenever we are in an environment like this, is we always focus on portfolios where there's leverage because any place where there's leverage by definition, there's risk. And so we have a very bright light under not only the watch areas that we've talked about before, but we also continue to look very closely at our leveraged finance book, which is about $2.4 billion in size, which is holding up really well. And we also spend a lot of time looking at our real estate book, which to date, has held up extremely well.

Helpful. I guess, so I'd point out, your ACL is at the low end of peer group. How do we think about further build to that loan loss reserve in the back half of the year in light of what you just said?

Sure. So let me start. We obviously think we're adequately reserved. And as you can imagine, we spend a lot of time modeling all this. If you just step back, one of the things that I think is really important is to talk about how we have de-risked this company over the last 10 years. There's no question that 10 years ago, we had pro-cyclical losses in real estate, principally, but we have de-risked our company across the entire company. And so as we look at where we're positioned, as we look at the fact that we're 75% commercial, 25% consumer. As we look at the fact that our C&I portfolio is 50% investment grade. And then you have other characteristics as well, for example, we have a relatively small credit card portfolio, which obviously has high loss content. So we feel very good about where we're reserved. Don, would you add anything to that?

I would just say that there's a couple of areas that would cause the reserve to go up. One is the economic outlook changes and gets worse. And no ability to predict what's going to happen as of the end of this month because we've seen volatility before, but through the current month, what we're seeing is an outlook that's fairly consistent with what we would have used back in the second quarter. And so we're not seeing a huge shift there. Probably the near term performance, whether it's GDP or unemployment, slightly better than what we would have assumed. Longer term, the assumption is they might be a little worse, but generally kind of balanced. The second area would just be the mix of the portfolio, the migration of the portfolio. And what we've seen, and Chris alluded to this earlier, is that we're seeing migration that's equal to or slightly better, in some cases, than what we would have modeled back in June. And so we're not seeing any signs yet that would suggest there should be any significant changes one way or the other as far as the overall reserve levels, and we're pleased with where we were reserved as of June 30 and don't see that changing materially at this point in time.

Got it. And just maybe delve a bit more into loan growth and maybe just aggregate into commercial and the consumer side in terms of what you're seeing, what your expectations are?

Sure. With respect to loan growth, we would anticipate that commercial loan growth would be relatively flat, Jason, for the balance of the year. As everyone knows, we saw an increase in utilization of lines. Those have basically come down to sort of pre-COVID levels. There is just not a whole lot of huge financing activity. So although in the past, we've always been a significant grower in C&I loans, I don't see that happening for the balance of the year. What I do see happening, which is sort of new for us, is to have these 2 growth engines that I mentioned in my comments. First of all, Laurel Road, which generated about $700 million last quarter. And also our commercial mortgage business, which at $2 billion last quarter, is about equal to what it was just a couple of years ago in terms of loan origination. So those would be the 2 areas where I think we will see growth on the consumer side, but I think on the commercial side, I'm looking forward to be flat through the balance of the year.

Helpful. Then maybe shifting gears. If -- what's the impact to Key if interest rates remain low for an extended period of time and the curve is relatively flat?

Yes. And maybe I'll go ahead and take a crack at that, Chris, but as far as the low rate environment, we clearly are experiencing that today. Some of the things that we've talked about before is we have a fairly modest interest rate risk for further rate declines. Keep in mind, too, that we have a high percentage of our loan, commercial loans with floors embedded in them, with 70% of those loans would have LIBOR floors, and so that's going to be helpful for protecting that margin compression going forward. The other levers that we have compared to some of our peers is that our deposit rates were elevated. We had programs in previous years that provide for some promotional rates that were locked in for upwards a year. And so we're seeing those roll-off. And we've talked last quarter end about seeing about a 15 basis point or so decline in the average interest-bearing rate paid on deposits, and we're seeing that come through this quarter, and so that could be helpful for us as well. And so while it is challenging for the industry, we do believe that we're positioned as well as peers from that perspective.

That maybe dovetails into -- next with the question we have from the audience, which I'll read is, could you discuss the swap portfolio and when we will see peak contribution from the $17.6 billion in swaps and a $7.8 billion in purchase floors. How does management expect to address this swap roll-off in terms of replacing NII contribution? Note that it goes unpunished.

Well, keep in mind, too, that our loan portfolio is highly variable. And so many of our peers would have more of a balanced mix between fixed and variable. And so part of that swap book that we've had in place really is to manage the overall balance sheet positioning, not specifically for that run-off of swaps. I would say our swaps, in general, have about a 2-year life that we do have -- some swaps are tied to debt issuances. And so those would tend to be a little bit longer life for those. And then on the floors, they tend to be about 2 to 3 years. And so we continue to reflect that as part of our impact in the overall asset sensitivity, and we don't have a. Lot of maturities coming off that book yet this calendar year.

Got it. Maybe just shift gears to the expense side, in an environment where revenue is under pressure. Maybe talk to -- does Key have any expense levers left or maybe wondering if some of your top opportunities and just how do you balance that against the need to invest in technology?

Sure. So I'm of a mindset that there's always opportunities to find expense opportunities. We are a huge believer, from a cultural perspective, in continuous improvement. And if you look back over the last several years, probably every year, we have taken out 3% to 5%. And I think there's a huge opportunity to continue and a responsibility to continue to take out expenses because that really is the raw material then, to your point, Jason, to invest in digital, to invest in other things that we want to invest in. And so as you look forward from the pandemic, I think there's some -- actually some new areas where we can make some significant cost savings. One is just occupancy. I mean, the world has changed. We all know that. And I think there's opportunities in occupancy. I think as you look at our branch network, last year, we consolidated 61 branches. This year-to-date, we haven't consolidated as many. We've consolidated 21, but I think there's an opportunity to continue to ramp that up. And I think there's a real opportunity to invest in technology. In technology, you kind of win on both sides of the equation because the ability to use technology to take out costs, and it's a better experience for your teammates and for your customers. So we will always talk all the time about pulling both levers. We will never stop looking for expenses. Some of those expense opportunities actually make us a better company and makes us easier to do business with.