KeyCorp (KEY) Earnings Call Transcript & Summary

Up next, we are once again happy to have KeyCorp. Key entered the downturn in a position of strength, driving positive operating leverage for 7 straight years, and thus far, has been successful in changing the narrative around its risk profile, which has much improved since the last downturn. More recently, focus has shifted to enhancing its digital investments and driving growth on the consumer side across both mortgage and Laurel Road, 2 initiatives that we look forward to hearing more about today. Joining us from KeyCorp is Chris Gorman, who is a veteran of the GS Conference, but he joins us today for the first time as Chairman and CEO. Also joining him is CFO, Don Kimble. So with that, I'm going to turn it over to Chris for a -- he's going to make some opening remarks, and then we're going to get into Q&A. Chris?

Great, Ryan, and thank you. It's great to be part of your conference again this year albeit in a little different format. We look forward to being with you in person next year. On Slide 2, you'll find our statement on forward-looking disclosures and non-GAAP financial measures. This covers my remarks as well as the Q&A. Most of the time this morning will be devoted to your questions, but I wanted to kick it off with just a few comments if I could. I'm now turning to Slide 3. This slide highlights some of our past accomplishments, but more importantly, focuses on the future, our strengths, our business model and our path forward. Key is uniquely positioned to grow, generate strong returns and achieve our long-term financial targets. It starts with having an outstanding team. Despite the challenging environment, I could not be more pleased with how the team has responded and the collaboration that has taken place across our company. We have maintained strong operational effectiveness, and most importantly, we have been there for our clients during the most critical times. The Paycheck Protection Program is a great example. Through a highly focused and coordinated effort supported by technology, 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 have continued to work with our clients, providing capital and advice to help them bridge through these challenging times. One of the things that sets Key apart is our unique relationship-based business model that continues to drive growth in both our commercial and consumer businesses. On the commercial side, we have built a strong leading commercial and investment bank, focused on middle-market clients in our 7 industry verticals. We have built scale in a very targeted way, which has resulted in Key being a leader in a number of high-growth areas. And I thought I would just mention a few that many of you are probably not that familiar with. In the important area of renewables financing, we ranked #1 in North America, according to Dealogic. In health care, we are one of the top advisers to facility-based health care providers. In commercial real estate, in each of the last 5 years, our affordable housing business has ranked in the top 5 nationally by volume according to Affordable Housing Finance. By the way, we think affordable housing will continue to be a high-growth area within real estate. Another one of our focus areas is our commercial mortgage servicing business with servicing assets in excess of $350 billion. By the way, that positions us in the top 3 in North America. We also are the named -- in addition to that, we're the named special servicer on $120 billion of special servicing. We -- that's where we provide strategic advice and generate fees for overseeing restructuring situations. This obviously is a countercyclical advisory business. The other thing our servicing business does for us is it gives us a unique insight into the market. Simply stated, we have been most successful where we have been most focused. On the consumer side, we made a leadership change earlier this year as we continue to position the business for success. I am excited about our new relationship-based growth engines, Laurel Road and consumer mortgage, which combined will generate approximately $10 billion of loan originations this year, well ahead of our expectations. We will continue to invest in Laurel Road and our consumer mortgage business to drive continued growth. Critical to the success of both our consumer and commercial businesses are the investments that we continue to make in digital. When I speak of digital, I mean front office to back office, creating an excellent experience for our clients and our teammates. As client preferences evolve, another aspect we continue to monitor is our branch network. In recent years, Key has consolidated on average 2% to 3% of our branches. We plan to accelerate this pace in 2021. We will discuss further details of our branch consolidation plans in our earnings call in January. Importantly, we will recognize cost savings associated with these closures. And due to the proximity of other branches, we do not expect material client attrition. A significant shift in client behavior has occurred and it's occurred rapidly. The pandemic accelerated consumers' move to digital, and much of this adoption, we believe, is permanent. Last quarter, we saw 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 to advance the pace of digitalization. One great example of how we have accelerated our digital transformation is our acquisition of Laurel Road, a born-digital company serving medical professionals. Laurel Road will generate around $2 billion of originations this year, and we have been leveraging their platform across other products such as consumer mortgage. One update that I'm pleased to share with you this morning is how we're leveraging the success and growth of Laurel Road. You've heard us speak of our plans to build a unique national digital affinity bank targeted specifically at health care professionals with whom we can build broader digital relationships. Just to remind you, these are high quality, high FICO score, high average income, digitally savvy clients to whom we know we can be relevant. We plan to roll out this national digital affinity bank formally at the end of the first quarter of 2021. With the right combination of technology and talent, we remain confident in our ability to grow revenue and deliver positive operating leverage. One of the headwinds our industry faces is the current rate environment. We have used a combination of on and off-balance sheet strategies to mitigate the impact of decline in interest rates. We will continue to reposition the balance sheet, including the use of hedges as the cycle unfolds. Our business model is -- uniquely positions us to grow fee income, which currently makes up around 40% of our total revenue. Despite the challenging backdrop, we have grown noninterest income on a year-over-year basis. We are well positioned to continue to grow our fee income businesses, and specifically, I'm referencing investment banking, payments and our consumer banking business. We also remain committed to disciplined expense management, and continuing to foster a culture of continuous improvement, balancing cost savings and the right investments in talent and technology. Over the past several years, we have reduced expenses by 3% to 5% annually, including $200 million of cost savings we recognized just last year, a portion of which we reinvested back into our company. Foundational to everything we do is having a strong balance sheet and maintaining our moderate risk profile. We have significantly reduced our risk profile over the past decade by focusing on relationships, and once again being very targeted in who we do business with. Our credit quality remains strong. Our exposure to COVID-impacted sectors is very modest. To date, these areas have performed in line or in many instances, better than our expectations. It is also worth noting that for the past 2 quarters, our criticized loans as a percentage of total loans have been among the best in our peer group. This is a reflection of both our business model and our concerted effort to derisk our business following the global financial crisis. Lastly, we have and will continue to be disciplined in the way we manage and deploy capital, focusing both on the return on and the return of capital. Our stated capital priorities are as follows, they're unchanged: support organic growth, dividends, and then share repurchases. Importantly, we remain committed to achieving our long-term targets listed on the bottom of the slide. We have positioned the company to both successfully navigate the current crisis and for growth and success in a post-COVID-19 world. With that, Ryan, let me conclude my remarks, and we're happy to take Q&A.

Thanks, Chris. I was just getting my audio and video back up here. So thanks -- thank you for the prepared remarks. Maybe just start with a couple of big picture questions before we dig into some of the details. You've been with Key for a long time, over 2 decades. You've now been CEO for around 7 months, and you gave us a handful of things that you're focused on here. Can you maybe just talk about some of your learnings over the first year in the job? And maybe how of your -- how have you shifted the priorities of the bank during 2020?

Sure. So I think the biggest learning is the resiliency of both our team and our clients. Starting with our clients as we always do, our core business has just a lot of momentum. And so our clients who are dealing with the same things you and I are, Ryan, I think it's really been resilient. Our team obviously has been resilient. And I think we've done a good job. And I measure that by what I call executing on our dual mandate. One, getting through the crisis. It's a real crisis. It's a humanitarian crisis. It's a health crisis. It's an economic crisis, and we're dealing with that. But I think it's really, really important that we position -- concurrently position the company for success. And I think the team has done a really good job of doing both. And as I look forward, I want us to be completely focused on -- staying focused on the client, that's first and foremost. The next thing is this whole notion of continuous improvement. I think that's really, really important because, frankly, that's the raw material for us to continue to reinvest in the business. The next thing is delivering on our commitments. And our biggest commitment right now is we've committed ourselves that we are going to outperform our peers from a credit perspective in this credit downturn, which is something that I know the markets had their eye on for some time. We're focused on that. And then lastly, just to be really good stewards of capital. And that goes back to what I just mentioned, that's both the return on and the return of capital. So that's been a huge learning for me in this process.

So Chris, you and I met in August, and you had mentioned that the pandemic had accelerated digital adoption by up to 5 years across certain products. And it seems like you're poised to accelerate some digital investments, particularly on the client-facing side. You highlighted the digital affinity bank for medical professionals that you're rolling out at the end of the first quarter. Can you maybe just talk about what are some of your priorities on the digital side? Where are you ahead of the pack? Where do you need to make more investments? And second, do you have enough investment capacity within your budget to make the necessary investments that you need to make?

Sure. So the premise of your question is absolutely right. The pandemic, Ryan, at least here at Key, completely accelerated the move to digital. We now have 1.8 million clients that are digitally active. That's about 60% of our entire universe. Going to your question on leadership, I would really point to Laurel Road. Laurel Road, I think, is a differentiator. I think it distinguishes us from others. It's a born-digital company that has successfully launched a very successful product, i.e., refinancing of student loans in a very focused way for doctors and dentists and now we're really migrating that from a product operation to a business as we go after medical professionals. That business has 30 full-stack engineers, for example, that work really well together, that have built something from the ground up. And I think that's unique. And I think that's a complete leadership position for us. We always talk about targeted scale. And for us, that's where it always starts. We start, first, with the client. What are the needs of the client? And then how do we put together the right combination of people and technology to get that done. And then to your last point, we clearly have the investment dollars that we need to make the kind of impact that we want to. And so I don't look at that as a constraint. What I look at as the constraint is, are we focused enough? Are we making sure we're spending the dollars where it really matters? And then what's the outcome? And as I said -- as I think about things like new -- net new households, we just had the strongest quarter that we've had since our First Niagara acquisition. So I think we're aiming the dollars in the right place.

Got it. You've mentioned numerous times targeted scale, a concept that you rolled out at the Investor Day several years ago with the whole notion of not needing to be everything to everyone, but instead really focusing in on the areas where you want to play, you highlighted a handful of them in your prepared remarks. Where are you seeing the most success with this strategy? And where are the areas that, as we look forward, you're looking to further enhance to drive greater scale across your business?

Sure. So as kind of a backdrop, we are absolutely most successful where we're most focused. And I don't think that's unusual, but a lot of organizations aren't really that focused. I think it's so important to know how you win, where you win and why you win. And that's something we're constantly pressure testing. You mentioned both Laurel Road and the Payroll Protection Program. I think PPP is a great example of that. It was a Sunday afternoon that we had 850 people on the line. There was a real need by our clients. We figured out basically how to, one, reach out to our clients; how to interpret what was coming out from the SBA; and then importantly, how to integrate that with robotic process automation so that we could help our clients succeed there. So that would be an example obviously of targeted scale. Other areas where you've seen us invest, and I think we're -- in retrospect, we're really, really good investments and fit in with targeted scale, Pacific Crest Securities, which obviously is focused on technology. As we think about our markets business, that was a really important acquisition. Cain Brothers, which, as I mentioned, is a leader in facilities-based health care advisory. It's interesting, Ryan, this dislocation in health care is going to really, really accelerate the whole consolidation of hospitals, huge doctor groups, et cetera. Then there's other areas where targeted scale, and I actually mentioned a few of them in my opening remarks, but businesses that we've built from scratch that we didn't buy, like our affordable business, which we weren't in 5 or 6 years ago; renewables, which we started from scratch based on our power business. And so I just think -- I think there's always areas where we're looking for niches that are underserved. We're trying to grow some of those organically. And we also, as you can well imagine, have a hit list of if certain businesses became available, we would be interested in buying them. When you think about our ability to identify, buy and integrate these entrepreneurial companies, whether it's Laurel Road, whether it's some of these fintech partnerships, whether it's Cain Brothers and Pacific Crest, I think that's a unique skill. And it's a tricky thing because if you don't integrate these businesses, frankly, you have negative leverage because you have the overlay of being a huge regulated bank. And if you over integrate them, so to speak, you destroy what you just purchased. So we feel confident that we can grow both organically and inorganically around targeted scale.

Chris, you -- on the last earnings call, came out and talked about your ability to deliver positive operating leverage into next year, which we'll come back to. But you mentioned in your prepared remarks that you had been reducing branches 2% to 3% per annum, but given all the accelerating trends in digital, you're now doing a deeper dive on the branch network. I know you're going to give us more color on this in January, but can you maybe just help us understand the framework you're using to approach this? Should we think about this as just being additive to the 2% to 3%? And is this more transformational in terms of really repurposing the branch network? And then second, what are some of the other areas you're looking to use to reduce costs outside of branches to help you generate that positive operating leverage?

Yes. So let me first speak to the branches. And I'll just give you a little bit of a historical context. We had 1,200 branches. We bought First Niagara. We went up to 1,600 branches. Today, we have 1,077 branches. And so we feel like we're pretty good at consolidating branches. We think we understand it. At one point, we thought that having a thin branch network in certain parts of the country, we thought that was actually a negative. I think when you look at the future, which is some combination that, by the way, I don't think anyone has figured out the perfect combination yet of digital and branches, we think actually having a thin branch network is an advantage. So as we look into 2021 and when we speak at the January call, I think you'll see a real step-up from the 2% to 3%. I think there's opportunities there. We have a very specific game plan that we'll roll out. And just as -- and what drives that, by the way, of course, is client preference. And so the reality is clients would rather have a frictionless experience on their phone for everyday transactions and go in and be able to talk to someone at a moment of truth, whether they're buying a house, planning for retirement, sending a kid to college. So that's what drives that. Similarly, on our team side, we have a lot of real estate. And the reality is there will be a significant number of people that will be working from home permanently. And similarly, on the nonbranch real estate side, I think that too represents an opportunity.

Got it. Before maybe we get into some of the operational trends of the business, maybe just to start with a short-term focus, I want to see if you wanted to take this opportunity to just provide an update on how the quarter is progressing and any updates you wanted to give before we move in to [ why it's early ].

Sure. We will have -- we'll have another successful quarter here in the fourth quarter at Key. We had provided guidance as to the quarter. I think our guidance around average loans and deposits will be right what we've been -- in the area that we talked about. I think as you look at net interest income, that will come in where we've guided to. I think where you'll see an improvement is noninterest income, and that will be driven by our investment banking business principally. I think we will perform better than we had otherwise provided guidance. And of course, the corollary to that is on the expense side, we had talked about expenses being down low single digits. Obviously, as the investment banking business is outperforming, there's a variable cost component of that, which will increase the expenses, as you can imagine. But most importantly, from a credit perspective, Ryan, we are performing exactly in line with where we thought we would be. And as you know, in this part of the cycle, that's the biggest driver of returns and financial performance.

Chris, maybe just on the back of the last comment, given that credit is performing in line, is -- should our expectation be that most provisioning from here is going to be from -- loan growth-driven? And are we at the point yet where we could start seeing reserve releases actually coming through?

So I think -- not until, Ryan, that we see a real confidence and stability in the economy, I don't think you're going to see a lot of reserve releases. Having said that, I think it's important to note, in the third quarter, we had $100 million qualitative overlap just based on the uncertainty. There were a lot of questions out there. As you well know, there's really 3 drivers of provision under CECL. The first is economic outlook. The second is credit migration. And I can tell you, our credit migration has been to date better than we would have thought. The third is loan growth. What our modeling is currently showing us, by the way, is that we will be in the 55 to 65 basis points of charge-offs really for the next few quarters. Further, we think that it will probably peak -- it being charge-offs, will probably peak sometime in the second or third quarter of next year. So those are the variables, and we'll see how it plays out.

Got it. Helpful. Chris, there's obviously a lot of uncertainty out there and you've been clear that loan growth is likely to come from the consumer side of the business in the near term. Just maybe thinking ahead, I know you'll give us guidance on the next quarter call, but just how are you thinking about loan growth across consumer versus commercial? And really, what's the mood of your commercial customers at this point? What are they looking for out of the economic backdrop to really begin to borrow? And are there strengths that you're seeing across your 7 verticals?

Sure. So let me start with commercial. And I think you can expect commercial loans to be somewhat muted, at least in the near future. Our clients have frankly a lot of liquidity. Our utilization rates are below what they were prepandemic. Having said that, I think the mindset of our customers is improved. And I think it's improved just from the end of the last quarter. So you have obviously the path of the virus, which is clearly a negative, but you also have the election behind us. You have obviously the vaccine. And one of the things that I always look at is what is going on in our M&A business. We had had a real sort of log jam in our M&A business in terms of things coming out of the pipe. And all of a sudden, people are starting to get visibility, and those deals are starting to come to fruition right now. And so I think people have sort of moved on and are looking ahead. As they look ahead, I think we're well positioned to get commercial loan growth. I think when people start restocking inventories, I think we'll finally get some of the utilization. I don't think that's going to happen for the balance of this year or even at the beginning of next, but I do think we're well positioned. Some of the areas where I think there'll be sort of outsized loan growth, I think you'll see it in health care. I mentioned earlier, I think there's going to be very significant transaction activity in health care. I think renewables, if you think about the new administration and the focus on renewables, I think that's going to be an area where there's going to be a lot to be done. And similarly, I think affordable housing will be a great area. In your question, you mentioned that you thought we would probably get most of our growth out of consumer, and we will. I mentioned in my remarks, if you look at our businesses of Laurel Road and our mortgage business, neither one of those -- well, our mortgage business existed, but it was less than $2 billion 3 years ago. And Laurel Road, we didn't own. So we've gone really from absolutely a standing start in those 2 areas to businesses that can generate originations of $10 billion. I would expect both of them to continue that trajectory. And you can rest assured, we'll continue to invest in those businesses from a technology perspective and a focus perspective.

Got it. Maybe a question for Don. I don't want him to feel left out here. But you've done a great job protecting the bank from net interest margin headwinds. Chris talked about the use of derivatives in his remarks. However, rates are likely to remain low, and you have a handful of swaps rolling off over the next 2 years, which will create NII and revenue headwinds. I think you've said recently, you expect the margin to settle in low 2.60s. Can you maybe just talk about some of the levers you have to offset NII headwinds whether it's deploying liquidity, reducing deposit costs beyond the levels you talked about? Maybe just touch upon some of the levers and the degree of confidence you have in that stabilization.

Sure, Ken. And I think you've been on a few of them already. One, I would suggest that, we've talked about it, is the benefit from repricing our deposits. We've talked about in the fourth quarter of this year, we would expect to see our deposit rates come down by 6 to 9 basis points, which will provide some support from that perspective. Longer term, we do think that we'll see our balance sheet remixed. But right now, we're -- we, in the industry, are burned from low rates, but also burn from excess liquidity, and both of those put pressure on NIM. And we would expect over time from some of the loan growth that Chris has talked about, whether it's consumer side or commercial as we start to see some increases in the utilization rates, we would expect to see a remixing of the balance sheet, which would help provide some additional support there. And then also with the loan growth, we're continuing to see a little bit better pricing of loans than what we did say a year ago. And I think that will also provide some support. And so I think those are the primary levers, just with the continued reset of the deposit rates, with the remixing of the balance sheet, with a little stronger spread on the new loan originations.

Got it. Chris, you announced your decision to exit indirect auto, despite it being a decent driver of growth. And I think you cited it was a one-product relationship, and it was -- it's harder to integrate with it into the bank. Was this part of a one-off decision or part of a broader review of the bank? And talk about how something like this fits in with your strategy regarding relevant scale and relationship banking. And how do decisions like this help you eventually achieve that longer-term target of 16% to 19% returns?

Sure. So first of all, we are absolutely committed to the concepts of relationship banking and targeted scale. So we always talk about being focused on where we can effectively compete and where we can win. And we look at every one of our businesses through that lens, Ryan. And as you look at this business, that being indirect auto, while it's a good book, the book performs well, if you look at it through the lens of, are you unique? Ask that question. Can this become a relationship? That's another question. And are we getting the kind of returns that we want to get? And for us, for that business, frankly, the indirect business doesn't check any of those boxes. The other thing that I will share with you is any business we're in, we want to be a significant player in, which means you have to invest in technology, you have to invest in people. And based on what I just shared with you, that was just not a business that we particularly wanted to invest in. The other thing to keep in mind is we had the luxury of these 2, what I call, growth engines, both Laurel Road and our consumer mortgage business that are originating around $10 billion a year, and our indirect auto business, that originated about $1.5 billion a year. So it wasn't as though we were too concerned about making up the difference and doing so in a relationship way. So we're focusing our attention and our capital on places where we can bring these high-value life of customer clients on to the platform.

Chris, you mentioned capital there and earlier on, you laid out your capital priorities. You're at the high end of your stated goal of 9% to 9.5%, and you're poised for that to continue to grow. I guess how are you approaching capital management given the uncertainty? And assuming regulators were to lift the restrictions, how quickly and aggressive could you be in returning capital?

Well, you're right. We're at the top end of our stated range of 9% to 9.5%. And our target is unchanged. So let's start with that. We fully plan to continue to generate profits, which will do nothing but grow our capital position. We clearly have the capital that we need, including the buffer, I might add, to serve our clients, first and foremost, to pay a dividend and then repurchase shares. And so my view is, once the regulation -- once the regulatory restrictions are lifted, Ryan, I think Key is well positioned to be back purchasing our shares.

Got it. Now I noticed that when you outlined your capital priorities, you noted organic growth, dividend and share repurchase, and there was no mention of M&A in there. And I guess a 2-part question. You've mentioned over time that you're not interested in whole bank M&A because you have the scale and the capabilities you need, but I'm just curious to hear your views on consolidation. Is there anything that comes to mind that could change this view of consolidation? And while First Niagara was transformational, would you consider bolt-on bank deals to fill in markets, if it helps with your targeted scale approach?

Sure. This is obviously something that I think everyone's been talking about lately. Look, there have been 3 deals that have been done. I think each of them are interesting, but I think each of them sort of has some unique characteristics to them. I do think, however, with 4,000 banks in the United States, I think you're going to see consolidation, particularly among smaller banks. I think we've talked about the interest rate environment. I think it's very, very challenging to have a really unique offering and to be able to return capital in this kind of environment. So I think you're going to see a fair amount of consolidation with smaller banks. I've always said we have what we need to succeed. Our best use of time and energy is to execute on our strategy and drive organic growth. I would say, as I mentioned earlier, we would be comfortable with some of these tuck-in acquisitions, add-on acquisitions. We've proven to ourselves and hopefully, to you, and the investors that we're capable of buying them, and successfully integrating them. And then the last thing I'd say is just as it relates to M&A is, we don't think anyone has a birthright to be an independent, publicly traded company. And it's something we, on the Board, take seriously, and we take seriously as a management team that we have to go out there every day and create value for the shareholders.

Well, I could keep going here. But unfortunately, we are out of time. So on behalf of myself and all the investors, just want to say thanks to you, Chris, to Don and the team. And we look forward to connecting again in January and then hopefully, live next year at the conference.

Thank you so much for including us. We appreciate it. Have a good time.

Take care, guys.