KeyCorp (KEY) Earnings Call Transcript & Summary

Thank you, everybody, for joining us here for our presentation with KeyBanc. We're delighted to have with us today Chris Gorman, Chairman and CEO; and Don Kimble, CFO. There's a few slides that you want to go through first, right, Chris? So I'll turn it over to Chris for the prepared remarks, and then we'll move on to Q&A.

Well, thank you so much, Betsy, and good afternoon. In addition to Don Kimble, I'm also joined by Vernon Patterson, who heads up our IR function; and Clark Khayat, who is our Chief Strategy Officer. On Slide 2, you'll find our statement on forward-looking disclosure and non-GAAP financial measures. This covers my remarks and as well as the Q&A, of course. Now moving to Slide 3. We'll spend most of our time today on a fireside chat with Betsy, but I wanted to start with a few opening comments. My main message today is that Key is well positioned to continue to deliver strong growth and returns. Our path to achieve our targeted financial returns this year is clearly different than we would have expected at the beginning of the year. Net interest income continues to exceed our expectations with stronger loan growth and the benefit of higher interest rates. Capital markets-related revenue has been lower than expected, reflecting volatile market conditions and more activity moving on to our balance sheet. One thing that has not changed, however, is our commitment to deliver positive operating leverage this year. We also made a number of specific and measurable commitments at our Investor Day on the 1st of March. These are shown on the right-hand side of the slide, we expect to make progress against each of these metrics that matter, and we'll report out on these metrics in September. Our unique targeted scale strategy and differentiated business model provide us with clear strategic opportunities for sound, profitable growth, especially relevant in the current environment we have. And we'll continue to benefit from the way in which we have positioned our company for higher interest rates. Given our active balance sheet management and the relatively short duration of both our hedges and short-term investments, we have significant upside, as these positions mature and reprice at higher rates over the next couple of years. Our outlook for net interest income also reflects strong loan growth, which we expect to be up mid-teens this year, excluding the impact of PPP and the sale of our indirect auto business which, you'll recall, we exited last September. This growth is being generated from across our franchise in both our commercial and consumer businesses. On the consumer side, we continue to benefit from our 2 growth engines, consumer mortgage and Laurel Road. We are excited about the growth and trajectory of Laurel Road. On May 6, National Nurses Day, Laurel Road launched a new offering for nurses, the largest segment of the health care industry. Nurses represent a sizable demographic looking for differentiated personalized financial products and services and Laurel Road has a unique opportunity to meet these needs. Additionally, last month, we announced the acquisition of GradFin, a leading loan counselor for health care professionals, with a digital platform that provides fast, effective solutions for debt relief and government forgiveness programs, including public service loan forgiveness sometimes referred to as PSLF, which is separate and apart from all the discussion you're hearing about student loan forgiveness. These are existing programs that are in place. The acquisition aligns well with Laurel Road and our recent rollout to nurses, and furthers our commitment to accelerate growth through targeted investments in niche digital businesses. Our commercial businesses -- we -- in our commercial businesses, we benefit from our ability to provide clients with a forward range of financing options, both on and off balance sheet. We remain one of the very few platforms that combine a high level of industry expertise and product capability focused exclusively on the middle market, which is a true differentiator. These capabilities allow us to support our clients through various market conditions, including times like the present, where markets are volatile and clients are seeking alternative financing options. Our investment banking fees in the second quarter will reflect the current market conditions and are expected to be slightly below those of the first quarter. Lower than expected capital markets revenue will also impact expenses with lower production-related incentives, reflecting the variable cost nature of the investment banking business. Overall, linked quarter expenses will remain relatively stable. Concurrent with our disciplined expense management, we will continue to make investments, investments in teammates, in digital and analytics that will drive our future growth. The final point on this slide reaffirms our commitment to maintain strong credit quality. We have derisked our business over the past decade. We will maintain our strict focus on risk management. Importantly, we continue to position Key to perform well through the entire business cycle. In closing, while our path to positive operating leverage will look different this year, we remain confident in our ability to deliver it, which speaks to the resiliency of our business model and the positioning of our company to deliver long-term growth and strong returns. With that, Betsy, I'll turn it over to you to lead the Q&A. Thank you.

All right. Thank you so much. So Chris, maybe we could start off first with just understanding a little bit more digging into what's driving the loan growth, first commercial than consumer. And really, the question here is around the commercial customers. What are you hearing from them? How much risk of recession are they perceiving? Is it impacting their activity? And how is the loan demand coming in? Is it as strong as what you expected back in April when you talked about it?

Sure. So let me start with the last comment, then I'll work back and kind of unpack. It was a pretty complex question.

I'll remind you.

The answer is we do expect the trajectory of loan growth to continue. We reported that we had grown on a year-over-year basis, about 15% at last quarter. We guided to mid-teens growth that's ex-PPP and ex-indirect auto, and we're seeing that trajectory continue. In terms of what our clients are saying and kind of what they're thinking about, I think they are -- they're more optimistic and probably less concerned about the markets than all of us in this room. Probably less concerned about the trajectory of interest rates than all of us, myself included. They're kind of -- in order of what they're worried about -- first and foremost, they're worried about labor. Nobody has -- they just cannot hire enough people. The second thing they're worried about, which is related to the first thing, is supply chain. They literally are still stressed about the supply chain. Lastly, of the 3, is inflation. And I think kind of you'll see a rotation from position 3 to position 1. The reason they're not so worried about inflation is right now, they've been able to pass through everything. So if you have it, whatever it is, you can get paid for it. And so they've been able to pass that through. Obviously, they'll come to a point where that will end. So in general, I'd say they're cautiously optimistic. Their business books are good. They have great visibility through 2022. Obviously, as you get into the out year, it gets a little murkier. With respect to loan growth, we benefit from a few things. First of all, our model is a little different than most of our peer banks. And that historically, we only put about 20% of the capital we raise on our balance sheet. So as a consequence, when you get into challenging markets like today, like Friday, and frankly, the way the market has been since near the end of the first quarter, we have the ability to put things on our balance sheet. And that's where our model really stands out because we have the ability to access all kinds of markets. 50% of our C&I customers are investment grade. So for us, it's not that hard to put it on our balance sheet and they can go out to the market at the appropriate time. As such, the trajectory will continue to be good. We are the -- we have focused on certain niches that are capital-intensive, for example, affordable housing. In affordable housing, we're the #2 financier of affordable housing in the United States. That's a huge unmet need that continues. We are the #2 financier in North America of renewable energy. That continues. We have a huge health care practice, and I don't need to tell all of you, these huge hospital complexes do nothing but continue to borrow money and invest. And we also have, obviously, a big technology business. Lastly, as it relates to growth, we will continue to benefit from utilization. Utilization in the last quarter went from 29% to 31%. Typically for us, with our business mix, it's been kind of mid-30s. And I think what you're going to see is, I think, it will overcorrect to past 35%. And the reason I think that is there's so much inflationary pressure in the system that people are actually right now incented to go long on inventory. And the other thing everyone has been burned by just-in-time inventory. So if utilization used to always hover around 35%, I don't know where it ends up, but I think it will probably swing past there. For Key, every percentage point is $1 billion. So it's not inconsequential, as we think about our loan growth. So that would be kind of what I gave you on the commercial side. Do you want me to cover consumer as well?

Yes, we can do consumer, and then a little bit on Laurel Road.

Sure. I'd be happy to. And in fact, those tie in together. So let's talk first about loans on the consumer side. Our -- we -- it's interesting. Key has never been a big player on the consumer loan side. And we've made a conscious effort to have more of a balanced business. That's why we bought First Niagara going back to 2016. And the areas where we've been able to really grow our loan book in consumer, first and foremost, is Laurel Road and I'll come back there in a moment. And the second is mortgage. Let me talk a little bit about mortgage. Mortgage is a business that obviously will be down for us. But since it's a newer business for us, and it's a relationship-based business, we will continue to take share and outgrow the market. We're focused mostly on purchase. For example, 20% of our mortgage business right now are doctors -- and I'm going to get to Laurel Road in a second, are doctors in the West. So those 2 loan growth engines will continue. We had now pivot to Laurel Road. Laurel Road had originations last quarter about $820 million. That was a record in terms of bringing in new households. I don't think it will be up at that level this quarter. One, that was a record level in terms of households and originations. And the second thing is there's kind of 3 factors, Betsy, there. One is interest rates. The second is the extension, again, of the federal student loan payment holiday. We would have thought that, that would have burned off. That was extended again. I don't think it will be extended forever, by the way. There's $1.6 trillion of student loans. They're priced at around 5%. So now we're in year 3 of the federal student loan payment holiday. That's expensive, obviously. So I don't think that will go on forever. And then last thing is there's just a lot of discussion around student loan debt forgiveness. That's differentiated from what I was talking about with the public service loan forgiveness, which is an existing program. I think those 3 things -- the business still has a lot of momentum, but I think those 3 things will probably cause a little bit of a down drift on a linked quarter basis.

Okay. Got it. I know you mentioned GradFin in your prepared remarks. Could you just help us understand specifically how that fits into the overall Laurel Road strategy?

Absolutely. So let me step back. So our strategy around Laurel Road is a national digital affinity bank. So for example, the preponderance of all of our customers don't come from our 15-state footprint. This is a national digital bank focused on doctors and dentists. We just expanded it in concentric circles to nurses. The nurse expansion is very important as you think about GradFin. So GradFin really is 2 businesses. One is GradFin advises people on student loan refinancing, which obviously ties in, Betsy, very closely with what we're doing around Laurel Road. And the second business is this public service loan forgiveness that I mentioned, which is available to people that work for not for profits. And by the way, if you think of any major hospital complex, whether it's in New York City or any other place, they're all not for profits. Half of the doctors and half of the nurses work for not-for-profits and, as such, are eligible to apply for this public service loan forgiveness, which is a huge opportunity. So if you kind of step back strategically, what does that mean for Key? So if we're calling on these large -- it gives us the opportunity to go B2B2C. And let me explain what I mean by that. So we're calling on these hospitals. We have Cain Brothers that provide strategic advice that has just a great business. We're obviously calling on the CFO, where we're providing payments and capital. But this gives us the opportunity to call on the Chief Human Resources Officer. I happen to be on the board of a huge hospital. The biggest challenge for all these hospitals, none of them have enough nurses. You can't run these hospitals without enough nurses. Depending on your people's numbers, there's 4 million nurses and there's something like 0.5 million open positions. It's -- and by the way, the demographics are such that it continues. So we go on and we call in the Chief Human Resources Officer, and the way that hospital can compete is these nurses, as they get out of school, we, Key, can help them with student loan forgiveness. So it ties in really well with Laurel Road. We're excited about it. And it's early days, we'll see where we can take it.

And therefore, your program to expand Laurel Road to nurses, you expect a bit of an uptick in the adoption rate with GradFin?

We do. Yes, we do.

You have a target out for 250,000 Laurel Road households by 2025, I believe, right?

Yes. Correct.

How do you envision that split between doctor, dentists, nurse clients? Is there any -- does that matter to you? Or...

I guess, right now -- we've obviously done a bunch of modeling, Betsy. Right now, we're thinking about it kind of half and half. You've got 1.1 doctors and dentists -- 1.1 million, I beg your pardon, doctors and dentists. You've got 4 million nurses, but we have kind of a running start at the doctors because we already have -- we've -- since from a standing start, we already have 60,000 doctor, dentist households. So for purposes of our modeling, right now, we're assuming about half and half. That will be further refined as we get further into it.

Okay. And then any other opportunities to lean into growth just on the overall book of business?

Yes. I think we have a lot of opportunities for growth. One, we'll continue to expand this health care Laurel Road and our national digital affinity bank focused on health care. And there's a bunch of -- we have doctors, we have dentists, we have nurses. There's a whole bunch of other people that are part of the health care ecosystem. After all, it's 18% or 20% of the GDP. So we'll continue to do that. The other areas where you're going to continue to see us invest and lean in is just our investment banking platform, just in total. One of our goals that you saw detailed on the slide was that we're going to significantly grow the number of bankers. This is a business that we started from scratch 20 years ago. That is a unique business. Middle market focused on 7 industry verticals. I believe it's under leveraged. We'll continue to invest in there. And then areas where we have a competitive advantage. I mentioned things like affordable housing, renewable energy, health care, technology, you'll see us lean into all those.

Okay. Turning to credit, the other side of lending. Is there any impact at all from the inflationary environment that we're in?

We aren't seeing it yet in our credit book. We're watching it very, very closely. Inflation -- let's talk first about the -- we'll talk about the consumer. Right now, we have 3.5 million consumers. Today, they have $6.5 billion more in their accounts than they did pre-pandemic. So -- yes, there's inflation. Are they spending a lot of money? They are. The current spend is up 20% to 25%. Travel is up 82%. But they're burning down pretty significant cash balances. So we're seeing inflation -- with our commercial customers, we see inflation kind of across the board. I mean they're paying more for people. They're paying more for goods and services. So inflation is kind of through the whole ecosystem, but it's not to the point where we're concerned about it from a credit perspective.

And what about the rate rise piece of this? A chunk of the C&I is very real-time rate hikes, right, because it's a function of the floater on the front end. Now half of your C&I book is investment grade. So I would expect that reduces any concern that you might have on the higher rates and how that impacts your borrowers. But from the outside, what should we be expecting on the C&I and the CRE books, as rates ratchet up pretty quickly here...

Well, I mean, I think as risk managers, we focus, first and foremost, any place where there's leverage. Anytime you have leverage and you have rising rates, it's an area where we pay a lot of attention to. And for example, we have 2% of our loans outstanding are in leverage finance transactions. They're within our 7 industry verticals. At a different point in my career, I spent my full time working on leveraged deals. We watch those very, very carefully. And I feel really good about where that book is. The other area where I pay close attention is in real estate, to your point, that's where there's leverage. I feel really good about our real estate book. We, by strategy, have focused on multifamily and industrial, which has been the right place through the cycle to be. The area that I think is going to be vulnerable with leverage, I think, is B and C class office space. Just -- what's interesting in all these major cities right now is you have this notion where you're getting huge rent increases. The multifamily folks are doing really well. But in the same cities, you have occupancy in the actual office buildings of 20% and 30%. And I don't think that's sustainable. That's something that I think people ought to keep a close eye on.

And how should we be thinking about the reserve build from here? Is it -- the reserve ratio was flat until you see some inflection in NCOs or are we covered for the normalization that could happen?

We obviously feel good about where our reserve ratio, as we look at it all the time. The big drivers under CECL, of course, are what are the macro factors -- and I'll come back to that because we made an adjustment in the first quarter based on sort of the macroeconomic outlook. The second is that, which is idiosyncratic to your book, and the third is loan growth. We made -- we were one of the few people that increased our reserve from a qualitative perspective in the first quarter. And our view is really simple. We couldn't see anything in our book that showed us that we needed to increase our reserve, but the reality is between the end of the first quarter and the end of the second quarter -- the end of the year and the end of the first quarter, there's a war, rampant inflation and continued supply chain issues. So we've increased our qualitative reserve by $50 million. But I'm satisfied with where -- in spite of the volatility that we're all experiencing, I'm satisfied with where it is.

Okay. I wanted to move over to fees. And on the April call, you spoke about the strong IB fees. And you mentioned in the prepared remarks that fees are down a little bit. Well, I'm not sure if you qualified how much, but they're down Q-on-Q, right?

Yes.

Is that just a function of deal closings, just getting pushed out or cancellations of deals? Do you have a sense as to what's driving that?

Sure. So the pipelines continue to be strong. But clearly, things are getting pushed out. And as I mentioned in my prepared remarks, some of that is just our business model. We're putting it on the balance sheet. I mean, for example, you'd have to be either crazy or desperate to be out issuing public equity in a market like this, for example. So what we see is -- and then on the other end of the spectrum, you've got syndicated finance, which is kind of just chugging along. In the middle of it, you have our entire M&A business. And what's happening with M&A transactions right now is as people look out and there's pretty good visibility for 2022, but as they look into 2023, there's just a whole lot of uncertainty. And I think buyers are not in a huge hurry to close because time is their friend, as we think about this uncertainty. So it isn't that deals are going away. It's that they're getting pushed out. But there's an inverse -- ultimately, there's an inverse relationship between the length of time deals that are in the pipeline and their probability of closing. We're just in a really interesting time right now, as people are kind of sorting out. I think the log jam will start to break once people have a clear view on what it is. But I think right now, 2022 is pretty clear, but I think 2023 is in question. By the way, as we get into 2023 and we have a slowdown on a relative basis, I think Key will perform very, very well based on all the de-risking we've done.

So just another question following up on the capital markets environment. Does it impact any of your banker hiring plans?

No. As I said, one of our 3 goals that we talked about is going out and hiring bankers, Betsy. We -- I mentioned it earlier, we have what we think is a unique and underleveraged platform. And we're going to be out there. I'm a big believer that whether it's serving your clients or out there recruiting, you can't be in sort of a start-stop mode. You have to consistently be out there executing your strategy. So we'll continue to be out there, recruiting.

Okay. All right. Great. Just panning for any questions in case there's questions from the audience. I usually do this at the 10-minutes-to-go mark, just so you know, in case you have any. All right. I did want to drill down a little bit on asset sensitivity. And there's a bunch of questions in here. One of them has to do with how you think about your loan-to-deposit ratio and how you think about funding that incremental loan growth. Maybe we could start with just understanding where do you want your loan-to-deposit ratio to be? What range are you comfortable with?

Sure. So our goal is to have 85% or 90% loan-to-deposit ratio, which obviously gives us some room to run. We, just in the last couple of weeks, were out and we issued some debt. We obviously have a really solid -- 60% of our deposits are retail and escrow deposits that are pretty sticky deposits. So I think we have a pretty good balance and we can kind of lean each way. Don, what would you add to that?

No, I would agree. There's a lot of cash flow that's coming off our investment portfolio and also with the additional wholesale borrowings that we have plenty of capacity there. Our loan-to-deposit ratio has been running less than 80%. And as Chris said, that 85% to 90%, even 95%, is a comfort zone for us. And so we've got a lot of room for growth to support that going forward.

And maybe we could talk a little bit about, therefore, how do you think about pricing deposits as we move through this rising rate environment. Is that something that you would seek to do to keep the loan-to-deposit ratio from going too high? Or do you let some outflow before you get more competitive on deposit ratio?

Well, we've -- what we've projected right now, and there's a bunch of variables and it's kind of uncharted territory. So it's a very interesting question that Don and I spend a lot of time talking about. We think in the second quarter, our deposit betas will be kind of high single digit. We think by the end of the year, it will be about 30%. So we're really fortunate in the 2 things. One, we've really focused on primacy; primacy on our consumer side and our commercial side. When we had a lot of liquidity, and we were pretty picky about what deposits and how we price them. So we feel pretty good about where we're positioned. What's going to be interesting though is with the increases that are coming, it's not just the absolute amount of increase, it's the rate of change. And it will be interesting to see what behavior is, and we've modeled a bunch of different scenarios, but we'll see how it plays out.

Okay. What's your most probable scenario?

Our most probable scenario is this rate cycle will mimic the previous rate cycles. I personally don't think it's going to be much different. You've got this way to change any time about, but you also have other things like -- I think some people will actually remember during the global financial crisis that the funds broke the buck. I think that will have an impact as well. So there'll be a bunch of puts and takes.

Okay. And then how do we think about the securities portfolio here? Because I think you're in the process of winding down fixed to floating right?

And for our securities portfolio, we really have 3 pieces to it. One is our U.S. treasuries, and that's a fairly short-term type of investment, about 2 years or so of average life remaining in that portfolio. That was done to deploy some of our excess liquidity before, and we could see that winding down over time just with maturities to help funds from the loan growth. The second is a small piece, and that's the left over from our indirect auto loan sale that we had in third quarter of last year. And so a little over $2 billion in that. And so we would expect that to wind down over time as well. And so the rest of the core portfolio is in the $37-ish billion range. And so we think that will remain relatively stable. It could be some pluses or minuses, depending upon what's going on with loan growth that -- the positive there is that we have a lot of upside as far as the redeployment of those cash flows that are coming off. But right now, we think that we're north of 3.5% yield on new purchases and what's running off is about a 2% kind of yield. And so if we don't have the use for the loan growth to fund, we clearly can put it to get to work at a much higher rate for us going forward.

So it sounds like some nice asset sensitivity.

It does. And if you combine that with our swap portfolio that we've got about $7 billion of swap on/off in the 2023 time period, another $7 billion in 2024. And so that allows us to reprice that as well to maintain our asset sensitivity. And that allows us to redeploy that over a 200 basis point lift. So between the short-term treasuries and the swap book, just repricing that would add over $500 million of net interest income from just putting those at today's rates.

Okay. And that will be over time though that you...

That's correct, yes.

Okay. Like a 1 year or 2?

I would say, over the next couple of years, there would just be some tailwind for us as opposed to this year. We're facing the headwinds of PPP and other initiatives.

Can we talk a little bit about capital, given the backup in the long rates? I'm just wondering how you've been managing that with regard to your securities book. Any further moves from AFS to HTM? You could speak to how if we ended the quarter at today's rate level, what the impact on AOCI might be?

Sure. And as far as our overall positioning, we do not have any plans to move any wholesale portions of the portfolio over to held to maturity. Now what we've been doing in the last quarter or so has been mixing about half of our purchases into the HTM versus AFS. And so that will help manage that going forward. And when you say the reprices today is this hour or next hour or what would it be as far as the remarketing, but I would say that even through today, we would see a less -- a lower amount of OCI impact from the current quarter's pricing of the portfolio versus what we saw in the first quarter. And so at a lower level, for sure. And keep in mind, too, that since we're a Category 4 bank, our regulatory capital ratios aren't impacted by our TCE ratio. It's really impacted by our CET1 ratio. And the mark-to-market on the investment portfolio doesn't flow through that. And so our CET1 is our primary capital indicator that we really manage our overall capital need to. And so TCE isn't as important to us as it might be to the SIFI banks that are forced to manage that on a day-to-day basis.

So it does not impact any buyback assumptions or it doesn't [indiscernible]?

It does not. And as we think about buybacks, our capital priorities continue to be supported our organic balance sheet growth. And it's been very strong in the last couple of quarters, last year for the most part. And so that would be the #1 governor. The second would be our dividends, and we want to continue to support a strong [indiscernible]. And third would be the use share buybacks to manage within that targeted capital range. And we ended the first quarter at a 9.4% TEC1 -- or CET1 ratio. And so that's in the upper end of our 9% to 9.5% target.

Okay. So there's really no level of TCE to TA that you really focus on or...

We do monitor it. And there are some that would pay attention to it, but we think it's a very low priority for us as far as prioritization as to how we manage our capital position.

Okay. So Chris, just last on just strategy overall. When we're sitting in this environment of a really unique period, right, high inflation, rising -- rapidly rising rates, QT kicking in, when you think out the next 3 years or so, maybe even 5, how do you feel your setup is into this environment? And then is there anything strategically that you think that you would like investors to understand as to what your plans are?

Sure. So our setup, I think, is quite good. We, as I said, have been -- we've embarked about a decade ago on the derisking of Key. And although we fared best-in-class on the stress test, that was kind of an academic exercise. I think -- let's face it -- we're going to face an economic downturn. How deep it's going to be? I don't know. But I think that will give us a chance on a relative basis to demonstrate that we're good risk managers and that we've positioned the business well. So I think that is -- it positions us well. The next thing that positions us well is just asset sensitivity. As Don mentioned, over the next couple of years, should we desire to -- and what we typically do, we're naturally a very asset-sensitive bank. And so what we do, Betsy, is we tamp down our sensitivity with swaps. We have the opportunity, if we wanted to, for example, if we -- right now, for a 200 basis point ramped increase, we'd be about 3.4%. If we didn't do anything, and I'm not saying that we wouldn't, we'd get an 8% sensitivity relatively quickly. But I just -- that gives you an indication that, that is a lever that we have. The other thing that's more important, I think, for us, from a strategic perspective, is we have really carved out a unique strategic place. We are not trying to be like every other bank. What we're trying to do is be really relevant to the customers and the prospects that we attempt to be. And whether it's our integrated corporate and investment bank in 7 industry verticals, focused -- and it's even sub-verticals or it's what we're trying to do on the consumer side where we take certain big swaths of the population and come up with unique offerings for them. It's a unique business. So you combine the balance sheet with the derisking with the unique strategy, I think we're well positioned as we go forward in the next few years.

Thanks so much for your time today.

Thank you, Betsy. I appreciate it.

Thanks, Don. Thanks, Chris.