Keycorp (KEY) — Q3 2019 Earnings Call Transcript

Thank you, operator. Good morning. And welcome to KeyCorp's third quarter 2019 earnings conference call. Joining me for the call is Don Kimble, our Chief Financial Officer; Chris Gorman, our newly appointed President and Chief Operating Officer; and Mark Midkiff, our Chief Risk Officer. Slide 2 is our statement and forward-looking disclosure and non-GAAP financial measures. It covers our presentation materials and comments, as well as the question-and-answer segment of our call. I'm now moving to Slide 3. And before I review our quarterly results, I want to comment on our leadership transition that we announced last month. In keeping with our thorough and robust succession planning process developed by our Board of Directors, I announced my upcoming retirement effective May 1st of next year, and Chris Gorman was appointed President and Chief Operating Officer and a member of our Board of Directors. Chris will succeed me as Chairman and CEO next May. And I will have opportunities to speak with you over the next several quarters. But I just want to say that my time at Key has represented some of my most rewarding years of my 40 years in banking. I’m proud of what this team has accomplished as we have transformed this company, our culture, our strategy, and our performance. And importantly, I will remain fully engaged over the next seven months and I’m committed to working with Chris for a seamless leadership transition. I look forward to Key’s continued success under Chris with our diverse and talented leadership team and I have very confidence in our future success. Now moving on to the results we reported this morning. My remarks will adjust for our previously reported fraud loss and notable items in prior periods. So let me start with a few headlines. Earnings per share grew 7% from the year-ago period and 9% from the second quarter. We reached the top end of our targeted cash efficiency ratio range of 54% to 56% with a reported 56%, which is our lowest level in over a decade. We delivered another quarter of positive operating leverage, driven by both revenue growth and a 3% sequential quarter decline in expenses. And we saw solid balance sheet growth and strong fee income with a record third quarter for investment banking and debt placement fees. On the revenue side, we saw good momentum across our company. We grew both loans and deposits 4% from the prior year, driven by activity in both our commercial and consumer businesses. We generated another quarter of strong broad-based growth in commercial and industrial loans and saw higher consumer loan balances driven by Laurel Road and strength in our consumer mortgage lending. Non-interest income was up 7% from the year-ago period benefiting from strong investment banking and debt placement fees, as well as growth in corporate services and consumer mortgage income. As I said, non-interest expense was down 3% from the year-ago period and reflects the successful execution of our cost initiatives, as well as our ongoing commitment to continuous improvement. And I would remind you that our expense levels relative to the prior year include the addition of our Laurel Road acquisition earlier this year. Importantly, although we are focused on bringing expenses down, we continue to invest a portion of our cost savings back into the business to drive future growth. And we continue to manage the company with a long-term perspective by taking action to position us to perform through the business cycle. This includes maintaining our disciplined credit underwriting and our risk profile. We also continue to manage capital, consistent with our stated capital priorities including returning a significant portion of our earnings back to our shareholders. In the third quarter, we increased our quarterly common stock dividend by 9% to $0.185 per share and continue to repurchase shares. Before I turn the call over to Don, let me just say that this was a good quarter for Key and clearly demonstrates the strength and resiliency of our business model. We saw topline growth in loans, deposits, and fees and paired this with strong expense control. This drove our cash efficiency ratio to 56%, hitting our targeted range this quarter. Clearly, there are some headwinds with lower interest rates and signs of a slowing economy, and although our clients have turned more cautious, we continue to see good engagement and solid pipelines. Our business model and the interest rate hedging also positions us well as we move through the different business cycles and rate environments. And expense management also remains a priority as we continue to identify opportunities to further improve efficiency. We remain committed to reaching our long-term targets, maintaining our moderate risk profile and ultimately delivering results for our shareholders. With that, I will close and turn the call over to Don.

Thanks, Beth. I'm now on slide 5. This morning we reported third quarter net income from continuing operations of $0.38 per common share. Adjusting for our previously disclosed fraud loss, earnings per share was $0.48. Our adjusted results compared to $0.45 per share in the year-ago period and $0.44 in the second quarter of 2019. As reported in July, we became aware of fraudulent activity conducted by a longstanding business customer. Due to ongoing investigation and litigation, we're limited in the information we can share. The fraud loss was recognized in our provision for credit losses this quarter with a pre-tax impact of $123 million. The after-tax impact was $94 million. The fraud was realized as an overdraft to two various operating accounts and charged off, resulting in a recognition through our provision for credit losses. We’re continuing to pursue all avenues of recovery and we will provide any material updates in our public filings. I would also point out the impact of interest rates on our return on tangible common equity. Over the last four quarters, our other comprehensive income component of our capital has increased by $1.2 billion primarily due to lower rates. This increase had a 170 basis point negative impact on our ROTCE compared to the third quarter of 2018. Said otherwise, if the OCI remained the same, our ROTCE and notable items would have been 17.1% in the third quarter of this year. I’ll cover many of the other items on this slide in the rest of my presentation, so I'm now turning to slide 6. Our business model continues to position us well to grow relationships and loan balances. Total average loans were $92 billion, up 4% from the third quarter of last year, driven primarily by the growth in commercial and industrial loans, which were up 8%. Linked quarter growth in average balances was also driven primarily by commercial and industrial loans, up 2%. Our growth continues to be broad-based across our footprint as well as through our targeted industry verticals. C&I growth was partially offset by decline in commercial real estate balances due to elevated paydowns and our more cautious stance on certain loan types and markets. Importantly, our growth continues to be more balanced with continued growth in consumer loans. We have made meaningful investments in our consumer mortgage business and completed the Laurel Road acquisition earlier this year and both are delivering results. For Laurel Road, we originated over $500 million of loans this quarter, and in our consumer mortgage business, we originated $1.3 billion of loans in the third quarter, more than double our volume from a year ago and up 20% from last quarter. Of this production, approximately 60% was retained on balance sheet. Importantly, we remain disciplined with our credit underwriting and we walked away from business that does not meet our moderate risk profile. We remain committed to performing well through the business cycle and we managed our credit quality with this longer-term perspective. Continue on to Slide 7. Average deposits totaled $110 billion for the third quarter 2019, up $4.7 billion or 4% compared to the year-ago period and up 1% from the prior quarter. Growth from the prior year was driven by both consumer and commercial clients. On a linked quarter basis, the increase in deposit balances was also driven by both consumer and commercial clients, as well as elevated levels of short-term deposits from certain commercial customers. Total interest bearing deposit costs were down one basis point from the prior quarter reflecting the lag in deposit pricing. We saw the impact of lower rates coming through late in the quarter and next quarter we would expect to see more of this benefit come through. We continue to have a strong stable core deposit base with consumer deposits accounting for 66% of our total deposit mix. Turning to Slide 8. Taxable equivalent net interest income was $980 million for the third quarter of 2019 compared to $993 million in the third quarter of 2018 and $989 million in the second quarter of this year. Our net interest margin was 3% for the third quarter 2019 compared to 3.18% for the third quarter 2018 and 3.06% for the second quarter. The decrease in net interest income from the third quarter of 2018 reflects lower interest rates, lower loan fees, as well as a decline in purchase accounting accretion. These declines were partially offset by higher earning asset balances. Net interest income decreased $9 million or 1% from the prior quarter driven by lower interest rates and loan fees. This quarter's net interest margin came in lower than expected. Our deposit rates were higher than forecasted reflecting a slower response to interest rates and market pressures. We did see our rates move down late in the quarter providing benefit for the fourth quarter. Other factors that impacted our margin included lower loan fees costing one basis point and lower LIBOR rates relative to the change in Fed funds. In the fourth quarter, we expect net interest income and net interest margin to remain relatively stable. Our outlook includes average interest bearing deposit rates declining by approximately 10 basis points relative to the third quarter. This also assumes an additional 25 basis point cut in rates in late October and continued growth in our loans. In the appendix of our slide deck, you can find additional information on our asset liability positioning. We’ve continued to actively hedge to reduce our exposure to declining rates, executing approximately $2.4 billion in interest rate floors in the third quarter. Our repositioning to reduce our risk to declining rates began in the third quarter of last year and since that time we’ve entered into a total of swaps and floors of $17 billion. Moving on to Slide 9. Key's non-interest income was $650 million for the third quarter 2019 compared to $609 million for the year-ago quarter. The change from the year-ago period reflects growth across most of these categories. We reached a record third quarter in investment banking debt placement fees, up $10 billion from last year. We also saw strong corporate services income, primarily driven by higher fees from derivatives, and we also saw year-over-year growth in both consumer mortgage income and mortgage servicing. Compared to the prior quarter, non-interest income increased by $28 million, driven by many of the same categories. Investment banking and debt placement fees increased $13 million from last quarter and we also saw growth in corporate services and consumer mortgage income. Now, turning to slide 10. Expense management continues to be a very positive story. As we’ve delivered on our expense and efficiency commitments. We completed our $200 million cost savings initiatives at the end of the second quarter and the results are fully in our third quarter run rate. We have also continued to reinforce our culture of continuous improvement throughout the organization. Third quarter non-interest expense was $939 million. This compares to $964 million in the third quarter of 2018 and $967 million in the prior quarter, excluding notable items in the second quarter. The table on the bottom left side of the slide breaks out the notable items. Non-interest expense decreased $25 million or 3% compared to the year-ago period. The year-over-year comparison reflects the successful implementation of Key's expense initiatives and elimination of the FDIC surcharge. These expenses were partially offset by the addition of Laurel Road early this year. Compared to the prior quarter, non-interest expense declined $28 million, excluding notable items in the prior period. The decline reflects the successful implementation of Key’s expense initiatives across the franchise, which drove lower personnel expense and positively impacted a number of other line items. Moving on to slide 11. As I said previously, our provision and net charge-offs included $123 million from our previously disclosed fraud loss. Excluding the fraud loss, net charge-offs were $73 million or 31 basis points of the average total loans in the third quarter, which continues to be below our - over the cycle range of 40 to 60 basis points. On a similar basis, again, excluding the fraud loss, the provision for credit losses was $77 million for the quarter, which slightly exceeded our net charge-offs reflecting continued loan growth. Non-performing loans were $585 million this quarter, up $24 million from the prior quarter, but down $60 million from the year-ago period. Non-performing loans represented 63 basis points of period-in loans compared to 61 basis points last quarter. Non-performing assets this quarter had a temporary increase with the transfer of several loans that held for sale. We believe these credits are properly marked and are moving through the sales process, which should be completed soon. Criticized loans and our 90-day past due loans both declined this quarter. Overall, credit quality remains strong. Our new loan originations in both the commercial and consumer book continue to be high quality relationship business. Turning on to slide 12. Capital ratios remain relatively stable this quarter with a Common Equity Tier 1 ratio of 9.52% at the end of the third quarter. As Beth mentioned earlier, we remain committed to our capital priorities, including returning a significant amount to our shareholders. In the third quarter, we declared a common share dividend of $0.185 a share, up 9% from the quarterly stock dividend. We also continue to repurchase common shares with $248 million repurchased this quarter. Turning to slide 13. Similar to our approach a year ago, we have provided fourth quarter guidance relative to our third quarter results. The guidance ranges - guidance range definitions are provided at the bottom of the slide. Average loans should be up in the low single-digit range driven by C&I and continued growth in the consumer balances from Laurel Road in our consumer mortgage business. Average deposits should be relatively stable. Net interest income should be relatively stable with the fourth - in the fourth quarter. This assumes a 25 basis point interest rate cut late in October and solid balance sheet growth and decreased deposit rates, which will help provide more stability in net interest income. Non-interest income should be up in the low single-digit range reflecting solid investment banking pipelines, as well as growth in our other fee businesses along with some seasonality in areas such as COLI. We would expect non-interest expenses to be also up in the low single-digit range as a result of the seasonal factors, including incentive compensation target lower capital markets business. Similar to past years, we would also expect to have a pension settlement charge in the fourth quarter to approximate the amount taken in the same period last year. On a credit quality, we see nothing on the horizon that changes our outlook. Net charge-offs including the fraud loss should remain stable, and we expect that our loan loss provision will slightly exceed net charge-offs reflecting continued loan growth. In our guidance for our GAAP tax rate will be approximately 16%. Overall, we expect a good finish to the year despite some headwinds from rates and signs of potentially slower economic growth. Our clients have become more cautious, but we continue to see good engagement and expect to grow through offering our targeted clients attractive on and off-balance sheet alternatives. Over time, we’ve reduced our net cash interest rate sensitivity and we remain diligent in our underwriting and risk management. And we’ll continue to manage expenses through our continuous improvement efforts while investing a portion of the savings back into the business. Finally, we expect to achieve our long-term targets, and I believe over time our market valuation will reflect our progress and improved results. I will now turn the call back over to the operator for instructions for the Q&A portion of the call.

Good morning, guys. Thanks for taking the question. I guess, first, congratulations on the succession to both of you. So maybe first question is on the tax rate. I think it came in a little lower than expected this quarter. It looks like the guide is perhaps for slightly lower one next quarter as well. Can you maybe talk to the nuance of that and if that's the kind of thing that would sustain itself into 2020 as well?

Yes. As far as the third quarter, what you're seeing in the reported tax rate is the impact of the fraud loss, and so that really is reported on an incremental basis. So if you would adjust for that, our effective tax rate was a little north of 16%. We would expect the same type of range for the fourth quarter, which reflects the benefit of credits that are available to us and also the impact of the updated outlook for pretax earnings as well.

Okay. Perfect. Thank you. And then just I guess a top level. Now that you’ve hit the top end of the efficiency range, do we think that's a number that you guys will be able to sustain into coming periods or improve upon, or how were you thinking about that dynamic as you look into the next several quarters?

Yes. Long term, we clearly want to operate within that range. We think that's appropriate given our business mix that we have here at Key. And it’s something that we feel is an indication of us being able to manage our overall cost structure efficiently and effectively. As far as next year, we’re still expecting to manage for the full year in that range. Now you could see quarters where like the first quarter of each year tends to be a little bit higher than through the rest of the year. But that would be our objective as well going forward.

Hey, thanks. Now, if I heard correctly, I think you said 10 basis points of deposit cost reductions in the fourth quarter, including the October cut. I guess presumably let's call that a 20% deposit beta given the 50 basis point reduction. Can you just talk about your ability to reduce deposit costs? Just in terms of your competition we hear it’s very slow for other banks bringing down their deposit costs. I'm just kind of wondering at what point does that actually start to accelerate? Thanks.

Yeah. Sure. We would probably define it as stronger than a 20% beta because that rate decline doesn't occur till late in October, and so the average throughout the quarter would suggest something probably in the 30% beta. Longer term, we would like to see that in the 40% to 45% range as far as reaction to rates. You’re absolutely right; we are seeing competitive pressures, especially on the consumer side that is resulting in some of those deposit rates being a little stickier than what we would've expected initially. We still think there’s plenty of opportunity for us to manage that down and to be in that 40% to 45% beta to allow us to have more stability in the margin prospectively.

All right. Great. And then could you provide an update on the impact to CECL?

Yeah. Sure. We’ll provide additional disclosure in our 10-Q. But what we have talked about is that for commercial loans, we really don't see an increase from the incurred loss method to CECL. And on the economic outlook, you could actually see a slight decline in commercial. Now offsetting that on the consumer side, we would expect the CECL reserve to probably be about three times the level that we’re seeing on the incurred loss method. And that really reflects more of a life-of-loan type of loss expectation as opposed to today. You probably have about a year and a half or so of charge-offs included in the consumer categories. And so luckily for us, our reserves are only about 15% consumer and about 85% commercial. So the relative impact to us should be fairly modest compared to some of the early indications we’ve seen from some of the other companies.

Good morning. Just want to get some additional color on what you’re seeing in terms of loan demand. I know that you've indicated that the pipelines are solid, but obviously we’ve seen a little bit of pullback in ISM and a little bit of pullback in CapEx activity. So, I just want to see if we could talk a little bit about what you're seeing on the commercial side? And then what does that mean in terms of how you're thinking about your broader loan growth when you look at 2020? Could it be near the 4% that you're looking at for ‘19? Thanks.

John. It's Chris. Good morning. Our loan growth this quarter was as a result of our continued focus and strength of our commercial businesses. What is differentiated now for Key vis-à-vis the past are the new engines that we have on the consumer side and as you’ve heard Don talk about the growth we have in mortgage and also now we have Laurel Road. So those will be opportunities for us to kick in loan growth as we go forward. We anticipate on the commercial side utilization being relatively flat. We have seen - as both Beth and Don mentioned, our customers are cautious. But having said that, we’re still out there talking to our customers, serving our customers. The pipelines remain strong, but I think clearly there are some challenges out there.

Okay. Thanks all right. That's helpful. On the - separately on the credit side, I was just wondering if we could get a little bit more color on the non-performers. I know that NPLs were up a bit for the quarter despite the higher charge-offs even when you exclude the fraud. So I just wanted to get a little bit of color on what drove the inflows into non-accruals in the quarter? And what - and also if you have any detail on how criticized assets trended for the quarter? Thanks.

Sure. As far as the change in the NPLs and the inflows, we did have three commercial credits that moved into non-performing status this quarter. They were criticized loans before and the status was changed from accruing to non-accruing. Those three loans totaled $100 million, and so that was isolated to those individual credits. As we’ve said before, you can have episodic type of issues or things that pop up that we believe are temporary. In connection with our nonperforming loans, we also - as we mentioned, transferred a pool of assets, which included some commercial and some residential real estate to held for sale, which are in the process of sale. We expect to close quickly and bring that level down. As far as the charge-offs, they came in at 31 basis points this quarter. I think they were 28 or 29 basis points last quarter. I think you will see some variability in that range, but I think in the low 30 basis point range is probably a good outlook going forward and reflects a very stable and strong credit quality overall. As far as criticized and classified, I’d say they're relatively stable and maybe even down a little bit linked quarter. But very, very stable as far as the overall credit quality from that perspective.

Good morning.

Good morning.

You guys had very nice momentum on the expenses, particularly driven I guess by the reduction in headcount. I’m just wondering, do you think you can drive expenses lower further in 2020?

Yeah. We’re always going to have a continuous improvement mindset. And what we would typically target would be to keep expenses relatively stable and allow us with that to make investments back in the business to grow the top line. We’re very focused on driving positive operating leverage, and we continue to expect to deliver that this year and we'll expect to do that again next year as well. And so these continuous improvement opportunities allow us to manage our expenses more efficiently, more effectively and it includes ongoing efforts like workflow redesign, branch consolidations and other things like that that we just think are part of our ongoing business model and it’s going to be critical for us to continue those efforts to make sure that we have the capacity to reinvest back in the business.

Hi, good morning.

Good morning.

Maybe just on CECL, I hear you that the overall impact day one is not that huge. But this is just the 3x on consumer and as you’re growing consumer into next year like $1 billion a quarter. Do we have to start thinking about like even though the cash flows haven't changed and the underlying performance hasn't changed just building in like a $20 million reserve for growth type placeholder you know just from the concept of running with a much higher reserve to loan on your consumers, and every time you put a loan on the books you got to fully upfront that reserve built day one.

You’re absolutely right as far as going forward. The new volume coming on the books will clearly have a higher reserve than we did historically under the incurred loss method. And we’ll provide more clarity on that as we get into the first quarter outlook at the end of our fourth quarter call. I don't know I’d - can hold a $20 million placeholder yet but that will provide some more color. But you're absolutely right. The initial provision required for a new loan origination is higher under CECL for consumers than it is under the incurred loss method.

Okay. Thanks, all right. That's helpful. On the - separately on the credit side, I was just wondering we could get a little bit more color on the non-performers. I know that NPLs were up a bit for the quarter despite the higher charge-offs even when you exclude the fraud. So I just wanted to get a little bit of color on what drove the inflows into non-accruals in the quarter?

Sure. As far as the change in the NPLs and the inflows, we did have three commercial credits that moved into non-performing status this quarter. They were criticized loans before and the status was changed from accruing to non-accruing. Those three loans totaled $100 million, and so that was isolated to those individual credits.

Thanks. Wanted to ask you a little bit about credit in a backward way, you had $123 million charge-off relating to this one loan. Does that represent the lumpiness in the portfolio because that took a charge-off from 30 basis points all the way up to 80? So you go from below your range to above your range with one loan. So, is that just a reflection of the exposure you have because of the commercial focus like you were saying earlier in the loan portfolio?

Marty as far as the $123 million, it was a fraud loss, and as we noted briefly, that the fraud loss came through because of the fraud resulted in a net overdraft position of several of the operating accounts from this entity. And as a result of those being considered overdraft the reporting requirements would say that that should be treated as a charge-off, and so we really consider this to be a true fraud loss and not reflective of a lending relationship. There were no loans outstanding to that entity that resulted in this fraud.

So, Marty I’d be delighted to. As I said, I think there is a lot of value in thinking as much about when and how is the right time to build succession and step down from a role like CEO and Chairman, as there is in the energy you put into it when you first get the opportunity. And I believe that with nine years in Chair, as our CEO, as of May 1st, if you recall I've been a two-term President. And I will be 65 years old next year and I believe that remaining our Chairman and CEO till May 1st is the appropriate thing to do. Chris and I, as he has indicated and I've said earlier, are very much working on a seamless transition and we've obviously worked together for many, many years. The team is solid, mature, and well-seasoned. The company has a lot of good momentum and this is the appropriate time for the company, the appropriate time for me and there’s always chapters to write. And I look forward to the things that I can do civically in my continued professional commitments as well as having a little more time for family, friends, and travel. And after May 1st, again from thorough discussions with our board as we went through this succession process planning, I believe the appropriate thing to do is that Chris will become our Chairman and CEO and that was done with much consideration with our board about what is the right leadership structure for Key, and yes, I will fully retire as of May 1st.

Hey, guys. I just wanted to ask on the fees for the third quarter, you had the 15 million in securities gains which is a little unusual for KeyCorp. Is that something - like, are you going to have additional securities gains going forward or as we think about. And, I guess, the genesis of the question is, as we think about the fourth quarter guide, that's off the reported $650 million base, right? So maybe you could talk a little bit more about sort of the puts and takes on fee momentum into the fourth quarter. Sound like the investment banking pipeline is solid, which should be helpful, of course, but maybe some of the other things that would drive growth off that base as well.

Scott, we didn’t have any security gains during the quarter. We did have a gain from the sale of some - an investment in a partnership we participated in, but I'm - I apologize, I don’t know where you're picking up the $15 million in security gains with all that.

I’m sorry, it's just in the footnote on slide 17.

Okay.

Three and nine months totaled $15 million. We can talk about that offline.

Good. We’ll go through that, I apologize. But that probably includes the gain there along with the gain on the securitization transaction we had from the sale of some of the Laurel Road loans, but we'll follow up with you on that as well.

Okay. PERFECT. Okay. So either way, though, the guide is indeed off that $650 million base, right?

I would say that the $650 million is core, and our guidance would be based or included to that, there from the reference for the $650 million, so we expect to see growth from there going forward.

Again, we thank you for participating in our call today. And if you have any follow-up questions, you can direct them to our Investor Relations team at 216-689-4221. That concludes our remarks, and thank you again for your time this morning.