We are downgrading our recommendation on KeyCorp (KEY) to Neutral from Outperform based on continued pressure on net interest margin and its inability to repay TARP money.
KeyCorp’s fourth quarter 2010 net income from continuing operations of 33 cents per share substantially outpaced the Zacks Consensus Estimate of 13 cents. This also compared favorably with net loss from continuing operations of 30 cents in the prior-year quarter.
A strong capital position and continued improvement in credit quality across the majority of loan portfolios in both Community Banking and Corporate Banking were also among the positives. However, lower average earning assets and average interest-bearing deposits were the downside.
KeyCorp remains focused on improving its branch and deposit density with an aim to increase its market share. The main focus will likely be on markets in its western footprint in either the Pacific Northwest or Rocky Mountain states. Management also remains open to the possibility of FDIC-assisted deals as well as unassisted transactions, as long as its M&A objectives are achieved by the transaction.
Improving credit quality remains a positive catalyst for KeyCorp at this point. Though credit quality metrics remained weak in 2009, a sharp improvement across the majority of loan portfolios in both Key Community Banking and Key Corporate Banking was witnessed during 2010. We expect the company’s business restructuring actions to further support thecredit quality in the upcoming quarters.
KeyCorp continues to reorganize and realign its operations and business segments in order to improve its business mix by exiting risky and unprofitable operations.
On the flip side, although management wishes to repay its $2.5 billion of Troubled Asset Relief Program (TARP) loans, the timing is unclear, given an uncertain near-term credit/earnings outlook and its focus on maintaining profitability. For repayment, KeyCorp might have to indulge in capital raise in the upcoming quarters, which might have a dilutive effect on its earnings per share.
In December 2010, the Basel Committee released its final framework for strengthening international capital and liquidity regulation (“Basel III”). While KeyCorp has a strong liquidity position, the Basel III liquidity framework could require the company to initiate additional liquidity management initiatives, including the addition of more liquid assets, issuing term debt and modifying product pricing for loans, commitments and deposits. All these will likely lead to additional expenses over the medium term and could hurt the company financials.
Finally, due to overall weak demand and high competition, balances in KeyCorp’s core portfolio continue to shrink. Until economic recovery gains momentum, these factors will continue to affect the financials of the company.
KeyCorp currently retains a Zacks #3 Rank, which translates into a short-term ‘Hold’ rating. Fifth Third Bancorp (FITB), one of KeyCorp’s closest competitors, also retains a Zacks #3 Rank (short-term ‘Hold’ rating).
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