Equity Research Report
Yao Yao
March 31st, 2014
412-251-8230
Yao.344@osu.edu
Student Investment Management Report
● Ticker: NYSE: KEY
● Current Price: $14.24 (March 31, 2014)
● Target Price: $16.92 (18.85% upside potential)
Sector: Financial Industry: Regional Banks
KeyCorp
● Recommendation: BUY
Company Profile
Market Profile (as of 3/31/2014)
52-Week Range
$9.29 – $14.70
P/E (ttm)
14.35
Price/BV
1.26
Beta
1.6
Dividend Yield
1.50%
ROE
8.44%
ROA
0.96%
Market Cap.
$12.43 billion
Institutional
Holdings
Shares
outstanding
Book Value per
Share
889.40M
Assets
$93 billion
Deposits
$69 billion
Cash per Share
$2.37
Branches
1,028
Employees
14,000
83.90%
$ in M except
per share data
Net Interest
Income
Noninterest
Income
Total Net
Loans
Total Assets
2013A
2014E
2015E
2016E
2017E
2018E
$2,325
$2,287
$2,882
$3,026
$3,177
$3,336
$1,734
$1,873
$2,023
$2,184
$2,359
$2,548
$53,609
$58,070
$60,974
$64,022
$67,227
$70,585
$92,934
$101,914
$105,750
$110,523
$115,535
$120,797
Basic EPS
$0.97
$1.11
$1.71
$1.94
$2.19
$2.45
Dividend Per
Share
$0.22
$0.27
$0.34
$0.39
$0.44
$0.49
ROA
1.01%
0.95%
1.03%
1.12%
1.23%
1.33%
ROE
8.88%
8.58%
9.40%
10.15%
11.30%
12.26%
Source: Company data, Bloomberg, analyst’s estimates
Company Description
$11.24
KeyCorp (KEY) operates as the bank holding company for KeyBank that
provides various retail and commercial banking services to individual,
corporate, and institutional clients in the U. S. through the company’s Key
Community Bank segment and Key Corporate Bank segment. KeyCorp also
provides personal, securities lending, custody services, access to mutual
funds, treasury, investment banking, and investment management services.
Investment Thesis
Source: Analyst estimates, Yahoo!
Finance
50%
Figure 1: Trailing 12-month
performance vs. S&P 500
I recommend a BUY on KEY for the following reasons:


40%
30%


20%
10%
I believe rising interest rates, among other improved macroeconomic
conditions will play out favorably for banks like KEY
Current discount of KEY shares is not justified by the company’s
healthy financial performance and promising strategies
Well-positioned in the Midwest market with fast-growing client base
Well-managed capital with industry leading payout ratio
Risks to Recommendation
0%

-10%
Mar-13
Sep-13
KEY
Mar-14
S&P 500
Source: Analyst estimates, Yahoo!
Finance


Failure to realize expense-saving initiatives could lead to KEY shares
underperforming its peers
Failure to spur organic growth under disciplined capital management
and risk control could result in KEY shares underperforming
Failure to grow its net interest income margin can lead to KEY lagging
its peers
OSU Student Investment Management
March 31, 2014
Table of Contents
Company Overview .............................................. 2
Business Segments ................................................ 2
Trends in the Banking Industry ............................... 3
Competitive Position and Current Strategies ......... 4
Overall Company Outlook ...................................... 5
Investment Thesis............................................ 6
Economic Analysis .................................................. 6
Financial Analysis ................................................... 7
Risk ................................................................... 8
Credit Risk .............................................................. 8
Capital and Liquidity Risk ....................................... 8
Interest Risk ........................................................... 9
Valuation ........................................................... 9
Trailing Twelve Month Performance ....................... 9
DCF Valuation ...................................................... 10
Relative Valuation................................................. 12
Risk to Target Price .............................................. 13
Conclusion ..................................................... 13
Appendices .................................................... 14
Sources ........................................................... 19
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March 31, 2014
Company Overview
Figure 2: Distribution of KeyCorp banking
network
Organized in 1958, the Cleveland, Ohio-based KeyCorp is a bank holding
company and is the 15th largest financial services company in the U.S., with
consolidated total assets of approximately $92.9 billion at December 31,
2013. Through KeyBank and certain other subsidiaries, KeyCorp provides a
wide range of retail and commercial banking, commercial leasing, investment
management, consumer finance, commercial mortgage servicing and special
servicing, and investment banking products and services to individual,
corporate, and institutional clients through two major business segments: Key
Community Bank and Key Corporate Bank.
As of December 31, 2013, KeyBank provides its services through 1,028 fullservice retail banking branches and a network of 1,355 ATMs in 12 states, as
well as additional offices, online and mobile banking capabilities, and a
telephone banking call center. KeyCorp and its subsidiaries had an average
of 14,783 full-time equivalent employees as of 2013.
Business Segments
KeyCorp has two major business segments: Key Community Bank and Key
Corporate Bank. Key Community Bank serves individuals and small to midsized businesses by offering services including deposit, investment, lending,
credit card and personalized wealth management products and business
advisory services. These products and services are offered through its
relationship managers and specialists working in its 12-state branch network,
which was reorganized during 2013 into nine internally-defined geographic
regions (See appendix 1 for detailed geographic presence of Key Community
Banks).
Key Corporate Bank is a full-service and investment bank focused primarily
on serving the needs of middle market clients in six industry sectors:
consumer, energy, healthcare, industrial, public sector and real estate. Key
Corporate Bank offers to its clients banking and capital markets products
including syndicated finance, debt and equity capital markets, commercial
payments, equipment finance, commercial mortgage banking, CMBS,
derivatives, foreign exchange, financial advisory, and public finance.
Trends in the Banking Industry
Regulation will continue to increase in 2014
As a result of powerful regulations including Dodd-Frank Act and Basel III
Capital guidelines, banks will continue to be closely regulated and required to
readjust the way they do business. In fact, the banking industry has already
seen some moves in response to increased regulation. For example,
Citigroup decided to sell off lines of business such as its consumer-lending
unit in 2012 as new regulations require specific compliance in each line of
business, adding costs to banks.
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Some provisions of Dodd-Frank and capital requirements of Basel III, among
others, have particularly acted as potential drags to banks’ profits going
forward. For example, one provision of Dodd-Frank cuts the fees merchants
have to pay each time their customers swipe a debit card—a revenue source
worth some $16 billion each year according to a Bloomberg estimate.
These regulations are likely to influence KeyCorp heavily as the bank would
have to readjust its business in compliance with the legislature. Some assets
of KeyCorp such as noninvestment-grade corporate loans and other high-risk
financial contracts such as derivatives will have to be reexamined before
KeyCorp can decide whether to continue to hold these assets.
Banks to focus on developing competitive advantage in
technology
New technology has change consumer behavior by allowing consumers to
complete transactions such as paying bills or making deposits directly without
going to a bank. The increasing popularity of online and mobile banking such
as PayPal and Google Wallet has narrowed the moat banks have in payment
and deposit networks. With technology advances, some non-financial
companies are able to provide financial services and capture some part of the
value chain of traditional financial institutions. For example, Google recently
introduced a plastic debit card for its Google Wallet; Starbucks now receives
one-third of its revenues through its own loyalty cards; Walmart launched a
prepaid card that works like a debit account. The rise of financial services
from non-financial companies has posed a threat to traditional banks
including KeyCorp.
As increased competition from non-financial companies raise expectations
between banks and their customers, failure to adopt technological innovations
could lead to loss of fee income, loss of customer deposits and related
income generated from those deposits. If KeyCorp fails to adapt to changing
consumer preferences of making payments and deposits and meet regulatory
standards, its market share and financial performance could be negatively
impacted.
Increased industry consolidation
In years following the financial crisis of 2008, greater concentration has been
resulted from mergers and acquisitions in the banking industry, posing
increased pressure on banks. As a result of increased M&A activities in the
banking industry, certain deposits and banking assets were redistributed and
captured by larger financial institutions. The 2008 financial crisis accelerated
the long-term contraction in the commercial banking industry and allowed the
four largest commercial banks to increase their market share. During the five
years to 2013, the number of commercial banks is on track to decline at an
average rate of 2.2% annually.
Growing through acquisitions has been a strategy of KeyCorp. In the recent
years, the company has expanded its financial service offerings through
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Figure 3: 2013 Revenue Components
Noninter
est
Income
40%
Interest
IncomeLoans
49%
Other
Interest
Income
11%
Source: Company 10-K
March 31, 2014
acquisitions of several mortgage servicing companies— in 2013, it purchased
from Bank of America a commercial mortgage servicing portfolio of $110.5
billion as well as a commercial mortgage-backed securities (CMBS) special
servicing portfolio of $ 14 billion, making it the fifth largest CMBS special
servicer in the United States. I believe there is very little chance that KeyCorp
will become a buyout target as KeyCorp has continuously set up financial
goals to improve its financial performance and the management has shown
no interest in selling the company. Additionally, KEY’s sizeable current market
capitalization will make the company a very expensive buyout target.
Competitive Position and Current Strategies
KEY’s competitors primarily include national and super-regional banks as well
as smaller community banks within the various geographic regions in which
KEY operates. Additionally, many of KeyCorp’s competitors in the shadowbanking industry enjoy few regulatory constraints such as capital requirement,
liquidity requirement, and reporting requirement. These differences enable
shadow-banking participants such as business development companies
(BDCs) and collateralized loan obligation (CLOs) finance companies to
provide less expensive source of capital and vie for businesses in need of
finance. To compete with both traditional and non-traditional financial service
companies, KeyCorp has to keep expanding its product lines and adapting its
products and services to evolving industry standards and clients’ preferences,
while maintaining competitive prices.
Focusing on organic growth
Figure 4: Components of
Noninterset Income-2013
Trust
and
investme
Other,
nt
24%
services,
22%
Investm
Cards&
ent
payment
banking
s, 9%
Service
and debt
Corporat charges
placeme
on
e
nt fees,
deposit
services,
19%
accounts
10%
, 16%
Source: Company 10-K
Historically, interest income from loans accounts for 60% of KEY’s revenues,
the majority of which is generated from the company’s loan portfolios. In
2013, period-end loans grew by 6.4% from prior year compared to 7% of
peers. Loan growth was mainly driven by the growth in Commercial, Financial
and Agricultural (CF&A) loans, which was up by 8% and accounts for 40% of
the total loan balances of KEY at the end of 2013. The most recent trend of
increasing loan commitments and stable utilization reflects KEY’s distinct
business model with a targeted approach in the middle market. KEY’s 2014
guidance is relatively positive and is very similar to what many banks have
guided to expect in the year ahead: mid-single digit loan growth, slight
downward pressure on net interest income and net interest margin.
Noninterest revenues continue to grow fast. KEY generated $333 million from
investment banking and debt placement fees in 2013, a 270% growth from
2008. Its card and payment services grew 20% and mortgage servicing more
than doubled in 2013. The fast-growing noninterest income reflects KeyCorp’s
diversified services, which enable the company to maintain a robust profit
generation in a low interest environment.
Overall Company Outlook
KeyCorp’s 2013 period-end loans were up 6.4% on a year-over-year basis
including 11% growth in Commercial and Industrial (C&I) and 10% growth in
Commercial Real Estate (CRE). From the 4Q13 earnings conference call, the
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company expects to see average loan growth in the mid-single digit range
(4%-6% as defined by the KEY’s management) for year 2014 with net interest
income margin regain close to current levels. Effects from the lower rate
environment will likely have a 1-2 bps quarterly impact, although this will likely
be largely offset by improved utilization rate. The company believes that the
4Q trends from CRE and equipment finance are a good launching point for
2014. Utilization rates were relatively stable, but are expected to increase,
while commitments were up.
Figure 5: Recent Trend in Average Loan Balances
1Q13
2Q13
3Q13
4Q13
Avg. Loans and leases ($b)
29.0
29.2
29.5
29.6
q/q % change
1.2%
0.7%
1.0%
0.3%
20.0
20.1
20.6
21.0
2.90%
0.5%
2.5%
1.9%
Community Bank
Corporate Bank
Avg. Loans and leases ($b)
q/q % change
Source: Company 10-K
Fee revenues were up 12% in 2013 and were 2% higher than a year ago.
KEY added 648 new corporate clients in 2013, adding $108 million in
revenues and 428 clients where the company expanded relationship, which
brought in another $259 in revenue. The management expects low singledigit fee income growth in 2014 with investment banking, debt placement fees
and cards leading the growth.
Expenses were a focal point of the discussion in KEY’s 4Q13 earnings
conference call. In the 4Q13, the company had one-time expenses of $24
million including expenses related to operating loss, technology costs and
compensation plans. Going forward, the management believes that these
costs are nonrecurring and there is room to further improve efficiency. The
management indicated that they expect to stay in the 60-65% efficiency range
throughout 2014. KEY expects to see a one-time cost of $30 million
associated with cost-saving initiatives, which is included in the company’s
2014 expense guidance.
Figure 6: Management Outlook for 2014
Average loan growth
Management Outlook for 2014
mid-single digit range
Net interest income
relatively stable from 2013
Fee income
grow in the low single-digit percentage range
from 2013
decline in the low single digit percentage range
from 2013
at the low-end or below targeted range of 40-60
bps
$90 million for 1Q14 approved by CCAR
Expense
Net charge-offs
Remaining repurchase
authorization
Source: KEY 4Q13 earnings conference call
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Investment Thesis
Economic Analysis
Improved U.S. manufacturing to push demand for commercial &
industrial loans high
According to Bloomberg, U.S. business inventory growth has improved in
early 2014 following signs of a turn in 4Q13. Growth had been decelerating
since peaking in May of 2011 and fell below its long-term average through
3Q13, reaching a trough pace of 3.1% in September. Growth has improved to
4.4% in January 2014, above historic averages. Business inventories drive
financing needs, and improving growth may lead to better commercial and
industrial (C&I) loan growth at banks like KEY.
Figure 7: US C&I Loans & Leases in comparison to US Manufacturing & Trade
Inventory growth and KEY’s Stock Price
50
1800
40
1600
1400
30
1200
20
1000
10
800
600
0
400
-10
-20
April-00
200
January-03
October-05
July-08
April-11
0
January-14
US C&I Loans & Leases
US Manufacturing & Trade Inventories Growth % YoY
KeyCorp - Last Price
Source: Bloomberg
Consumer spending to accelerate in 2014 and 2015
Estimates from Bloomberg Industry imply that U.S. consumer spending is
expected to grow on a real basis at 2.5% in 2014 and 2.7% in 2015. In
addition, U.S. consumer borrowing as a share of income has grown relatively
to savings rate since 2010, indicating expansionary consumer spending,
which can help support higher payment volume received by banks.
Improvement in job market leads to better credit quality
Credit card delinquencies declined to 2.5% in 2Q2013 for the U.S. banks—an
all-time low since tracking began in 1991. U.S. initial jobless claims tend to
lead credit card delinquencies, which reflect credit costs. Further decline in
U.S. initial jobless claims has helped banks achieve low delinquencies, which
in turn, help reduce costs and increase profit margins.
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Figure 8: U.S. Initial Jobless Claims
Rising rates to play out favorably for banks like KEY
I believe rising interest rates with meaningful economic growth would play out
favorably for banks like KEY. Although most banks have already realized
much cost savings from optimizing its branch network and investing in mobile
technology since late 2008, Net Income Margin (NIM) continues to be
squeezed in the low interest rate environment due to banks’ assets including
loans and securities being repriced at lower rates. When rates move up,
banks’ securities portfolios will be marked down; however, the executives of
KEY mentioned that the duration and characteristics of KEY’s loan and
investment portfolio continue to positions to realize more benefit from a rise in
the shorter end of yield curve. As commercial and industrial lending enter the
year of 2014 in a high note and foreseeable rising interest, mortgage banking
revenue would come back as a source of strength for regional banks like KEY
with higher gains for banks on newly originated loans.
Figure 9: DuPont Analysis (2013)
ROE
8.44% 7.92%
Specifically, KEY would benefit more from a rise in short-term rates than longterm rates as home-equity loans, credit-card rates and working capital lines of
credit to businesses are among banks assets that are priced to short-term
borrowing benchmarks such as the prime rate, fed funds rate or Libor.
Financial Analysis
Better-than-peers profit generation
ROA
0.96% 0.85%
ASSET/EQUITY
8.79 9.32
NET INCOME/SALES
22.3% 18.1%
SALES/ASSETS
0.043 0.047
*Competitors’ data in black
Source: Capital IQ
KEY operates as the second largest bank in the state of Ohio. According to
the data provided by the market research of Mercer Capital (Appendix 6), as
th
th
of March 21, 2014, KEY’s 52-week ROE and ROA were ranked 7 and 5
among 16 Ohio-based regional banks, both higher than the average of peers.
th
Its loan loss reserve as a percentage of total loans was ranked 5 /16,
reflecting a conservative management of credit. High loan provision normally
can help increase capital market multiples such as P/E as it make banks
report less net earnings; however, KEY’s last-twelve-month P/E was only
th
ranked as the 10 /16. KEY’s Forward P/E in the 2014 improved significantly
th
to the 6 among its peers, indicating market’s expectation of higher-thanth
peers cash flow growth. Except for the efficiency ratio ranked 10 /16, KEY
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has no other disadvantages compared to its Ohio-based peers.
Based on the DuPont analysis, KEY’s ROE is 50 bps higher than the average
of Ohio-based commercial banks, which is primarily due a better return on
assets even with a lower-than-peers leverage ratio. KEY’s ROA, on the other
hand, is driven by better net profit margins from all of its business lines.
Expense efficiency remains management’s focus in 2014
In addressing expenses, KEY has consolidated 8% of branches through
4Q13. The company achieved cost savings target with $241 million in saving
through Dec. 31, 2013 and a 65% cash efficiency ratio in for 2013, excluding
charges related to the efficiency initiatives. Although the company’s fell short
of analysts’ expectation, I expect the efficiency ratio to rise steadily in 2014 as
the company indicated in its earnings call that some expense items will be
nonrecurring going forward.
Outstanding payout ratio
KEY currently maintains a dividend payout ratio of 22%. After the company
2014 capital plan has been approved by the Fed Reserve, KEY is estimated
to achieve a total payout ratio of 78% including share repurchases—the
highest in its peer group.
Risks
KEY constantly faces certain risk factors that could potentially threaten the
performance of KEY’s business. Specifically, these risk factors could impose
volatility on the company’s income, cash flow, and financial flexibility and
should, therefore, be closely watched.
Credit Risk
KEY could incur losses in the case of defaults and collateral being liquidated
at a price insufficient to recover the full amount of loan. Unforeseen loan
losses or charge-offs may force KEY to increase its loan and lease loss
provisions, which decrease its net income and capital.
70% of KEY’s loans consisted of commercial, financial and agricultural loans,
commercial real estate loans, and commercial leases. These types of loans
are typically larger than residential real estate loans and consumer loans and
could have a significant impact on KEY’s financial performance.
Capital and Liquidity Risk
In compliance with the Dodd-Frank Act and the Regulatory Capital Rules,
financial institutions like KEY are required to maintain a higher level of liquid
short-term investment, or readjust their mix of funding alternatives, which may
impact business relationships with certain customers. It reduces KEY’s ability
to invest in some longer-term assets even if more desirable from a balance
sheet management perspective. For example, KEY has raised concerns that
some of the market-making activities and trades of less liquid securities
demanded by its clients of KEY can be deemed as proprietary trades and
banned under Volcker Rule.
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In addition, Federal Reserve requires bank holding companies to be approved
before distributing capital, such as dividends, stock repurchases. On March
th
26 , 2014, KeyCorp announced that its proposed capital plan submitted
during the 2014 Comprehensive Capital Analysis and Review has been
approved by the Federal Reserve. KEY’s 2014 capital plan includes a
common share repurchase program of up to $542 million and an increase in
the quarterly common share dividend from $0.055 per share up to $0.065 per
share.
Interest Risk
In its FOMC meeting in March 2014, the Federal Reserve has decided to
scale back its monthly security purchase program by $10 for the second time
in a row, keeping the anticipated taper on course as the U.S. economy
continues to improve. The start of taper grow market’s anticipation of
increased interest rate, fueling an upward movement of debt yields, which
could discourage borrowing and hinder KEY’s lending business.
KEY’s earnings and cash flows are greatly dependent upon its net interest
income as interest income historically accounts for about 60% of the total
revenue of KEY. Interest rate is highly dependent to many macro-economic
factors that are beyond KEY’s control.
Changes in interest rates could impact the amount of interest KEY receives
on loans and securities, the amount of interest KEY pays for deposits and
borrowings, the company’s ability to originate loans and receive deposits, and
the fair value of KEY’s financial assets and liabilities. KEY uses interest rate
swaps to manage and adjust its interest rate position. According to KEY’s 1Q
earnings conference call, KEY expects the net interest income to be relatively
stable with reported level in 2013.
Valuation
Figure 10: Valuation Summary
Valuation
Estimated Price
Weights
Target Price
DCF
Multiple
Pricing
$20.23
$15.51
30%
70%
$16.92
Source: Analyst estimates
Trailing Twelve Months Price Performance
KEY’s stock price in the past twelve months has outperformed both S&P 500
Index and KBW Bank Index, an index consisting of the stocks of 24
companies representing leading national and regional banks. For the period
of March 2013-March 2014, KEY shares have increased 41.48% versus
26.21% for the KBW Bank Index and 18.31% for the S&P 500. In January
2014, KEY reported its 4Q 2013 net income from continuing operations
available to common shareholders of $229 million, or 25 cents a share, up
from $190 million, 20 cents a share from 3Q 2013. The higher 4Q EPS
reflected a lower share count as KEY repurchased $474 million worth of
common shares during 2013, including $99 million in buybacks during the 4Q.
Combining dividends and share repurchases, KEY has returned 76% of
earnings in total to shareholders in 2013, making it one of the banks with
highest payout ratio in the industry.
While KEY’s interest income has continued to be the company most reliable
source of income, supported by a modest loan growth of 3.4% from a year
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earlier to 53.6 $billion and noninterest income continue to post strong growth
in 2013, KEY shares still trade at a sizable discount to peers. In KEY’s most
recent quarter, in spite of beating the analysts’ earnings forecast, KEY shares
have seen a sell-off following higher-than-expected expenses posted in the
4Q 2013. However, I believe the company is currently on the right track of
improving efficiency and further spurring its growth in a revitalizing lending
market. In addition to KEY’s already strong noninterest income growth,
continued improvement in efficiency can be achieved within FY 2014, which
should drive share price up.
50%
Figure 12: KEY stock performance compared to S&P 500 and
KBW Bank Index
40%
41.48%
30%
26.21%
20%
18.31%
10%
0%
-10%
Mar-13
May-13
Jul-13
KEY
Aug-13
Oct-13
KBW Bank Index
Dec-13
Jan-14
Mar-14
S&P 500
Source: Yahoo! Finance
DCF Valuation
KEY provides well-established financial products and services and has a long
history of stable revenues and returns; therefore, the current financial
statements provide a reliable source for estimating free cash flows to the
company from existing assets, which are reflected in the DCF model. The
comparable companies have been selected among publicly traded Midwest
banks, most of which are based in Ohio. Since many of the assets KEY holds
are financial assets that are traded, and get valued and revalued in a timely
manner, the market prices, which are reflected in the price multiples are
sufficiently relevant when valuing KEY. In other word, there is a lesser need
for subjective judgment with financial assets and thus, by using the pricemultiple valuation, we can avoid, to some extent, subjective judgment that we
might not be able to avoid in other valuation approaches. Therefore, in
establishing the target price of KEY, the DCF is given a 30% weight and the
relative valuation is given a 70% weight.
Based on the DCF analysis, the implied price for KEY is $20.23 per share
(See appendix 4 for detailed DCF analysis). Assumptions for my DCF model
are based on KEY’s most recent 3-year financial performance as well as the
management’s suggested outlook for 2014:
Pretax income margin
The pretax income margin reflects the top line financial performance of KEY.
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Pretax income margin is driven by growth in interest income, noninterest
income, and control over costs. Based on my analysis, I projected an average
pretax income margin of 27% over the projected period of 2014-2023.
Sensitivity analysis (appendix 7) further shows that the company’s implied
share price would vary from a price range of $16.9 to $24.0 due to variation in
the forecasted pretax income margin.
Figure 13: Cost of Capital Estimate
Components of WACC
Risk-free Rate (10yr US TBond)
Beta
Expected Market Return
2.74%
1.6
11.59%
Expected Market Premium
8.85%
Risk-free Rate
2.74%
Cost of Debt
Effective Tax Rate
Cost of Preferred Stock
2.32%
28%
Cost of capital
KEY capital structure is a combination of equity, debt, and preferred equity.
My estimated cost of capital (WACC) is 10.42%. I used the US 10-year
Treasury Bill rate of 2.74% as quoted on 3/31/2014 as risk-free rate. I use
Bloomberg’s estimated market premium of 8.85% and I believe risk premiums
and interest rates in the U.S. will not change drastically over our projection
period. I applied an adjusted beta of 1.6 in calculating KEY’s cost of equity,
which is based on the 3-year regression analysis of KEY stock prices on
S&P500 index during the period of 2011-2013. According to my sensitivity
analysis, the largest amount of price variation in DCF-implied KEY share price
is caused by the variation of WACC (appendix 7).
9.62%
Source: Analyst estimates, Bloomberg
interest income growth
In January, 2014, KEY reported earnings for the fiscal 2013 fourth quarter.
KEY reported a net interest income of $589 million, increasing slightly from
$584 million the previous quarter. On a year-over-year basis, KEY’s interest
income was up 7.86% in spite of a narrow net interest margin. Average total
loans grew 0.6% during the fourth quarter and 3.4% from a year earlier to
$53.6 billion. Following the trend for many large regional banks, the strongest
growth category was commercial and industrial loans, which were up 7.9%
year-over-year. As the company estimated that its interest income will be
relatively stable in 2014, I used a 2% growth rate for interest income through
the projection period.
Noninterest Income Growth
Figure 14: Fee revenues of investment
banking and debt placement
In the fourth quarter of 2013, KEY’s noninterest income totaled $453 million,
up 3.2% from $439 million a year earlier and was up 2% from prior year,
benefitting from strong growth in investment banking, cards and payments,
and mortgage servicing fees. I used 3% growth rate for the noninterest
income through the projection period.
Loan and Lease Losses % of Interest Income
I used the historical data of Loan and Lease Losses as a percentage of
interest income, which is 9%, in the projection period of DCF model.
Terminal Growth Rate
Sources: Company 4Q2013 earnings
review
I estimated KEY’s terminal growth rate after the discrete forecast period by
taking into account of the US GDP growth rate and the industry outlook for
the U.S. commercial banking industry. The commercial banking industry is
characterized by increased M&A, market saturation and intense product
competition. During the period of 2008-2018, industry value added (IVA),
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March 31, 2014
which measures the industry’s contribution to the overall economy, is
expected to grow at an annualized rate of 2.2%, compared with a 2.1%
average annual growth rate for the US economy’s GDP. This level of IVA
growth suggests the industry is growing at the same rate as the US economy
and that this industry is in the mature phase of its life cycle. Therefore, I used
a terminal rate of 2.1% in my DCF model.
Figure 16: United States GDP annual Growth Rate
Tax Rate
The company estimated a 26%-28% effective tax rate going forward in 2014,
excluding the impact from any additional ease terminations. I used tax rate of
28% in the DCF model.
Relative Valuation
Figure 17: KEY historical P/B ratio
2.50
Historical P/B ratio
2.00
1.50
1.26
1.00
0.50
0.00
2002
2006
Source: Capital IQ
2010
2014
For the relative valuation, I used price multiples of KEY and selected regional
banks, including Fifth Third Bancorp (FITB), M&T Bank Corp. (MTB)
Huntington Bancshares Inc. (HTBN), Regions Financial Corp. (RF), First
Financial Bancorp. (FFBC), FirstMerit Corporation (FMER), and Park National
Corporation (PRK) (See appendix 2 for the business descriptions of
competitors). Enterprise value multiples such as EV/EBITDA are not adapted
in the valuation of KEY because neither enterprise value nor operating
income can be consistently defined across different banks. The price
multiples used in the relative valuation include price to earnings (P/E), price to
book (P/B), and price to sales (P/S) ratios. The relative valuation implied
share price ranges from $14.85 to $15.90 (See Appendix 5).
KEY shares currently trade at 1.3 times its book value, 14.35 its trailing twelve
month earnings and 3.19 times sales, while KEY’s P/E and P/S ratios are
close to the average value of all the comparable companies, KEY’s P/B value
is notably lower than peers. The current P/B value of 1.26 is only at a medium
level compared to what it was historically. Over the last 5 years, KEY shares
have traded with a P/E ratio in the ranged of 7.19 to 17.24, P/B ratio in the
range of 0.59 to 2.07, and P/S ratio in the range of 1.67 to 4.32.
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Risk to Target Price
Figure 18: Historical Price vs. Target Price
$20
Target price: $16.92
$18
$16
18.85% upside
potential
$14
$12
$10
$8
$6
$4
$2
$0
Jan-12
Feb-13
Mar-14
Source: Analyst estimates, Yahoo!
Finance
The effectiveness of the DCF valuation depends on the quality of my forecast
of the Company’s future financial performance—income growth, expense
ratio as well as cost of capital. The assumptions used in the DCF model are
based on my understanding of the company’s business activities in its current
state. Should the company sees a significant deterioration in operations,
which impacts the company’s profits negatively, KEY shares may
underperform.
I view the current growing trend of KEY’s loan portfolios and noninterest
business lines as stable. Should the company’s loan portfolios and sources of
noninterest income shrink in the future, KEY shares could underperform
compared to its peers.
I performed Monte Carlo simulation and sensitivity analysis (See appendix 7
for detailed sensitivity analysis on KEY share price) on my model to check to
what degree the DCF-implied share value is subject to changes in the
valuation assumptions. From the Monte Carlo analysis (See Appendix 8 for
detailed Monte Carlo analysis) I derived a mean share price of $20.49, which
is in line with my base-case DCF estimate.
Conclusion
I believe the current market price of KEY trades at a significant discount to its
peers; therefore, I recommend a Buy on KEY with an upside potential of
18.85%, as suggested in my valuation. Specifically:






As the company continues to implement its cost-reduction initiatives, I
believe some one-time expenses will not be recurring in 2014.
I believe the company will improved its operation efficiency going
forward.
I believe rising interest rates, especially short-term interest rates, will
benefit KEY as the NIM of KEY’s loan portfolios becomes wider.
In spite of costs associated with compliance with stricter regulations,
KEY has been able to readjust its business model to generate
consistent profits.
Keycorp has well positioned itself in the Midwest market as loans
continue to grow in line with peers and fee revenues continue to grow
fast.
KEY’s management looks to return 78% of its earnings in 2014 to its
shareholders, following a 76% total payout ratio in 2013, which is
significantly higher than its peers.
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Appendix 1: Geographic Presence of Key Community Bank
Geographic Region
($ in millions)
12/31/2013
Oregon
& Alaska
Average deposits
Percent of total
Average commercial
loans
East
Ohio
Easter
n New
York
New
England
Western
New
York
NonRegion
Total
$4,461
$8,675
$8,055
$2,913
$5,005
$2,648
$49,723
4.6%
9.0%
17.4%
16.2%
5.9%
10.1%
5.3%
100.0%
$1,620
$806
$1,179
$2,064
$1,753
$790
$526
$2,839
$15,041
Washington
Rocky
Mountains
Indiana
West
Ohio/Michigan
$4,289
$6,597
$4,768
$2,312
8.6%
13.3%
9.6%
$1,649
$1,815
Percent of total
Average home
equity loans
11.0%
12.1%
10.8%
5.4%
7.8%
13.7%
11.7%
5.3%
3.5%
18.9%
100.0%
$1,338
$1,861
$1,553
$467
$832
$1,255
$1,284
$625
$760
$111
$10,086
Percent of total
13.3%
18.5%
15.4%
4.6%
8.2%
12.4%
12.7%
6.2%
7.5%
1.1%
100.0%
Source: Company 10-K
Appendix 2: Competitors in Midwest
Competitors
Business Description
Fifth Third Bancorp
Fifth Third Bancorp operates as a diversified financial services company through four segments:
Commercial Banking, Branch Banking, Consumer Lending, and Investment Advisors. As of February 5,
2014, the company operated 1,313 full-service banking centers, including 102 Bank Mart locations, as
well as 2,607 automated teller machines. Fifth Third Bancorp is headquartered in Cincinnati, Ohio.
M&T Bank Corp.
M&T Bank Corporation operates as the bank holding company for M&T Bank that provides commercial
and retail banking services. As of December 31, 2013, it had 720 banking offices in New York,
Pennsylvania, Maryland, Delaware, Virginia, West Virginia, and the District of Columbia; a commercial
banking office in Ontario, Canada; and an office in George Town, the Cayman Islands. The company
was founded in 1856 and is headquartered in Buffalo, New York.
Huntington
Bancshares
Huntington Bancshares Incorporated operates as the bank holding company for The Huntington
National Bank that provides commercial, small business, and consumer banking services. As of
February 13, 2014, it had approximately 700 branches and 1,500 automated teller machines in Ohio,
Michigan, Pennsylvania, Indiana, West Virginia, and Kentucky. Huntington Bancshares Incorporated is
headquartered in Columbus, Ohio.
Regions Financial
Regions Financial Corporation, together with its subsidiaries, provides banking and bank-related
services to individual and corporate customers through three segments: Business Services, Consumer
Services, and Wealth Management.
First Financial
Bancorp
Headquartered in Cincinnati, Ohio, First Financial Bancorp operates as a holding company for First
Financial Bank that provides commercial banking and other banking and banking-related services to
individuals and businesses. It offers various deposit products that include interest-bearing and
noninterest-bearing accounts, time deposits, and cash management services for commercial
customers. As of December 31, 2013, the company operated 110 banking centers consisting of 57
banking centers located in Ohio, 49 banking centers in Indiana, and 4 banking centers in Kentucky.
FirstMerit
Headquartered in Akron, Ohio, FirstMerit Corp. operates as a bank holding company for FirstMerit
Bank, N.A. that provides various banking, fiduciary, financial, insurance, and investment services to
corporate, institutional, and individual customers. As of December 31, 2013, it operated a network of
404 banking offices and 431 automated teller locations, which included 156 branches in Ohio; 44
branches in Chicago, Illinois; 153 Michigan branches; 47 Wisconsin branches; and 4 branches in
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March 31, 2014
Western Pennsylvania, as well as a loan production office in Indianapolis, Indiana.
Park National
Headquartered in Newark, Ohio, Park National Corporation operates as the bank holding company for
Park National Bank that provides commercial banking and trust services in Ohio and northern
Kentucky. As of March 31, 2013, the company operated 123 bank branches. Park National, through its
subsidiaries, also engages in consumer finance, aircraft financing, trust, and asset management
businesses. In addition, it is involved in marketing and selling real estate properties purchased from
Vision Bank.
Source: Bloomberg
Appendix 3: Income Statement
KeyCorp - Income Statement
Historical
($ in Millions Except Per Share Data)
Projected
Year
2011
2012
2013
Total Interest Income
$2,889
$2,705
$2,620
$2,859
$3,002
$3,152
$2,979
$3,128
$622
$441
$295
$572
$720
$756
$794
$834
$2,267
$2,264
$2,325
$2,287
$2,281
$2,396
$2,184
$2,294
-$60
$229
$130
$150
$150
$150
$150
$150
Net Interest Income
$2,327
$2,035
$2,195
$2,137
$2,131
$2,246
$2,034
$2,144
Total Noninterest Income
$1,808
$1,967
$1,734
$1,873
$2,023
$2,184
$2,359
$2,548
Net Revenue
$4,135
$4,002
$3,929
$4,010
$4,154
$4,430
$4,393
$4,691
$4,160
$4,340
$4,738
Total Interest Expense
Net Interest Income
Provision for Loan and Lease Losses
Company Guidance (Bloomberg)
2014 E
2015 E
2016 E
2017 E
2018 E
Total Noninterest Expense
$2,790
$2,907
$2,793
$2,737
$2,765
$2,792
$2,820
$2,848
Pre-tax Income
$1,345
$1,095
$1,136
$1,273
$1,390
$1,638
$1,573
$1,843
Income Taxes
$369
$239
$271
$305
$333
$393
$378
$442
Income from Continuing Operations
$976
$856
$865
$967
$1,056
$1,245
$1,196
$1,401
Income from Discontinued Operations, Net of Taxes
-$44
$9
$45
$45
$45
$45
$45
$45
Net Income
$932
$865
$910
$1,012
$1,101
$1,290
$1,241
$1,446
$12
$7
$0
$0
$0
$0
$0
$0
$920
$858
$910
$1,012
$1,101
$1,290
$1,241
$1,446
Less: Net Income Attributable to Noncontrolling Interests
Net Income Attributable to KEY
Per Common Share:
$954
$924
$988
$912
$912
$912
$912
$912
Income from Continuing Operations
$0.90
$0.90
$0.92
$1.11
$1.21
$1.41
$1.36
$1.58
-$0.05
$0.01
$0.05
$0.05
$0.05
$0.05
$0.05
$0.05
$0.85
$0.90
$0.97
$1.16
$1.26
$1.46
$1.41
$1.63
$1.02
$1.13
$1.34
$1.60
Income from Discontinued Operations, Net of Taxes
Net Income attributable to Key Common Shareholders
Analyst Consensus EPS (Bloomberg)
Source: Team estimates, Company annual report
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Appendix 4: DCF Analysis
KeyCorp DCF Projection
($ in millions)
Fiscal Year Ending in Dec. 31
2013
2014 E
2015 E
2016 E
2017 E
2018 E
2019 E
2020 E
2021 E
2022 E
2023 E
Total Interest Income
Provision for Loan and Lease
Losses
$2,620
$2,672
$2,726
$2,780
$2,836
$2,893
$2,951
$3,010
$3,070
$3,131
$3,194
$130
$214
$218
$222
$227
$231
$236
$241
$246
$250
$256
Total Noninterest Income
$1,734
$1,786
$1,840
$1,895
$1,952
$2,010
$2,070
$2,133
$2,197
$2,262
$2,330
Net Revenue
$4,224
$4,245
$4,347
$4,453
$4,561
$4,671
$4,785
$4,901
$5,021
$5,143
$5,269
Total Pre-tax Income
$1,136
$1,146
$1,174
$1,202
$1,231
$1,261
$1,292
$1,323
$1,356
$1,389
$1,423
Income Taxes
Income from Continuous
Operations
Income from Discontinued
Operations
$271
$321
$329
$337
$345
$353
$362
$371
$380
$389
$398
$865
$825
$845
$866
$887
$908
$930
$953
$976
$1,000
$1,024
$45
$0
$0
$0
$0
$0
$0
$0
$0
$0
$0
Net Income
$910
$825
$845
$866
$887
$908
$930
$953
$976
$1,000
$1,024
Free Cash Flow
$910
% Growth
Current P/E
Projected P/E
$825
$845
$866
$887
$908
$930
$953
$976
$1,000
$1,024
-9.3%
2.4%
2.4%
2.4%
2.4%
2.4%
2.4%
2.4%
2.4%
2.4%
2013
2014
2015
13.94
15.37
15.01
19.81
21.84
21.33
Terminal
P/E
10.64
Source: analyst estimates, Company annual report
KeyCorp-DCF Assumptions
Interest Income Growth Rate
2.00%
Noninterest Income Growth Rate
3.00%
Loan and Lease Losses % Interest Income
8.00%
Pre-tax Income Margin
27%
Cost of Capital
10.42%
Terminal Growth Rate
2.1%
Effective Tax Rate
28%
KeyCorp-DCF Ouputs ($ in millions)
NPV of CFs
$5,454
NPV of Terminal Value
$12,569
Implied Equity Value
$18,023
Terminal Value as % of Equity Value
70%
Common Shares Outstanding
891
Implied Share Price
$20.23
Current Share Price
$14.24
Source: analyst estimates, Company annual report
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Appendix 5: Relative Valuation
Price Multiples
Price-to-earnings (P/E)
Price-to-book (P/B)
Price-to-sales (P/S)
KeyCorp (KEY)
14.35
1.26
3.19
Fifth Third Bancorp (FITB)
11.19
1.47
3.16
M&T Bank Corp. (MTB)
14.58
1.52
3.64
Huntington Bancshares (HBAN)
13.48
1.44
3.17
Regions Financial (RF)
13.99
0.99
2.99
First Financial Bancorp (FFBC)
21.26
1.51
3.52
FirstMerit (FMER)
17.24
1.32
3.63
Park National (PRK)
15.03
1.79
4.01
Target Multiple
15.25
1.43
3.45
Target Price
$15.03
$16.10
$15.27
6.3%
13.8%
8.0%
% chg from Current Price
Source: Team estimates, Company annual report
Appendix 6: Selected Financial Ratios-Major Ohio-based Banks
Ticker
Market
Cap ($M)
P/E
LTM
Forward
P/E FY 14
P/BV
Efficiency
Ratio
ROE
ROA
Loan Loss
Reserve/Loans
Park National Corporation
PRK
1,186
15.38
15.94
1.82
62.72%
11.96%
1.15%
1.29%
First Financial Bancorp.
FFBC
1,042
21.82
16.04
1.53
64.27%
6.89%
0.77%
1.58%
Fifth Third Bancorp
FITB
19,916
11.58
13.15
1.48
62.78%
12.73%
1.48%
1.77%
Huntington
HBAN
8,333
13.74
13.89
1.44
64.09%
10.80%
1.13%
1.49%
Regional Banks
LCNB Corp.
LCNB
164
16.01
14.68
1.38
63.10%
9.02%
0.93%
0.62%
FirstMerit Corporation
FMER
3,568
18.32
14.00
1.37
60.71%
7.63%
0.85%
0.99%
KeyCorp
Farmers National Banc
Corp.
KEY
12,772
14.35
14.02
1.28
67.85%
8.83%
1.02%
1.54%
FMNB
141
18.29
16.82
1.25
75.62%
6.66%
0.68%
1.20%
Peoples Bancorp
PEBO
275
15.46
13.33
1.21
70.31%
7.92%
0.91%
1.42%
United Bancorp
UBCP
46
16.11
n/a
1.18
77.99%
7.02%
0.63%
0.94%
Ohio Valley Banc Corp.
OVBC
92
11.25
n/a
1.15
68.14%
10.40%
1.04%
1.09%
LNB Bancorp
LNBB
107
18.13
14.02
1.03
70.65%
5.62%
0.51%
1.93%
NB&T Financial Group
NBTF
65
15.32
n/a
0.96
75.66%
6.10%
0.64%
1.01%
United Bancshares
UBOH
55
11.82
n/a
0.87
67.22%
7.32%
0.83%
1.36%
First Citizens Banc Corp
FCZA
70
14.28
9.81
0.86
82.26%
5.97%
0.53%
1.92%
SB Financial Group
SBFG
40
7.76
n/a
0.72
73.70%
9.52%
0.81%
1.45%
Average
15.00
14.15
1.22
69.19%
8.40%
0.87%
1.35%
Median
15.35
14.02
1.23
68.00%
7.78%
0.84%
1.39%
10th/16
6th/11
7th/16
10th/16
7th/16
5th/16
5th/16
KeyCorp Ranking
2nd/16
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March 31, 2014
Appendix 7: Sensitivity Analysis
Sensitivity Analysis-Implied Shared Price-KEY
Cost of Capital
Pre-tax Income Margin
$17.3
$24.8
$16.9
Terminal Growth Rate
$24.0
$19.9
$21.2
Noninterest Income Growth Rate
$20.1
$20.8
Interest Income Growth Rate
$20.2
$20.8
$15.0
$17.0
$19.0
$21.0
$23.0
$25.0
Source: Analyst estimates
Appendix 8: Monte Carlo Simulation
Monte Carlo Sensitivity Analysis-DCF
1800
1600
Buy Range:
85% of the distribution=$15.55 and
above
1400
Frequency
1200
1000
800
600
400
200
$3.43
$4.88
$6.33
$7.77
$9.22
$10.67
$12.11
$13.56
$15.01
$16.45
$17.90
$19.35
$20.79
$22.24
$23.69
$25.13
$26.58
$28.03
$29.47
$30.92
$32.37
$33.81
$35.26
$36.71
$38.15
$39.60
$41.05
$42.49
$43.94
0
Source: Team estimates, @Risk
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March 31, 2014
Sources
Banks’ New Competitors: Starbucks, Google, and Alibaba
http://blogs.hbr.org/2014/02/banks-new-competitors-starbucks-google-and-alibaba/
Bloomberg
S&P Capital IQ
IBISWorld Industry Report 52211—Commercial Banking in the US
KeyCorp 2013 10-K
http://www.thestreet.com/story/12260525/1/keycorp-grows-earnings-205-year-over-year.html
KeyCorp Q4 2013 Earnings Call Transcript
http://www.morningstar.com/earnings/earnings-call-transcript.aspx?t=KEY
KeyCorp Q4 2013 Investor Presentation
KeyCorp to Acquire Commercial Mortgage Assets from Bank of America
http://www.fool.com/investing/general/2013/05/10/keycorp-to-acquire-commercial-mortgage-assets-from.aspx
Mercer Capital’s Midwest Public Bank Peer Report
http://mercercapital.com/assets/MW-03-21-14.pdf
Yahoo Finance!
http://finance.yahoo.com
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