Since the start of the banking crisis in March, large and super regional bank stocks have been hit especially hard. The SPDR S&P Regional Banking ETF is down nearly 29% this year.
But KeyCorp (KEY -2.14%) has been hit even harder, with shares down about 40%. The bank had a rough first quarter and certainly faces some near-term challenges. But given the big sell-off, is it time for investors to jump in and buy the dip? Let's take a look.
Why the big sell-off
As I pointed out in an article published on the eve of the banking crisis, KeyCorp's deposit beta performed very well in 2022, coming in at just 16%. The deposit beta looks at how much a bank will raise deposit pricing in response to changes in interest rates over a set period of time, so the lower the beta the better. Furthermore, management in January projected deposit beta to peak at less than 30%, which would have outperformed its peer group.
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When I wrote the article, I didn't know if KeyCorp would be able to deliver on this promise but noted that it could lead to a higher stock price if the bank did. As it happens, KeyCorp did not deliver on this promise and in fact underdelivered. Deposit costs jumped pretty significantly in Q1, and management is now predicting that its deposit beta will peak in the low 40s percentile.
While most banks struggled with deposits in Q1 due to the banking crisis, this was a more outsized struggle than KeyCorp's experienced as a group. Furthermore, higher deposit costs have really cut into the bank's net-interest income (NII) and net-interest margin (NIM). NII is the money banks make on loans and securities after funding those assets, while NIM essentially looks at the difference between the rate on a bank's interest-earning assets such as loans and the rate on interest-bearing liabilities such as deposits. Both NII and NIM are big drivers of bank profitability.
In Q1, KeyCorp's NII fell by nearly 10% from the sequential quarter, while the NIM narrowed by 27 basis points (0.01 = 1 basis point). Furthermore, management significantly lowered its full-year NII forecast and now expects NII to fall between 1% and 3% from 2022 levels. Previously, management had projected NII growth of 1% to 4%.
Additionally, KeyCorp also invested a little bit too early in bonds that it intends to sell before maturity. As interest rates have soared, the value of the bonds has plummeted, which has hit KeyCorp's tangible common-equity ratio pretty hard in recent quarters, bringing it all the way down to 4.6%. Investors likely aren't too keen right now to invest in banks with this low of a tangible common-equity ratio, especially with an uncertain outlook, because there is not a huge buffer built in if things take a bad turn, and it makes share repurchases and dividend increases difficult for the foreseeable future.
Can the bank navigate the difficult environment?
The good news for KeyCorp is that if it can navigate the near-term challenges, things are expected to greatly improve between now and the end of 2024.
The bank currently has many lower-yielding, shorter-duration U.S. Treasury and interest-rate swaps that are expected to soon roll off the bank's balance sheet. Management estimates that this will improve NII by $720 million to $1 billion between now and Q1 2025 and should also benefit NIM significantly as well.
In addition, roughly 40% of KeyCorp's unrealized losses in its bond portfolio that the bank plans to sell before maturity are expected to be recouped between now and the end of 2024. This should happen as bond yields stabilize and potentially decline, which will boost KeyCorp's tangible common-equity ratio back to more appropriate levels. KeyCorp has also suspended share repurchases, which I'm sure investors don't love. But this move will allow the bank to rebuild capital more quickly.
As long as KeyCorp can keep its deposit base somewhat stable and can ride out some of this pressure, then NII and NIM should rebound after Q2. Currently, management expects average deposits to end the year little changed to down 2%.
This seems realistic considering that more than 60% of the bank's deposits are from consumers, wealth management, small businesses, and escrow accounts. Meanwhile, roughly 80% of the bank's large commercial-deposit base are operating accounts, meaning companies are using the bank for more than just storing deposits.
Time to buy?
The next several months should be the most difficult for KeyCorp, but if the company can navigate this stretch and hold deposits stable and correctly predict a bottom for the NIM in Q2, then I think there is a lot of upside from here.
I'm guessing that after management miscalculated on its deposit betas and full-year guidance, the market is going to want to see clear proof that management has control of the situation. KeyCorp has been around a long time and has been able to develop strong consumer and commercial relationships while not getting over-concentrated in one customer segment, which gives me confidence it can reasonably hold the line on deposits.
With the bank trading at just around tangible book value, or its net worth, and roughly 6.3 times forward earnings, I think a lot of the risk has been priced in at this point, making the stock a buy.
