KeyCorp a Solid Play for Interest Rates, Efficiency: Oppenheimer

NEW YORK ( TheStreet) -- KeyCorp ( KEY) is very well positioned for rising interest rates, and its conservative strategy and "above-peer capital levels" have set up an attractive long-term play for investors, according to Oppenheimer analyst Terry McEvoy.

"Sentiment on Key is improving as investors reassess the prospects from more consistent growth led by a management team that is proving to be more disciplined with excess capital," McEvoy wrote in a note to clients on Sunday.

McEvoy rates KeyCorp of Cleveland "outperform," with a 12-to-18-month price target of $12.00. The analyst estimates the bank will earn 87 cents a share this year, with EPS rising to a dollar in 2014.

KeyCorp's shares closed at $10.78 Friday, returning 29% this year, following a 12% return during 2012. The shares trade for 11.2 times the consensus 2014 EPS estimate of 96 cents, among analysts polled by Thomson Reuters. The consensus 2013 EPS estimate is 89 cents.

KeyCorp's shares this year have outperformed the KBW Bank Index ( I:BKX), which was up 20% through Friday, underlining a second consecutive year of stellar performance for banks stocks.

Early last month, KBW analyst Christopher Mutascio wrote that the run-up in KeyCorp's shares to $10.23 on May 7 was " unjustified," because the shares were trading at higher valuations than many other large-cap banks that posted stronger earnings. With all boats continuing to rise since then, Mutascio's observation on valuations continues to hold true.

Here's a quick look at the lower forward price-to-earnings valuations for four big banks that beat KeyCorp's first-quarter return on average assets (ROA) of 0.99:
  • Wells Fargo's (WFC) first-quarter ROA was 1.41% and its return on average tangible common equity, or ROTCE, was 17.76%. The shares closed at $40.55 Friday, trading for 10.4 times the consensus 2014 EPS estimate of $3.90.
  • U.S. Bancorp (USB) of Minneapolis achieved a first-quarter ROA was 1.65% and its ROTCE was a very strong 23.79%. The company has been the best earnings performer among the 24 components of the KBW Bank Index through and after the credit crisis. The shares closed at $35.06 Friday, trading for 10.8 times the consensus 2014 EPS estimate of $3.24.
  • For BB&T (BBT) of Winston-Salem, N.C., the first-quarter ROA was 1.11% and the ROTCE was 8.25%. The shares closed at $32.92 Friday, trading for 10.6 times the consensus 2014 EPS estimate of $3.10.
  • Fifth Third Bancorp (FITB) of Cincinnati had a first-quarter ROA of 1.34% and ROTCE of 15.23%. The shares closed at $18.20 Friday, trading for 10.5 times the consensus 2014 EPS estimate of $1.73. Applying the multiple of 12.9 to KBW's 2014 EPS estimate of $1.77 would lead to a price target of $23, for upside potential of 31%.

But McEvoy sees several advantages for KeyCorp. One of them is the ability of the company to defend its net interest margin, which is the difference between the average yield on loans and investments and the average cost for deposits and borrowings. With the Federal Reserve keeping its short-term federal funds rate in a range of zero to 0.25% since late 2008, most banks have already enjoyed the bulk of savings on the funding cost side, while assets continued to reprice lower.

According to the Federal Deposit Insurance Corporation, the U.S. banking industry's aggregate net interest margin narrowed to 3.27% during the first quarter from 3.35% the previous quarter and 3.51% a year earlier.

With the market rate on 10-Year U.S Treasury bonds rising considerably over the past few weeks and contradictory comments among Federal Reserve Chairman Ben Bernanke and other members of the Federal Open Market Committee, the biggest question right now for investors is whether the Federal Reserve might decide to curtail its bond-buying at the next FOMC meeting beginning on June 18.

If short-term rates remain in their current range, which is quite possible even if the Fed limits its bond-buying and long-term rates rise more, short-term rates may remain in their current range for quite some time. This will benefit KeyCorp. "From 2Q13 to 2014, $6.3B of CDs are maturing with an average rate of 1.40%, and $1.1B with average rates of 2.60% are maturing in 2015 and beyond," McEvoy wrote.

And if long-term and short-term rates rise together, KeyCorp should still benefit, as the company describes itself as "moderately asset sensitive," meaning its assets will reprice upward faster than its liabilities.

Another major advantage for KeyCorp and its shareholders is a strong capital base, which can feed expansion in more profitable business lines, or can be used to repurchase shares, those lowering the share count and boosting EPS. KeyCorp's March 31 Tier 1 common equity ratio was 11.4%, according to McEvoy, which was considerably higher than the 10.0% average for 12 large regional banks covered by his firm.

KeyCorp has a program in place to repurchase up to $426 million in common stock through the first quarter of 2014. The company pays a quarterly dividend of 6 cents on common shares, for a yield of 2.04%, based on Friday's close.

Most large-cap banks are focused on cutting expenses, and KeyCorp is no exception, with the goal of its "Keyvolution" program to reduce the bank's efficiency ratio to a range of 60% to 65%. KeyCorp reported a first-quarter efficiency ratio of 66.0%, improving from 67.7% a year earlier. The efficiency ratio is, essentially, the number of pennies of overhead expenses incurred for each dollar of revenue.

"In addition to the target, the company is also striving to create a more variable cost structure in order to maintain profitability and efficiency throughout market cycles," McEvoy wrote.

"Key is executing a strategy aiming to create a less volatile, lower risk revenue stream, and we are already starting to see positive trends within certain businesses," according to McEvoy, who added "the stock remains undervalued at 10.8x our '14 estimate and 1.1x TBV. Multiple expansion can continue this year, in our view, as a 'new' Key emerges from the financial crisis."

KEY Chart KEY data by YCharts

Interested in more on KeyCorp? See TheStreet Ratings' report card for this stock.

-- Written by Philip van Doorn in Jupiter, Fla.

>Contact by Email.

Philip W. van Doorn is a member of TheStreet's banking and finance team, commenting on industry and regulatory trends. He previously served as the senior analyst for Ratings, responsible for assigning financial strength ratings to banks and savings and loan institutions. Mr. van Doorn previously served as a loan operations officer at Riverside National Bank in Fort Pierce, Fla., and as a credit analyst at the Federal Home Loan Bank of New York, where he monitored banks in New York, New Jersey and Puerto Rico. Mr. van Doorn has additional experience in the mutual fund and computer software industries. He holds a bachelor of science in business administration from Long Island University.