KeyCorp Upgraded to Outperform

We are upgrading our recommendation on KeyCorp (KEY) to Outperform from Neutral, based on its strong earnings and improving fundamentals. KeyCorp’s third quarter results mark its second consecutive profitable quarter since the beginning of the financial crisis in early 2008.

Third quarter net income from continuing operations came in at 19 cents per share, substantially better than the Zacks Consensus Estimate of 3 cents. This also compares favorably with a net loss from continuing operations of 50 cents in the prior-year quarter.

A significant decrease in provision for loan losses, solid expense management and improved fee income were the primary factors that boosted results.

Improving credit quality remains a positive catalyst for KeyCorp at this point. Though credit quality metrics remained weak during the last few quarters, a sharp improvement across the majority of loan portfolios in both Community Banking and National Banking was witnessed during the second and third quarters of 2010. Stabilization in consumer and commercial portfolios primarily helped improve the credit quality during the last couple of quarters. We expect the business restructuring actions to further support the credit quality in the upcoming quarters.

KeyCorp continues to reorganize its operations in order to improve its business mix by exiting risky and unprofitable businesses. The company continued to take decisive steps to exit low-return, indirect businesses to focus on its relationship strategy and use its capital and resources where it has cross-selling opportunities within its franchise. During 2008, KeyCorp was successful in exiting its direct and indirect retail as well as floor-plan lending for marine and recreational vehicle products. Also, in September 2009, the company decided to close its government-guaranteed education lending business.

Most importantly, KeyCorp is gaining market share through its restructuring actions. The company opened 34 new branches during the first nine months of 2010 and expects to end the fiscal year with 5 additional branches, increasing its presence in selected markets of its 14-state branch network. In addition, KeyCorp continues with its plans to renovate its existing branches.

On the downside, pressure on net interest margin is a concern for KeyCorp at this point. Though the company has started benefiting from improved funding costs and better earning asset yields since the second half of 2009, we expect margin pressure to remain over the near term due to soft new loan demand as a result of sluggish economic recovery.

Also, market dislocations over the last couple of years have led to deterioration in the valuation of many of the asset categories in KeyCorp’s balance sheet. This has also reduced the company’s ability to sell assets at acceptable prices. As a result, balance sheet stability remains a major challenge for the company at this point. Besides, as a result of the overall weak demand and high competition, balance in the company’s core portfolio continues to shrink. Until the economic recovery gains momentum, these factors will continue to affect the financials of the company.

Although management wishes to repay its $2.5 billion of TARP loans, it is unclear on the timing, given an uncertain near-term credit/earnings outlook, and its focus on maintaining profitability. For repayment, the company might have to indulge in capital raise in the upcoming quarters, which might have a dilutive effect on its earnings per share.

Concerns related to the near-term impact of the finance reform law also persist. While results continue to be affected by the volatile operating environment, we expect the business restructuring actions undertaken by the company will fuel its credit quality, capital position and liquidity. Moreover, KeyCorp is expected to benefit from its focus on community banking expansion.

We are also maintaining our Outperform recommendation on KeyCorp’s peer Fifth Third Bancorp (FITB).

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