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KeyCorp Upgraded to Outperform

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We have upgraded our recommendation on KeyCorp (KEY - Free Report) to ‘Outperform’ from ‘Neutral’ to reflect the recent announcement of its cost-cutting initiatives along with sound capital deployment activities. Moreover, we believe that the company’s strong capital ratios and improving credit quality have contributed to the raise. Nevertheless, we remain wary of the persisting slow economic recovery, stringent regulatory restrictions and the low interest rate scenario.

KeyCorp is expected to announce its third-quarter results on October 18. The Zacks Consensus Estimate for the quarter is 21 cents on revenue expectation of $1.03 billion. The company’s second quarter 2012 earnings were ahead of the Zacks Consensus Estimate.

In July this year, KeyCorp launched an expense saving program, which aims at rationalizing the cost structure to make it compatible with the shifting economy and the continual low interest rate environment. The company intends to reduce its expenses by $150–$200 million by the end of 2013 and expects the subsequent quarters to benefit from the initiatives. By the end of this year, Key Corp expects to save $30–$50 million. Management anticipates efficiency ratio to remain in the range of 60–65% in the next several quarters attributable to these initiatives.

Further, in August, KeyCorp announced a couple of strategic measures to reinforce its consumer and commercial payments businesses. These include the acquisition of credit card assets from Elan Financial Services and an amendment of its merchant services agreement with Elavon, Inc. With the implementation of these agreements, Keycorp will become a front-runner in debit payment solutions and processing. Also, the deal is expected to bolster its operating efficiency and expense management, besides broadening its revenue base and solidifying its relationship with customers.

Moreover, KeyCorp remains an attractive pick for yield-seeking investors. During the first quarter of 2012, after receiving the approval from the Federal Reserve, the company announced a $344 million share repurchase program, which will be executed by March 2013. The company purchased shares worth $85 million in the first half of 2012. Furthermore, in May, KeyCorp announced an increase in its quarterly dividend by 66.7% to 5 cents per share. These capital deployment activities will significantly boost investors’ confidence in the stock.

On the flip side, pressure on net interest margin (NIM) remains a major concern for KeyCorp. Though the company has been benefiting from improved funding costs and better earning asset yield since the second half of 2009, we expect the margin pressure to remain in the near term due to the soft new loan demand. NIM has remained under pressure over the last several quarters, but the recent redemption of trust preferred securities and debt maturities have eased the pressure to some extent. However, low interest rate environment and the company’s asset-sensitive position are likely to compress NIM in the future.

In addition, 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 thereby lowering its ability to sell assets at acceptable prices. Consequently, stability of the balance sheet remains a major challenge for the company at this point. Similarly, due to the overall weak demand and high competition, balances in the company’s core portfolio continue to shrink. Until the economic recovery gains momentum, these factors will continue to adversely impact its financials.

KeyCorp currently retains a Zacks #3 Rank, which translates into a short-term Hold rating. One of its peers, SunTrust Banks, Inc. (STI - Free Report) retains a Zacks #2 Rank (a short-term Buy rating).

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