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.

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.

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).