TCFC: Improved Asset & Funding Mix Should Boost NIM, Loan Growth Remains Solid; Maintaining Price Target, Reiterating Outperform Rating.

        The Community Financial Corporation (TCFC – NASDAQ – Recent Price: $33.51)

                       Rating: Outperform / Buy Price: $33.00  / Target (Sell) Price: $37.00

4Q19 Results:

TCFC reported 4Q19 net income of $4.1 million, up 10.3% compared to the $3.7 million posted in 3Q19. On a per share basis, 4Q19 results were $0.73 compared to the $0.66 recorded in the prior quarter. Reported EPS fell $0.05 short of our $0.78 estimate, and $0.03 shy of the $0.76 median Street estimate. The underperformance versus our estimate was primarily driven by higher-than-anticipated noninterest expenses (mainly employee compensation and OREO expenses), lower net interest income, and a higher loan loss provision, offset partially by higher noninterest income. Highlights from the quarter include:

· Gross loans held for investment grew $38.9 million or 2.7% sequentially, exceeding the 1.3% growth we were projecting. CRE was by far the primary driver, rising $32.4 million or 3.5% linked-quarter. Also contributing to the sequential increase were the residential mortgage and construction segments, which rose $4.0 million or 2.4% and $3.4 million or 10.9%, respectively. Other segments posting growth were commercial equipment segment (up 4.2%), consumer loans (up 17.8%), and residential rentals (up 2.0%). Offsetting some of this growth were declines of $6.1 million or 8.8% in commercial loans and $0.1 million or 0.2% in home equity & second mortgages. The non-acquired/originated loan portfolio grew $47.1 million during the quarter while the acquired portfolio declined by $8.4 million. The company reports a solid loan pipeline, of approximately $104 million at December 31, 2019, which is down from $120 million at the previous quarter-end. The company decreased its cash and liquid investments during 4Q19, helping to support loan growth, as the loans-to-deposits ratio rose from 90.8% at September 30, 2019 to 96.3% at December 31, 2019.

· Total deposits decreased $48.1 million or 3.1% sequentially in 4Q19. CDs accounted for the bulk of the decline, as they fell $40.6 million or 9.3% sequentially. Interest bearing demand accounts also declined, dropping $15.7 million or 2.9% while noninterest bearing demand deposits slipped $2.3 million or 0.9%. There was some growth in money market and savings deposits, which rose $8.7 million and $1.7 million, respectively. As a result, core (non-CD) accounts rose to 73.9% of total deposits from 72.1% at September 30, 2019.

· Net interest income rose $188k or 1.4% linked-quarter, as a 2.6% increase in average earning assets was partially offset by 4 bps of NIM compression to 3.29%. Purchase accounting accretion boosted the NIM by roughly 6 bps in 4Q19, unchanged from 3Q19. Average loan yields slipped 10 bps compared to 3Q19, and average securities yields decreased 12 bps sequentially, leading to an 11 bps drop in average earning asset yields. As the average balance of CDs, the highest cost deposit category, declined, the average cost of CDs fell 8 bps. Meanwhile, the average cost of interest bearing demand and money market accounts, the largest funding category, grew 1 bps sequentially. These changes resulted in a 9 bps decrease in the average cost of interest bearing liabilities.

· Noninterest income advanced $974k or 78.6% sequentially, driven by a $740k rise in customer interest rate hedging fees on a hedging product offered through a third-party provider. This hedging product is still a new offering from the bank, and we expect revenues from this product to match 2019 levels in 2020 and beyond. Securities gains rose $169k LQ and service charges on deposits climbed $82k.

· Noninterest expenses rose $264k or 2.9% sequentially to $9.5 million. The main drivers of the increase were a $170k rise in “other” noninterest expenses, and a $126 increase in professional fees. Employee compensation costs climbed $55k and occupancy costs were up $82k. The company received a $170k credit from previously paid insurance premiums after the Bank Insurance Fund reached its mandated threshold level. Management expects the bank’s quarterly run rate of expenses to range between $9.2 million and $9.4 million in 2020.

· TCFC recorded an effective tax rate of 27.7% in 4Q19, up slightly from the 27.4% posted in 3Q19, and slightly above the 27.4% we had in our model. We still anticipate an effective tax rate of 27.5% for 2020 and beyond.

· The loan loss provision in 4Q19 was $805k, up from $450k in the preceding quarter. The provision fell short of the $1.1 million in charge-offs during the quarter. Net charge-offs to average loans was 0.31% in 4Q19 compared to 0.03% in 3Q19. As a result, the allowance for loan & lease losses declined 2.8% sequentially to $10.9 million, representing 0.75% reserve coverage of total loans compared to 0.79% at September 30, 2019.

· Asset quality was mixed in 4Q19, with some measures posting noticeable deterioration and others substantial improvement. Classified loans decreased $0.1 million or 0.4% in 4Q19, while nonaccrual loans advanced $2.4 million or 15.7% LQ. Meanwhile, performing TDRs were essentially unchanged and OREO dipped $2.4 million or 23.8%, as the expected resolution of one significant OREO property was achieved. These changes resulted in a 1.6% rise in NPAs. Combined with the concurrent 3.1% decline in total assets during the quarter, NPAs/Assets (including performing TDRs) edged up to 1.46% from 1.42% at the prior quarter-end. Early stage delinquencies (loans 30-89 days past due) fell $1.7 million or 75.6% from the prior quarter-end.

· TCFC completed a private placement of 312,747 shares on December 31, 2019, raising net proceeds of $10.6 million. Management plans to use these proceeds to help redeem $23.0 million of 6.25% fixed-to-floating subordinated notes due February 25, 2025. Redeeming these notes will result in annual interest expense savings of $1.4 million.

· TCFC’s regulatory capital ratios improved as a result of the capital raise on the last day of the year, as noted above. All of the capital ratios are well above the minimum levels required to be considered “well capitalized”. The company’s TCE ratio jumped to 9.44% from 8.37% at September 30, 2019. Tangible book value per share grew to $28.57 from $27.63 at September 30, 2019.

Earnings Estimates: Despite higher-than-expected operating expenses and higher provisioning in 4Q19, we were encouraged by most trends during the quarter. While migration of a few significant loans to nonaccrual caused a noticeable uptick in net charge-offs and the loan loss provision, we believe these were just a part of normal variations and we see no negative trends in asset quality. In fact, early stage delinquencies declined sharply, suggesting little additional migration to NPLs in the near term. Loan growth was good in the quarter, though deposits declined. The reduction in deposits was centered on higher-cost CDs, as management continues to improve the funding mix as well as the asset mix of the bank.

We have adjusted our earnings model to reflect the increase in swap fee income. On the expense side, we have boosted our estimate for employee compensation, but we believe that some of the other factors driving higher expenses in 4Q19 will prove to be temporary, resulting in little change to our expense projections. We boosted our loan growth forecast slightly, reflecting the strong growth in 4Q19. We have also incorporated the impact of the capital raise on the last day of 2019 in terms of the share count going forward. We are also including the anticipated redemption of subordinated debt in mid-February on interest expenses. This debt redemption could provide roughly 8 bps of lift to the NIM, with the full impact seen in 2Q20. However, a weaker interest rate environment since our last update means that our projections for net interest income do not change significantly. We are now projecting higher 2020 net income than in our prior model, but the increased share count from the capital raise will dilute net income to common shareholders.

After making the preceding adjustments, we are reducing our 2020 estimate from $3.10 to $3.03, while maintaining our 2021 EPS estimate at $3.23.

Stock Price Implications: TCFC currently trades at 12.2x trailing twelve-month EPS, a noticeable discount compared to the 15.2x median valuation of similar-size peer banks in the Maryland/Virginia region. The bank also trades at a discount to peers in terms of the price-to-tangible book value metric – 117.3% for TCFC versus 140.9% for the peers – and in terms of price-to-forward EPS. TCFC is trading at just 11.6x the median estimate for 2020 EPS while peers are trading at a median of 14.3x 2020 estimates.

We still believe that TCFC has good prospects for improving profitability and EPS growth. Considerable turmoil in the local banking market, including the pending BB&T-SunTrust Merger and the recently announced acquisitions of Old Line Bancshares by WesBanco, and Revere Bank by Sandy Spring Bank, should provide opportunities for TCFC to gain some market share. The consolidating banking market could also have an impact on TCFC’s valuation. Our $37.00 price target is based on the stock’s current 12.2x multiple, applied to the $3.03 EPS we are projecting over the next four quarters (1Q20-4Q20). Our target suggests a potential gain of roughly 10.4% over the next twelve months, or a total return of 11.9% including the stock’s 1.49% dividend yield. Consequently, we are reiterating our Outperform rating for shares of TCFC.