COMMUNITY FINANCIAL CORP /MD/ - Quarter Report: 2005 March (Form 10-Q)

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

(Mark One)

For the Quarterly Period Ended March 31, 2005

OR

For the transition period from                      to                     

Commission File Number 0-18279

Tri-County Financial Corporation

(301) 843-0854

Not applicable

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).
Yes o No þ

As of April 26, 2005, the registrant had 1,163,336 shares of common stock outstanding.

TRI-COUNTY FINANCIAL CORPORATION

PART I — FINANCIAL INFORMATION

See notes to consolidated financial statements

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TRI-COUNTY FINANCIAL CORPORATION

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TRI-COUNTY FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME (UNAUDITED)
THREE MONTHS ENDED MARCH 31, 2005 AND 2004

Share and per share data have been retroactively adjusted to effect a three for two common stock split declared on October 22, 2004 as if it had occurred on January 1, 2004.

See notes to consolidated financial statements

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TRI-COUNTY FINANCIAL CORPORATION

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TRI-COUNTY FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
THREE MONTHS ENDED MARCH 31, 2005 AND 2004

See notes to consolidated financial statements

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

     Share and per share data have been retroactively adjusted to effect a three for two common stock split declared on October 22, 2004 as if it had occurred on January 1, 2004.

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ITEM 2 MANAGEMENT’S DISCUSSION AND ANALYSIS OF OPERATIONS AND FINANCIAL CONDITION

This document contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, including discussions of Tri-County Financial Corporation’s (the “Company”) goals, strategies and expected outcomes; estimates of risks and future costs; and reports of the Company’s ability to achieve its financial and other goals. Forward-looking statements are generally preceded by terms such as “expects,” “believes,” “anticipates,” “intends” and similar expressions. These forward-looking statements are subject to significant known and unknown risks and uncertainties because they are based upon future economic conditions, particularly interest rates, competition within and without the banking industry, changes in laws and regulations applicable to the Company and various other matters. Because of these uncertainties, there can be no assurance that actual results, performance or achievements of the Company will not differ materially from any future results, performance or achievements expressed or implied by these forward-looking statements. The Company does not undertake – and specifically disclaims any obligation – to publicly release the result of any revisions that may be made to any forward-looking statement to reflect events or circumstances after the date of such statements or to reflect the occurrence of anticipated or unanticipated events.

GENERAL

The Company is a bank holding company organized in 1989 under the laws of the State of Maryland. It presently owns all the outstanding shares of capital stock of the Community Bank of Tri-County (the “Bank”), a Maryland-chartered commercial bank. The Company engages in no significant activity other than holding the stock of the Bank, the payment of its subordinated debt, and operating the business of the Bank. Accordingly, the information set forth in this report, including financial statements and related data, relates primarily to the Bank and its subsidiaries.

The Bank serves the Southern Maryland area through its main office and seven branches located in Waldorf, Bryans Road, Dunkirk, Leonardtown, La Plata, Charlotte Hall, and California, Maryland. The Bank is engaged in the commercial and retail banking business as authorized by the banking statutes of the State of Maryland and applicable Federal regulations. The Bank accepts demand and time deposits and uses these funds along with borrowings from the Federal Home Loan Bank (“FHLB”), to fund loan originations to individuals, associations, partnerships and corporations. The Bank makes real estate loans including residential first and second mortgage loans, home equity lines of credit and commercial mortgage loans. The Bank also makes commercial loans including secured and unsecured loans. The Bank is a member of the Federal Reserve and FHLB Systems. The Savings Association Insurance Fund (“SAIF”) of the Federal Deposit Insurance Corporation (“FDIC”) provides deposit insurance coverage up to applicable limits.

Since its conversion to a state chartered commercial bank in 1997, the Bank has sought to increase its commercial, commercial real estate, construction, second mortgage, home equity, and consumer lending business as well as the level of transactional deposits to levels consistent with similarly sized commercial banks. As a result of this emphasis, the Bank’s percentage of assets invested in residential first mortgage lending has declined since 1997. Conversely, targeted loan types have increased. The Bank has also seen an increase in transactional deposit accounts while the percentage of total liabilities represented by certificates of deposits has declined. Management believes that these changes will enhance the Bank’s overall long-term financial performance.

Management recognizes that the shift in composition of the Bank’s loan portfolio will tend to increase its exposure to credit losses. The Bank continues to evaluate its allowance for loan losses and the associated provision to compensate for the increased risk. Any evaluation of the allowance for loan losses is inherently inexact and reflects management’s expectations as to future economic conditions in the Southern Maryland area as well as individual borrower’s circumstances. Management believes that its allowance for loan losses is adequate. For further information on the Bank’s allowance for loan losses see the discussion in the sections captioned “Financial Condition” and “Critical Accounting Policies” as well as the relevant discussions in the Form 10-K and annual report for the year ended December 31, 2004.

For several quarters until the fourth quarter of 2004, the economy was recovering from a mild recession. In the last several quarters, the Federal Reserve has signaled through rate increases its belief that the economy’s greatest danger appears to be inflation rather than recession. Accordingly the Federal Funds rate has increased from its recent low of 1.00% in June 2004 to 2.75% in March of 2005. While we believe that we are positioned to perform well in a moderate rate increase environment, substantially higher interest rates could effect our future financial performance particularly if key interest rates increased funding costs faster than they increased yields on earning assets. Our ability to increase asset yields in a rising interest rate environment is limited by periodic and lifetime caps on interest rates embedded in many of our loans and investments. In addition, certain of our loans and investments are for fixed rates. Moreover, substantially higher interest rates would tend to increase borrowing costs for our customers and might lead to an increase in loan

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delinquency caused by the borrowers’ inability to pay these higher costs in some cases.

SELECTED FINANCIAL DATA

Share and per share data have been retroactively adjusted to effect a three for two common stock split declared on October 22, 2004 as if it had occurred on January 1, 2004.

RESULTS OF OPERATIONS

Net income for the three-month period ended March 31, 2005 totaled $1,024,361 ($0.89 basic and $0.84 diluted earnings per share) compared with a total of $889,198 ($0.79 basic and $0.75 diluted earnings per share) for the same period in the prior year. This increase of $135,163 or 15.20% was caused by an increase in net interest income combined with a slight decline in provision for loan loss, a small increase in non-interest income, which offset higher non-interest expense and higher tax expense. For the three-month period ended March 31, 2005, interest income increased by $1,971,057 or 42.91% to $6,564,868. The increase was due to higher average balances of earning assets which offset slightly lower yields. The Bank earned slightly lower yields as the percentage of its assets invested in securities increased and the percentage of assets invested in loans decreased. Interest expense also increased to $2,809,080 in the three-month period ending March 31, 2005 as compared to $1,564,289 in the same period in the prior year, an increase of $1,244,791 or 79.58%. The increase was the result of higher average balances and slightly higher rates. The average rate paid on liabilities increased as the Bank made greater use of non-retail deposit funding sources. The changes in interest income and expense reflect the effects of the changing interest rate environment, increased size of the balance sheet, and changes in balance sheet composition that have taken place in the last year.

Provision for loan losses decreased slightly from prior year levels to $63,027 for the three months ended March 31, 2005 from $70,202 for the three month period ended March 31, 2004. The decrease in provision expense was caused by the Bank’s continued success in controlling delinquency and write-offs in its loan portfolio. Management will continue to periodically review its allowance for loan losses and the related provision and adjust as deemed necessary. This review will include a review of economic conditions nationally and locally, as well as a review of the performance of significant major loans and the overall portfolio.

Noninterest income increased to $401,329 for the three-month period ending March 31, 2005, an increase of $5,101 or 1.29% over the prior year total of $396,228. In 2005, the Bank sold certain foreclosed property which had previously been written off. The gain of $36,000 was recognized in 2005, while no similar gain was recognized in 2004. Loan appraisal, credit, and miscellaneous charges decreased by $3,297 to $62,907. These charges are highly variable and collection of them is often dependent on specific local market conditions. The Bank reported a net gain on selling mortgage loans of $21,404 in 2004. No gains from selling loans were earned in 2005. The Bank recorded a decline in income from bank-owned life insurance based on a decline in yield in 2005. The Bank also recorded a loss of $14,581 in

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2005 on the sale of certain short-term securities compared to no loss in 2004. Finally, service charges increased to $255,874 in 2005 from the prior year amount of $234,772, an increase of $21,102 or 8.99% due to higher amounts of activity in certain demand deposit accounts.

Noninterest expense for the three-month period increased by $152,991 or 6.39% to $2,548,714 from $2,395,723 in the same period for the prior year. Salary and employee benefits increased by 12.75% to $1,463,962 from $1,298,380 for the same period in the prior year. The increase was attributable to an increase in employees and to increases in average salary costs per employee. Occupancy expense increased from $181,873 to $231,873, an increase of 27.49%, due to additional locations. Advertising expenses decreased to $87,412 from $142,539, a decrease of $55,127 or 38.68%. The reduction in expenses was attributable to the internalization of the marketing function as well as the realignment of expenses to coincide with objectives. Data processing expense increased to $160,824 from a prior year total of $151,998, an increase of $8,826 or 5.81%. This increase was due to increases in the Bank’s size and customer base. Legal and professional fees increased to $119,445 from $38,155, an increase of $81,290 or 213.05%. This increase in expense included increased expenses relating to preparing the Company to meet the additional requirements of Sarbanes–Oxley compliance including increases in outsourced accounting, legal, and other professional services. Telephone communications declined to $29,194 from $37,975 in the prior year, a decline of $8,781 or 23.12%. This decline reflected a change in service providers which offset higher usage. The provision for valuation allowances on foreclosed real estate decreased to $0 in 2005 from $113,827 for the three months ended March 31, 2004 as no further increases to the valuation allowance were considered necessary. ATM related expenses decreased by $10,304 to $69,794 for the period ending March 31, 2005, a decrease of 12.86% due to price concessions by our ATM service providers. Office supplies expense decreased to $30,364 from the prior year amount of $39,419, a decrease of $9,055 or 22.97%. These expenses related to increased marketing efforts in the prior year. Office equipment expenses decreased to $9,702 in 2005 from $26,391 in 2004, a decrease of $16,689 or 63.24%. This decrease was caused by the retirement of certain equipment. Other expenses increased to $259,044 from $197,868 an increase of $61,176 or 30.92%, reflecting larger asset size and increased overall business activity.

Income tax expense increased to $521,015 or 33.71% of pretax income in the current year, from $70,627 or 7.36% of pretax income in the prior year. The prior year’s low income tax rate was primarily attributable to the contribution of a foreclosed property to an environmental organization which generated a large income tax deduction, effectively reducing the overall rate.

FINANCIAL CONDITION

Assets

Total assets as of March 31, 2005 increased by $34,233,554 or 6.77% to $540,000,677 from the December 31, 2004 level of $505,767,123. Cash and due from banks decreased by $2,332,903 or 38.76% from December 31, 2004’s total. Federal funds sold decreased to $297,526 from $777,519, a decline of $479,993 or 61.73%. Interest-bearing deposits with banks increased by $979,405 or 8.97% during the period to $11,899,569 at March 31, 2005. Changes in the amounts of these cash equivalents reflect short-term cash changes to fund loans and investments. Investment securities, including both the available for sale and held to maturity portfolios, increased from $175,690,126 to $182,256,864, an increase of $6,566,738 or 3.74%. Increases were primarily the result of additional purchases of investments, primarily floating rate longer-term securities which adjust to a margin over LIBOR.

The Bank’s loan portfolio increased by $27,622,348 or 9.55% during the three-month period ended March 31, 2005 to $316,947,399 from $289,325,051 at December 31, 2004. The increase was primarily the result of increases in the Bank’s portfolio of commercial real estate loans, residential construction loans, and commercial lines of credit. The increase in commercial real estate lending was a reflection of the strong local economy and continuing sales efforts by the Bank in this area. Residential construction has increased as local builders continue to develop land. The increase in commercial lines of credit reflect the Bank’s continued effort to build its commercial lending business. At March 31, 2005 the Bank’s allowance for loan losses totals $3,120,585 or 0.95% of loan balances as compared to $3,057,558 or 1.04% of loan balances at December 31, 2004. Management’s determination of the adequacy of the allowance is based on a periodic evaluation of the portfolio with consideration given to the overall loss experience; current economic conditions; volume, growth and composition of the loan portfolio; financial condition of the borrowers; and other relevant factors that, in management’s judgment, warrant recognition in providing an adequate allowance. Management believes that the allowance is adequate. Additional loan information for prior years is presented in the Company’s Form 10-K for the year ended December 31, 2004.

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The following table sets forth information concerning the Bank’s aggregate loans by type at the dates indicated.

The following table summarizes changes in the allowance for loan losses for the periods indicated.

The following table provides information with respect to our non-performing assets at the dates indicated.

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Premises and equipment increased due to the renovation of parts of the home office building and the construction of the Prince Frederick Branch. These improvements were partially offset by depreciation. Accrued interest receivable increased by $216,155 due to increases in asset size. Investment in bank-owned life insurance increased due to income accruals. Other assets decreased to $2,111,663 from $2,351,303 at December 31, 2004.

Liabilities

Deposit balances increased by $13,809,124 or 5.18% for the three months ended March 31, 2005. This increase was primarily in interest bearing deposits. Management believes that ongoing stock market volatility combined with questions about certain mutual fund operations has made bank deposits more attractive to the general public. The Bank has also increased marketing efforts for all deposit products in the last year. Short-term borrowings increased to $125,064,912, an increase of $9,760,702 or 8.47% while long term-debt also increased to $92,848,897, an increase of $9,917,784, or 11.96%. These funds were used to fund loans and purchase investments. Accrued expenses decreased slightly to $2,501,187. The decline was caused by the timing of certain tax payments.

Stockholders’ Equity

Stockholders’ equity increased $898,478 or 2.89% to $32,022,053 at March 31, 2005 compared to $31,123,575 at December 31, 2004. This reflects the net income of $1,024,361 for the three months period. Other changes in equity occurred as a result of using $41,780 to purchase 1,198 shares, the exercise of stock options of $155,168, and activity related to the ESOP shares of $60,395. Book value on a per share basis was $27.65 at March 31, 2004, as compared to $27.14 at December 31, 2004.

LIQUIDITY AND CAPITAL RESOURCES

The Company currently has no business other than that of the Bank and does not currently have any material funding commitments, other than the payment of dividends, the payment of dividends and principal on debentures, and the repurchase of common shares. The Company’s principal sources of liquidity are cash on hand and dividends received from the Bank. The Bank is subject to various regulatory restrictions on the payment of dividends.

The Bank’s principal sources of funds for investments and operations are net income, deposits from its primary market area, principal and interest payments on loans, interest received on investment securities and proceeds from maturing investment securities. Its principal funding commitments are for the origination or purchase of loans and the payment of maturing deposits. Deposits are considered a primary source of funds supporting the Bank’s lending and investment activities. The Bank also uses various wholesale funding instruments including FHLB advances and reverse repurchase agreements. The Bank may borrow up to 40% of consolidated Bank assets on a line of credit available from the FHLB. As of March 31, 2005, the maximum available under this line would be $216 million, while outstanding advances totaled $141 million. In order to draw on this line the Bank must have sufficient collateral. Qualifying collateral includes residential 1-4 family first mortgage loans, certain second mortgage loans, certain commercial real estate loans, and various investment securities. At March 31, 2005, the Bank had pledged collateral sufficient to draw $164 million under the line.

The Bank’s most liquid assets are cash and cash equivalents, which are cash on hand, amounts due from financial institutions, federal funds sold, and money market mutual funds. The levels of such assets are dependent on the Bank’s operating financing and investment activities at any given time. The variations in levels of cash and cash equivalents are influenced by deposit flows and anticipated future deposit flows.

Cash, cash equivalents, and interest-bearing deposits with banks as of March 31, 2005 totaled $15,882,288, a decrease of $1,833,491 or 10.35% from the December 31, 2004 total of $17,715,779. This decrease was due to the Bank’s increase in loans and investment securities.

The Bank’s principal sources of cash flows are its financing activities including deposits and borrowings. During the first quarter in 2005, all financing activities provided $33,661,394 in cash compared to $18,988,985 for the first quarter of 2004. The increase in cash flows from financing activities during the most recent period was principally due to an increase in borrowing activity in 2005. Short-term borrowing provided a net increase in cash of $9,760,702 in 2005, compared to a use of cash of $3,570,983 in 2004. During the first quarter of 2005, net deposit growth was $13,809,124 compared to $12,537,258 in 2004. The Bank also receives cash from its operating activities, which provided $1,137,449 in the first quarter of 2005 compared to $1,599,913 during the first quarter of 2004. The decrease in operating cash flows

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during 2005 was primarily due to a decrease in proceeds from sale of loans held for sale.

The Bank’s principal use of cash has been in investing activities including its investments in loans for portfolio, investment securities and other assets. During the quarter ended March 31, 2005, the Bank invested a total of $36,632,446 compared to $22,878,161 in 2004. The principal reason for the increase in cash used in investing activities was an increase in the purchase of investments.

REGULATORY MATTERS

The Bank is subject to Federal Reserve Board capital requirements as well as statutory capital requirements imposed under Maryland law. At March 31, 2005, the Bank’s tangible, leverage and risk-based capital ratios were 7.21%, 9.52% and 10.27%, respectively. These levels are in excess of the required 4.0%, 4.0% and 8.0% ratios required by the Federal Reserve Board as well as the 5.0%, 5.0%, and 10% ratios required to be considered well capitalized.

CRITICAL ACCOUNTING POLICIES

The Company’s financial statements are prepared in accordance with accounting principles generally accepted in the United States of America (GAAP). The financial information contained within the financial statements is, to a significant extent, financial information that is based on measures of financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value that is obtained when earning of income, recognizing an expense, recovering an asset or relieving a liability. We use historical loss factors as one in determining the inherent loss that may be present in our loan portfolio. Actual losses could differ significantly from the historical factors that we use. In addition GAAP itself may change from one previously acceptable method to another method. Although the economics of our transactions would be the same, the timing of events that would impact our transactions could change.

The Company considers the allowance for loan losses to be a critical accounting policy. The allowance for loan losses is an estimate of the losses that may be sustained in our loan portfolio. The allowance is based on two basic principles of accounting: (1) SFAS 5, “Accounting for Contingencies,” which requires that losses be accrued when they are probable of occurring and estimable and (2) SFAS 114, “Accounting by Creditors for Impairment of a Loan,” which requires that losses be accrued based on the differences between the value of collateral, present value of future cash flows or values that are observable in the secondary market and the loan balance.

Management has significant discretion in making the judgments inherent in the determination of the provision and allowance for loan losses, including in connection with the valuation of collateral, a borrower’s prospects of repayment, and in establishing allowance factors on the non-specific allowance. The establishment of allowance factors is a continuing exercise, based on management’s continuing assessment of the global factors such as delinquencies, loss history, trends in the volume and term of loans, national and local economic trends, concentration of credit, loan classification, and other factors. Changes in allowance factors will have a direct impact on the amount of the provision and a corresponding effect on net income. Errors in management’s perception and assessment of the global factors and their impact on the portfolio could result in the allowance not being adequate to cover losses in the portfolio, and may result in additional provisions or charge offs.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK

Not applicable. The Company qualifies as a “small business issuer.”

ITEM 4. CONTROLS AND PROCEDURES

As of the end of the period covered by this report, management of the Company carried out an evaluation, under the supervision and with the participation of the Company’s principal executive officer and principal financial officer, of the effectiveness of the Company’s disclosure controls and procedures. Based on this evaluation, the Company’s principal executive officer and principal financial officer concluded that the Company’s disclosure controls and procedures are effective in ensuring that information required to be disclosed by the Company in reports that it files or submits under the Securities Exchange Act of 1934, as amended, (1) is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission’s rules and forms and (2) is accumulated and communicated to the Company’s management, including its principal and executive and financial officers as appropriate to allow timely decisions regarding required disclosure. It should be noted that the design of the Company’s disclosure controls and procedures is based in part upon certain reasonable assumptions about the likelihood of future events, and there can be no reasonable assurance that any design of disclosure controls and procedures will succeed in

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achieving its stated goals under all potential future conditions, regardless of how remote, but the Company’s principal executive and financial officers have concluded that the Company’s disclosure controls and procedures are, in fact, effective at a reasonable assurance level.

In addition, there have been no changes in the Company’s internal control over financial reporting (to the extent that elements of internal control over financial reporting are subsumed within disclosure controls and procedures) identified in connection with the evaluation described in the above paragraph that occurred during the Company’s last fiscal quarter, that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

PART II — OTHER INFORMATION

Item 1 — Legal Proceedings – The Company is not involved in any pending legal proceedings. The Bank is not involved in any pending legal proceedings other than routine legal proceedings occurring in the ordinary course of business. Such routine legal proceedings, in the aggregate, are believed by management to be immaterial to the financial condition and results of operations of the company.

Item 2 — Unregistered sales of equity securities and use of proceeds

On October 25, 2004, Tri-County Financial Corporation announced a repurchase program under which it would repurchase 57,000 shares of its common stock. The program will continue until it is completed or terminated by the Board of Directors.

Item 3 — Default Upon Senior Securities — None

Item 4 — Submission of Matters to a Vote of Security Holders —None

Item 5 — Other Information — None

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Item 6 — Exhibits

Exhibit 31 Rule 13a-14(a) Certifications

Exhibit 32 Section 1350 Certifications

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.