With banks trading at uncommonly low valuations – Barclays analyst Jason Goldberg calculated recent sector valuation as being in the 15th percentile of the past 35 years – you can pretty much throw a dart blindfolded and find a cheap bank. While it’s true that sector performance determines a lot of individual stock performance (I’ve seen studies suggesting about 70%), I still believe quality eventually wins out, and I think TCF Financial (TCF) has more quality to it than the shares would seem to reflect.

The integration of the merger of equals between Chemical Financial (NASDAQ:CHFC) and TCF is off to a good start, and there are still meaningful synergies to look forward to, as management continues to target meaningful (mid-teens) savings relative to the pro forma starting point. Beyond that, though, I also see underappreciated potential to take share in its upper Midwest operating footprint, grow the commercial business through low-risk cross-selling, and remain active in M&A in the relatively near future.

Credit Looks Manageable

TCF came out of the second quarter with a relatively low level of reserves, with the allowance for credit losses (or ACL) ratio at 1.5%, adjusted for PPP loans, versus a peer group average closer to 1.75%. It’s important to remember the loan marks that went with the merger, though, and that adds an additional buffer worth about 35bp, meaning the “real” reserve position is closer to 1.85% of loans, which is a more comfortable level.

It’s also well worth mentioning other credit-relevant items. First, the bank sold off TCF’s higher-risk auto loan book before the end of 2019, and Chemical had a strong underwriting history prior to the merger (TCF less so). Also, overall levels of non-performing loans remain relatively low at about 0.8%, with low charge-offs relative to the peer group in recent quarters.

TCF also doesn’t seem to be experiencing particularly negative changes due to COVID-19. Only about 5% of loan balances were on deferral coming out of the second quarter, with 8% of CRE and 5% C&I loans on deferral, and that was comfortably below the 7% to 8% average of the peer group.

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Management has also highlighted a very low level of lending exposure to high-risk business segments, with only about 5% of the loan book at meaningful risk. While I’ve generally found that management teams are underestimating their risk exposures relative to my own analysis (I’d include more risk in healthcare verticals, for instance), the fact remains that TCF doesn’t really do energy lending and has very manageable exposures to areas like hospitality, retail, transportation, and consumer services.

One area that may be at greater risk is the company’s equipment leasing business (recession risk, not so much COVID-19 risk), but over the last 15 years or so, the Capital Solutions business has generated net charge-off ratios about half of the banking industry average for C&I lending, so I can’t really see an argument for excessive pessimism here.

Near-Term Challenges, Longer-Term Opportunities

I do see some near-term challenges for TCF, particularly from a revenue growth perspective. With the Fed apparently looking to keep rates low for several years, spread leverage is going to be hard to come by. I do see some opportunities for TCF to drive better pricing in its deposit base, and the bank is skewed toward some relatively more attractive areas of lending (like equipment leasing), but I think NIM leverage will be tough for the next few years.

I also think the overall environment for lending growth will be soft for a few years. One possible counterbalance for TCF will be in executing on cross-selling opportunities. Chemical has a meaningful commercial lending footprint, but it hasn’t historically done much leasing business, so bringing TCF leasing products to these customers, most of whom will likely have leasing business with other banks, should be an opportunity.

One negative is TCF’s collection of fee-generating businesses. At about one-quarter of revenue, this isn’t as strong as I’d like – First Horizon (FHN) and KeyCorp (KEY) are around 40%, and Huntington (HBAN) is at around 33%. Moreover, it’s not really structured to offer counter-cyclical benefits, as most of it comes from leasing and service charges. Building up fee-generating businesses is something I’d like to see figure a little more prominently into the bank’s long-term strategic planning.

Still, while there are near-term challenges, there are also opportunities both near and far. Management has already done a good job so far on the integration of the two banks, and further expense synergies should be a meaningful driver as the efficiency ratio moves from 62% down toward 60% and below in later years.

Apart from the aforementioned cross-selling opportunities, I also see an opportunity for TCF to flex its leverage to grow deposit share. About half of the deposits in Michigan (the bank’s strongest market in terms of deposit share) are held by smaller banks, and I believe many of these banks are going to struggle to keep pace with the level of IT investment necessary to provide customers with the range and quality of services they expect. I likewise see some opportunities in Minnesota on a similar basis.

Last and not least is the possibility of additional M&A. TCF has a rather strong capital position now (11.1% Tier 1 common ratio), and while I think management will wait for the integration of Chemical and TCF to be closer to completion, it could be an active player in sizable M&A relatively quickly and consolidate other markets in the upper Midwest.

The Outlook

Core pro-forma earnings growth is going to be challenging for a while, and I do worry that the shares could stay out of favor on pre-provision profit contraction in both 2021 and 2022. On the other hand, I expect a strong rebound in ’23, and I think mid-single-digit core growth is possible on a longer-term basis.

My long-term discounted core earnings and ROTCE-driven P/TBV models give me exactly the same number for fair value today – there’s no special significance to that other than it’s not something that happens all that often. In both cases, I think the fair value here is about $35.

The Bottom Line

The dividend yield here is good at 5.5%, and while I think the Fed is going to limit what banks can do in terms of returning capital to shareholders for a little while longer, I think the dividend is safe unless there’s a severe change in the outlook for the U.S. economy (and/or more specifically the upper Midwest). All told, TCF isn’t the cheapest-looing bank I follow, but it does look undervalued and I like the potential leverage and synergies from the merger of equals, and this is a name worth considering while banks are still deeply out of favor.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.