UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
_________________________
FORM 10-Q
x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2018
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from to
Commission file number: 001-37700
NICOLET BANKSHARES, INC.
(Exact Name of Registrant as Specified in its Charter)
WISCONSIN
(State or Other Jurisdiction of Incorporation or Organization)
47-0871001
(I.R.S. Employer Identification No.)
111 North Washington Street
Green Bay, Wisconsin
(Address of Principal Executive Offices)
54301
(Zip Code)
(920) 430-1400
(Registrant’s Telephone Number, Including Area Code)
N/A
(Former Name, Former Address and Former Fiscal Year, if Changed Since Last Report)
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 x No ¨
Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes x No ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.
Emerging Growth Company x
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
As of July 31, 2018 there were 9,644,774 shares of $0.01 par value common stock outstanding.
Nicolet Bankshares, Inc.
TABLE OF CONTENTS
PART I – FINANCIAL INFORMATION
Item 1. FINANCIAL STATEMENTS:
Consolidated Balance Sheets(In thousands, except share and per share data)
December 31, 2017
(Audited)
See accompanying notes to unaudited consolidated financial statements.
ITEM 1. Financial Statements Continued:
Consolidated Statements of Income
(In thousands, except share and per share data) (Unaudited)
Three Months Ended
June 30,
Six Months Ended
Consolidated Statements of Comprehensive Income
(In thousands) (Unaudited)
Consolidated Statement of Stockholders’ Equity
Noncontrolling
Interest
Total
Consolidated Statements of Cash Flows
* Cash and cash equivalents include restricted cash of $6.8 million and $1.7 million at June 30, 2018 and 2017, respectively, for the reserve balance required with the Federal Reserve Bank.
Notes to Unaudited Consolidated Financial Statements
Note 1 – Basis of Presentation
General
In the opinion of management, the accompanying unaudited consolidated financial statements contain all adjustments necessary to present fairly the consolidated balance sheets, statements of income, comprehensive income, changes in stockholders’ equity and cash flows of Nicolet Bankshares, Inc. (the “Company” or “Nicolet”) and its subsidiaries, for the periods presented, and all such adjustments are of a normal recurring nature. All material intercompany transactions and balances have been eliminated. The results of operations for the interim periods are not necessarily indicative of the results to be expected for the entire year.
These interim consolidated financial statements have been prepared according to the rules and regulations of the Securities and Exchange Commission and, therefore, certain information and footnote disclosures normally presented in accordance with generally accepted accounting principles in the United States of America (“U.S. GAAP”) have been omitted or abbreviated. These consolidated financial statements should be read in conjunction with the Company’s audited consolidated financial statements and footnotes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017.
Critical Accounting Policies and Estimates
Preparation of consolidated financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying disclosures. These estimates are based on management’s best knowledge of current events and actions the Company may undertake in the future. Estimates are used in accounting for, among other items, the allowance for loan losses, valuation of loans in acquisition transactions, useful lives for depreciation and amortization, fair value of financial instruments, other-than-temporary impairment calculations, valuation of deferred tax assets, uncertain income tax positions and contingencies. Estimates that are particularly susceptible to significant change for the Company include the determination of the allowance for loan losses, the determination and assessment of deferred tax assets and liabilities, and the valuation of loans acquired in acquisition transactions; therefore, these are critical accounting policies. Factors that may cause sensitivity to the aforementioned estimates include but are not limited to: external market factors such as market interest rates and employment rates, changes to operating policies and procedures, changes in applicable banking or tax regulations, and changes to deferred tax estimates. Actual results may ultimately differ from estimates, although management does not generally believe such differences would materially affect the consolidated financial statements in any individual reporting period presented.
There have been no material changes or developments with respect to the assumptions or methodologies that the Company uses when applying what management believes are critical accounting policies and developing critical accounting estimates as disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017.
Recent Accounting Developments Adopted
In May 2017, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2017-09, Compensation – Stock Compensation (Topic 718). ASU 2017-09 applies to entities that change the terms or conditions of a share-based payment award to provide clarity and reduce diversity in practice as well as cost and complexity when applying the guidance in Topic 718 to the modification to the terms and conditions of a share-based payment award. The updated guidance is effective for interim and annual reporting periods beginning after December 15, 2017. The Company adopted the updated guidance effective January 1, 2018 with no material impact on its consolidated financial statements.
In January 2017, the FASB issued ASU 2017-01, Business Combinations (Topic 805): Clarifying the Definition of a Business, to clarify the definition of a business to assist entities with evaluating whether transactions should be accounted for as acquisitions (or disposals) of assets versus businesses. The update narrows the definition of a business by adding three principal clarifications: (1) if substantially all the fair value of the gross assets in the asset group is concentrated in either a single identifiable asset or group of similar identifiable assets the transaction does not involve a business, (2) if the asset group does not include a minimum of an input and a substantive process, it does not represent a business, and (3) if the integrated set of activities (including its inputs and processes) does not create, or have the ability to create, goods or services to customers, investment income (e.g., dividends or interest) or other revenue, it is not a business. The overall intention is to provide consistency in applying the guidance and make the definition of a business more operable. This update is effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years and should be applied prospectively. The Company adopted the updated guidance effective January 1, 2018 with no material impact on its consolidated financial statements.
In November 2016, the FASB issued ASU 2016-18,Statement of Cash Flows (Topic 230): Restricted Cash to provide guidance on the presentation of restricted cash or restricted cash equivalents in the statement of cash flows to reduce diversity in practice. The amendment requires that a statement of cash flow explain the change during the period in the total cash, cash equivalents, and amounts generally described as restricted cash or restricted cash equivalents. Therefore, amounts generally described as restricted cash or restricted cash equivalents should be included in cash and cash equivalents when reconciling the beginning and end of period total amounts shown on the statement of cash flow. This amendment is effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years and should be applied retrospectively to each period presented. The Company adopted the updated guidance effective January 1, 2018 with no material impact on its consolidated financial statements. See the consolidated statements of cash flows for additional disclosures related to this ASU.
In August 2016, the FASB issued ASU 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts to address diversity in how certain cash receipts and cash payments are presented and classified in the statement of cash flows. The amendments provide guidance on specific cash flow issues, including: debt prepayment or debt extinguishment costs, contingent consideration payments made after a business combination, proceeds from the settlement of insurance claims, proceeds from the settlement of Corporate-Owned Life Insurance Policies, including Bank-Owned Life Insurance Policies, and distributions received from equity method investees. The amendments are effective for public business entities for fiscal years beginning after December 31, 2017, and interim periods within those fiscal years. The Company adopted the updated guidance effective January 1, 2018 with no material impact on its consolidated financial statements.
In January 2016, the FASB issued ASU 2016-01, Financial Instruments – Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities, to address certain aspects of recognition, measurement, presentation, and disclosure of financial instruments. This amendment supersedes the guidance to classify equity securities with readily determinable fair values into different categories, requires equity securities to be measured at fair value with changes in the fair value recognized through net income, and simplifies the impairment assessment of equity investments without readily determinable fair values. The amendment also requires public business entities that are required to disclose the fair value of financial instruments measured at amortized cost on the balance sheet to measure that fair value using the exit price notion. The amendment requires separate presentation of financial assets and financial liabilities by measurement category and form of financial asset on the balance sheet or in the accompanying notes to the financial statements. This amendment is effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. Entities are required to apply the amendment by means of a cumulative-effect adjustment as of the beginning of the fiscal year of adoption, with the exception of the amendment related to equity securities without readily determinable fair values, which should be applied prospectively to equity investments that exist as of the date of adoption. The Company adopted the updated guidance effective January 1, 2018 and recognized a cumulative-effect adjustment at adoption of approximately $0.9 million for the after tax impact of the unrealized gain on equity securities. See the consolidated statement of stockholders’ equity and Note 5 for additional disclosures related to this ASU.
In May 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers (Topic 606), with several subsequent updates. The core principle of the guidance is that an entity should recognize revenue to depict the transfer of promised goods and services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods and services. Topic 606 provides a five-step model to apply to revenue recognition, consisting of the following: (1) identify the contract; (2) identify the performance obligation in the contract; (3) determine the transaction price; (4) allocate the transaction price to the performance obligations; and (5) recognize revenue when or as the performance obligation is satisfied. The guidance is effective for annual reporting periods beginning after December 15, 2017, including interim periods within that reporting period. The Company adopted the updated guidance using the modified retrospective approach effective January 1, 2018, with no material impact on its consolidated financial statements. See Note 10 for the new disclosures related to this ASU.
Operating Segment
While the chief-operating decision makers monitor the revenue streams of the various products and services, and evaluate costs, balance sheet positions and quality, all such products, services and activities are directly or indirectly related to the business of community banking, with no regular, formal or material segment delineations. Operations are managed and financial performance is evaluated on a company-wide basis, and accordingly, all the financial service operations are considered by management to be aggregated in one reportable operating segment.
Reclassifications
Certain amounts in the 2017 consolidated financial statements have been reclassified to conform to the 2018 presentation.
Note 2 – Acquisition
On April 28, 2017, the Company consummated its merger with First Menasha Bancshares, Inc. (“First Menasha”) pursuant to the Agreement and Plan of Merger by and between the Company and First Menasha dated November 3, 2016, (the “Merger Agreement”), whereby First Menasha was merged with and into the Company, and The First National Bank-Fox Valley, the wholly owned commercial bank subsidiary of First Menasha serving the Fox Valley area of Wisconsin, was merged with and into Nicolet National Bank (the “Bank”). The system integration was completed, and five branches of First Menasha opened on May 1, 2017, as Nicolet National Bank branches, expanding its presence in Calumet and Winnebago Counties, Wisconsin. The Company closed one of its Calumet County locations concurrently with the First Menasha merger.
The purpose of the merger was to continue Nicolet’s interest in strategic growth, consistent with its plan to improve profitability through efficiency, leverage the strengths of each bank across the combined customer base, and add shareholder value. With the merger, Nicolet became the leading community bank to serve the Fox Valley area of Wisconsin.
Pursuant to the Merger Agreement, the final purchase price consisted of issuing 1,309,885 shares of the Company’s common stock (given the final stock-for-stock exchange ratio of 3.126 except for First Menasha shares owned by the Company immediately prior to the time of the merger), for common stock consideration of $62.2 million (based on $47.52 per share, the volume weighted average closing price of the Company’s common stock over the preceding 20 trading day period) plus cash consideration of $19.3 million. Approximately $0.2 million in direct stock issuance costs for the merger were incurred and charged against additional paid-in capital.
Upon consummation, the Company added $480 million in assets, $351 million in loans, $375 million in deposits, $4 million in core deposit intangible, and $41 million of goodwill. The Company accounted for the transaction under the acquisition method of accounting, and thus, the financial position and results of operations of First Menasha prior to the consummation date were not included in the accompanying consolidated financial statements. The accounting required assets purchased and liabilities assumed to be recorded at their respective estimated fair values at the date of acquisition.
Note 3 – Earnings per Common Share
Basic earnings per common share are calculated by dividing net income available to common shareholders by the weighted average number of common shares outstanding during the period. Diluted earnings per common share are calculated by dividing net income available to common shareholders by the weighted average number of shares adjusted for the dilutive effect of common stock awards (outstanding stock options and unvested restricted stock), if any. Presented below are the calculations for basic and diluted earnings per common share.
*Cumulative quarterly per share performance may not equal annual per share totals due to the effects of the amount and timing of capital increases. When computing earnings per share for an interim period, the denominator is based on the weighted-average shares outstanding during the interim period, and not on an annualized weighted-average basis. Accordingly, the sum of the quarters' earnings per share data will not necessarily equal the year to date earnings per share data.
For the three and six months ended June 30, 2018, options to purchase approximately 0.1 million shares are excluded from the calculation of diluted earnings per common share as the effect of their exercise would have been anti-dilutive. There was no anti-dilutive effect of options outstanding for the three and six months ended June 30, 2017.
Note 4 – Stock-based Compensation
The Company may grant stock options and restricted stock under its stock-based compensation plans to certain officers, employees and directors. At June 30, 2018, approximately 145,000 shares were available for grant under these stock-based compensation plans.
A Black-Scholes model is utilized to estimate the fair value of stock option grants, while the market price of the Company’s stock at the date of grant is used to estimate the value of restricted stock awards. The weighted average assumptions used in the Black-Scholes model for valuing stock option grants for the six months ended June 30, 2018 and 2017, respectively, were as follows.
Activity in the Company’s Stock Incentive Plans is summarized in the following tables:
Option Shares Outstanding
* The terms of the stock option agreements permit having a number of shares of stock withheld, the fair market value of which as of the date of exercise is sufficient to satisfy the exercise price and/or tax withholding requirements. No such shares were surrendered to the Company for the six months ended June 30, 2018.
Intrinsic value represents the amount by which the fair market value of the underlying stock exceeds the exercise price of the stock options. The intrinsic value of options exercised for the six months ended June 30, 2018 and 2017 was approximately $1.4 million and $1.8 million, respectively.
* The terms of the restricted stock agreements permit the surrender of shares to the Company upon vesting in order to satisfy applicable tax withholding requirements at the minimum statutory withholding rate, and accordingly, 1,615 shares were surrendered during the six months ended June 30, 2018.
The Company recognized approximately $2.3 million and $0.9 million of stock-based compensation expense during the six months ended June 30, 2018 and 2017, respectively, associated with its common stock awards. As of June 30, 2018, there was approximately $14.7 million of unrecognized compensation cost related to equity award grants. The cost is expected to be recognized over the remaining vesting period of approximately four years. The Company recognized a tax benefit of approximately $0.2 million for both the six months ended June 30, 2018 and 2017, respectively, for the tax impact of stock option exercises and vesting of restricted stock.
Note 5 – Securities Available for Sale
Amortized cost and fair value of securities available for sale are summarized as follows:
Gross
Unrealized
Gains
* Effective January 1, 2018, the Company adopted ASU 2016-01, which requires equity securities with readily determinable fair values to be measured at fair value with changes in the fair value recognized through net income. Such securities are no longer reflected as securities AFS. As a result of this accounting change, the Company recognized a cumulative-effect adjustment at adoption from accumulated other comprehensive income to retained earnings of approximately $0.9 million in the consolidated statement of stockholders’ equity for the net of tax impact of the unrealized gain on equity securities as of the date of adoption and recognized a gain of approximately $330,000 for the six months ended June 30, 2018, in the consolidated statements of income for the change in fair value on equity securities since adoption. In addition, the approximately $3.1 million current fair value of equity securities is now reflected within other investments on the consolidated balance sheets rather than as securities AFS. Prior periods have not been restated for the impact of this accounting change. See Note 1 for additional information on this new accounting standard.
The following table represents gross unrealized losses and the related estimated fair value of investment securities available for sale, aggregated by investment category and length of time individual securities have been in a continuous unrealized loss position.
Fair
Value
Losses
As of June 30, 2018, the Company does not consider its securities AFS with unrealized losses to be other-than-temporarily impaired, as the unrealized losses in each category have occurred as a result of changes in interest rates, market spreads and market conditions subsequent to purchase, not credit deterioration. The Company has the ability and intent to hold its securities to maturity. There were no other-than-temporary impairments charged to earnings during the six-month periods ended June 30, 2018 or 2017.
The amortized cost and fair value of securities AFS by contractual maturity at June 30, 2018 are shown below. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties; as this is particularly inherent in mortgage-backed securities, these securities are not included in the maturity categories below.
Proceeds from the sale of securities AFS were as follows.
Note 6 – Loans, Allowance for Loan Losses, and Credit Quality
The loan composition as of June 30, 2018 and December 31, 2017 is summarized as follows.
% of
A roll forward of the allowance for loan losses for the six months ended June 30, 2018 and 2017, and the year ended December 31, 2017, respectively, is summarized as follows.
Practically all of the Company’s loans, commitments, and letters of credit have been granted to customers in the Company’s market area. Although the Company has a diversified loan portfolio, the credit risk in the loan portfolio is largely influenced by general economic conditions and trends of the counties and markets in which the debtors operate, and the resulting impact on the operations of borrowers or on the value of underlying collateral, if any.
The following tables present the balance and activity in the ALLL by portfolio segment and the recorded investment in loans by portfolio segment at or for the six months ended June 30, 2018:
As a further breakdown, the June 30, 2018 ALLL is summarized by originated and acquired as follows:
The following tables present the balance and activity in the ALLL by portfolio segment and the recorded investment in loans by portfolio segment at or for the year ended December 31, 2017:
As a further breakdown, the December 31, 2017 ALLL is summarized by originated and acquired as follows:
The following table presents nonaccrual loans by portfolio segment in total and then as a further breakdown by originated or acquired as of June 30, 2018 and December 31, 2017.
The following tables present past due loans by portfolio segment as of June 30, 2018 and December 31, 2017:
A description of the loan risk categories used by the Company follows:
Grades 1-4, Pass: Credits exhibit adequate cash flows, appropriate management and financial ratios within industry norms and/or are supported by sufficient collateral. Some credits in these rating categories may require a need for monitoring but elements of concern are not severe enough to warrant an elevated rating.
Grade 5, Watch: Credits with this rating are adequately secured and performing but are being monitored due to the presence of various short-term weaknesses which may include unexpected, short-term adverse financial performance, managerial problems, potential impact of a decline in the entire industry or local economy and delinquency issues. Loans to individuals or loans supported by guarantors with marginal net worth or collateral may be included in this rating category.
Grade 6, Special Mention: Credits with this rating have potential weaknesses that, without the Company’s attention and correction may result in deterioration of repayment prospects. These assets are considered Criticized Assets. Potential weaknesses may include adverse financial trends for the borrower or industry, repeated lack of compliance with Company requests, increasing debt to net worth, serious management conditions and decreasing cash flow.
Grade 7, Substandard: Assets with this rating are characterized by the distinct possibility the Company will sustain some loss if deficiencies are not corrected. All foreclosures, liquidations, and nonaccrual loans are considered to be categorized in this rating, regardless of collateral sufficiency.
Grade 8, Doubtful: Assets with this rating exhibit all the weaknesses as one rated Substandard with the added characteristic that such weaknesses make collection or liquidation in full highly questionable.
Grade 9, Loss: Assets in this category are considered uncollectible. Pursuing any recovery or salvage value is impractical but does not preclude partial recovery in the future.
The following tables present total loans by risk categories as of June 30, 2018 and December 31, 2017:
The following tables present impaired loans as of June 30, 2018 and December 31, 2017.
Total purchased credit impaired loans (in aggregate since the Company’s 2013 acquisitions) were initially recorded at a fair value of $43.6 million on their respective acquisition dates, net of an initial $34.4 million non-accretable mark and a zero accretable mark. At June 30, 2018, $9.9 million of the $43.6 million remain in impaired loans.
Non-accretable discount on purchase credit impaired (“PCI”) loans:
Troubled Debt Restructurings
At June 30, 2018, there were five loans classified as troubled debt restructurings with a current outstanding balance of $0.9 million and pre-modification balance of $2.7 million. In comparison, at December 31, 2017, there were eight loans classified as troubled debt restructurings with an outstanding balance of $5.6 million and pre-modification balance of $6.9 million. There were no loans classified as troubled debt restructurings during the previous twelve months that subsequently defaulted during the six months ended June 30, 2018. As of June 30, 2018, there were no commitments to lend additional funds to debtors whose terms have been modified in troubled debt restructurings.
Note 7 – Goodwill and Other Intangibles and Mortgage Servicing Rights
Management periodically reviews the carrying value of its intangible assets to determine if any impairment has occurred, in which case an impairment charge would be recorded as an expense in the period of impairment, or whether changes in circumstances have occurred that would require a revision to the remaining useful life which would impact expense prospectively. In making such determination, management evaluates whether there are any adverse qualitative factors indicating that an impairment may exist, as well as the performance, on an undiscounted basis, of the underlying operations or assets which give rise to the intangible. The Company’s quarterly assessment indicated no impairment charge on goodwill, core deposit intangibles or customer list intangibles was required for the year ended December 31, 2017 or the six months ended June 30, 2018.
Goodwill: Goodwill was $107.4 million at both June 30, 2018 and December 31, 2017. During 2017, goodwill increased due to the First Menasha acquisition. See Note 2 for additional information on the First Menasha acquisition.
Other intangible assets: Other intangible assets, consisting of core deposit intangibles (related to branch or bank acquisitions) and customer list intangibles (related to the customer relationships acquired in connection with the 2016 financial advisor business acquisition), are amortized over their estimated finite lives. During 2017, core deposit intangibles increased due to the First Menasha acquisition and customer list intangibles increased due to a modification to the contingent earn-out payment on the financial advisor business acquired in 2016, fixing the previously variable earn-out payment on a portion of the purchase price. See Note 2 for additional information on the First Menasha acquisition.
Mortgage servicing rights: Mortgage servicing rights are amortized in proportion to and over the period of estimated net servicing income, and assessed for impairment at each reporting date, with the amortization recorded in mortgage income, net, in the consolidated statements of income. Mortgage servicing rights are carried at the lower of the initial capitalized amount, net of accumulated amortization, or estimated fair value, and are included in other assets in the consolidated balance sheets. Activity in the mortgage servicing rights asset for the year ended December 31, 2017 and the six months ended June 30, 2018 was as follows:
The Company periodically evaluates its mortgage servicing rights asset for impairment. At each reporting date, impairment is assessed based on an estimated fair value using estimated prepayment speeds of the underlying mortgage loans serviced and stratifications based on the risk characteristics of the underlying loans serviced (predominantly loan type and note interest rate). No valuation allowance or impairment charge was recorded for the year ended December 31, 2017 or the six months ended June 30, 2018. See Note 9 for additional information on the fair value of the MSR asset.
The following table shows the estimated future amortization expense for amortizing intangible assets and the MSR asset. The projections are based on existing asset balances, the current interest rate environment and prepayment speeds as of the June 30, 2018. The actual amortization expense the Company recognizes in any given period may be significantly different depending upon acquisition or sale activities, changes in interest rates, prepayment speeds, market conditions, regulatory requirements and events or circumstances that indicate the carrying amount of an asset may not be recoverable.
Note 8 – Short and Long-Term Borrowings
Short-Term Borrowings:
The Company did not have any short-term borrowings (borrowing with an original maturity of one year or less) outstanding at June 30, 2018 or December 31, 2017.
Long-Term Borrowings:
The components of long-term borrowings (borrowing with an original maturity greater than one year) at June 30, 2018 and December 31, 2017 were as follows:
FHLB Advances: The FHLB advances bear fixed rates and require interest-only monthly payments. The weighted average rate of the FHLB advances was 1.72% and 1.71% at June 30, 2018 and December 31, 2017, respectively.
The following table shows the maturity schedule of the FHLB advances as of June 30, 2018.
Junior Subordinated Debentures:The following table shows the breakdown of junior subordinated debentures as of June 30, 2018 and December 31, 2017. Interest on all debentures is current. Any applicable discounts (initially recorded to carry an acquired debenture at its then estimated fair market value) are being accreted to interest expense over the remaining life of the debentures. All the debentures below are currently callable and may be redeemed in part or in full at par plus any accrued but unpaid interest. At June 30, 2018 and December 31, 2017, $28.7 million and $28.5 million, respectively, qualify as Tier 1 capital.
6/30/2018
Unamortized Discount
Carrying Value
12/31/2017
Subordinated Notes: In 2015, the Company placed an aggregate of $12 million in subordinated Notes in private placements with certain accredited investors. All Notes were issued with 10-year maturities, have a fixed annual interest rate of 5% payable quarterly, are callable on or after the fifth anniversary of their respective issuances dates, and qualify for Tier 2 capital for regulatory purposes. The carrying value of these subordinated Notes was $11.9 million at both June 30, 2018 and December 31, 2017.
Note 9 – Fair Value Measurements
Fair value represents the estimated price at which an orderly transaction to sell an asset or transfer a liability would take place between market participants at the measurement date under current market conditions (i.e., an exit price concept), and is a market-based measurement versus an entity-specific measurement.
The Company records and/or discloses financial instruments on a fair value basis. These financial assets and financial liabilities are measured at fair value in three levels, based on the markets in which the assets and liabilities are traded and the observability of the assumptions used to determine fair value. These levels are:
In instances where the fair value measurement is based on inputs from different levels, the level within which the entire fair value measurement will be categorized is based on the lowest level input that is significant to the fair value measurement in its entirety. This assessment of the significance of an input requires management judgment.
Recurring basis fair value measurements:
The following table presents the balances of assets and liabilities measured at fair value on a recurring basis for the periods presented.
* Effective January 1, 2018, the Company adopted ASU 2016-01, which requires equity securities with readily determinable fair values to be measured at fair value with changes in the fair value recognized through net income. As a result, the approximately $3.1 million current fair value of equity securities is now reflected within other investments on the consolidated balance sheets compared to securities AFS at December 31, 2017. Prior periods have not been restated for the impact of this accounting change. See Note 1 for additional information on this new accounting standard and see Note 5 for additional information on the impact to securities AFS.
The following is a description of the valuation methodologies used by the Company for the securities AFS and equity securities measured at fair value on a recurring basis, as noted in the tables above. Where quoted market prices on securities exchanges are available, the investments are classified as Level 1. Level 1 investments primarily include exchange-traded equity securities. If quoted market prices are not available, fair value is generally determined using prices obtained from independent pricing vendors who use pricing models (with typical inputs including benchmark yields, reported trades for similar securities, issuer spreads or relationship to other benchmark quoted securities), or discounted cash flows, and are classified as Level 2. Examples of these investments include U.S. government agency securities, mortgage-backed securities, obligations of state, county and municipals, and certain corporate debt securities. Finally, in certain cases where there is limited activity or less transparency around inputs to the estimated fair value, investments are classified within Level 3 of the hierarchy. Examples of these include private municipal bonds and corporate debt securities, which include trust preferred security investments. At June 30, 2018 and December 31, 2017, it was determined that carrying value was the best approximation of fair value for these Level 3 securities, based primarily on the internal analysis on these securities.
The following table presents the changes in the Level 3 securities AFS measured at fair value on a recurring basis:
Nonrecurring basis fair value measurements:
The following table presents the Company’s assets measured at fair value on a nonrecurring basis for the periods presented, aggregated by level in the fair value hierarchy within which those measurements fall.
The following is a description of the valuation methodologies used by the Company for the items noted in the table above. For individually evaluated impaired loans, the amount of impairment is based upon the present value of expected future cash flows discounted at the loan’s effective interest rate, the estimated fair value of the underlying collateral for collateral-dependent loans, or the estimated liquidity of the note. For OREO, the fair value is based upon the estimated fair value of the underlying collateral adjusted for the expected costs to sell. To estimate the fair value of the MSR asset, the underlying serviced loan pools are stratified by interest rate tranche and term of the loan, and a valuation model is used to calculate the present value of the expected future cash flows for each stratum. The valuation model incorporates assumptions that market participants would use in estimating future net servicing income, such as costs to service, a discount rate, ancillary income, default rates and losses, and prepayment speeds. Although some of these assumptions are based on observable market data, other assumptions are based on unobservable estimates of what market participants would use to measure fair value.
Financial instruments:
The carrying amounts and estimated fair values of the Company’s financial instruments are shown below.
The carrying value of certain assets and liabilities such as cash and cash equivalents, bank owned life insurance, short-term borrowings, and nonmaturing deposits, approximate their estimated fair value. For those financial instruments not previously disclosed, the following is a description of the valuation methodologies used.
Certificates of deposits in other banks:Fair values are estimated using discounted cash flow analysis based on current interest rates being offered by instruments with similar terms and represents a Level 2 measurement.
Other investments: The valuation methodologies utilized for exchange-traded equity securities are discussed under “Recurring basis fair value measurements” above. The carrying amount of Federal Reserve Bank, Bankers Bank, Federal Agricultural Mortgage Corporation, and FHLB stock is a reasonably accepted fair value estimate given their restricted nature. Fair value is the redeemable (carrying) value based on the redemption provisions of the instruments which is considered a Level 2 measurement. The carrying amount of the remaining other investments (particularly common stocks of companies or other banks that are not publicly traded) approximates their fair value, determined primarily by analysis of company financial statements and recent capital issuances of the respective companies or banks, if any, and represents a Level 3 measurement.
Loans held for sale: The fair value estimation process for the loans held for sale portfolio is segregated by loan type. The estimated fair value was based on what secondary markets are currently offering for portfolios with similar characteristics and represents a Level 2 measurement.
Loans, net: For variable-rate loans that reprice frequently and with no significant change in credit risk or other optionality, fair values are based on carrying values. Fair values for all other loans are estimated by discounting contractual cash flows using estimated market discount rates, which reflect the credit and interest rate risk inherent in the loan. Collateral-dependent impaired loans are included in loans, net. The fair value of loans is considered to be a Level 3 measurement due to internally developed discounted cash flow measurements.
Deposits: The fair value of deposits with no stated maturity (such as demand deposits, savings, interest and non-interest checking, and money market accounts) is, by definition, equal to the amount payable on demand at the reporting date. Fair values for fixed-rate certificates of deposit are estimated using a discounted cash flow calculation that applies interest rates currently being offered in the market place on certificates of similar remaining maturities. Use of internal discounted cash flows provides a Level 3 fair value measurement.
Long-term borrowings: The fair value of the FHLB advances is obtained from the FHLB which uses a discounted cash flow analysis based on current market rates of similar maturity debt securities and represents a Level 2 measurement. The fair values of the junior subordinated debentures and subordinated notes utilize a discounted cash flow analysis based on an estimate of current interest rates being offered by instruments with similar terms and credit quality. Since the market for these instruments is limited, the internal evaluation represents a Level 3 measurement.
Lending-related commitments: At June 30, 2018 and December 31, 2017, the estimated fair value of letters of credit and outstanding mandatory commitments to sell residential mortgage loans into the secondary market was insignificant.
Limitations: Fair value estimates are made at a specific point in time, based on relevant market information and information about the financial instrument. These estimates do not reflect any premium or discount that could result from offering for sale at one time the Company’s entire holdings of a particular financial instrument. Fair value estimates may not be realizable in an immediate settlement of the instrument. In some instances, there are no quoted market prices for the Company’s various financial instruments, in which case fair values may be based on estimates using present value or other valuation techniques, or based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of the financial instruments, or other factors. Those techniques are significantly affected by the assumptions used, including the discount rate and estimate of future cash flows. Subsequent changes in assumptions could significantly affect the estimates.
Note 10 – Revenue Recognition
As of January 1, 2018, the Company adopted ASU 2014-09 (Topic 606) using the modified retrospective approach. The adoption of the guidance had no material impact on the measurement, timing, or recognition of revenue; however, additional disclosures have been added in accordance with the ASU. See Note 1 for additional information on this new accounting standard.
Topic 606 does not apply to revenue associated with financial instruments, including revenue from loans and securities. In addition, certain noninterest income categories such as gains or losses associated with mortgage servicing rights, derivatives, and income from bank owned life insurance are not within the scope of the new guidance. The main types of revenue contracts within the scope of Topic 606 include trust services income, brokerage fee income, service charges on deposit accounts, card interchange income, and certain other noninterest income. These contracts are discussed in detail below:
Trust services and brokerage fee income: A contract between the Company and its customers to provide fiduciary and / or investment administration services on trust accounts and brokerage accounts in exchange for a fee. Trust services and brokerage fee income is based upon the month-end market value of the assets under management and the applicable fee rate, which is recognized over the period the underlying trust or brokerage account is serviced (generally on a monthly basis). Such contracts are generally cancellable at any time, with the customer subject to a pro-rated fee in the month of termination.
Service charges on deposit accounts: The deposit contract obligates the Company to serve as a custodian of the customer’s deposited funds and is generally terminable at will by either party. This contract permits the customer to access the funds on deposit and request additional services related to the deposit account. Service charges on deposit accounts consist of account analysis fees (net fees earned on analyzed business and public checking accounts), monthly service charges, nonsufficient fund (“NSF”) charges, and other deposit account related charges. The Company’s performance obligation for account analysis fees and monthly service charges is generally satisfied, and the related revenue recognized, over the period in which the service is provided (typically on a monthly basis); while NSF charges and other deposit account related charges are largely transactional based and the related revenue is recognized at the time the service is provided.
Card interchange income: A contract between the Company, as a card-issuing bank, and its customers whereby the Company receives a transaction fee from the merchant’s bank whenever a customer uses a debit or credit card to make a purchase. The performance obligation is completed and the fees are recognized as the service is provided (i.e., when the customer uses a debit or credit card).
Other noninterest income: Other noninterest income includes several items, such as wire transfer income, check cashing fees, check printing fees, safe deposit box rental fees, management fee income, and consulting fees. These fees are generally recognized at the time the service is provided.
ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Nicolet Bankshares, Inc. (the “Company” or “Nicolet”) is a bank holding company headquartered in Green Bay, Wisconsin. Nicolet provides a diversified range of traditional banking and wealth management services to individuals and businesses in its market area and through the branch offices of its banking subsidiary, Nicolet National Bank (the “Bank”), in northeastern and central Wisconsin and in Menominee, Michigan.
Forward-Looking Statements
Statements made in this document and in any documents that are incorporated by reference which are not purely historical are forward-looking statements, as defined in the Private Securities Litigation Reform Act of 1995, including any statements regarding descriptions of management’s plans, objectives, or goals for future operations, products or services, and forecasts of its revenues, earnings, or other measures of performance. Forward-looking statements are based on current management expectations and, by their nature, are subject to risks and uncertainties. These statements generally may be identified by the use of words such as “believe,” “expect,” “anticipate,” “plan,” “estimate,” “should,” “will,” “intend,” or similar expressions. Shareholders should note that many factors, some of which are discussed elsewhere in this document, could affect the future financial results of Nicolet and could cause those results to differ materially from those expressed in forward-looking statements contained in this document. These factors, many of which are beyond Nicolet’s control, include, but are not necessarily limited to the following:
These factors should be considered in evaluating the forward-looking statements, and you should not place undue reliance on such statements. Nicolet specifically disclaims any obligation to update factors or to publicly announce the results of revisions to any of the forward-looking statements or comments included herein to reflect future events or developments.
Overview
The following discussion is management’s analysis of the consolidated financial condition as of June 30, 2018 and December 31, 2017 and results of operations for the three and six-month periods ended June 30, 2018 and 2017. It should be read in conjunction with Nicolet’s audited consolidated financial statements included in Nicolet’s Annual Report on Form 10-K for the year ended December 31, 2017.
The timing of Nicolet’s April 2017 acquisition of First Menasha Bancshares, Inc. (“First Menasha”), at approximately 20% of pre-merger assets at the time of acquisition, impacts financial comparisons to 2017 periods. Certain income statement results, average balances and related ratios for 2018 and the last two quarters of 2017 each include three months of First Menasha operations, versus no contribution of First Menasha in the first quarter 2017 period and two months of contribution in the second quarter of 2017. Given the merger activity, quarterly results included non-recurring other direct merger and integration pre-tax expenses of $0.2 million and $0.3 million in the first and second quarters of 2017, respectively. See Note 2, “Acquisition,” in the Notes to Unaudited Consolidated Financial Statements under Part I, Item 1, for additional information on this acquisition.
Performance Summary
Table 1: Earnings Summary and Selected Financial Data
*Income statement-related ratios for partial-year periods are annualized.
Net income was $19.3 million for the six months ended June 30, 2018, an increase of $4.8 million or 33% over $14.5 million for the six months ended June 30, 2017. Earnings per diluted common share was $1.93 for the first six months of 2018, 26% higher than $1.53 for the first six months of 2017. Annualized return on average assets for the first six months of 2018 and 2017 was 1.31% and 1.19%, respectively.
INCOME STATEMENT ANALYSIS
Net Interest Income
Tax-equivalent net interest income is a non-GAAP measure, but is a preferred industry measurement of net interest income (and its use in calculating a net interest margin) as it enhances the comparability of net interest income arising from taxable and tax-exempt sources. The tax-equivalent adjustments bring tax-exempt interest to a level that would yield the same after-tax income by applying the effective Federal corporate tax rates to the underlying assets. Tables 2 and 3 present information to facilitate the review and discussion of selected average balance sheet items, tax-equivalent net interest income, interest rate spread and net interest margin.
Table 2: Average Balance Sheet and Net Interest Income Analysis – Tax-Equivalent Basis
Table 2: Average Balance Sheet and Net Interest Income Analysis – Tax-Equivalent Basis (continued)
Table 3: Volume/Rate Variance – Tax-Equivalent Basis
Tax-equivalent net interest income was $53 million for the first six months of 2018, $6 million or 13% higher than $47 million for the first six months of 2017. Between the comparative six-month periods, the interest rate spread decreased 41 bps due to a higher cost of funds (up 37 bps) and a decrease in the interest-earning asset yield (down 4 bps). The contribution from net free funds increased 10 bps, due mostly to the increase in noninterest-bearing demand deposits and the higher rate environment. As a result, the tax-equivalent net interest margin was 3.98% for the first half of 2018, down 31 bps compared to 4.29% for the first half of 2017.
Between the comparable six-month periods, average interest-earning assets increased $481 million or 22% to $2.7 billion, primarily due to a $371 million or 21% increase in loans (attributable to the acquired balances and organic loan growth) and a $95 million increase in other interest-earning assets (mainly low earning cash due to the large deposit previously noted). Tax-equivalent interest income increased $11 million or 21% to $62 million for the first six months of 2018, while the related interest-earning asset yield decreased 4 bps to 4.63%. Interest income on loans increased $10 million from the first half of 2017, while the related yield was level at 5.25% as the higher yield on new, renewed and variable rate loans in the rising rate environment was substantially offset by $1 million lower aggregate discount accretion income between the periods. Interest income on non-loan earnings assets increased $1 million or 19% from the first half of 2017, while the related yield decreased 14 bps due mostly to the lower corporate effective tax rate for 2018 reducing the benefit (and thus yields) of tax-exempt investment securities and the higher volume of lower interest-earning cash.
Average interest-bearing liabilities were $2.0 billion, an increase of $352 million or 21% compared to the first half of 2017, primarily due to a $333 million or 21% increase in interest-bearing deposits (attributable to the acquired balances and organic deposit growth, including the large customer deposit previously noted). Interest expense was $9 million for the first six months of 2018, up $5 million over the first half of 2017, and the related cost of funds increased 37 bps to 0.87%, driven predominantly by the cost and volume of deposits. Interest expense on deposits increased $4 million from the first half of 2017 and the average cost of interest-bearing deposits increased 37 bps to 0.73%, influenced by increases in select deposit rates from general rate pressures of the federal funds rate changes since the start of 2017. The Federal Reserve raised short-term interest rates by 125 bps since January 1, 2017.
Of note for the first half of 2018, the large customer deposit previously noted was a positive contributor to net interest income, though at a very low net spread, compressing the related margin components for 2018. The inclusion of the large deposit lowered the 2018 earning asset yield and net interest margin by approximately 11 bps and 12 bps, respectively, with no material impact on the cost of funds.
Provision for Loan Losses
The provision for loan losses was $1.0 million for the six months ended June 30, 2018, exceeding net charge-offs of $0.8 million. In comparison, the provision for loan losses for the six months ended June 30, 2017, was $0.9 million, exceeding net charge-offs of $0.1 million. Asset quality trends remained strong with continued resolutions of problem loans. The ALLL was $12.9 million (0.60% of loans) at June 30, 2018, compared to $12.7 million (0.61% of loans) at December 31, 2017 and $12.6 million (0.63% of loans) at June 30, 2017.
The provision for loan losses is predominantly a function of Nicolet’s methodology and judgment as to qualitative and quantitative factors used to determine the appropriateness of the ALLL. The appropriateness of the ALLL is affected by changes in the size and character of the loan portfolio, changes in levels of impaired and other nonperforming loans, historical losses and delinquencies in each portfolio segment, the risk inherent in specific loans, concentrations of loans to specific borrowers or industries, existing and future economic conditions, the fair value of underlying collateral, and other factors which could affect potential credit losses. For additional information regarding asset quality and the ALLL, see “Balance Sheet Analysis — Loans,” “— Allowance for Loan Losses,” and “— Nonperforming Assets.”
Noninterest Income
Table 4: Noninterest Income
Noninterest income grew $3.2 million or 20% over the first half of 2017, with all categories up year-over-year.
Trust service fees were up $0.3 million or 11% between the comparable six-month periods due to higher assets under management. Between the first half periods, brokerage fees were up $650,000 or 24%, attributable to growth within the financial advisor business.
Mortgage income represents net gains received from the sale of residential real estate loans into the secondary market, capitalized mortgage servicing rights (“MSRs”), servicing fees, offsetting MSR amortization, valuation changes, if any, and to a smaller degree some related income. Net mortgage income increased $0.4 million or 16% between the comparable six-month periods, commensurate with higher secondary mortgage production and increased net servicing fees on the growing portfolio of mortgage loans serviced for others.
Service charges on deposit accounts were $2.4 million for the first six months of 2018, up $0.3 million or 12% over the first six months of 2017, resulting from an increased number of accounts partly from the First Menasha acquisition and an increase to the fee charged on overdrafts implemented during mid-2017. Card interchange income grew $0.4 million or 21% due to higher volume and activity.
BOLI income was up 6% over the first six months of 2017, commensurate with the growth in average BOLI investments. Other noninterest income was $2.1 million, up $0.6 million or 41% over the first half of 2017, mostly attributable to an increase of $0.3 million in income from the equity interest in UFS (a data processing company interest acquired with a 2016 bank merger) and $0.3 million of annual card contract incentives received in first quarter 2018.
The $1.2 million net asset gains in 2018 were primarily attributable to $0.6 million of net gains on the sale of fixed assets, a $0.3 million fair value mark on equity securities, and a $0.2 million gain on the sale of equity securities. The $0.8 million net asset gains in 2017 primarily consisted of a $0.9 million gain on the sale of vacated bank branches, $0.4 million of net losses and write-downs on assets and OREO properties (predominantly the fair market value loss on two closed bank branches transferred to OREO), and a $0.2 million gain on the liquidation of an other investment.
Noninterest Expense
Table 5: Noninterest Expense
Noninterest expense increased $6.5 million or 17% over the first half of 2017, mostly due to the expanded workforce and larger operating base. Excluding $0.5 million of merger-related expenses from the 2017 period, noninterest expense would have increased $7.0 million or 18%.
Personnel expense was $25.2 million for the first half of 2018, up $4.3 million or 20% compared to the first half of 2017, partly due to the expanded workforce resulting from the 2017 acquisition, with average full-time equivalent employees up 9% between the comparable six-month periods. Additionally, the increase results from merit increases between the periods, additional competitive market-based wage increases made more broadly across staff positions starting in early 2018, cash and equity incentives timing, and higher health and other benefits costs.
Occupancy, equipment and office expense was $7.2 million for the first half of 2018, up $1.2 million or 20% compared to 2017, primarily the result of the larger operating base and higher software and technology costs.
Business development and marketing expense increased $0.6 million, or 25%, between the comparable six-month periods, largely due to $0.5 million higher donation expense, as well as the expanded operating base influencing additional marketing, promotions and media.
Data processing expenses, which are primarily volume-based, rose $0.5 million or 13% between the first half periods; however, excluding the $0.2 million of merger-based processing expense from the 2017 period, data processing expense would have increased $0.7 million or 18%, in line with the higher volumes from the 2017 acquisition and organic growth.
Intangible amortization increased due to the addition of core deposit intangibles related to the First Menasha acquisition, offset partly by lower amortization on the aging intangibles of previous acquisitions. Other noninterest expense was down $0.2 million or 7% between the comparable first half periods; however, removing the $0.3 million of merger-based legal expenses from the 2017 period, other noninterest expense would have increased $0.1 million or 3% given the larger operating base offset by certain economies of scale.
Income Taxes
Income tax expense was $6.2 million (effective tax rate of 24.0%) for the first six months of 2018, compared to $7.5 million (effective tax rate of 33.7%) for the comparable period of 2017. The underlying corporate tax rate declined to 21% (beginning in 2018) from 35% (for 2017) as a result of the Tax Cuts and Jobs Act passed in December 2017, impacting the effective tax rates between the years. Additionally, a tax benefit of $159,000 and $161,000 was recorded against income tax expense for the six months ended June 30, 2018 and 2017, respectively, related to the tax impact of stock option exercises and vesting of restricted stock.
Income Statement Analysis – Three Months Ended June 30, 2018 versus Three Months Ended June 30, 2017
Net income was $9.7 million for the three months ended June 30, 2018, an increase of $1.4 million or 17% over $8.3 million for the three months ended June 30, 2017. Earnings per diluted common share was $0.98 for second quarter 2018, 18% higher than $0.83 for second quarter 2017. Annualized return on average assets for second quarter 2018 and 2017 was 1.28% and 1.27%, respectively.
BALANCE SHEET ANALYSIS
At June 30, 2018, assets were $2.9 billion and deposits were $2.5 billion, minimally changed from December 31, 2017; however, both decreased $0.3 billion from March 31, 2018, attributable to a $0.3 billion short-term transaction deposit of a long-standing commercial customer accepted in late March and distributed by mid-June. At June 30, 2018, loans were $2.1 billion, up $41 million or 2% over December 31, 2017.
Compared to June 30, 2017, assets increased $96 million or 3%, including an increase of $119 million or 6% in loans. Deposits increased $66 million or 3% over the same period.
Total stockholders’ equity was $371 million, an increase of $6 million from December 31, 2017, with net income and stock issuances partially offset by stock repurchases and net fair value investment changes. Compared to June 30, 2017, stockholders’ equity increased $18 million, primarily due to net income and stock issuances, partially offset by stock repurchases over the year.
Loans
Nicolet services a diverse customer base throughout northeastern and central Wisconsin and in Menominee, Michigan. It continues to concentrate its efforts in originating loans in its local markets and assisting its current loan customers. The loan portfolio is widely diversified by types of borrowers, industry groups, and market areas. Significant loan concentrations are considered to exist for a financial institution when there are amounts loaned to multiple numbers of borrowers engaged in similar activities that would cause them to be similarly impacted by economic or other conditions. At June 30, 2018, no significant industry concentrations existed in Nicolet’s portfolio in excess of 10% of total loans. Nicolet has also developed guidelines to manage its exposure to various types of concentration risks. See also Note 6, “Loans, Allowance for Loan Losses, and Credit Quality” of the Notes to Unaudited Consolidated Financial Statements under Part I, Item 1, for additional disclosures on loans.
An active credit risk management process is used to ensure that sound and consistent credit decisions are made. The credit management process is regularly reviewed and the process has been modified over the past several years to further strengthen the controls. Factors that are important to managing overall credit quality are sound loan underwriting and administration, systematic monitoring of existing loans and commitments, effective loan review on an ongoing basis, early problem loan identification and remedial action to minimize losses, an appropriate ALLL, and sound nonaccrual and charge-off policies.
Table 6: Period End Loan Composition
Broadly, the loan portfolio at June 30, 2018, is 76% commercial-based and 24% retail-based. Commercial-based loans are considered to have more inherent risk of default than retail-based loans, in part because of the broader list of factors that could impact a commercial borrower negatively. In addition, the commercial balance per borrower is typically larger than that for retail-based loans, implying higher potential losses on an individual customer basis. Credit risk on commercial-based loans is largely influenced by general economic conditions and the resulting impact on a borrower’s operations or on the value of underlying collateral, if any.
Commercial-based loans of $1.6 billion increased $52 million or 3% since December 31, 2017, primarily due to a $29 million or 5% increase in commercial and industrial and an $18 million or 4% increase in owner-occupied CRE. Commercial and industrial loans continue to be the largest segment of Nicolet’s portfolio and increased to 31.3% of the total portfolio at June 30, 2018, up from 30.5% at December 31, 2017.
Commercial real estate loans of $0.5 billion increased $6 million or 1% from year-end 2017, with a shift in mix. CRE investment loans increased $19 million or 6%, while construction and land development loans decreased $15 million or 16%. Lending in the CRE investment and construction and land development categories has been focused on loans that are secured by commercial income-producing properties as opposed to speculative real estate development.
Residential real estate loans declined $13 million or 2% since year-end 2017, and represented 23.2% of total loans at June 30, 2018, compared to 24.3% at year-end 2017. Residential first mortgage loans include conventional first-lien home mortgages and residential junior mortgage real estate loans consist mainly of home equity lines and term loans secured by junior mortgage liens. As part of its management of originating residential mortgage loans, Nicolet’s long-term, fixed-rate residential real estate mortgage loans are largely sold in the secondary market with or without retaining the servicing rights. Mortgage loans retained in the portfolio are typically of high quality and have historically had low net charge-off rates.
Retail and other loans represented approximately 1% of the total loan portfolio, and include predominantly short-term and other personal installment loans not secured by real estate. The loan balances in this portfolio remained relatively unchanged from December 31, 2017 to June 30, 2018.
Allowance for Loan Losses
In addition to the discussion that follows, see also Note 6, “Loans, Allowance for Loan Losses, and Credit Quality,” in the Notes to Unaudited Consolidated Financial Statements under Part I, Item 1, for additional disclosures on the allowance for loan losses.
Credit risks within the loan portfolio are inherently different for each loan type as described under “Balance Sheet Analysis-Loans.” Credit risk is controlled and monitored through the use of lending standards, a thorough review of potential borrowers, and on-going review of loan payment performance. Active asset quality administration, including early problem loan identification and timely resolution of problems, aids in the management of credit risk and minimization of loan losses.
The level of the ALLL represents management’s estimate of an amount of reserves that provides for estimated probable credit losses in the loan portfolio at the balance sheet date. To assess the appropriateness of the ALLL, an allocation methodology is applied by Nicolet which focuses on evaluation of qualitative and environmental factors, including but not limited to: (i) evaluation of facts and issues related to specific loans; (ii) management’s ongoing review and grading of the loan portfolio; (iii) consideration of historical loan loss and delinquency experience on each portfolio segment; (iv) trends in past due and nonperforming loans; (v) the risk characteristics of the various loan portfolios; (vi) changes in the size and character of the loan portfolio; (vii) concentrations of loans to specific borrowers or industries; (viii) existing and forecasted economic conditions; (ix) the fair value of underlying collateral; and (x) other qualitative and quantitative factors which could affect potential credit losses.
Management allocates the ALLL by pools of risk within each loan portfolio segment. The allocation methodology consists of the following components. First, a specific reserve for the estimated shortfall is established for all loans determined to be impaired. The specific reserve in the ALLL is equal to the aggregate collateral or discounted cash flow shortfall calculated from the impairment analyses. Management has defined impaired loans as nonaccrual credit relationships over $250,000, all loans determined to be troubled debt restructurings (“restructured loans”), plus additional loans with impairment risk characteristics. Second, management allocates the ALLL with historical loss rates by loan segment. The loss factors applied in the methodology are periodically re-evaluated and adjusted to reflect changes in historical loss levels on an annual basis. The look-back period on which the average historical loss rates are determined is a rolling 20-quarter (5 year) average. Lastly, management allocates the ALLL to the remaining loan portfolio using the qualitative factors mentioned above. Consideration is given to those current qualitative or environmental factors that are likely to cause estimated credit losses as of the evaluation date to differ from the historical loss experience of each loan segment. Management conducts its allocation methodology on both the originated loans and on the acquired loans separately to account for differences, such as different loss histories and qualitative factors, between the two loan portfolios.
At June 30, 2018, the ALLL was $12.9 million compared to $12.7 million at December 31, 2017. The $0.2 million increase was the net result of a $1.0 million provision for loan losses, partially offset by net charge-offs of $0.8 million. Comparatively, the provision for loan losses in the first half of 2017 was $0.9 million and net charge-offs were $0.1 million. Annualized net charge-offs as a percent of average loans were 0.08% in the first six months of 2018 compared to 0.01% for the first six months of 2017 and 0.08% for the entire 2017 year.
The ratio of the ALLL as a percentage of period-end loans was 0.60% at June 30, 2018, compared to 0.61% at December 31, 2017, and 0.63% at June 30, 2017. The ALLL to loans ratio is impacted by the accounting treatment of Nicolet’s bank acquisitions, which combined at their acquisition dates (from 2013 to 2017) added no ALLL to the numerator and $1.3 billion of loans into the denominator at their then estimated fair values. Remaining outstanding acquired loans were $770 million and $844 million at June 30, 2018 and December 31, 2017, respectively. The related allowance for acquired loans was $2.0 million, representing 0.26% of acquired loans, at June 30, 2018, compared to an allowance for acquired loans of $2.1 million, representing 0.25% of acquired loans, at December 31, 2017. Originated loans outstanding, the related allowance and the ALLL to loans ratio at June 30, 2018 were $1.4 billion, $10.9 million and 0.80%, respectively, compared to $1.2 billion, $10.5 million and 0.85%, respectively, at December 31, 2017.
Table 7: Allowance for Loan Losses
Nonperforming Assets
As part of its overall credit risk management process, Nicolet’s management is committed to an aggressive problem loan identification philosophy. This philosophy has been implemented through the ongoing monitoring and review of all pools of risk in the loan portfolio to ensure that problem loans are identified early and the risk of loss is minimized. See also Note 6, “Loans, Allowance for Loan Losses, and Credit Quality” of the Notes to Unaudited Consolidated Financial Statements under Part I, Item 1, for additional disclosures on credit quality.
Nonperforming loans are considered one indicator of potential future loan losses. Nonperforming loans are defined as nonaccrual loans, including those defined as impaired under current accounting standards, and loans 90 days or more past due but still accruing interest. Loans are generally placed on nonaccrual status when contractually past due 90 days or more as to interest or principal payments. Additionally, whenever management becomes aware of facts or circumstances that may adversely impact the collectability of principal or interest on loans, it is management’s practice to place such loans on nonaccrual status immediately. Nonaccrual loans decreased to $10.9 million (consisting of $4.9 million originated loans and $6.0 million acquired loans) at June 30, 2018 compared to $13.1 million at December 31, 2017 (consisting of $3.3 million originated loans and $9.8 million acquired loans), with the decline primarily attributable to the favorable resolution of a large purchased credit impaired commercial loan. Nonperforming assets (which include nonperforming loans and OREO) were $12.1 million at June 30, 2018 compared to $14.4 million at December 31, 2017. OREO was $1.2 million at June 30, 2018, down slightly from $1.3 million at year-end 2017, the majority of which is closed bank branch property. Nonperforming assets as a percent of total assets were 0.41% at June 30, 2018 compared to 0.49% at December 31, 2017.
The level of potential problem loans is another predominant factor in determining the relative level of risk in the loan portfolio and in determining the appropriate level of the ALLL. Potential problem loans are generally defined by management to include loans rated as Substandard by management but that are in performing status; however, there are circumstances present which might adversely affect the ability of the borrower to comply with present repayment terms. The decision of management to include performing loans in potential problem loans does not necessarily mean that Nicolet expects losses to occur, but that management recognizes a higher degree of risk associated with these loans. The loans that have been reported as potential problem loans are predominantly commercial-based loans covering a diverse range of businesses and real estate property types. Potential problem loans were $14.6 million (0.7% of loans) and $13.6 million (0.7% of loans) at June 30, 2018 and December 31, 2017, respectively. Potential problem loans require a heightened management review of the pace at which a credit may deteriorate, the duration of asset quality stress, and uncertainty around the magnitude and scope of economic stress that may be felt by Nicolet’s customers and on underlying real estate values.
Table 8: Nonperforming Assets
2018
2017
Deposits
Deposits represent Nicolet’s largest source of funds. The deposit composition, including brokered deposits within total deposits, was as follows:
Table 9: Deposits
Amount
Lending-Related Commitments
As of June 30, 2018 and December 31, 2017, Nicolet had the following off-balance sheet lending-related commitments:
Table 10: Commitments
Interest rate lock commitments to originate residential mortgage loans held for sale (included above in commitments to extend credit) and forward commitments to sell residential mortgage loans held for sale are considered derivative instruments and represented $34.5 million and $11.9 million, respectively, at June 30, 2018. The fair value of these interest rate lock commitments and forward commitments was not significant at June 30, 2018.
Liquidity Management
Liquidity management refers to the ability to ensure that cash is available in a timely and cost-effective manner to meet cash flow requirements of depositors and borrowers and to meet other commitments as they fall due, including the ability to pay dividends to shareholders, service debt, invest in subsidiaries, repurchase common stock, and satisfy other operating requirements.
Funds are available from a number of basic banking activity sources, including but not limited to, the core deposit base; repayment and maturity of loans; investment securities calls, maturities, and sales; and procurement of brokered deposits. All securities AFS and equity securities (included in other investments) are reported at fair value on the consolidated balance sheet. At June 30, 2018, approximately 31% of the $402 million securities AFS portfolio was pledged to secure public deposits and short-term borrowings, as applicable, and for other purposes as required by law. Additional funding sources at June 30, 2018, consist of a $10 million available and unused line of credit at the holding company, $158 million of available and unused Federal funds lines, available borrowing capacity at the FHLB of $177 million, and borrowing capacity in the brokered deposit market.
Cash and cash equivalents at June 30, 2018 and December 31, 2017 were $104.1 million and $154.9 million, respectively. The decrease in cash and cash equivalents since year-end 2017 was largely attributable to loan growth, net investment purchases, a reduction in deposits, and common stock purchases. Nicolet’s liquidity resources were sufficient as of June 30, 2018 to fund loans, accommodate deposit cycles and trends, and to meet other cash needs as necessary.
Interest Rate Sensitivity Management and Impact of Inflation
A reasonable balance between interest rate risk, credit risk, liquidity risk and maintenance of yield, is highly important to Nicolet’s business success and profitability. As an ongoing part of its financial strategy and risk management, Nicolet attempts to understand and manage the impact of fluctuations in market interest rates on its net interest income. The consolidated balance sheet consists mainly of interest-earning assets (loans, investments and cash) which are primarily funded by interest-bearing liabilities (deposits and other borrowings). Such financial instruments have varying levels of sensitivity to changes in market rates of interest. Market rates are highly sensitive to many factors beyond our control, including but not limited to general economic conditions and policies of governmental and regulatory authorities. Our operating income and net income depends, to a substantial extent, on “rate spread” (i.e., the difference between the income earned on loans, investments and other earning assets and the interest expense paid to obtain deposits and other funding liabilities).
Asset-liability management policies establish guidelines for acceptable limits on the sensitivity to changes in interest rates on earnings and market value of assets and liabilities. Such policies are set and monitored by management and the board of directors’ Asset and Liability Committee.
To understand and manage the impact of fluctuations in market interest rates on net interest income, Nicolet measures its overall interest rate sensitivity through a net interest income analysis, which calculates the change in net interest income in the event of hypothetical changes in interest rates under different scenarios versus a baseline scenario. Such scenarios can involve static balance sheets, balance sheets with projected growth, parallel (or non-parallel) yield curve slope changes, immediate or gradual changes in market interest rates, and one-year or longer time horizons. The simulation modeling uses assumptions involving market spreads, prepayments of rate-sensitive instruments, renewal rates on maturing or new loans, deposit retention rates, and other assumptions.
Nicolet assessed the impact on net interest income in the event of a gradual +/-100 bps and +/-200 bps change in market rates (parallel to the change in prime rate) over a one-year time horizon to a static (flat) balance sheet. The interest rate scenarios are used for analytical purposes only and do not necessarily represent management’s view of future market interest rate movements. Based on financial data at June 30, 2018 and December 31, 2017, the projected changes in net interest income over a one-year time horizon, versus the baseline, are presented in Table 11 below. The results are within Nicolet’s guidelines of not greater than -10% for +/- 100 bps and not greater than -15% for +/- 200 bps.
Table 11: Interest Rate Sensitivity
Actual results may differ from these simulated results due to timing, magnitude and frequency of interest rate changes, as well as changes in market conditions and their impact on customer behavior and management strategies.
The effect of inflation on a financial institution differs significantly from the effect on an industrial company. While a financial institution’s operating expenses, particularly salary and employee benefits, are affected by general inflation, the asset and liability structure of a financial institution consists largely of monetary items. Monetary items, such as cash, investments, loans, deposits and other borrowings, are those assets and liabilities which are or will be converted into a fixed number of dollars regardless of changes in prices. As a result, changes in interest rates have a more significant impact on a financial institution’s performance than does general inflation.
Capital
Management regularly reviews the adequacy of its capital to ensure that sufficient capital is available for current and future needs and is in compliance with regulatory guidelines and actively reviews capital strategies in light of perceived business risks associated with current and prospective earning levels, liquidity, asset quality, economic conditions in the markets served, and level of returns available to shareholders. Management intends to maintain an optimal capital and leverage mix for growth and for shareholder return.
As shown in Table 12, Nicolet’s regulatory capital ratios remain well above minimum regulatory ratios. At June 30, 2018, the Bank’s regulatory capital ratios qualify the Bank as well-capitalized under the prompt-corrective action framework. This strong base of capital has allowed Nicolet to be opportunistic in the current environment and in strategic growth. A summary of Nicolet’s and the Bank’s regulatory capital amounts and ratios as of June 30, 2018 and December 31, 2017 are presented in the following table.
Table 12: Capital
In managing capital for optimal return, we evaluate capital sources and uses, pricing and availability of our stock in the market, and alternative uses of capital (such as the level of organic growth or acquisition opportunities) in light of strategic plans. During the first half of 2018, $12.5 million was utilized to repurchase and cancel approximately 226,500 shares of common stock pursuant to our 2014 common stock repurchase program, bringing the life-to-date cumulative totals to 933,700 shares repurchased for $36.6 million. On July 17, 2018, Nicolet’s board authorized an increase to the program of $12 million or up to 200,000 shares. As a result, there remains $17.4 million authorized under the repurchase program to be utilized from time-to-time to repurchase shares in the open market, through block transactions or in private transactions.
Critical Accounting Policies
In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the balance sheet and revenues and expenses for the period. Actual results could differ significantly from those estimates. Estimates that are particularly susceptible to significant change include the valuation of loan acquisition transactions, as well as the determination of the allowance for loan losses and income taxes. A discussion of these policies can be found in the “Critical Accounting Policies” section in Management’s Discussion and Analysis of Financial Condition and Results of Operations included in the Company’s 2017 Annual Report on Form 10-K. There have been no changes in the Company’s application of critical accounting policies since December 31, 2017.
Future Accounting Pronouncements
Recent accounting pronouncements adopted are included in Note 1, “Basis of Presentation” of the Notes to Unaudited Consolidated Financial Statements within Part I, Item 1.
In August 2017, the FASB issued ASU 2017-12, Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities. ASU 2017-12 expands the activities that qualify for hedge accounting and simplifies the rules for reporting hedging transactions. The updated guidance is effective for interim and annual reporting periods beginning after December 15, 2018, with early adoption permitted. The Company is currently assessing the impact of the new guidance on its consolidated financial statements, and it is not expected to have a significant impact on its consolidated financial statements because the Company does not have any significant derivatives and does not currently apply hedge accounting to derivatives.
In June 2016, the FASB issued ASU 2016-13, Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments intended to improve the financial reporting by requiring timelier recording of credit losses on loans and other financial instruments held by financial institutions and other organizations. The ASU requires the measurement of all expected credit losses for financial assets held at the reporting date based on historical experience, current conditions, and reasonable and supportable forecasts. Financial institutions and other organizations will now use forward-looking information to better inform their credit loss estimates. The ASU is effective for SEC filers for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019. Entities should apply the amendment by means of a cumulative-effect adjustment to retained earnings as of the beginning of the fiscal year of adoption. Early application will be permitted for all organizations for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018. The Company expects to adopt the new accounting standard in 2020, as required, and is currently assessing the impact of the new guidance on its consolidated financial statements. A cross-functional team has been established to assess and implement the new standard.
In February 2016, the FASB issued ASU 2016-02,Leases (Topic 842). The core principle of the guidance is a lessee should recognize the assets and liabilities that arise from leases. The recognition, measurement, and presentation of expenses and cash flows arising from a lease by a lessee primarily will depend on its classification as a finance or operating lease. However, unlike current GAAP which requires only capital leases to be recognized on the balance sheet, the new standard will require both types of leases to be recognized on the balance sheet. The updated guidance is effective for annual reporting periods beginning after December 15, 2018. Early application is permitted. The Company will adopt the new accounting standard in 2019, as required, and is currently assessing the impact of the new guidance on its consolidated financial statements.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
See section “Interest Rate Sensitivity Management and Impact of Inflation” within Management’s Discussion and Analysis of Financial Condition and Results of Operations under Part I, Item 2.
ITEM 4. CONTROLS AND PROCEDURES
As of the end of the period covered by this report, management, under the supervision, and with the participation, of our Chairman, President and Chief Executive Officer and our Chief Financial Officer, evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as such term is defined in Rule 13a-15(e) and 15d-15(e) under the Exchange Act pursuant to Exchange Act Rule 13a-15). Based upon, and as of the date of such evaluation, the Chairman, President and Chief Executive Officer and the Chief Financial Officer concluded that our disclosure controls and procedures were effective.
There have been no changes in the Company’s internal controls or, to the Company’s knowledge, in other factors during the quarter covered by this report that have materially affected, or are reasonably likely to materially affect, the Company’s internal controls over financial reporting. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
PART II – OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
We and our subsidiaries may be involved from time to time in various routine legal proceedings incidental to our respective businesses. Neither we nor any of our subsidiaries are currently engaged in any legal proceedings that are expected to have a material adverse effect on our results of operations or financial position.
ITEM 1A. RISK FACTORS
There have been no material changes in the risk factors previously disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017.
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
Following are Nicolet’s monthly common stock purchases during the second quarter of 2018.
Total Number of
Shares Purchased(a)
Average Price
Paid per Share
Shares Purchased as
Part of Publicly
Announced Plans
or Programs
Maximum Number of
Shares that May Yet
Be Purchased Under
the Plans
or Programs(b)
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None.
ITEM 4. MINE SAFETY DISCLOSURES
Not applicable.
ITEM 5. OTHER INFORMATION
ITEM 6. EXHIBITS
The following exhibits are filed herewith:
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.