Nicolet Bankshares - 10-Q quarterly report FY2013 Q3

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 September 30, 2013

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 333-90052

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 54301 (920) 430-1400 (Address, including zip code, and telephone number, including area code, of Registrant’s principal executive offices)

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 o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Date File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer o Accelerated filer o

Non-accelerated filer o (Do not check if a smaller reporting company) Smaller reporting company x

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No x

As of November 12, 2013 there were 4,233,044 shares of $0.01 par value common stock outstanding.

Nicolet Bankshares, Inc.

TABLE OF CONTENTS


PART I	FINANCIAL INFORMATION		PAGE
	Item 1.	Financial Statements:
		Consolidated Balance Sheets September 30, 2013 (unaudited) and December 31, 2012	3
		Consolidated Statements of Income Three Months and Nine Months Ended September 30, 2013 and 2012 (unaudited)	4

		Consolidated Statements of Comprehensive Income Three Months and Nine Months Ended September 30, 2013 and 2012 (unaudited)	5

		Consolidated Statement of Changes in Stockholders’ Equity Nine Months Ended September 30, 2013 (unaudited)	6

		Consolidated Statements of Cash Flows Nine Months Ended September 30, 2013 and 2012 (unaudited)	7
		Notes to Unaudited Consolidated Financial Statements	8-25
	Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	26-49
	Item 3.	Quantitative and Qualitative Disclosures About Market Risk	50
	Item 4.	Controls and Procedures	50

PART II	OTHER INFORMATION
	Item 1. Item 1A.	Legal Proceedings Risk Factors	50 50
	Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	50
	Item 3.	Defaults Upon Senior Securities	50
	Item 4. Item 5. Item 6.	Mine Safety Disclosures Other Information Exhibits Signatures	50 50 51 51

PART I – FINANCIAL INFORMATION

Item 1. Financial Statements:

NICOLET BANKSHARES, INC. AND SUBSIDIARIES

Consolidated Balance Sheets

(In thousands, except share and per share data)


	September 30, 2013 (Unaudited)			December 31, 2012 (Audited)
Assets
Cash and due from banks	$	13,524		$	26,988
Interest-earning deposits		35,321			54,516
Federal funds sold		655			499
Cash and cash equivalents		49,500			82,003
Certificates of deposit in other banks		1,960			-
Securities available for sale (“AFS”)		132,356			55,901
Other investments		7,982			5,221
Loans held for sale		3,333			7,323
Loans		871,932			552,601
Allowance for loan losses		(9,187	)		(7,120	)
Loans, net		862,745			545,481
Premises and equipment, net		29,486			19,602
Bank owned life insurance		23,576			18,697
Accrued interest receivable and other assets		23,732			11,027
Total assets	$	1,134,670		$	745,255
Liabilities and Stockholders’ Equity
Liabilities:
Demand	$	173,002		$	108,234
Money market and NOW accounts		425,125			322,507
Savings		95,435			46,907
Time		266,628			138,445
Total deposits		960,190			616,093
Short-term borrowings		17,693			4,035
Notes payable		32,482			35,155
Junior subordinated debentures		12,079			6,186
Accrued interest payable and other liabilities		8,685			6,408
Total liabilities		1,031,129			667,877

Stockholders’ Equity:
Preferred equity		24,400			24,400
Common stock		42			34
Additional paid-in capital		49,301			36,243
Retained earnings		29,217			14,973
Accumulated other comprehensive income (“AOCI”)		580			1,683
Total Nicolet Bankshares Inc. stockholders’ equity		103,540			77,333
Noncontrolling interest		1			45
Total stockholders’ equity and noncontrolling interest		103,541			77,378
Total liabilities, noncontrolling interest and stockholders’ equity	$	1,134,670		$	745,255
Preferred shares authorized (no par value)		10,000,000			10,000,000
Preferred shares issued		24,400			24,400
Common shares authorized (par value $0.01 per share)		30,000,000			30,000,000
Common shares outstanding		4,228,535			3,425,413
Common shares issued		4,280,658			3,479,888

See accompanying notes to unaudited consolidated financial statements.

ITEM 1. Financial Statements Continued:

NICOLET BANKSHARES, INC. AND SUBSIDIARIES

Consolidated Statements of Income

(In thousands, except share and per share data) (Unaudited)


	Three Months Ended September 30,					Nine Months Ended September 30,
	2013			2012		2013		2012
Interest income:
Loans, including loan fees	$	12,856		$	6,815	$	29,465	$	19,801
Investment securities:
Taxable		309			149		714		450
Non-taxable		195			201		555		640
Other interest income		77			47		222		168
Total interest income		13,437			7,212		30,956		21,059
Interest expense:
Money market and NOW accounts		525			418		1,502		1,222
Savings and time deposits		618			694		1,667		2,407
Short term borrowings		11			1		18		3
Junior subordinated debentures		221			127		510		377
Notes payable		259			322		886		997
Total interest expense		1,634			1,562		4,583		5,006
Net interest income		11,803			5,650		26,373		16,053
Provision for loan losses		1,975			975		3,925		3,350
Net interest income after provision for loan losses		9,828			4,675		22,448		12,703
Noninterest income:
Service charges on deposit accounts		510			293		1,264		859
Trust services fee income		1,060			759		2,936		2,213
Mortgage income		353			846		1,939		2,254
Brokerage fee income		114			77		331		241
Gain on sale of assets, net		1,333			5		1,382		388
Bank owned life insurance		224			186		605		523
Rent income		204			264		728		744
Investment advisory fees		82			83		244		254
Bargain purchase gains		1,480			-		11,915		-
Other		382			172		920		509
Total noninterest income		5,742			2,685		22,264		7,985
Noninterest expense:
Salaries and employee benefits		5,333			3,325		14,447		9,991
Occupancy, equipment and office		1,822			1,094		4,392		3,335
Business development and marketing		573			437		1,471		1,134
Data processing		724			444		1,719		1,255
FDIC assessments		240			134		480		408
Core deposit intangible amortization		342			155		776		490
Other		1,190			340		2,865		1,109
Total noninterest expense		10,224			5,929		26,150		17,722

Income before income tax expense		5,346			1,431		18,562		2,966
Income tax expense		2,421			453		3,387		828
Net income		2,925			978		15,175		2,138
Less: net income (loss) attributable to noncontrolling interest		(22	)		13		16		39
Net income attributable to Nicolet Bankshares, Inc.		2,947			965		15,159		2,099
Less: preferred stock dividends and discount accretion		305			305		915		915
Net income available to common shareholders	$	2,642		$	660	$	14,244	$	1,184

Basic earnings per common share	$	0.62		$	0.19	$	3.66	$	0.34
Diluted earnings per common share	$	0.62		$	0.19	$	3.65	$	0.34

Weighted average common shares outstanding:
Basic		4,228,386			3,414,561		3,889,751		3,449,916
Diluted		4,238,009			3,431,321		3,900,289		3,465,031

See accompanying notes to unaudited consolidated financial statements.

ITEM 1. Financial Statements Continued:

NICOLET BANKSHARES, INC. AND SUBSIDIARIES

Consolidated Statements of Comprehensive Income

(In thousands) (Unaudited)


	Three Months Ended September 30,						Nine Months Ended September 30,
	2013			2012			2013			2012
Net income	$	2,925		$	978		$	15,175		$	2,138
Other comprehensive (loss) income, net of tax:
Securities available for sale:
Net unrealized holding gains/(losses) arising during the period		(475	)		471			(1,604	)		1,105
Less: reclassification adjustment for net (gains)/losses realized in net income		(442	)		-			(203	)		(440	)
Net unrealized gains/losses on securities before tax expense		(917	)		471			(1,807	)		665
Income tax expense/(benefit)		357			(160	)		704			(226	)
Total other comprehensive (loss) income		(560	)		311			(1,103	)		439
Comprehensive income	$	2,365		$	1,289		$	14,072		$	2,577

See accompanying notes to unaudited consolidated financial statements.

ITEM 1. Financial Statements Continued:

NICOLET BANKSHARES, INC. AND SUBSIDIARIES

Consolidated Statement of Stockholders’ Equity

(In thousands) (Unaudited)


	Nicolet Bankshares, Inc. Stockholders’ Equity
	Preferred Equity		Common Stock		Additional Paid-In Capital			Retained Earnings			Accumulated Other Comprehensive Income			Noncontrolling Interest			Total
Balance, December 31, 2012	$	24,400	$	34	$	36,243		$	14,973		$	1,683		$	45		$	77,378
Comprehensive income		-		-		-			15,159			(1,103	)		16			14,072
Stock compensation expense		-		-		480			-			-			-			480
Exercise of stock options		-		-		206			-			-			-			206
Purchase and retirement of common stock		-		-		(63	)		-			-			-			(63	)
Common stock issued, net of capitalized issuance costs of $401		-		8		12,435			-			-			-			12,443
Preferred stock dividends		-		-		-			(915	)		-			-			(915	)
Distribution from noncontrolling interest		-		-		-			-			-			(60	)		(60	)
Balance, September 30, 2013	$	24,400	$	42	$	49,301		$	29,217		$	580		$	1		$	103,541

See accompanying notes to unaudited consolidated financial statements.

ITEM 1. Financial Statements Continued:

NICOLET BANKSHARES, INC. AND SUBSIDIARIES

Consolidated Statement of Cash Flows

(In thousands) (Unaudited)


	Nine Months Ended September 30,
	2013			2012
Cash Flows From Operating Activities:
Net income	$	15,175		$	2,138
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation, amortization, and accretion		3,149			1,825
Provision for loan losses		3,925			3,350
Increase in cash surrender value of life insurance		(605	)		(523	)
Stock compensation expense		480			376
Gain on sale of assets, net		(1,382	)		(388	)
Gain on sale of loans held for sale, net		(1,939	)		(2,254	)
Proceeds from sale of loans held for sale		120,246			144,716
Origination of loans held for sale		(114,317	)		(134,572	)
Bargain purchase gain		(11,915	)		-
Net change in:
Accrued interest receivable and other assets		2,585			(43	)
Accrued interest payable and other liabilities		(31	)		320
Net cash provided by operating activities		15,371			14,945
Cash Flows From Investing Activities:
Net decrease in certificates of deposit in other banks		-			248
Net increase in loans		(39,992	)		(77,484	)
Purchases of securities available for sale		(9,608	)		(11,830	)
Proceeds from sales of securities available for sale		44,833			5,415
Proceeds from calls and maturities of securities available for sale		14,485			7,075
Purchase of other investments		(797	)		(9	)
Purchase of bank owned life insurance		-			(3,750	)
Purchase of premises and equipment		(2,115	)		(1,720	)
Proceeds from sales of other real estate and other assets		2,902			1,479
Net cash received in business combinations		37,622			-
Net cash provided (used) by investing activities		47,330			(80,576	)
Cash Flows From Financing Activities:
Net increase (decrease) in deposits		(43,780	)		3,322
Net change in short term borrowings		(12,447	)		182
Proceeds from notes payable		5,000			5,000
Repayments of notes payable		(45,867	)		(5,162	)
Purchase of common stock		(63	)		(1,329	)
Stock issuance costs		(401	)		-
Proceeds from issuance of common stock		3,123			-
Proceeds from exercise of common stock options		206			56
Noncontrolling interest in joint venture		(60	)		(100	)
Cash dividends paid on preferred stock		(915	)		(915	)
Net cash provided (used) by financing activities		(95,204	)		1,054
Net decrease in cash and cash equivalents		(32,503	)		(64,577	)
Cash and cash equivalents:
Beginning	$	82,003			92,129
Ending	$	49,500		$	27,552
Supplemental Disclosures of Cash Flow Information:
Cash paid for interest	$	4,759		$	5,075
Cash paid for taxes		2,013			705
Transfer of loans to other real estate owned		3,097			1,506

Acquisitions:
Fair value of assets acquired		483,446			-
Fair value of liabilities assumed		462,269			-
Net assets acquired		21,177			-

See accompanying notes to unaudited consolidated financial statements.

NICOLET BANKSHARES, INC. AND SUBSIDIARIES

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 Nicolet Bankshares, Inc. (the “Company”) and its subsidiaries, consolidated balance sheets, statements of income, comprehensive income, changes in stockholders’ equity and cash flows for the periods presented, and all such adjustments are of a normal recurring nature. All material intercompany transactions and balances are 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 financial statements should be read in conjunction with the Company’s audited consolidated financial statements and footnotes for the year ended December 31, 2012 which is contained in the Joint Proxy Statement-Prospectus dated March 26, 2013, as filed with the Securities and Exchange Commission pursuant to Rule 424(b)(5) under the Securities Act of 1933, as amended (the “Securities Act”) on March 27, 2013.

Preparation of 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, useful lives for depreciation and amortization, fair value of financial instruments, 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 and the assessment of deferred tax assets and liabilities, and therefore are critical accounting policies. Management does not anticipate any material changes to estimates in the near term. 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, and changes in applicable banking regulations. 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.

The following information related to critical accounting policies has been expanded within this document to include the discussion on policies which were impacted by the acquisition.

Method of Accounting for Loans Acquired

The Company accounts for its acquisitions under Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 805, Business Combinations, which requires the use of the acquisition method of accounting. All identifiable assets and liabilities acquired, including loans, are recorded at fair value. No allowance for loan losses related to the acquired loans is recorded on the acquisition date because the fair value of the loans acquired incorporates assumptions regarding credit risk. Loans acquired are recorded at fair value in accordance with the fair value methodology prescribed in FASB ASC Topic 820, Fair Value Measurements and Disclosures. The fair value estimates associated with the loans include estimates related to expected prepayments and the amount and timing of expected principal, interest and other cash flows.

Acquired loans are recorded at their estimated fair value at the acquisition date, and are initially classified as either purchase credit impaired (“PCI”) loans (i.e. loans that reflect credit deterioration since origination and it is probable at acquisition that the Company will be unable to collect all contractually required payments) or purchased non-impaired loans. PCI loans are accounted for under the accounting guidance for loans and debt securities acquired with deteriorated credit quality, found in FASB ASC Topic 310-30, Receivables—Loans and Debt Securities Acquired with Deteriorated Credit Quality, formerly American Institute of Certified Public Accountants (“AICPA”) Statement of Position (SOP) 03-3, Accounting for Certain Loans or Debt Securities Acquired in a Transfer. The Company estimates the amount and timing of expected principal, interest and other cash flows for each loan or pool of loans meeting the criteria above, and determines the excess of the loan’s scheduled contractual principal and contractual interest payments over all cash flows expected to be collected at acquisition as an amount that should not be accreted. These credit discounts (“nonaccretable marks”) are included in the determination of initial fair value for acquired loans; therefore, an allowance for loan losses is not recorded at the acquisition date. Differences between the estimated fair values and expected cash flows of acquired loans at the acquisition date that are not credit-based (“accretable marks”) are subsequently accreted to interest income over the estimated life of the loans using a method that approximates a level yield method if the timing and amount of the future cash flows is reasonably estimable.

Subsequent to the acquisition date for PCI loans, increases in cash flows over those expected at the acquisition date are recognized prospectively as interest income. Decreases in expected cash flows after the acquisition date are recognized through the provision for loan losses.

Loans acquired through business combinations that do not meet the specific criteria of FASB ASC Topic 310-30, but for which a discount is attributable at least in part to credit quality, are also accounted for under this guidance. All fair value discounts initially recorded in 2013 on acquired loans were deemed to be credit related. The nonaccretable difference represents cash flows not expected to be collected. Subsequently, based on re-evaluation of cash flows and facts available, some nonaccretable differences may be reclassified to accretable.

Allowance for loan losses

The allowance for loan and lease losses related to PCI loans is based on an analysis that is performed each period to estimate the expected cash flows for each loan deemed PCI. To the extent that the expected cash flows of a PCI loan have decreased since the acquisition date, the Company establishes or increases the allowance for loan losses.

For acquired loans that are not deemed credit impaired at acquisition, credit discounts representing the principal losses expected over the life of the loan are a component of the initial fair value. Subsequent to the purchase date, the methods utilized to estimate the required allowance for loan losses for these loans is similar to originated loans. The remaining differences between the purchase price and the unpaid principal balance at the date of acquisition are recorded in interest income over the economic life of the loans.

Income Taxes

Deferred income taxes are recognized for the tax consequences of temporary differences between financial statement carrying amounts and the tax bases of existing assets and liabilities that will result in taxable or deductible amounts in future years. These temporary differences are multiplied by the enacted income tax rate expected to be in effect when the taxes become payable or receivable. The effect on deferred taxes of a change in tax rates is recognized in income in the period that includes the enactment date. Deferred tax assets are reduced, if necessary, by the amount of such benefits that are not expected to be realized based on available evidence. At acquisition, deferred taxes were evaluated in respect to the acquired assets and assumed liabilities (including the acquired net operating losses), and a net deferred tax asset was recorded. Certain limitations within the provisions of the tax code are placed on the amount of net operating losses which can be utilized as part of acquisition accounting rules and were incorporated into the calculation of the deferred tax asset. In addition, a portion of the fair market value discounts on PCI loans which resolve in the first twelve months after the acquisition may be disallowed under provisions of the tax code.

Note 2 – Acquisitions

Bank of Wausau: On August 9, 2013, Nicolet National Bank entered into an agreement with the Federal Deposit Insurance Corporation (“FDIC”), purchasing selected Bank of Wausau assets and assuming all of its deposits, in a transaction that was effective immediately. The financial position and results of operations of Bank of Wausau prior to its acquisition date were not included in the accompanying consolidated financial statements. The FDIC-assisted transaction carried no loss-share provisions. With the addition of Bank of Wausau’s one branch, Nicolet National Bank now operates two branches in Wausau, WI. As of the acquisition date, the transaction added approximately $47 million in assets at fair value, including mostly cash as well as $9.4 million of investments and $12.5 million in loans, of which $1.4 million were classified as PCI loans. Of the $42 million of deposits assumed, $18 million were immediately repriced certificates of deposit that were rate-sensitive in nature, and were subsequently redeemed in full by September 30, 2013. Given the nature and rates of the remaining deposits assumed, no core deposit intangible was recorded. The third quarter of 2013 included approximately $0.2 million pre-tax acquisition costs and a $2.4 million pre-tax bargain purchase gain.

Mid-Wisconsin Financial Services, Inc. (“Mid-Wisconsin”): On April 26, 2013, the Company consummated its acquisition of Mid-Wisconsin, pursuant to the Agreement and Plan of Merger by and among the Company and Mid-Wisconsin dated November 28, 2012, as amended January 17, 2013 (the “Merger Agreement”), whereby Mid-Wisconsin was merged with and into the Company, and Mid-Wisconsin Bank, Mid-Wisconsin’s wholly owned commercial bank subsidiary serving central Wisconsin, was merged with and into Nicolet National Bank. The system integration was completed, and the eleven branches of Mid-Wisconsin opened on April 29, 2013 as Nicolet National Bank branches.

Note 2 – Acquisitions, continued

The purpose of the merger was for strategic reasons beneficial to the Company. The acquisition is consistent with its growth plans to build a community bank of sufficient size to flourish in various economic environments, serve its expanded customer base with a wide variety of products and services, and effectively and efficiently meet growing regulatory compliance and capital requirements. The Company believes it is well-positioned to achieve stronger financial performance and enhance shareholder value through synergies of the combined operations.

Pursuant to the terms of the Merger Agreement, the outstanding shares of Mid-Wisconsin common stock, other than dissenting shares as defined in the merger agreement, were converted into the right to receive 0.3727 shares of Company common stock (and in lieu of any fractional share of Company common stock, $16.50 in cash) per share of Mid-Wisconsin common stock or, for record holders of 200 or fewer shares of Mid-Wisconsin common stock, $6.15 in cash per share of Mid-Wisconsin common stock. As a result, the total value of the consideration to Mid-Wisconsin shareholders was $10.2 million, consisting of $0.5 million in cash and 589,159 shares of the Company’s common stock. The Company’s common stock was valued at $16.50 per share, which was the value assigned in the merger agreement and considered to be the fair value of the stock on the date of the acquisition. Concurrently with the merger, the Company also closed a private placement of 174,016 shares of its common stock at an offering price of $16.50 per share, for an aggregate of $2.9 million in proceeds. Approximately $401,000 in direct stock issuance costs for the merger and private placement were incurred and charged against additional paid in capital.

The Company accounted for the transaction under the acquisition method of accounting, and thus, the financial position and results of operations of Mid-Wisconsin 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 fair values at the date of acquisition. The Company determined the fair value of core deposit intangibles, securities, premises and equipment, loans, other real estate owned, deposits, debt and deferred taxes with the assistance of third party valuations, appraisals, and third party advisors. The estimated fair values will be subject to refinement as additional information relative to the closing date fair values becomes available through the measurement period of approximately one year from consummation.

The fair value of the assets acquired and liabilities assumed on April 26, 2013 was as follows:

(in millions)	As recorded by Mid-Wisconsin		Fair value adjustments				As recorded by Nicolet
Cash, cash equivalents and securities available for sale	$	134	$	(1	)		$	133
Loans, net		284		(12	)			272
Other real estate owned		5		(3	)			2
Core deposit intangible		-		4				4
Premises, equipment, and other assets		17		8		(1)(3)		25
Total assets acquired	$	440	$	(4	)		$	436

Deposits	$	345	$	1			$	346
Junior subordinated debentures, borrowings and other liabilities		72		(2	)	(2)(3)		70
Total liabilities acquired	$	417	$	(1	)		$	416

Excess of assets acquired over liabilities acquired	$	23	$	(3	)		$	20
Less: purchase price							$	10
Bargain purchase gain							$	10

(1) Includes premises and equipment adjustment of $2 million and deferred tax asset of $6 million.

(2) Includes borrowings adjustment increase of $2 million and subordinated debentures adjustment decrease of $5 million.

(3) Includes a $0.9 million adjustment due to a change in estimate as discussed in Note 11.

The following unaudited pro forma information presents the results of operations for three months ended and nine months ended September 30, 2013 and 2012, as if the acquisition had occurred January 1 of each year. The Company expects to achieve further operating cost savings and other business synergies as a result of the acquisition which are not reflected in the pro forma amounts. These unaudited pro forma results are presented for illustrative purposes and are not intended to represent or be indicative of the actual results of operations of the combined company that would have been achieved had the acquisition occurred at the beginning of each period presented, nor are they intended to represent or be indicative of future results of operations.

Note 2 – Acquisitions, continued

	Three Months Ended September 30,				Nine Months Ended September 30,
	2013		2012		2013		2012
(in thousands)
Total revenues, net of interest expense	$	17,697	$	13,654	$	46,538	$	40,290
Net income		3,138		1,127		13,347		270

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 share is 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.


	Three Months Ended September 30,				Nine Months Ended September 30,
	2013		2012		2013		2012
(In thousands except per share data)
Net income, net of noncontrolling interest	$	2,947	$	965	$	15,159	$	2,099
Less: preferred stock dividends		305		305		915		915
Net income available to common shareholders	$	2,642	$	660	$	14,244	$	1,184
Weighted average common shares outstanding		4,228		3,415		3,890		3,450
Effect of dilutive stock instruments		10		16		10		15
Diluted weighted average common shares outstanding		4,238		3,431		3,900		3,465
Basic earnings per common share*	$	0.62	$	0.19	$	3.66	$	0.34
Diluted earnings per common share*	$	0.62	$	0.19	$	3.65	$	0.34

*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.

Options to purchase approximately 0.5 million shares were outstanding at the quarters and nine months ending September 30, 2013 and 2012, but excluded from the calculation of diluted earnings per common share as the effect would have been anti-dilutive.

Note 4 – Stock-based Compensation

Activity of the Company’s Stock Incentive Plans is summarized in the following tables:

Stock Options	Weighted- Average Fair Value of Options Granted		Option Shares Outstanding			Weighted- Average Exercise Price		Exercisable Shares
Balance – December 31, 2011				702,907		$	17.78		533,074
Granted	$	4.87		184,625			16.50
Exercise of stock options				(25,750	)		12.50
Forfeited				(36,250	)		16.84
Balance – December 31, 2012				825,532			17.70		548,623
Granted		-		-			-
Exercise of stock options				(15,625	)		13.20
Forfeited				(4,250	)		15.06
Balance – September 30, 2013				805,657		$	17.80		570,635

Options outstanding at September 30, 2013 are exercisable at option prices ranging from $12.50 to $26.00. There are 363,583 options outstanding in the range from $12.50 - $17.00, 396,074 options outstanding in the range from $17.01 - $22.00, and 46,000 options outstanding in the range from $22.01 - $26.00. The exercisable options have a weighted average remaining contractual life of approximately 4 years as of September 30, 2013.

Note 4 – Stock-based Compensation, continued

Intrinsic value represents the amount by which the fair market value of the underlying stock exceeds the exercise price of the stock options. The total intrinsic value of options exercised in the first nine months of 2013, and full year of 2012 was approximately $48,000, and $103,000, respectively. The weighted average exercise price of stock options exercisable at September 30, 2013 was $18.24.

Restricted Stock	Weighted- Average Grant Date Fair Value		Restricted Shares Outstanding
Balance – December 31, 2011	$	-		-
Granted		16.50		54,725
Vested		-		-
Forfeited		16.50		(250	)
Balance – December 31, 2012		16.50		54,475
Granted		16.50		10,606
Vested *		16.50		(12,958	)
Forfeited		-		-
Balance – September 30, 2013	$	16.50		52,123

*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 3,812 shares were surrendered accordingly during the nine months ended September 30, 2013.

The Company recognized approximately $480,000 and $376,000 of stock-based employee compensation expense during the nine months ended September 30, 2013 and 2012, respectively, associated with its stock equity awards. As of September 30, 2013, there was approximately $1.6 million of unrecognized compensation cost related to equity award grants. The cost is expected to be recognized over the weighted average remaining vesting period of approximately five years.

Note 5- Securities Available for Sale

Amortized costs and fair values of securities available for sale are summarized as follows:

	September 30, 2013
(in thousands)	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Fair Value
U.S. government sponsored enterprises	$	2,327	$	4	$	8	$	2,323
State, county and municipals		55,134		1,072		696		55,510
Mortgage-backed securities		72,592		594		1,374		71,812
Corporate debt securities		220		-		-		220
Equity securities		1,131		1,360		-		2,491
	$	131,404	$	3,030	$	2,078	$	132,356

	December 31, 2012
(in thousands)	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Fair Values
State, county and municipals	$	31,642	$	1,079	$	34	$	32,687
Mortgage-backed securities		19,876		803		11		20,668
Equity securities		1,624		922		-		2,546
	$	53,142	$	2,804	$	45	$	55,901

Note 5- Securities Available for Sale, continued

The following table represents gross unrealized losses and the related 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, at September 30, 2013 and December 31, 2012.

	September 30, 2013
	Less than 12 months				12 months or more				Total
(in thousands)	Fair Value		Unrealized Losses		Fair Value		Unrealized Losses		Fair Value		Unrealized Losses
U.S. government sponsored enterprises	$	509	$	8	$	-	$	-	$	509	$	8
State, county and municipals		20,750		696		-		-		20,750		696
Mortgage-backed securities		45,334		1,374		-		-		45,334		1,374
	$	66,593	$	2,078	$	-	$	-	$	66,593	$	2,078

	December 31, 2012
	Less than 12 months				12 months or more				Total
(in thousands)	Fair Value		Unrealized Losses		Fair Value		Unrealized Losses		Fair Value		Unrealized Losses
State, county and municipals	$	4,250	$	34	$	-	$	-	$	4,250	$	34
Mortgage-backed securities		3,507		11		-		-		3,507		11
	$	7,757	$	45	$	-	$	-	$	7,757	$	45

As of September 30, 2013 the Company does not consider securities with unrealized losses to be other-than-temporarily impaired. The unrealized losses in each category have occurred as a result of changes in interest rates, market spreads and market conditions subsequent to purchase. 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 three and nine month periods ending September 30, 2013 or 2012.

The amortized cost and fair values of securities available for sale at September 30, 2013 by contractual maturity 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. Fair values of securities are estimated based on financial models or prices paid for the same or similar securities. It is possible interest rates could change considerably, resulting in a material change in estimated fair value.

	September 30, 2013
(in thousands)	Amortized Cost		Fair Value
Due in less than one year	$	10,304	$	10,377
Due in one year through five years		33,682		34,356
Due after five years through ten years		12,517		12,159
Due after ten years		1,178		1,161
		57,681		58,053
Mortgage-backed securities		72,592		71,812
Equity securities		1,131		2,491
Securities available for sale	$	131,404	$	132,356

Proceeds from sales of securities available for sale during the first nine months of 2013 and 2012 were approximately $44.8 million and $5.4 million respectively. Net gains of approximately $203,000 and $440,000 were realized on sales of securities during the first nine months of 2013 and 2012.

Note 6 – Loans, Allowance for Loan Losses, and Credit Quality

The loan composition as of September 30, 2013 and December 31, 2012 is summarized as follows.

	2013						2012
(in thousands)	Amount			% of Total			Amount			% of Total
Commercial & industrial	$	251,590			28.9	%	$	197,301			35.7	%
Agricultural production		14,071			1.6			215			0. 1
Owner-occupied commercial real estate (“CRE”)		203,715			23.4			106,888			19.3
Agricultural real estate		37,738			4.3			11,354			2.1
CRE investment		106,763			12.2			76,618			13.9
Construction & land development		38,757			4.4			21,791			3.9
Residential construction		12,831			1.5			7,957			1.4
Residential first mortgage		150,117			17.2			85,588			15.5
Residential junior mortgage		49,518			5.7			39,352			7.1
Retail & other		6,832			0.8			5,537			1.0
Loans		871,932			100.0	%		552,601			100.0	%
Less allowance for loan losses		9,187						7,120
Loans, net	$	862,745					$	545,481
Allowance for loan losses to loans		1.05	%					1.29	%

Practically all of the Company’s loans, commitments, and standby 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 allowance for loan and lease losses (“ALLL”) represents management’s estimate of probable and inherent credit losses in the Company’s loan portfolio at the balance sheet date. In general, estimating the amount of the ALLL is a function of a number of factors, including but not limited to changes in the loan portfolio, net charge-offs, trends in past due and impaired loans, and the level of potential problem loans, all of which may be susceptible to significant change. To the extent actual outcomes differ from management estimates, additional provisions for loan losses could be required that could adversely affect our earnings or financial position in future periods. Allocations to the ALLL may be made for specific loans but the entire ALLL is available for any loan that, in management’s judgment, should be charged-off or for which an actual loss is realized.

The allocation methodology used by the Company includes specific allocations for impaired loans evaluated individually for impairment based on collateral values and for the remaining loan portfolio collectively evaluated for impairment primarily based on historical loss rates and other qualitative factors. Loan charge-offs and recoveries are based on actual amounts charged-off or recovered by loan category. Management allocates the ALLL by pools of risk within each loan portfolio. Due to the short period of time since the acquisitions and consistent with acquisition accounting rules, no ALLL has been recorded on acquired loans at September 30, 2013.

Note 6 – Loans, Allowance for Loan Losses, and Credit Quality, continued

The following table presents the balance and activity in the ALLL by portfolio segment and the recorded investment in loans by portfolio segment based on the impairment method for the periods indicated:

	Nine Months ended September 30, 2013
(in thousands) ALLL:	Commercial & industrial			Agricultural production			Owner- occupied CRE			Agricultural real estate			CRE investment			Construction & land development			Residential construction			Residential first mortgage			Residential junior mortgage			Retail & other			Total
Beginning balance	$	1,969		$	-		$	1,069		$	-		$	337		$	2,580		$	137		$	685		$	312		$	31		$	7,120
Provision		194			8			(398	)		-			642			3,498			62			(168	)		50			37			3,925
Charge-offs		(474	)		-			(113	)		-			(798	)		(319	)		-			(86	)		(142	)		(46	)		(1,978	)
Recoveries		27			-			83			-			-			-			-			8			1			1			120
Ending balance	$	1,716		$	8		$	641		$	-		$	181		$	5,759		$	199		$	439		$	221		$	23		$	9,187
As percent of ALLL		18.7	%		0.1	%		7.0	%		-	%		2.0	%		62.5	%		2.2	%		4.8	%		2.4	%		0.3	%		100.0	%

ALLL: Individually evaluated	$	-		$	-		$	-		$	-		$	-		$	3,230		$	-		$	-		$	-		$	-		$	3,230
Acquired loans subsequently impaired		-			-			-			-			-			-			-			-			-			-			-
PCI loans		-			-			-			-			-			-			-			-			-			-			-
Collectively evaluated		1,716			8			641			-			181			2,529			199			439			221			23			5,957
Ending balance	$	1,716		$	8		$	641		$	-		$	181		$	5,759		$	199		$	439		$	221		$	23		$	9,187

Loans:
Individually evaluated	$	-		$	-		$	-		$	-		$	857		$	8,213		$	-		$	371		$	-		$	-		$	9,441
Acquired loans subsequently impaired		100			-			4,300			-			1,562			529			-			-			-			-			6,491
PCI loans		1			13			1,334			444			4,030			691			-			2,216			232			-			8,961
Collectively evaluated		251,489			14,058			198,081			37,294			100,314			29,324			12,831			147,530			49,286			6,832			847,039
Total loans	$	251,590		$	14,071		$	203,715		$	37,738		$	106,763		$	38,757		$	12,831		$	150,117		$	49,518		$	6,832		$	871,932

Less ALLL	$	1,716		$	8		$	641		$	-		$	181		$	5,759		$	199		$	439		$	221		$	23		$	9,187
Net loans	$	249,874		$	14,063		$	203,074		$	37,738		$	106,582		$	32,998		$	12,632		$	149,678		$	49,297		$	6,809		$	862,745

	Nine Months ended September 30, 2012
(in thousands) ALLL:	Commercial & industrial			Agricultural production			Owner- occupied CRE			Agricultural real estate			CRE investment			Construction & land development			Residential construction			Residential first mortgage			Residential junior mortgage			Retail & other			Total
Beginning balance	$	1,965		$	-		$	347		$	-		$	393		$	2,035		$	311		$	405		$	419		$	24		$	5,899
Provision		(533	)		-			1,979			127			394			931			134			334			(29	)		13			3,350
Charge-offs		(129	)		-			(1,200	)		(127	)		(305	)		(307	)		(396	)		(216	)		(118	)		(38	)		(2,836	)
Recoveries		34			-			9			-			-			22			-			7			5			1			78
Ending balance	$	1,337		$	-		$	1,135		$	-		$	482		$	2,681		$	49		$	530		$	277		$	-		$	6,491
As percent of ALLL		20.6	%		-	%		17.5	%		-	%		7.4	%		41.2	%		0.8	%		8.2	%		4.3	%		0.0	%		100.0	%

ALLL: Individually evaluated	$	-		$	-		$	165		$	-		$	-		$	-		$	-		$	-		$	-		$	-		$	165
Collectively evaluated		1,337			-			970			-			482			2,681			49			530			277			-			6,326
Ending balance	$	1,337		$	-		$	1,135		$	-		$	482		$	2,681		$	49		$	530		$	277		$	-		$	6,491

Loans:
Individually evaluated	$	3,986		$	-		$	354		$	-		$	380		$	8,558		$	397		$	1,326		$	-		$	151		$	15,152
Collectively evaluated		197,063			315			105,231			1,201			76,393			18,406			7,273			78,216			40,928			5,530			530,556
Total loans	$	201,049		$	315		$	105,585		$	1,201		$	76,773		$	26,964		$	7,670		$	79,542		$	40,928		$	5,681		$	545,708

Less ALLL	$	1,337		$	-		$	1,135		$	-		$	482		$	2,681		$	49		$	530		$	277		$	-		$	6,491
Net loans	$	199,712		$	315		$	104,450		$	1,201		$	76,291		$	24,283		$	7,621		$	79,012		$	40,651		$	5,681		$	539,217

Note 6 – Loans, Allowance for Loan Losses, and Credit Quality, continued

Loans are generally placed on nonaccrual status when management has determined collection of the interest on a loan is doubtful or when a loan is contractually past due 90 days or more as to interest or principal payments. When loans are placed on nonaccrual status or charged-off, all current year unpaid accrued interest is reversed against interest income. The interest on these loans is subsequently accounted for on the cash basis until qualifying for return to accrual status. If collectability of the principal is in doubt, payments received are applied to loan principal. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.

The following table presents nonaccrual loans by portfolio segment as of September 30, 2013 and December 31, 2012. Of the nonaccrual loans initially acquired in 2013 mergers, $9.0 million remains included in the $17.4 million of nonaccruals at September 30, 2013.

(in thousands)	2013		% to Total			2012		% to Total
Commercial & industrial	$	115		0.7	%	$	784		11.2	%
Agricultural production		15		0.1			-		-
Owner-occupied CRE		5,521		31.7			1,960		27.9
Agricultural real estate		451		2.6			-		-
CRE investment		6,447		37.0			-		-
Construction & land development		1,310		7.5			2,560		36.4
Residential construction		-		-			-		-
Residential first mortgage		3,112		17.9			1,580		22.5
Residential junior mortgage		322		1.8			-		-
Retail & other		129		0.7			142		2.0
Nonaccrual loans	$	17,422		100.0	%	$	7,026		100.0	%

The following tables present past due loans by portfolio segment:

	September 30, 2013
(in thousands)	30-89 Days Past Due (accruing)			90 Days & Over or non- accrual			Current			Total
Commercial & industrial	$	168		$	115		$	251,307		$	251,590
Agricultural production		9			15			14,047			14,071
Owner-occupied CRE		47			5,521			198,147			203,715
Agricultural real estate		78			451			37,209			37,738
CRE investment		498			6,447			99,818			106,763
Construction & land development		32			1,310			37,415			38,757
Residential construction		-			-			12,831			12,831
Residential first mortgage		1,159			3,112			145,846			150,117
Residential junior mortgage		53			322			49,143			49,518
Retail & other		-			129			6,703			6,832
Total loans	$	2,044		$	17,422		$	852,466		$	871,932
As a percent of total loans		0.2	%		2.0	%		97.8	%		100.0	%

	December 31, 2012
(in thousands)	30-89 Days Past Due (accruing)			90 Days & Over or nonaccrual			Current			Total
Commercial & industrial	$	-		$	784		$	196,517		$	197,301
Agricultural production		-			-			215			215
Owner-occupied CRE		-			1,960			104,928			106,888
Agricultural real estate		-			-			11,354			11,354
CRE investment		-			-			76,618			76,618
Construction & land development		-			2,560			19,231			21,791
Residential construction		-			-			7,957			7,957
Residential first mortgage		-			1,580			84,008			85,588
Residential junior mortgage		-			-			39,352			39,352
Retail & other		6			142			5,389			5,537
Total loans	$	6		$	7,026		$	545,569		$	552,601
As a percent of total loans		0.0	%		1.3	%		98.7	%		100.0	%

Note 6 – Loans, Allowance for Loan Losses, and Credit Quality, continued

A description of the loan risk categories used by the Company follows:

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.

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.

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.

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 non-accrual loans are considered to be categorized in this rating, regardless of collateral sufficiency.

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.

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 loans by loan grade:

	September 30, 2013
(in thousands)	Grades 1- 4			Grade 5			Grade 6			Grade 7			Grade 8		Grade 9		Total
Commercial & industrial	$	236,939		$	8,900		$	4,951		$	800		$	-	$	-	$	251,590
Agricultural production		13,739			232			-			100			-		-		14,071
Owner-occupied CRE		184,174			8,012			3,283			8,246			-		-		203,715
Agricultural real estate		26,160			10,378			63			1,137			-		-		37,738
CRE investment		96,507			2,355			308			7,593			-		-		106,763
Construction & land development		26,202			1,986			971			9,598			-		-		38,757
Residential construction		12,471			-			-			360			-		-		12,831
Residential first mortgage		145,578			703			-			3,836			-		-		150,117
Residential junior mortgage		48,951			219			-			348			-		-		49,518
Retail & other		6,668			17			-			147			-		-		6,832
Total loans	$	797,389		$	32,802		$	9,576		$	32,165		$	-	$	-	$	871,932
Percent of total		91.4	%		3.8	%		1.1	%		3.7	%		-		-		100	%

	December 31, 2012
(in thousands)	Grades 1- 4			Grade 5			Grade 6			Grade 7			Grade 8		Grade 9		Total
Commercial & industrial	$	192,426		$	1,969		$	604		$	2,517		$	-	$	-	$	197,516
Owner-occupied CRE		96,313			16,502			1,832			3,595			-		-		118,242
CRE investment		66,358			8,545			-			1,715			-		-		76,618
Construction & land development		12,351			855			877			7,708			-		-		21,791
Residential construction		6,775			-			-			1,182			-		-		7,957
Residential first mortgage		82,914			1,094			-			1,580			-		-		85,588
Residential junior mortgage		38,582			199			249			322			-		-		39,352
Retail & other		5,537			-			-			-			-		-		5,537
Total loans*	$	501,256		$	29,164		$	3,562		$	18,619		$	-	$	-	$	552,601
Percent of total		90.7	%		5.3	%		0.6	%		3.4	%		-		-		100	%

* Agricultural production and agricultural real estate loans were not significant at December 31, 2012 and it was not practical to restate commercial & industrial and CRE investment, respectively for these changes.

Note 6 – Loans, Allowance for Loan Losses, and Credit Quality, continued

Management considers a loan to be impaired when it is probable the Company will be unable to collect all contractual principal and interest payments due in accordance with the terms of the loan agreement. For determining the adequacy of the ALLL, management defines impaired loans as nonaccrual credit relationships of over $250,000, plus additional loans with impairment risk characteristics. Management instituted the nonaccrual scope criteria in the second quarter of 2013, particularly in response to the higher volume of smaller nonaccrual loans acquired in the 2013 mergers. At the time an individual loan goes into nonaccrual status, however, management evaluates the loan for impairment and possible charge-off regardless of loan size.

In determining the appropriateness of the ALLL, management includes allocations for specifically identified impaired loans and loss factor allocations for all remaining loans, with a component primarily based on historical loss rates and another component primarily based on other qualitative factors. Impaired loans are individually assessed and are measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate or, as a practical expedient, at the loan’s observable market price or the fair value of the collateral if the loan is collateral dependent.

Loans that are determined not to be impaired are collectively evaluated for impairment, stratified by type and allocated loss ranges based on the Company’s actual historical loss ratios for each strata, and adjustments are also provided for certain current environmental and qualitative factors. An internal loan review function rates loans using a grading system based on nine different categories. Loans with grades of seven or higher (“classified loans”) represent loans with a greater risk of loss and may be assigned allocations for loss based on specific review of the weaknesses observed in the individual credits if classified as impaired. Classified loans are constantly monitored by the loan review function to ensure early identification of any deterioration.

Note 6 – Loans, Allowance for Loan Losses, and Credit Quality, continued

The following tables present impaired loans as of the dates indicated. PCI loans acquired in the 2013 mergers were initially recorded at a fair value of $16.7 million on their respective acquisition dates, net of an initial $12.2 million nonaccretable mark and a zero accretable mark. At September 30, 2013, the initially acquired PCI loans represent $9.0 million of the $18.4 million impaired loans at September 30, 2013 shown below; this $9.0 million of PCI loans are net of a remaining $10.9 million nonaccretable difference and a zero accretable mark. Also included in the September 30, 2013 impaired loans is the one troubled debt restructuring loan described below under “Troubled Debt Restructurings.”

(in thousands)	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
September 30, 2013
With no related allowance:
Commercial & industrial	$	101	$	170	$	-	$	108	$	6
Agricultural production		13		40		-		17		4
Owner-occupied CRE		5,634		6,942		-		6,180		318
Agricultural real estate		444		554		-		447		8
CRE investment		6,450		10,955		-		6,678		499
Construction & land development		5,570		6,170		-		5,652		76
Residential construction		-		-		-		-		-
Residential first mortgage		2,586		4,088		-		2,684		161
Residential junior mortgage		232		499		-		236		14
Retail & Other		-		-		-		-		-
With a related allowance:						-
Commercial & industrial	$	-	$	-	$	-	$	-	$	-
Agricultural production		-		-		-		-		-
Owner-occupied CRE		-		-		-		-		-
Agricultural real estate		-		-		-		-		-
CRE investment		-		-		-		-		-
Construction & land development		3,863		3,863		3,230		3,863		-
Residential construction		-		-		-		-		-
Residential first mortgage		-		-		-		-		-
Residential junior mortgage		-		-		-		-		-
Retail & Other		-		-		-		-		-
Total:
Commercial & industrial	$	101	$	170	$	-	$	108	$	6
Agricultural production		13		40		-		17		4
Owner-occupied CRE		5,634		6,942		-		6,180		318
Agricultural real estate		444		554		-		447		8
CRE investment		6,450		10,955		-		6,678		499
Construction & land development		9,433		10,033		3,230		9,515		76
Residential construction		-		-		-		-		-
Residential first mortgage		2,586		4,088		-		2,684		161
Residential junior mortgage		232		499		-		236		14
Retail & Other		-		-		-		-		-
Total	$	24,893	$	33,281	$	3,230	$	25,865	$	1,086

Note 6 – Loans, Allowance for Loan Losses, and Credit Quality, continued

(in thousands)	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
December 31, 2012
With no related allowance:
Commercial & industrial	$	784	$	1,287	$	-	$	3,015	$	265
Owner-occupied CRE		1,960		1,960		-		636		95
CRE investment		-		-		-		439		-
Construction & land development		2,560		2,560		-		6,333		-
Residential construction		-		-		-		620		-
Residential first mortgage		1,580		1,696		-		1,298		88
Residential junior mortgage		-		-		-		58		-
Retail & Other		142		150		-		120		7
With a related allowance:						-
Commercial & industrial	$	-	$	-	$	-	$	177	$	-
Owner-occupied CRE		-		-		-		162		-
CRE investment		-		-		-		-		-
Construction & land development.		-		-		-		-		-
Residential construction		-		-		-		-		-
Residential first mortgage		-		-		-		-		-
Residential junior mortgage		-		-		-		-		-
Retail & other		-		-		-		-		-
Total:
Commercial & industrial	$	784	$	1,287	$	-	$	3,192	$	265
Owner-occupied CRE		1,960		1,960		-		798		95
CRE investment		-		-		-		439		-
Construction & land development		2,560		2,560		-		6,333		-
Residential construction		-		-		-		620		-
Residential first mortgage		1,580		1,696		-		1,298		88
Residential junior mortgage		-		-		-		58		-
Retail & other		142		150		-		120		7
Total*	$	7,026	$	7,653	$	-	$	12,858	$	455

Troubled Debt Restructurings

At September 30, 2013, there was one construction and land development loan classified as a troubled debt restructuring, and no such loans at December 31, 2012. This loan had a premodification balance of $3.9 million and at September 30, 2013, had a balance of $3.9 million, was in compliance with its modified terms, was not past due, and was included in impaired loans with a specific reserve allocation of $3.2 million. This loan is disclosed as impaired as a result of its recent classification as a troubled debt restructuring. There were no other loans which were modified and classified as troubled debt restructurings at September 30, 2013. There were no loans which were classified as troubled debt restructurings during the previous twelve months that subsequently defaulted during the nine months ended September 30, 2013. Loans which were considered troubled debt restructurings by Mid-Wisconsin prior to the acquisition are not required to be classified as troubled debt restructurings in the Company’s financial statements unless or until such loans would subsequently meet criteria to be classified as such, since acquired loans were recorded at their estimated fair values at the time of the acquisition.

Note 7- Other Real Estate Owned (“OREO”)

A summary of OREO, net of valuation allowances, for the periods indicated is as follows:

	Three Months ended September 30,						Nine Months ended September 30,
(in thousands)	2013			2012			2013			2012
Balance at beginning of period	$	3,360		$	890		$	193		$	641
Transfer of loans at net realizable value to OREO		981			337			3,097			1,506
Sale proceeds		(1,894	)		(615	)		(2,887	)		(1,478	)
Net gain (loss) from sale of OREO		889			5			1,177			(52	)
Acquired balance, net		524			-			2,280			-
Balance at end of period	$	3,860		$	617		$	3,860		$	617

Note 8- Borrowings

At September 30, 2013 the Company had short-term borrowings maturing within twelve months consisting of short term repurchase agreements of approximately $17.7 million.

The Company had the following long term notes payable:

(in thousands)	September 30, 2013		December 31, 2012
Joint venture note	$	9,982	$	10,155
Federal Home Loan Bank (“FHLB”) advances		22,500		25,000
Notes payable	$	32,482	$	35,155

At the completion of the construction of the Company’s headquarters building in 2005 and as part of a joint venture investment related to the building, the Company and the other joint venture partners guaranteed a joint venture note to finance certain costs of the building. This note is secured by the building, bears a fixed rate of 5.81% and requires monthly principal and interest payments until its maturity on June 1, 2016.

At September 30, 2013 and December 31, 2012, the Company’s fixed-rate FHLB advances totaled $22.5 million and $25 million, respectively, require interest-only monthly payments, and have maturities through August 2016. The weighted average rate of FHLB advances was 1.85% and 2.87% at September 30, 2013 and December 31, 2012, respectively. The FHLB advances are collateralized by a blanket lien on qualifying first mortgages, home equity loans, multi-family loans and certain farmland loans which totaled approximately $80.3 million and $54.2 million at September 30, 2013 and December 31, 2012, respectively.

The following table shows the maturity schedule of the notes payable as of September 30, 2013:

Years Ending December 31,	(in thousands)
2013	$	60
2014		11,248
2015		5,762
2016		14,412
2017		-
2018		1,000
	$	32,482

Note 9 - Junior Subordinated Debentures

At September 30, 2013, the Company’s carrying value of junior subordinated debentures was $12.1 million. In July 2004 Nicolet Bankshares Statutory Trust I (the “Statutory Trust”), issued $6.0 million of guaranteed preferred beneficial interests (“trust preferred securities”) that qualify as Tier I capital under Federal Reserve Board guidelines. All of the common securities of the Statutory Trust are owned by the Company. The proceeds from the issuance of the common securities and the trust preferred securities were used by the Statutory Trust to purchase $6.2 million of junior subordinated debentures of the Company, which pay an 8% fixed rate. Interest on these debentures is current. The debentures may be redeemed in part or in full, on or after July 15, 2009 at par plus any accrued but unpaid interest. The maturity date of the debenture, if not redeemed, is July 15, 2034.

Note 9 - Junior Subordinated Debentures, continued

As part of the Mid-Wisconsin acquisition, the Company assumed $10.3 million of junior subordinated debentures related to $10.0 million of issued trust preferred securities. The trust preferred securities and the debentures mature on December 15, 2035 and have a floating rate of the three-month LIBOR plus 1.43% adjusted quarterly. Interest on these debentures is current. The debentures may be called at par in part or in full, on or after December 15, 2010 or within 120 days of certain events. At acquisition the debentures were recorded at a fair value of $5.8 million, with the discount being accreted to interest expense over the remaining life of the debentures. The September 30, 2013, carrying value of these trust preferred securities of $5.9 million qualifies as Tier 1 capital.

Note 10 - Fair Value Measurements

The relevant accounting standard (ASC Topic 820, “Fair Value Measurements and Disclosures”) defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. This standard applies under other accounting pronouncements that require or permit fair value measurements; accordingly, the standard amends numerous accounting pronouncements but does not require any new fair value measurements of reported balances. The standard emphasizes that fair value (i.e. the price that would be received in an orderly transaction that is not a forced liquidation or distressed sale at the measurement date), among other things, is based on exit price versus entry price, should include assumptions about risk such as nonperformance risk in liability fair values, and is a market-based measurement versus an entity-specific measurement.

The fair value hierarchy prioritizes inputs used to measure fair value into three broad levels. Level 1 inputs are quoted market prices in active markets for identical assets or liabilities that a company has the ability to access at the measurement date. Level 2 inputs are inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. Level 3 inputs are unobservable inputs for the asset or liability, which are typically based on an entity’s own assumptions, as there is little, if any, related market activity. 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.

The following table presents items measured at fair value on a recurring basis as of September 30, 2013 and December 31, 2012, aggregated by the level in the fair value hierarchy within which those measurements fall.

Assets Measured at Fair Value on a Recurring Basis
	September 30, 2013
			Fair Value Measurements Using
(in thousands)	Total		Level 1		Level 2		Level 3
U.S. government sponsored enterprises	$	2,323	$	-	$	2,323	$	-
State, county and municipals		55,510				55,160		350
Mortgage-backed securities		71,812		-		71,812		-
Corporate debt securities		220		-		-		220
Equity securities		2,491		2,491		-		-
Securities available for sale, September 30, 2013	$	132,356	$	2,491	$	129,295	$	570

	December 31, 2012
			Fair Value Measurements Using
(in thousands)	Total		Level 1		Level 2		Level 3
State, county and municipals	$	32,687	$	-	$	32,312	$	375
Mortgage-backed securities		20,668		-		20,668		-
Equity securities		2,546		2,546		-		-
Securities available for sale, December 31, 2012	$	55,901	$	2,546	$	52,980	$	375

The following is a description of the valuation methodologies used by the Company for the items noted in the table above, including the general classification of such instruments in the fair value hierarchy. Where quoted market prices on securities exchanges are available, the investment is classified in Level 1 of the fair value hierarchy. Level 1 investments primarily include exchange-traded equity securities available for sale. If quoted market prices are not available, fair value is generally determined using pricing models (such as matrix pricing which is a mathematical technique used widely in the industry to value debt securities without relying exclusively on quoted market prices for the specific securities but rather by relying on the securities’ relationship to other benchmark quoted securities), quoted market prices of securities with similar characteristic (adjusted for differences between the quoted instruments and the instrument being valued), or discounted cash flows, and are classified in Level 2 of the fair value hierarchy. 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 auction rate securities available for sale (for which there has been no liquid market since 2008) and corporate debt securities. At September 30, 2013 and December 31, 2012, it was determined that carrying value was the best approximation of fair value for these Level 3 securities, based primarily on receipt of par from refinances for the auction rate securities.

Note 10 - Fair Value Measurements, continued

The following table presents the Company’s collateral-dependent impaired loans and other real estate owned measured at fair value on a nonrecurring basis as of September 30, 2013 and December 31, 2012, aggregated by the level in the fair value hierarchy within which those measurements fall.

Assets Measured at Fair Value on a Nonrecurring Basis
	September 30, 2013
			Fair Value Measurements Using
(in thousands)	Total		Level 1		Level 2		Level 3
Collateral-dependent impaired loans	$	18,402	$	-	$	-	$	18,402
Other real estate owned		3,860		-		-		3,860

	December 31, 2012
			Fair Value Measurements Using
(in thousands)	Total		Level 1		Level 2		Level 3
Collateral-dependent impaired loans	$	7,026	$	-	$	-	$	7,026
Other real estate owned		193		-		-		193

The following is a description of the valuation methodologies used by the Company for the items noted in the table above, including the general classification of such instruments in the fair value hierarchy. For individually evaluated impaired loans, the amount of impairment is based upon the estimated fair value of the underlying collateral for collateral-dependent loans. For other real estate owned, the fair value is based upon the estimated fair value of the underlying collateral adjusted for the expected costs to sell.

Summarized below are the estimated fair values of the Company’s financial instruments at September 30, 2013 and December 31, 2012, along with the methods and assumptions used by the Company in estimating the fair value disclosures.


	September 30, 2013
	Carrying		Estimated		Fair Value Measurements Using
(in thousands)	Amount		Fair Value		Level 1		Level 2		Level 3
Financial assets:
Cash and cash equivalents	$	49,500	$	49,500	$	49,500	$	-	$	-
Certificates of deposit in other banks		1,960		1,960		1,960		-		-
Securities available for sale		132,356		132,356		2,491		129,295		570
Other investments		7,982		7,982		-		5,841		2,141
Loans held for sale		3,333		3,333		3,333		-		-
Loans, net		862,745		845,221		-		-		845,221
Bank owned life insurance		23,576		23,576		23,576		-		-
Financial liabilities:
Deposits	$	960,190	$	962,438	$	-	$	-	$	962,438
Short-term borrowings		17,693		17,693		17,693		-		-
Notes payable		32,482		32,664		-		32,664		-
Junior subordinated debentures		12,079		11,751		-		-		11,751

Note 10 - Fair Value Measurements, continued

	December 31, 2012
	Carrying		Estimated		Fair Value Measurements Using
(in thousands)	Amount		Fair Value		Level 1		Level 2		Level 3
Financial assets:
Cash and cash equivalents	$	82,003	$	82,003	$	82,003	$	-	$	-
Securities available for sale		55,901		55,901		2,546		52,980		375
Other investments		5,221		5,221		-		3,243		1,978
Loans held for sale		7,323		7,323		7,323		-		-
Loans, net		545,481		540,887		-		-		540,887
Bank owned life insurance		18,697		18,697		18,697		-		-
Financial liabilities:
Deposits	$	616,093	$	617,677	$	-	$	-	$	617,677
Short-term borrowings		4,035		4,035		4,035		-		-
Notes payable		35,155		36,017		-		36,017		-
Junior subordinated debentures		6,186		6,186		-		-		6,186

The following is a description of the valuation methodologies used for assets and liabilities which are either recorded or disclosed at fair value.

Cash and cash equivalents and certificates of deposit in other banks: For these short-term instruments, the carrying amount is a reasonable estimate of fair value.

Securities available for sale and other investments: Fair values for securities are based on quoted market prices on securities exchanges, when available, which is considered a Level 1 measurement. If quoted market prices are not available, fair value is generally determined using pricing models widely used in the industry, quoted market prices of securities with similar characteristics, or discounted cash flows, which is considered a Level 2 measurement, and Level 3 was deemed appropriate for auction rate securities (for which there has been no liquid market since 2008) and corporate debt securities which include trust preferred security investments. The corporate debt securities were acquired in the Mid-Wisconsin acquisition and valued based on discounted cash flows and the credit quality of the underlying issuer. The fair value approximates the acquired cost at September 30, 2013. For other investments, the carrying amount of Federal Reserve Bank 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 carrying amount of loans held for sale approximates the fair value, given the short-term nature of the loans between origination and sale, which is considered a Level 1 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.

Bank owned life insurance: The carrying value of these assets approximates fair value, which is considered a Level 1 measurement.

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 on certificates within the market place. Use of internal discounted cash flows provides a Level 3 fair value measurement.

Short-term borrowings: Due to the short-term nature of these instruments, the carrying amount is a reasonable estimate of fair value.

Note 10 - Fair Value Measurements, continued

Notes payable: The fair values of notes payable are estimated using discounted cash flow analysis based on current interest rates being offered by instruments with similar terms and credit quality which represents a Level 2 measurement.

Junior subordinated debentures: The fair values of junior subordinated debentures are estimated based on an evaluation 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.

Off-balance-sheet instruments: The estimated fair value of letters of credit at September 30, 2013 and December 31, 2012 was insignificant. Loan commitments on which the committed interest rate is less than the current market rate are also insignificant at September 30, 2013 and December 31, 2012.

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 11 – Subsequent Event

The Company announced earnings for the three months and nine months ended September 30, 2013 on October 15, 2013. Subsequent to that date, there have been developments related to an ongoing legal matter acquired in the Mid-Wisconsin transaction. Such litigation was pre-existing at the time of acquisition. The recent events in the fourth quarter support a change in estimate of loss on this litigation to $0.9 million, net of tax, which has been recorded against the bargain purchase gain of the Mid-Wisconsin transaction and imposed back against third quarter earnings.

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION

Nicolet Bankshares, Inc. is a bank holding company headquartered in Green Bay, Wisconsin, providing a diversified range of traditional banking and wealth management services to individuals and businesses in its market area through the 23 branch offices of its banking subsidiary, Nicolet National Bank, in northeastern and central Wisconsin and Menominee, Michigan.

The primary revenue sources of Nicolet Bankshares, Inc. and its subsidiaries (“Nicolet”) are net interest income, representing interest income from loans and other interest earning assets such as investments, less interest expense on deposits and other borrowings, and noninterest income, including, among others, trust fees, secondary mortgage income and other fees or revenue from financial services provided to customers or ancillary to loans and deposits. Business volumes and pricing drive revenue potential and tend to be influenced by overall economic factors, including market interest rates, business spending, consumer confidence, economic growth and competitive conditions within the marketplace.

At September 30, 2013, total assets were $1.1 billion and net income for the nine months ended September 30, 2013 was $15.2 million. Financial results as of September 30, 2013 and for the three and nine months ended September 30, 2013, are largely impacted by the Company’s acquisition of Mid-Wisconsin Financial Services, Inc. (“Mid-Wisconsin”), consummated on April 26, 2013, and its FDIC-assisted transaction acquiring Bank of Wausau, effective August 9, 2013. The eleven banking branches of Mid-Wisconsin and the one branch of Bank of Wausau opened as Nicolet National Bank branches on April 29 and August 10, 2013, respectively. The transactions were accounted for under the acquisition method of accounting, and thus, the results of operations of Mid-Wisconsin and Bank of Wausau prior to their respective consummation dates were not included in the accompanying consolidated financial statements. At acquisition, the Mid-Wisconsin transaction increased total assets by $435 million, total liabilities by $415 million, common equity by approximately $9.3 million, and resulted in a bargain purchase gain of $10.4 million during the second quarter of 2013. In the third quarter, a $0.9 million negative adjustment was recorded due to a change in estimate as discussed in Note 11. The income statement also included approximately $1.7 million of pre-tax, non-recurring merger related expenses tied to preparation for, consummation of and integration of Mid-Wisconsin into the Company. On a smaller scale, the Bank of Wausau transaction increased total assets by $47 million at acquisition, and resulted in pre-tax bargain purchase gain of $2.4 million and approximately $0.2 million of pre-tax, non-recurring merger related expenses during the third quarter of 2013. Finally, acquisition accounting requires assets purchased and liabilities assumed to be recorded at their respective fair values at the date of acquisition, which impacted various ratios, but most notably asset quality measures (as loans are recorded directly at their estimated fair value and no addition to the allowance for loan losses is recorded at consummation) and taxes. For additional details, see “Note 2 – Acquisitions”, “Note 6 – Loans, Allowance for Loan Losses, and Credit Quality”, and “Income Taxes” within this document.

On November 28, 2012, Nicolet entered into a merger agreement with Mid-Wisconsin and initially filed a Registration Statement on Form S-4 (Regis. No. 333-186401) (the “Registration Statement”) with the Securities and Exchange Commission under the provisions of the Securities Act. On March 26, 2013, the Registration Statement became effective and Nicolet became a public reporting company under Section 15(d) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”).

Forward-Looking Statements

Statements made in this document and in 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. Stockholders 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:

●

operating, legal and regulatory risks, including the effects of the Dodd-Frank Wall Street Reform and Consumer Protection Act and regulations promulgated thereunder, as well as the rules by the Federal bank regulatory agencies to implement the Basel III capital accord;

●

economic, political and competitive forces affecting Nicolet’s banking and wealth management businesses;

●

changes in interest rates, monetary policy and general economic conditions, which may impact Nicolet’s net interest income;

●

potential difficulties in integrating the operations of Nicolet with Mid-Wisconsin and Bank of Wausau;

●

the risk that Nicolet’s analyses of these risks and forces could be incorrect and/or that the strategies developed to address them could be unsuccessful; and

●

other factors discussed under “Risk Factors” included in the Joint Proxy Statement-Prospectus contained in the Registration Statement.

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.

Critical Accounting Policies

The consolidated financial statements of Nicolet Bankshares, Inc. and its subsidiaries are prepared in conformity with U.S. GAAP and follow general practices within the industry in which it operates. This preparation requires management to make estimates, assumptions and judgments that affect the amounts reported in the consolidated financial statements and accompanying notes. These estimates, assumptions and judgments are based on information available as of the date of the financial statements; accordingly, as this information changes, actual results could differ from the estimates, assumptions and judgments reflected in the financial statements. Certain policies inherently have a greater reliance on the use of estimates, assumptions and judgments and, as such, have a greater possibility of producing results that could be materially different than originally reported. Estimates that are particularly susceptible to significant change include the valuation of loans acquired in the Mid-Wisconsin and Bank of Wausau transactions, as well as the determination of the allowance for loan losses and income taxes and, therefore, are critical accounting policies.

Business Combinations and Valuation of Loans Acquired in Business Combinations

We account for acquisitions under FASB ASC Topic 805, Business Combinations, which requires the use of the acquisition method of accounting. Assets acquired and liabilities assumed in a business combination are recorded at estimated fair value on their purchase date. As provided for under GAAP, management has up to 12 months following the date of the acquisition to finalize the fair values of acquired assets and assumed liabilities, where it was not possible to estimate the acquisition date fair value upon consummation. Once management has finalized the fair values of acquired assets and assumed liabilities within this 12-month period, management considers such values to be the Day 1 Fair Values.

In particular, the valuation of acquired loans involves significant estimates, assumptions and judgment based on information available as of the acquisition date. Substantially all loans acquired in the transaction are evaluated either individually or in pools of loans with similar characteristics; and since the estimated fair value of acquired loans includes a credit consideration, no carryover of any previously recorded allowance for loan losses is recorded at acquisition. A number of factors are considered in determining the estimated fair value of purchased loans including, among other things, the remaining life of the acquired loans, estimated prepayments, estimated loss ratios, estimated value of the underlying collateral, estimated holding periods, contractual interest rates compared to market interest rates, and net present value of cash flows expected to be received.

In determining the Day 1 Fair Values of acquired loans, management calculates a non-accretable difference (the credit mark component of the acquired loans) and an accretable difference (the market rate or yield component of the acquired loans). The non-accretable difference is the difference between the undiscounted contractually required payments and the undiscounted cash flows expected to be collected in accordance with management’s determination of the Day 1 Fair Values. Subsequent decreases to the expected cash flows will generally result in a provision for loan losses. Subsequent increases in cash flows will result in a reversal of the provision for loan losses to the extent of prior charges and then an adjustment to accretable yield, and nonaccretable difference which would have a positive impact on interest income.

The accretable yield on acquired loans is the difference between the expected cash flows and the initial investment in the acquired loans. The accretable yield is recognized into earnings using the effective yield method over the term of the loans. Management separately monitors the acquired loan portfolio and periodically reviews loans contained within this portfolio against the factors and assumptions used in determining the Day 1 Fair Values.

Allowance for Loan Losses

The allowance for loan losses (the “ALLL”) is a reserve for estimated credit losses on individually evaluated loans determined to be impaired as well as estimated credit losses inherent in the loan portfolio. Actual credit losses, net of recoveries, are deducted from the ALLL. Loans are charged off when management believes that the collectability of the principal is unlikely. Subsequent recoveries, if any, are credited to the ALLL. A provision for loan losses, which is a charge against earnings, is recorded to bring the ALLL to a level that, in management’s judgment, is adequate to absorb probable losses in the loan portfolio. Management’s evaluation process used to determine the appropriateness of the ALLL is subject to the use of estimates, assumptions, and judgment. The evaluation process involves gathering and interpreting many qualitative and quantitative factors which could affect probable credit losses. Because interpretation and analysis involves judgment, current economic or business conditions can change, and future events are inherently difficult to predict, the anticipated amount of estimated loan losses and therefore the appropriateness of the ALLL could change significantly.

The allocation methodology applied by Nicolet is designed to assess the appropriateness of the ALLL and includes allocations for specifically identified impaired loans and loss factor allocations for all remaining loans, with a component primarily based on historical loss rates and a component primarily based on other qualitative factors. The methodology includes evaluation and consideration of several factors, such as, but not limited to, management’s ongoing review and grading of loans, facts and issues related to specific loans, historical loan loss and delinquency experience, trends in past due and nonaccrual loans, existing risk characteristics of specific loans or loan pools, the fair value of underlying collateral, current economic conditions and other qualitative and quantitative factors which could affect potential credit losses. While management uses the best information available to make its evaluation, future adjustments to the allowance may be necessary if there are significant changes in economic conditions or circumstances underlying the collectability of loans. Because each of the criteria used is subject to change, the allocation of the ALLL is made for analytical purposes and is not necessarily indicative of the trend of future loan losses in any particular loan category. The total allowance is available to absorb losses from any segment of the loan portfolio. Management believes the ALLL is appropriate. The allowance analysis is reviewed by the board of directors on a quarterly basis in compliance with regulatory requirements. In addition, various regulatory agencies periodically review the ALLL. These agencies may require Nicolet to make additions to the ALLL based on their judgments of collectability based on information available to them at the time of their examination.

Income taxes

The assessment of income tax assets and liabilities involves the use of estimates, assumptions, interpretation, and judgment concerning certain accounting pronouncements and federal and state tax codes. There can be no assurance that future events, such as court decisions or positions of federal and state taxing authorities, will not differ from management’s current assessment, the impact of which could be significant to the consolidated results of operations and reported earnings. Nicolet files a consolidated federal income tax return and a combined state income tax return (both of which include Nicolet and its wholly owned subsidiaries). Accordingly, amounts equal to tax benefits of those companies having taxable federal losses or credits are reimbursed by the companies that incur federal tax liabilities. Amounts provided for income tax expense are based on income reported for financial statement purposes and do not necessarily represent amounts currently payable under tax laws. Deferred income tax assets and liabilities are computed annually for differences between the financial statement and tax bases of assets and liabilities that will result in taxable or deductible amounts in the future based on enacted tax law rates applicable to the periods in which the differences are expected to affect taxable income. As changes in tax laws or rates are enacted, deferred tax assets and liabilities are adjusted through provision for income tax expense. Valuation allowances are established when it is more likely than not that a portion of the full amount of the deferred tax asset will not be realized. In assessing the ability to realize deferred tax assets, management considers the scheduled reversal of deferred tax liabilities, projected future taxable income and tax planning strategies. Nicolet may also recognize a liability for unrecognized tax benefits from uncertain tax positions. Unrecognized tax benefits represent the differences between a tax position taken or expected to be taken in a tax return and the benefit recognized and measured in the financial statements. Penalties related to unrecognized tax benefits are classified as income tax expense.

The following discussion is Nicolet management’s analysis of the consolidated financial condition as of September 30, 2013 and December 31, 2012 and results of operations for the three-month and nine-month periods ended September 30, 2013 and 2012. It should be read in conjunction with Nicolet’s audited consolidated financial statements as of December 31, 2012 and 2011, and for the three years ended December 31, 2012, included in the Registration Statement.

Performance Summary

Nicolet reported net income of $15.2 million for the nine months ended September 30, 2013, compared to $2.1 million for the comparable period of 2012. Net income available to common shareholders for the first nine months of 2013 was $14.2 million, or $3.65 per diluted common share, compared to net income available to common shareholders of $1.2 million, or $0.34 per diluted common share, for the first nine months of 2012. Income statement results and average balances for 2013 include approximately five months of Mid-Wisconsin and two months of Bank of Wausau activity (as results of operations of both entities prior to consummation are appropriately not included in the accompanying consolidated financial statements). Results for the first nine months of 2013 included total bargain purchase gains of $11.9 million and pre-tax, non-recurring expenses of approximately $1.9 million specifically related to the consummation and integration of the Mid-Wisconsin and Bank of Wausau transactions combined.

●

Net interest income was $26.4 million for the first nine months of 2013, an increase of $10.3 million or 64% over the $16.1 million for the first nine months of 2012. The improvement was predominantly volume related, given the timing of the acquisitions, but also favorably impacted by an increase in interest rate spread on higher average earning assets. On a tax-equivalent basis, the net interest margin for the first nine months of 2013 was 4.09%, up 51 basis points (“bps”) from 3.58% for the comparable 2012 period. The cost of interest-bearing liabilities was 0.85%, 47 bps lower than the first nine months of 2012, while the average yield on earning assets was 4.80%, 12 bps higher than the first nine months of 2012, resulting in a 59 bps improvement in the interest rate spread.

●

Loans were $872 million at September 30, 2013, up $319 million or 58% over $553 million at December 31, 2012, and up $326 million or 60% over $546 million at September 30, 2012. Removing the $284 million of loans added at acquisition (i.e. $272 million from Mid-Wisconsin and $12 million from Bank of Wausau), loans grew organically up 6% and 8% over December 31 and September 30, 2012, respectively. Between the comparative nine month periods, average loans were $720 million in 2013 yielding 5.43%, compared to $510 million in 2012 yielding 5.15%.

●

Total deposits were $960 million at September 30, 2013, up $344 million or 56% over $616 million at December 31, 2012, and up $405 million or 73% over $555 million at September 30, 2012. Removing the $370 million of deposits added at acquisition (i.e. $346 million from Mid-Wisconsin and $24 million net deposits acquired from Bank of Wausau given the quick redemption of $18 million of rate-sensitive certificates of deposit), deposits grew organically 6% over September 30, 2012, while down 4% from December 31, 2012, evidencing a customary pattern of deposit decline historically following year ends through the first nine months. Between the comparative nine month periods, average total deposits were $777 million, with interest-bearing deposits costing 0.65%, compared to $532 million in 2012, with interest-bearing deposits costing 1.06%.

●

Asset quality measures remained relatively strong, though have been impacted by the 2013 acquisitions. Nonperforming assets were 1.88% of total assets at September 30, 2013, compared to 0.97% at year end 2012. The allowance for loan losses was $9.2 million or 1.05% of loans at September 30, 2013 (impacted by the mergers adding no allowance for loan losses while adding $284 million to loans at acquisition), compared to $7.1 million or 1.29%, respectively, at December 31, 2012. The provision for loan losses was $3.9 million with net charge offs of $1.9 million for the first nine months of 2013, versus provision of $3.4 million with $2.8 million of net charge offs for the comparable 2012 period.

●

Noninterest income was $22.3 million for the first nine months of 2013, up $14.3 million over the first nine months of 2012, with $11.9 million of this variance attributable to the bargain purchase gains recorded in conjunction with the mergers. Other notable increases over prior year, largely due to increased business from the expanded size of the company, were seen in service charges (up $0.4 million or 47%), trust fee income (up $0.7 million or 33%), net gains on sale of assets (up $1.0 million, mainly in favorable sale resolutions of other real estate owned), and other income (up $0.4 million, of which $0.3 million increase is due to income from higher debit card volumes). Mortgage income was $0.3 million or 14% lower than the comparable nine-month period of 2012, resulting from a significant third quarter 2013 decline in mortgage production, largely in response to rising mortgage rates and uncertainties in economic and political events of the quarter.

●

Noninterest expense was $26.2 million for the first nine months of 2013, up $8.4 million over the first nine months of 2012, as the 2013 period included increased operations for approximately five months from the Mid-Wisconsin and two months from the Bank of Wausau transactions and approximately $1.9 million of non-recurring merger-related expenses. Most notably, salaries and benefits accounted for $4.5 million of the increase (of which approximately $1 million was attributable to non-recurring merger expenses), other expenses increased $1.8 million (of which nearly $0.9 million was attributable to non-recurring merger expenses), and core deposit intangible amortization increased $0.3 million, fully attributable to the Mid-Wisconsin merger.

Net Interest Income

Nicolet’s earnings are substantially dependent on net interest income. Net interest income is the primary source of Nicolet’s revenue and is the difference between interest income earned on interest earning assets, such as loans and investments, and interest expense on interest-bearing liabilities, such as deposits and other borrowings. Net interest income is directly impacted by the sensitivity of the balance sheet to changes in interest rates and by the amount and composition of earning assets and interest-bearing liabilities, including characteristics such as the fixed or variable nature of the financial instruments, contractual maturities, and repricing frequencies.

Comparison of the nine months ending September 30, 2013 versus 2012

Net interest income in the consolidated statements of income (which excludes any taxable equivalent adjustment) was $26.4 million in the first nine months of 2013, compared to $16.1 million in the first nine months of 2012. Taxable equivalent adjustments (adjustments to bring tax-exempt interest to a level that would yield the same after-tax income had that been subject to a 34% tax rate) were $444,000 and $464,000 for the first nine months of 2013 and 2012, respectively, resulting in taxable equivalent net interest income of $26.8 million for the first nine months of 2013 and $16.5 million for the first nine months of 2012.

Taxable 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.

Tables 1 through 5 present information to facilitate the review and discussion of selected average balance sheet items, taxable equivalent net interest income, interest rate spread and net interest margin.

Table 1: Year-To-Date Net Interest Income Analysis


	For the Nine Months Ended September 30,
	2013							2012
(in thousands)	Average Balance		Interest		Average Rate			Average Balance		Interest		Average Rate
ASSETS
Earning assets
Loans (1) (2) (3)(4)	$	719,717	$	29,550		5.43	%	$	509,536	$	19,916		5.15	%
Investment securities
Taxable		70,492		714		1.35	%		27,350		480		2.34	%
Tax-exempt (2)		30,991		914		3.93	%		26,492		958		4.82	%
Other interest-earning assets		44,384		222		0.67	%		42,849		169		0.53	%
Total interest-earning assets		865,584	$	31,400		4.80	%		606,227	$	21,523		4.68	%
Cash and due from banks		15,107							11,317
Other assets		59,964							41,856
Total assets	$	940,655						$	659,400
LIABILITIES AND STOCKHOLDERS’ EQUITY
Interest-bearing liabilities
Savings	$	73,353	$	155		0.28	%	$	29,767	$	99		0.44	%
Interest-bearing demand		146,614		905		0.83	%		86,602		617		0.95	%
MMA		209,583		571		0.36	%		161,664		580		0.48	%
Core CDs and IRAs		181,859		1,313		0.97	%		136,907		1,875		1.82	%
Brokered deposits		39,023		225		0.77	%		40,395		458		1.51	%
Total interest-bearing deposits		650,432		3,169		0.65	%		455,335		3,629		1.06	%
Other interest-bearing liabilities		64,932		1,414		2.87	%		46,676		1,377		3.88	%
Total interest-bearing liabilities		715,364		4,583		0.85	%		502,011		5,006		1.32	%
Noninterest-bearing demand		126,420							76,460
Other liabilities		6,970							4,601
Total equity		91,901							76,328
Total liabilities and stockholders’ equity	$	940,655						$	659,400
Net interest income and rate spread			$	26,817		3.95	%			$	16,517		3.36	%
Net interest margin						4.09	%						3.58	%

(1)	Nonaccrual loans are included in the daily average loan balances outstanding.
(2)	The yield on tax-exempt loans and tax-exempt investment securities is computed on a tax-equivalent basis using a federal tax rate of 34% and adjusted for the disallowance of interest expense.

(3)

(4)

Interest income for the nine-month period ending September 30, includes loan fees of $417,000 in 2013, and $100,000 in 2012.

Includes accretable yield from acquired loans

Table 2: Volume/Rate Variance

Comparison of nine months ended September 30, 2013 versus 2012:

	Increase (decrease) Due to Changes in
(in thousands)	Volume			Rate			Net(3)
Earning assets

Loans (1)(2)(4)	$	8,477		$	1,157		$	9,634
Investment securities
Taxable		478			(244	)		234
Tax-exempt (2)		148			(192	)		(44	)
Other interest-earning assets		40			13			53

Total interest-earning assets	$	9,143		$	734		$	9,877

Interest-bearing liabilities
Savings deposits	$	103		$	(47	)	$	56
Interest-bearing demand		379			(91	)		288
MMA		149			(158	)		(9	)
Core CDs and IRAs		496			(1,058	)		(562	)

Brokered deposits		(15	)		(218	)		(233	)
Total interest-bearing deposits		1,112			(1,572	)		(460	)
Other interest-bearing liabilities		337			(300	)		37

Total interest-bearing liabilities		1,449			(1,872	)		(423	)
Net interest income	$	7,694		$	2,606		$	10,300

(1)	Nonaccrual loans are included in the daily average loan balances outstanding.
(2)	The yield on tax-exempt loans and tax-exempt investment securities is computed on a tax-equivalent basis using a federal tax rate of 34% adjusted for the disallowance of interest expense.
(3)	The change in interest due to both rate and volume has been allocated in proportion to the relationship of dollar amounts of change in each.
(4)	Includes accretable yield from acquired loans

Table 3: Quarterly Net Interest Income Analysis


	For the Three Months Ended September 30,
	2013							2012
(in thousands)	Average Balance		Interest		Average Rate			Average Balance		Interest		Average Rate
ASSETS
Earning assets
Loans (1) (2) (3)(4)	$	854,404	$	12,892		5.93	%	$	538,989	$	6,852		5.00	%
Investment securities
Taxable		93,943		309		1.32	%		28,491		159		2.23	%
Tax-exempt (2)		35,125		329		3.75	%		26,629		302		4.53	%
Other interest-earning assets		32,852		75		0.91	%		22,297		47		0.84	%
Total interest-earning assets		1,016,324	$	13,605		5.26	%		616,406	$	7,360		4.70	%
Cash and due from banks		26,019							15,421
Other assets		70,179							46,405
Total assets	$	1,112,522						$	678,232
LIABILITIES AND STOCKHOLDERS’ EQUITY
Interest-bearing liabilities
Savings	$	92,123	$	57		0.25	%	$	35,358	$	40		0.45	%
Interest-bearing demand		168,685		315		0.74	%		91,455		228		0.99	%
MMA		232,778		200		0.34	%		156,080		177		0.45	%
Core CDs and IRAs		232,658		462		0.79	%		132,153		584		1.75	%
Brokered deposits		45,780		109		0.94	%		54,634		83		0.60	%
Total interest-bearing deposits		772,024		1,143		0.59	%		469,680		1,112		0.94	%
Other interest-bearing liabilities		71,332		490		2.69	%		47,275		450		3.72	%
Total interest-bearing liabilities		843,356		1,633		0.77	%		516,955		1,562		1.19	%
Noninterest-bearing demand		158,353							79,905
Other liabilities		7,592							5,023
Total equity		103,221							76,349
Total liabilities and stockholders’ equity	$	1,112,522						$	678,232
Net interest income and rate spread			$	11,972		4.49	%			$	5,798		3.51	%
Net interest margin						4.63	%						3.70	%


(1)	Nonaccrual loans are included in the daily average loan balances outstanding.
(2)	The yield on tax-exempt loans and tax-exempt investment securities is computed on a tax-equivalent basis using a federal tax rate of 34% and adjusted for the disallowance of interest expense.
(3)	Interest income for the period ending September 30, includes loan fees of $243,000 in 2013, and $51,000 in 2012.
(4)	Includes accretable yield from acquired loans

Table 4: Volume/Rate Variance

Comparison of three months ended September 30, 2013 versus 2012:


	Increase (decrease) Due to Changes in
(in thousands)	Volume			Rate			Net(3)
Earning assets

Loans (1)(2)(4)	$	4,531		$	1,509		$	6,040
Investment securities
Taxable		217			(67	)		150
Tax-exempt (2)		85			(58	)		27
Other interest-earning assets		26			2			28

Total interest-earning assets	$	4,859		$	1,386		$	6,245

Interest-bearing liabilities
Savings deposits	$	42		$	(25	)	$	17
Interest-bearing demand		155			(68	)		87
MMA		73			(50	)		23
Core CDs and IRAs		302			(424	)		(122	)

Brokered deposits		(15	)		41			26

Total interest-bearing deposits		557			(526	)		31
Other interest-bearing liabilities		133			(93	)		40

Total interest-bearing liabilities		690			(619	)		71
Net interest income	$	4,169		$	2,005		$	6,174


(1)	Nonaccrual loans are included in the daily average loan balances outstanding.
(2)	The yield on tax-exempt loans and tax-exempt investment securities is computed on a tax-equivalent basis using a federal tax rate of 34% adjusted for the disallowance of interest expense.
(3)	The change in interest due to both rate and volume has been allocated in proportion to the relationship of dollar amounts of change in each.
(4)	Includes accretable yield from acquired loans

Table 5: Interest Rate Spread, Margin and Average Balance Mix — Taxable-Equivalent Basis


	Nine Months Ended September 30,
	2013							2012
(in thousands)	Average Balance		% of Earning Assets		Yield/Rate			Average Balance		% of Earning Assets			Yield/Rate
Total loans	$	719,717	83.1	%		5.43	%	$	509,536		84.1	%	5.15	%

Securities and other earning assets		145,867	16.9	%		1.69	%		96,691		15.9	%	2.22	%
Total interest-earning assets	$	865,584	100	%		4.80	%	$	606,227		100	%	4.68	%

Interest-bearing liabilities	$	715,364	82.6	%		0.85	%	$	502,011		82.8	%	1.32	%

Noninterest-bearing funds, net		150,220	17.4	%					104,216		17.2	%
Total funds sources	$	865,584	100	%		0.70	%	$	606,227		100	%	1.09	%
Interest rate spread						3.95	%						3.36	%
Contribution from net free funds						0.14	%						0.22	%
Net interest margin						4.09	%						3.58	%

Taxable-equivalent net interest income was $26.8 million for the first nine months of 2013, an increase of $10.3 million or 62% over the same period in 2012. The $10.3 million increase in taxable-equivalent net interest income was predominantly volume related, given the timing of the acquisitions, but was also favorably impacted by an increase in interest rate spread on higher average earning assets as well as a higher level of purchase-accounting loan accretion on acquired loans. In particular, during the third quarter of 2013, two acquired loans resolved fully at approximately $1.0 million better than their carrying values, improving both interest income and the reported loan yield for the three and nine months ending September 30, 2013. Taxable equivalent interest income increased $9.9 million between the nine month periods driven by loans (including $8.5 million from higher loan volumes and $1.2 million from higher loan rates, mainly from the two favorably resolved loans noted above). Interest expense fell $0.4 million between the nine month periods due to beneficial growth in the mix of lower-costing funds (with $1.9 million less interest expense from favorable rate changes, but $1.4 million more interest expense from higher interest-bearing liabilities volume).

The taxable-equivalent net interest margin was 4.09% for the first nine months of 2013, up 51 bps over the first nine months of 2012, with improvement in the cost of funds at 0.85% (down 47 bps), a higher earning asset yield of 4.80% (up 12 bps) and a 8 bps decrease in net free funds. In general, there has been and will be underlying downward margin pressure as assets mature in this prolonged low-rate environment, with current reinvestment rates substantially lower than previous rates and less opportunity to offset such with similar changes in the already low cost of funds; however, in 2013 such pressure was partially mitigated by the favorable income from acquired loans.

The earning asset yield was comprised mainly of loans, representing 83.1% of average earning assets and yielding 5.43% for first nine months of 2013, compared to 84.1% and 5.15%, respectively, for the first nine months of 2012. The 28 bps improvement in loan yield between the nine month periods was aided in part by the positive rate profile of acquired loans and by the two favorably resolved loans during third quarter 2013 noted above as acquired loans marked to estimated fair value at acquisition resolve more favorably than originally anticipated. All other interest earning assets combined yielded 1.69%, down 53 bps compared to the first nine months of 2012, though aided in part by a higher mix of investments (representing 11.7% of average earning assets, versus 8.9% for the comparable 2012 period) that earn more than the other cash-equivalent earning assets.

Nicolet’s cost of funds continued its favorable decline during the low-rate environment, at 0.85% for the first nine months of 2013, 47 bps lower than the first nine months of 2012. The average cost of interest-bearing deposits (which represent over 90% of average interest-bearing liabilities for both years), was 0.65% for the first nine months of 2013, down 41 bps versus the first nine months of 2012, with favorable rate variances in all deposit categories and higher mix of balances in lower-costing transactional deposits (savings, checking and MMA). Average brokered deposit balances remained stable for the comparable nine month periods, however, their cost decreased from 1.51% in 2012 to 0.77% in 2013, as a significant portion of the higher rate brokered deposit balances matured since September 30, 2012, and were replaced with less-costly brokered deposits in the lower rate environment. The cost of other interest-bearing liabilities (comprised of short- and long-term borrowings) decreased to 2.87%, down 101 bps between the nine month periods, mainly from favorable rates on new advances, the prepayment of $10 million in higher-costing advances during first quarter 2013, and the acquisition at fair value of a lower-rate junior subordinated debenture in second quarter 2013.

Average interest-earning assets were $866 million for the first nine months of 2013, $259 million or 43% higher than the first nine months of 2012, led by a $210 million increase in average loans (to $720 million or 83% of interest earning assets) and a $48 million increase in average investments (to $101 million or 12% of earning assets), both heavily influenced by the size and timing of the acquisitions in 2013.

Average interest-bearing liabilities were $715 million, up $213 million or 42% over the first nine months of 2012, led by a $196 million increase in non-brokered interest-bearing deposits (to $611 million or 85% of average interest-bearing liabilities) and an $18 million increase in average other interest-bearing liabilities (to $65 million), both heavily influenced by the size and timing of the acquisitions in 2013.

Provision for Loan Losses

The provision for loan losses for the nine months ended September 30, 2013 and 2012 was $3.9 million and $3.4 million, respectively. The provision for loan losses increased in the third quarter of 2013 as a result of one significant credit which was provided for as a result of deteriorating performance. This credit relationship resulted in the recording of a troubled debt restructuring. Aside from this credit and the impact of the 2013 acquisitions, asset quality trends remained relatively strong, particularly in the non-acquired portfolio (primarily from work-outs of problem loans and declining net charge-offs). At December 31, 2012, the ALLL was $7.1 million which grew to $9.2 million at September 30, 2013, given the $3.9 million provision for loan losses and net charge offs of $1.9 million during the first nine months of 2013. The ratio of the ALLL to total loans was 1.05% at September 30, 2013, impacted most notably by the 2013 acquisitions, which added no allowance for loan losses to the numerator at acquisition and $284 million of loans into the denominator as of the dates of their acquisition. As events occur in the acquired loan portfolio, an ALLL will be established for this pool of assets as appropriate. Comparatively, the ALLL to total loans was 1.29% at December 31, 2012. Nonperforming loans were improving prior to the acquisitions, starting at $7.0 million (or 1.3% of total loans) at December 31, 2012, decreasing to $2.7 million (or 0.5% of loans) at March 31, 2013, and then increasing to $17.4 million (or 2.0% of loans) at September 30, 2013. Of the nonaccrual loans initially acquired in 2013 mergers, $9.0 million remains included in the $17.4 million of nonaccruals at September 30, 2013.

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 adequacy of the ALLL. The adequacy 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,” and “Balance Sheet Analysis — Impaired Loans and Nonperforming Assets.”

Noninterest Income

Table 6: Noninterest Income


	For the three months ended September 30,										For the nine months ended September 30,
(in thousands)	2013		2012		$ Change			% Change			2013		2012		$ Change			% Change
Service charges on deposit accounts	$	510	$	293	$	217			74.1	%	$	1,264	$	859	$	405			47.1	%
Trust services fee income		1,060		759		301			39.7			2,936		2,213		723			32.7
Mortgage income		353		846		(493	)		(58.3	)		1,939		2,254		(315	)		(14.0	)
Brokerage fee income		114		77		37			48.1			331		241		90			37.3
Gain on sale of assets, net		1,333		5		1,328			N/M			1,382		388		994			256.2
Bank owned life insurance (“BOLI”)		224		186		38			20.4			605		523		82			15.7
Rent income		204		264		(60	)		(22.7	)		728		744		(16	)		(2.2	)
Investment advisory fees		82		83		(1	)		(1.2	)		244		254		(10	)		(3.9	)
Bargain purchase gains		1,480		-		1,480			100.0			11,915		-		11,915			100.0
Other		382		172		210			122.1			920		509		411			80.7
Total noninterest income	$	5,742	$	2,685	$	3,057			113.9	%	$	22,264	$	7,985	$	14,279			178.8	%
Total without bargain purchase gains	$	4,262	$	2,685	$	1,577			58.7	%	$	10,349	$	7,985	$	2,364			29.6	%

N/M means not meaningful.

Comparison of the nine months ending September 30, 2013 versus 2012

Noninterest income was $22.3 million for the first nine months of 2013, up $14.3 million or 179% over the first nine months of 2012, with $11.9 million of this variance attributable to the bargain purchase gains recorded in conjunction with the mergers. The bargain purchase gains were calculated as the net difference in the fair value of the net assets acquired less the consideration paid resulting in the net bargain purchase gain of $9.5 million for Mid-Wisconsin and $2.4 million for Bank of Wausau. The details of the acquisition accounting are located in Note 2 of the notes to the unaudited consolidated financial statements. Without the bargain purchase gains, noninterest income was up $2.4 million or 29.6% between the nine-month periods, largely due to increased business from the expanded size of the company and timing of the mergers.

Service charges on deposit accounts were $1.3 million for the first nine months of 2013, up $0.4 million (or 47.1%) over the comparable period of 2012. The increase is primarily from increased service charges on deposits given the increase in deposit balances and number of accounts mainly from the mergers, and higher non-sufficient funds fees.

Trust service fees increased to $2.9 million for the first nine months of 2013, up $0.7 million or 32.7% over the comparable 2012 period. In addition to the larger base of customers acquired through the merger, there was continued market improvement over last year on assets under management, on which fees are based. Similarly, brokerage fees were $0.3 million, up $90,000 or 37.3% over the first nine months of 2012, mainly from increased legacy business, market improvements and to a lesser degree from the merger. Management believes the expanded footprint of the bank should provide growth potential for wealth management in future periods.

Mortgage income represents net gains received from the sale of residential real estate loans service-released into the secondary market and to a small degree, some related income. Residential refinancing activity and new purchase activity remained steady for the first six months of 2013, despite mortgage rates being higher than a year ago and trending upward. However, mortgage production slowed considerably in the third quarter 2013, largely in response to rising mortgage rates and uncertainties in economic and political events of the quarter. As a result, third quarter 2013 mortgage income was $0.4 million, less than half the $0.8 million level of third quarter 2012, and was $1.9 million for the first nine months of 2013, down $0.3 million or 14.0% from the comparable 2012 period. The change between nine-month periods was not significantly impacted by the acquisitions.

During the first nine months of 2013, Nicolet recognized a $1.4 million net gain on sale of assets compared to a $0.4 million net gain in the comparable period of 2012. The activity in 2013 consisted of $0.2 million net gains on sales of investments (mainly the result of selling a large portion of the acquired investment portfolio in second quarter to prepay higher costing debt assumed in the Mid-Wisconsin merger at a net loss and selling a portion of an equity holding in third quarter for a net gain), and $1.2 million net gains on sales of OREO (as properties were generally resolved at better than expected terms).

Bank owned life insurance (“BOLI”), income was $0.6 million for the first nine months of 2013, up $0.1 million from the comparable period in 2012, or 15.7%, mainly from the timing of additional BOLI procured. New BOLI investment of $3.8 million was procured in the first quarter 2012 and $4.3 million was acquired in the Mid-Wisconsin transaction (bringing the 2013 nine-month average of BOLI investment to $21.4 million, up 23% over the comparable period last year). Rent income, investment advisory fees and other noninterest income combined were $1.9 million for the first nine months of 2013 compared to $1.5 million for the comparable 2012 period, with the majority of the increase due to ancillary fees tied to deposit-related products, most particularly debit card, check cashing and wire fee income.

Noninterest Expense

Table 7: Noninterest Expense


	For the three months ended September 30,									For the nine months ended September 30,
	2013		2012		$ Change		% Change			2013		2012		$ Change		% Change
(in thousands)
Salaries and employee benefits	$	5,333	$	3,325	$	2,008		60.4	%	$	14,447	$	9,991	$	4,456		44.6	%
Occupancy, equipment and office		1,822		1,094		728		66.6			4,392		3,335		1,057		31.7
Business development and marketing		573		437		136		31.1			1,471		1,134		337		29.7
Data processing		724		444		280		63.1			1,719		1,255		464		37.0
FDIC assessments		240		134		106		79.1			480		408		72		17.6
Core deposit intangible amortization		342		155		187		120.6			776		490		286		58.4
Other		1,190		340		850		250.0			2,865		1,109		1,756		158.3
Total noninterest expense	$	10,224	$	5,929	$	4,295		72.4	%	$	26,150	$	17,722	$	8,428		47.6	%

Comparison of the nine months ending September 30, 2013 versus 2012

Total noninterest expense was $26.2 million for the first nine months of 2013, up $8.4 million over the first nine months of 2012, as the 2013 period included increased operations for approximately five months from the Mid-Wisconsin and two months from the Bank of Wausau transactions and approximately $1.9 million of non-recurring merger-related expenses. Most notably, salaries and benefits accounted for $4.5 million of the increase (of which approximately $1 million was attributable to non-recurring merger expenses, such as stay bonuses, severances and related payroll taxes), other expense increased $1.8 million (of which nearly $0.9 million was attributable to non-recurring merger expenses, predominantly legal or consulting in nature for consummation and integration), and core deposit intangible amortization increased $0.3 million, fully attributable to the Mid-Wisconsin merger.

Salaries and employee benefits expense was $14.4 million, up $4.5 million or 44.6%, over the first nine months of 2012, with approximately $1 million attributable to nonrecurring merger-related costs as noted above. The increase was otherwise commensurate with the growing workforce and was impacted by merit increases between the years, higher overtime in preparation for the merger, higher equity award expense given the timing of 2012 grants and higher incentive expense given 2013 performance. Average full time equivalent employees for the first nine months of 2013 were 247, versus 158 for the comparable 2012 period (up 56%).

Occupancy, equipment and office expense increased $1.1 million to $4.4 million for the first nine months of 2013 compared to 2012. This 31.7% increase is in line with the addition of 11 Mid-Wisconsin branches which nearly doubled our physical facilities and depreciation expense for five of the first nine months in 2013 and the costs of the one Bank of Wausau location added for two of the nine months. Utilities, rent, and other occupancy expenses increased proportionately in conjunction with the merger.

Business development and marketing expense for the first nine months of 2013 increased $0.3 million compared to the same period in 2012. This 29.7% increase was a result of the greater focus on growth in new markets and loans, sales seminars and events, higher charitable donations in 2013, and merger-related travel and business development costs.

Data processing, FDIC assessments and core deposit intangible amortization increased to $3.0 million on a combined basis for the first nine months in 2013, up $0.8 million from $2.2 million for the same period in 2012. Core deposit intangible amortization increased $0.3 million, given the new $4.0 million core deposit intangible recorded at acquisition for Mid-Wisconsin and being amortized on an accelerated basis over 10 years. Data processing expenses (which are primarily volume based) rose individually $0.5 million or 37.0%, in line with the larger operating base and conversion activities. FDIC assessments increased slightly (up $72,000) given the increased size in assets.

Other expense increased $1.8 million for the first nine months of 2013, compared to the same time period in 2012. Legal, consulting, and accounting fees combined accounted for $1.0 million of the increase and were predominantly related to the Mid-Wisconsin merger activity. The remaining increase is primarily from higher foreclosure expenses (up $0.5 million over the first nine months of 2012) given additional OREO properties added from the acquisitions and resolution activities, and from higher insurance costs (up $0.1 million over the 2012 period) related to Nicolet’s increased size and public nature.

Income Taxes

For the first nine months of 2013, income tax expense was $3.4 million compared to $0.8 million for the same period of 2012. The effective tax rates were 18% and 28% for first nine months of 2013 and 2012, respectively, with 2013 influenced largely by the Mid-Wisconsin bargain purchase gain, which was a tax free transaction. The tax rate for the first nine months of 2013 without the bargain purchase gain would have been 38%. GAAP requires that deferred income taxes be analyzed to determine if a valuation allowance is required. A valuation allowance is required if it is more likely than not that some portion of the deferred tax asset will not be realized. No valuation allowance was determined to be necessary as of September 30, 2013 and December 31, 2012.

Comparison of the three months ending September 30, 2013 versus 2012

Nicolet reported net income of $2.9 million for the three months ended September 30, 2013, compared to $1.0 million for the comparable period of 2012, with third quarter 2013 including the $2.4 million bargain purchase gain from the Bank of Wausau acquisition, approximately $0.2 million of non-recurring, pre-tax merger-related expenses related to the FDIC-assisted transaction of Bank of Wausau, and a $0.9 million negative adjustment due to a change in estimate as discussed in Note 11. Net income available to common shareholders for the third quarter of 2013 was $2.6 million, or $0.62 per diluted common share, compared to net income available to common shareholders of $0.7 million, or $0.19 per diluted common share, for the third quarter of 2012. Income statement results and average balances for third quarter 2013 include approximately two months of activity from Bank of Wausau and three months of Mid-Wisconsin, versus no activity from the acquisitions in the third quarter of 2012.

Taxable equivalent net interest income was $12.0 million for third quarter 2013, up $6.2 million and more than double the $5.8 million for third quarter 2012, with $4.2 million of the increase from volume variances (given the larger balance sheet following the acquisitions, and a 65% increase in average earning assets), and $2.0 million improvement from rate variances (predominantly from favorable loan rates assisted in the 2013 quarter by favorable resolution of two acquired loans at $1.0 million greater than their estimated fair values; and also from lower cost of funds between the comparable quarters).

For the third quarter of 2013, the earning asset yield was 5.26%, 56 bps higher than the third quarter of last year, mainly due to favorable yield adjustments on acquired loans. Third quarter 2013 interest income was positively impacted by approximately $1.0 million of loan income as a result of better than expected resolutions of two acquired loans resulting in an overall average loan yield of 5.93%, 93 bps higher than the third quarter of 2012. The impact of this increased loan yield was tempered partly by non-loan earning assets (which earn less than loans) representing a higher percentage of average earning assets, to 15.9% for third quarter 2013 versus 12.6% for the same period a year ago.

Between the third quarter periods, the cost of funds declined 42 bps to 0.77% in 2013 versus 1.19% in 2012. All funding categories (except brokered deposits) showed significantly lower rates between the third quarter periods, as the majority of maturities of higher costing CDs or wholesale debt were renewed in full or in part into shorter-term, lower-costing funding, and rates offered on many transaction deposit products (within savings, checking and MMA) have reset to lower rates in the continued low rate environment since September 30, 2012. Between the third quarter periods, the cost of brokered deposits increased 34 bps as longer term brokered deposits were procured to manage a lengthening asset portfolio.

Noninterest income was $5.7 million for third quarter 2013, and without the net gains (i.e. $1.5 million bargain purchase gain and $1.3 million of net gains on sale of assets) was $2.9 million, compared to $2.7 million for third quarter 2012. Mortgage origination volume has slowed with the rising rates and economic uncertainties compared to the third quarter a year ago, impacting mortgage income which was $0.4 million for third quarter 2013 versus $0.8 million for third quarter 2012. Increases in service charges on deposits, trust and brokerage fees, BOLI income and other income (which is largely debit card and ancillary fees tied to deposit activities) are due to and commensurate with additional business volumes, mainly from the acquisitions.

Noninterest expense was $10.2 million for the third quarter of 2013, up $4.3 million over second quarter 2012, including approximately $0.2 million of non-recurring, merger-based expenses and reflecting proportionate increases as a result of the timing and size of the mergers. For the quarter, personnel costs were $2.0 million or 60% higher than third quarter 2012, commensurate with the larger operating base. Average full time equivalent employees were 288 and 159 for third quarter 2013 and 2012, respectively. The $0.2 million increase in core deposit intangible amortization was solely due to the Mid-Wisconsin transaction. Of the $0.8 million increase in other expense, $0.4 million was due to higher foreclosure/OREO costs given the increased activity, $0.2 million was merger-based expense and $0.1 million was increased legal and audit expenses combined. The remaining categories combined were up $1.3 million or 59%, in line with the increased operating base between periods.

The provision for loan losses for the three months ended September 30, 2013 and 2012 was $2.0 million and $1.0 million respectively. The provision for loan losses increased in third quarter 2013 as a result of one significant credit which was provided for as a result of deteriorating performance. At September 30, 2013, the ALLL was $9.2 million (or 1.05% of total loans) compared to $6.5 million (or 1.19% of total loans) at September 30, 2012. Net charge offs for the quarter ending September 30, 2013 were $0.4 million compared to $0.5 million for the same period in 2012.

Income tax expense was $2.4 million and $0.5 million for the third quarters of 2013 and 2012, respectively. The effective tax rates were 45% for third quarter 2013 and 32% for third quarter 2012.

BALANCE SHEET ANALYSIS

Loans

Nicolet services a diverse customer base throughout Northeast and Central Wisconsin and in Menominee, Michigan including the following industries: manufacturing, agriculture, wholesaling, retail, service, and businesses supporting the general building industry. It continues to concentrate its efforts in originating loans in its local markets and assisting its current loan customers. It actively utilizes government loan programs such as those provided by the U.S. Small Business Administration to help customers weather current economic conditions and position their businesses for the future.

Nicolet’s primary lending function is to make commercial loans, consisting of commercial and industrial business loans, agricultural production, and owner-occupied commercial real estate loans; commercial real estate (“CRE”) loans, consisting of commercial investment real estate loans, agricultural real estate, and construction and land development loans; residential real estate loans, including residential first mortgages, residential junior mortgages (such as home equity loans and lines), and to a lesser degree residential construction loans; and retail and other loans.

Total loans were $872 million at September 30, 2013 compared to $553 million at December 31, 2012. This $319 million increase included $284 million of acquired loans at acquisition and $35 million (or 6% over year end 2012) of net organic growth.

Table 8: Period End Loan Composition

	For the three months ended,
	September 30, 2013				December 31, 2012				September 30, 2012
(in thousands)	Amount		% of Total		Amount		% of Total		Amount		% of Total
Commercial & industrial	$	251,590	28.8	%	$	197,301	35.7	%	$	201,049	36.8	%
Agricultural production		14,071	1.6			215	0.1			315	0.1
Owner-occupied CRE		203,715	23.4			106,888	19.3			105,585	19.3
Total commercial loans		469,376	53.8			304,404	55.1			306,949	56.2
Agricultural real estate		37,738	4.3			11,354	2.1			1,201	0.2
CRE investment		106,763	12.3			76,618	13.9			76,773	14.1
Construction & land development		38,757	4.4			21,791	3.9			26,964	4.9
Total CRE loans		183,258	21.0			109,763	19.9			104,938	19.2
Residential construction		12,831	1.5			7,957	1.4			7,670	1.4
Residential first mortgage		150,117	17.2			85,588	15.5			79,542	14.6
Residential junior mortgage		49,518	5.7			39,352	7.1			40,928	7.5
Total residential real estate loans		212,466	24.4			132,897	24.0			128,140	23.5
Retail & other		6,832	0.8			5,537	1.0			5,681	1.1
Total loans	$	871,932	100.0	%	$	552,601	100.0	%	$	545,708	100.0	%

Total commercial and total CRE loans combined were 74.8% at September 30, 2013 compared to 75.0% of the total loan portfolio at December 31, 2012. Mid-Wisconsin had a higher proportion of CRE loans, thus post-merger total CRE rose to 21.0% at September 30, 2013 compared to 19.9% at December 31, 2012 and total commercial loans declined to 53.8% versus 55.1% for the respective periods. The Bank of Wausau acquisition did not have a significant impact on the commercial loan portfolio. All commercial loans (commercial and CRE combined) are considered to have more inherent risk of default than residential mortgage or retail loans, in part because the commercial balance per borrower is typically larger than that for residential and mortgage loans, implying higher potential losses on an individual customer basis, and the underlying dependence of the commercial borrower’s success on many influences such as health of the economy, real estate values, and efficient business practices.

Total commercial loans were 53.8% of total loans at September 30, 2013. The increase in commercial loan balances from September 2012 to September 2013 resulted primarily from the acquisition, but also from renewed loan demand from business borrowers based on cautious optimism for improving economic conditions versus a year ago. The increase in agricultural production loans was almost entirely the result of the acquisition with the central region of the state having a strong farming base. All commercial loan segments include a diverse range of industries. The credit risk related to commercial and industrial loans, agricultural production loans, and owner-occupied CRE 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.

Total CRE loans were 21.0% of total loans at September 30, 2013. CRE investment loans comprised 12.3% of the portfolio at September 30, 2013 compared to 13.9% at December 31, 2012. The CRE investment loan classification primarily includes commercial-based mortgage loans that are secured by non-owner occupied, nonfarm/nonresidential real estate properties, and multi-family residential properties. The increase in agricultural real estate loans (at 4.3% of total loans versus 2.1% at September 30, 2013 and year end 2012, respectively) was almost entirely the result of the Mid-Wisconsin acquisition, with the central region of Wisconsin having a strong farming base. Construction and land development loans were 4.4% at September 30, 2013 compared to 3.9% December 31, 2012. Loans in this classification provide financing for the development of commercial income properties, multi-family residential development, and land designated for future development. Credit risk on these types of loans is controlled by making loans in familiar markets, reviewing the merits of individual projects, controlling loan structure, and monitoring the progress of projects through the analysis of construction advances. This category has been decreasing as Nicolet has limited new construction and land development lending to lessen its credit exposure, and the acquisition did not significantly impact this category. Lending in this segment has been focused on loans that are secured by commercial income-producing properties as opposed to speculative real estate development. Credit risk on both CRE investment loans and construction and land development loans is managed by employing sound underwriting guidelines, lending primarily to borrowers in local markets, periodically evaluating the underlying collateral, and formally reviewing the borrower’s financial soundness and relationships on an ongoing basis.

Residential construction loans were $12.8 million or 1.5% of total loans at September 30, 2013 compared to 1.4% at December 31, 2012 representing a steady yet small portion of the loan portfolio.

Residential first mortgage real estate loans increased slightly from 15.5% of total loans at year end 2012 to 17.2% at September 30, 2013, largely as a result of acquired balances. Residential first mortgage loans include conventional first-lien home mortgages and exclude loans held for sale in the secondary market. On a measured basis, Nicolet has retained specific high quality residential mortgages, in part as an alternative to investing in greater volumes of mortgage-backed securities in the low rate environment. Residential junior mortgage real estate loans increased slightly in balance but declined as a percent of loans from 7.1% at December 31, 2012 to 5.7% of loans at September 30, 2013. Residential junior mortgage real estate loans consist of home equity lines and term loans secured by junior mortgage liens. While Nicolet has not experienced significant losses in the residential real estate category, if declines in market values that have occurred in the residential real estate markets worsen, particularly in Nicolet’s market area, the value of collateral securing its real estate loans could decline further, which could cause an increase in the provision for loan losses. In light of the uncertainty that exists in the economy and credit markets, there can be no guarantee that Nicolet will not experience additional deterioration resulting from a downturn in credit performance by its residential real estate loan customers. As part of its management of originating residential mortgage loans, the vast majority of Nicolet’s long-term, fixed-rate residential real estate mortgage loans are sold in the secondary market without retaining the servicing rights. At September 30, 2013, $3.3 million of residential mortgages were held for resale to the secondary market, compared to $7.3 million at December 31, 2012.

Retail and other loans totaled $6.8 million at September 30, 2013, an increase of $1.3 million since December 31, 2012, and represented 0.8% and 1.0% of total loans, respectively. Loans in this classification include predominantly short-term and other personal installment loans not secured by real estate. The decline in retail and other loans is largely a result of consumers preferring home equity-based loans over consumer installment loans, as well as the uncertain and difficult economic conditions reducing consumer demand for leverage in general. Credit risk is primarily controlled by reviewing the creditworthiness of the borrowers, monitoring payment histories, and taking appropriate collateral and guaranty positions.

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 adequate ALLL, and sound nonaccrual and charge-off policies. An active credit risk management process is used for commercial loans to further 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.

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 September 30, 2013, no significant industry concentrations existed in Nicolet’s portfolio in excess of 25% of total loans. Nicolet has also developed guidelines to manage its exposure to various types of concentration risks.

Allowance for Loan and Lease Losses

Credit risks within the loan portfolio are inherently different for each loan type. 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 ALLL is established through a provision for loan losses charged to expense to appropriately provide for potential credit losses in the existing loan portfolio. Loans are charged against the ALLL when management believes that the collection of principal is unlikely. 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 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 segments; (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. Nicolet’s methodology reflects guidance by regulatory agencies to all financial institutions.

At September 30, 2013, the ALLL was $9.2 million, an increase of $2.1 million since December 31, 2012. The ALLL as a percentage of total loans was 1.05% at September 30, 2013, down from 1.29% at December 31, 2012, largely the result of the acquisitions, as $284 million of acquired loans were recorded directly at their estimated fair value (inclusive of credit-related marks) and no addition to the allowance for loan losses was recorded at consummation. Loss history on the acquired loans will be developed as charge-offs occur and an allocation will be made for these loans in future periods as or if needed. Provision for loans losses for the first nine months of 2013 was $3.9 million compared to $3.4 million for the first nine months of 2012 and $4.3 million for all of 2012. Net charge-offs were $1.9 million for the first nine months of 2013 compared to $2.8 million for the same period in 2012 and $3.1 million for the entire year of 2012. Commercial and industrial, CRE investment, and construction and land development loans experienced the largest increases in net charge-offs between the nine month periods, while owner-occupied CRE saw the most improvement. Loans charged off are subject to continuous review, and specific efforts are taken to achieve maximum recovery of principal, accrued interest, and related expenses. The level of the provision for loan losses is directly correlated to the assessment of the adequacy of the allowance, including, but not limited to, consideration of the amount of net charge-offs, loan growth, levels of nonperforming loans, and trends in the risk profile of the loan portfolio.

The ratio of ALLL to nonperforming assets was 43% at September 30, 2013, versus 99% at December 31, 2012, with the 2013 ratio impacted by the acquisitions initially adding no ALLL to the numerator and $284 million of loans to the denominator. Issues impacting asset quality over the past few years have included historically depressed economic factors, such as weakened commercial and residential real estate markets, depressed collateral values, volatile energy prices, heightened unemployment, and depressed consumer confidence, leading to elevated levels of nonperforming loans and net charge-offs, as well as long resolution periods at low returns. Rigorous workout and resolution plans on problem credits and enhanced underwriting and credit monitoring, particularly beginning in 2010have resulted in more stabilized asset quality especially in 2012 and into 2013 before acquisitions, but with nonperforming assets growing with each of the 2013 acquisitions. Management has and is making steady progress in working acquired nonperforming assets to resolution.

Nicolet’s 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 collateral or discounted cash flow shortfall is established for all loans determined to be impaired. The specific reserve in the ALLL is equal to the aggregate collateral shortfall calculated from the impairment analysis. Loans measured for impairment include nonaccrual loans, troubled debt-restructurings (“restructured loans”), or other loans determined to be impaired by management. Second, Nicolet’s management allocates 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. Lastly, management allocates 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.

At September 30, 2013, the largest portion of the ALLL is allocated to construction and land development loans at $5.8 million, representing 62.7% of the ALLL (compared to 36.2% allocated to this segment at December 31, 2012), and commensurate with risks in this segment, past loss history and nonaccrual activity, and the addition in third quarter of 2013 of a $3.9 million troubled debt restructuring with a specific reserve allocation of $3.2 million. Owner-occupied CRE, CRE investment, and residential first mortgage loans all show significant increase in nonperforming levels, however, the majority of the increase was due to acquired loans which have been marked to fair value and do not require additional allowance at September 30, 2013. Of the nonaccrual loans initially acquired in the 2013 mergers, $9.0 million remains included in the $17.4 million total nonaccrual loans at September 30, 2013; thus, the remaining $8.4 million are nonaccrual originated loans, up slightly from the $7.0 million nonaccrual loans at December 31, 2012.

Management performs ongoing intensive analyses of its loan portfolio to allow for early identification of customers experiencing financial difficulties, maintains prudent underwriting standards, understands the economy in its markets, and considers the trend of deterioration in loan quality in establishing the level of the ALLL.

Consolidated net income and stockholders’ equity could be affected if management’s estimate of the ALLL necessary to cover expected losses is subsequently materially different, requiring a change in the level of provision for loan losses to be recorded. While management uses currently available information to recognize losses on loans, future adjustments to the ALLL may be necessary based on newly received appraisals, updated commercial customer financial statements, rapidly deteriorating customer cash flow, or changes in economic conditions that affect Nicolet’s customers. As an integral part of their examination process, federal regulatory agencies also review the ALLL. Such agencies may require additions to the ALLL or may require that certain loan balances be charged-off or downgraded into criticized loan categories when their credit evaluations differ from those of management based on their judgments about information available to them at the time of their examination.

Table 9: Loan Loss Experience


	For the nine months ended						Year ended
(in thousands)	September 30, 2013			September 30, 2012			December 31, 2012
Allowance for loan losses (ALLL):
Balance at beginning of period	$	7,120		$	5,899		$	5,899
Provision for loan losses		3,925			3,350			4,325
Charge-offs		1,978			2,836			3,507
Recoveries		120			78			403
Net charge-offs		1,858			2,758			3,104
Balance at end of period	$	9,187		$	6,491		$	7,120

Net loan charge-offs:
Commercial & industrial	$	447		$	95		$	259
Agricultural production		-			-			-
Owner-occupied CRE		30			1,191			900
Agricultural real estate		-			127			128
CRE investment		798			305			278
Construction & land development		319			285			691
Residential construction		-			396			396
Residential first mortgage		78			209			254
Residential junior mortgage		141			113			160
Retail & other		45			37			38
Total net loans charged-off	$	1,858		$	2,758		$	3,104

ALLL to total loans		1.05	%		1.19	%		1.29	%
ALLL to net charge-offs		370	%		176	%		229	%
Net charge-offs to average loans, annualized		0.35	%		0.61	%		0.60	%

The allocation of the ALLL is based on Nicolet’s estimate of loss exposure by category of loans and is shown in Table 10 for September 30, 2013 and December 31, 2012.

Table 10: Allocation of the Allowance for Loan Losses

(in thousands)		September 30, 2013		% of Loan Type to Total Loans			December 31, 2012		% of Loan Type to Total Loans
ALLL allocation
Commercial & industrial	$	1,716		28.8	%	$	1,969		35.7	%
Agricultural production		8		1.6			-		0.1
Owner-occupied CRE		641		23.4			1,069		19.3
Agricultural real estate		-		4.3			-		2.1
CRE investment		181		12.3			337		13.9
Construction & land development		5,759		4.4			2,580		3.9
Residential construction		199		1.5			137		1.4
Residential first mortgage		439		17.2			685		15.5
Residential junior mortgage		221		5.7			312		7.1
Retail & other		23		0.8			31		1.0
Total ALLL	$	9,187		100.0	%	$	7,120		100.0	%
ALLL category as a percent of total ALLL:
Commercial & industrial		18.7	%				27.7	%
Agricultural production		0.1					-
Owner-occupied CRE		7.0					15.0
Agricultural real estate		-					-
CRE investment		2.0					4.7
Construction & land development		62.5					36.2
Residential construction		2.2					1.9
Residential first mortgage		4.8					9.6
Residential junior mortgage		2.4					4.4
Retail & other		0.3					0.5
Total ALLL		100.0	%				100.0	%

Impaired Loans and Nonperforming Assets

As part of its overall credit risk management process, 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.

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. As shown in Table 11, nonperforming loans were $17.4 million and $7.0 million at September 30, 2013 and December 31, 2012, respectively. Of the nonaccrual loans initially acquired in the 2013 mergers, $9.0 million remains included in the $17.4 million total nonaccrual loans at September 30, 2013; thus, the remaining $8.4 million are nonaccrual originated loans, up slightly from year end 2012.

Impaired loans are another asset quality indicator used to determine the adequacy of the ALLL. Loans measured for impairment include significant nonaccrual loans, troubled debt restructurings (“restructured loans”), or other loans determined to be impaired by management. As shown in Note 6 – Loans, Allowance for Loan Losses and Credit Quality, impaired loans were $24.9 million at September 30, 2013 (including a new $3.9 million troubled debt restructuring which carries a $3.2 million specific allocation, $9.0 million of remaining balance of the initially acquired PCI loans, $6.5 million of acquired loans subsequently determined to be impaired, and $5.5 million of other impaired loans), compared to impaired loans of $7.0 million at year end 2012.

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 adequacy of the ALLL. Potential problem loans are generally defined by management to include loans rated as Substandard by management that are in performing status; but, 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 loans covering a diverse range of businesses and real estate property types.

Potential problem loans totaled $14.7 million (or 1.7% of total loans) at September 30, 2013 and $11.6 million (or 2.1% of total loans) at December 31, 2012. The $3.1 million increase in potential problem loans since year end 2012 is mainly attributable to the third quarter 2013 down grade of a $4.4 million credit relationship to substandard and nonaccrual.

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.

OREO increased to $3.9 million at September 30, 2013 from $0.2 million at December 31, 2012. The increase was related to several originated loans which had been on nonaccrual and were foreclosed during 2013 with the remaining balance of $1.7 million being acquired in the Mid-Wisconsin merger. Total nonperforming assets increased from $7.2 million at December 31, 2012 to $21.3 million at September 30, 2013. The increase in nonperforming assets included acquired loans with a balance of $9.0 million at September 30, 2013. Nicolet’s management actively seeks to ensure properties held are monitored to minimize Nicolet’s risk of loss. Evaluations of the fair market value of the OREO properties are done quarterly and valuation adjustments, if necessary, are recorded in Nicolet’s consolidated financial statements.

Table 11: Nonperforming Assets


(in thousands)	September 30, 2013			December 31, 2012			September 30, 2012
Nonaccrual loans:
Commercial & industrial	$	115		$	784		$	3,986
Agricultural production		15			—			—
Owner-occupied CRE		5,521			1,960			354
Agricultural real estate		451			—			—
CRE investment		6,447			—			380
Construction & land development		1,310			2,560			8,558
Residential construction		—			—			397
Residential first mortgage		3,112			1,580			1,326
Residential junior mortgage		322			—			—
Retail & other		129			142			151
Total nonaccrual loans		17,422			7,026			15,152
Accruing loans past due 90 days or more		—			—			—
Total nonperforming loans	$	17,422		$	7,026		$	15,152
CRE investment	$	874		$	71		$	393
Owner-occupied CRE		552			—			—
Construction & land development		1,963			17			19
Residential real estate owned		471			105			205
OREO		3,860			193			617
Total nonperforming assets	$	21,282		$	7,219		$	15,769
Total restructured loans accruing	$	3,862		$	—		$	—
Ratios
Nonperforming loans to total loans		2.00	%		1.27	%		2.78	%
Nonperforming assets to total loans plus OREO		2.43	%		1.31	%		2.89	%
Nonperforming assets to total assets		1.88	%		0.97	%		2.46	%
ALLL to nonperforming assets		43	%		99	%		41	%
ALLL to total loans		1.05	%		1.29	%		1.19	%

Table 12: Investment Securities Portfolio


	September 30, 2013							December 31, 2012
(in thousands)	Amortized Cost		Fair Value		% of Total			Amortized Cost		Fair Value		% of Total
U.S. government sponsored enterprises	$	2,327	$	2,323		2	%	$	-	$	-		-	%
State, county and municipals		55,134		55,510		42	%		31,642		32,687		58	%
Mortgage-backed securities		72,592		71,812		54	%		19,876		20,668		37	%
Corporate debt securities		220		220		-	%		-		-		-	%
Equity securities		1,131		2,491		2	%		1,624		2,546		5	%
Total	$	131,404	$	132,356		100	%	$	53,142	$	55,901		100	%

At September 30, 2013 the total carrying value of investment securities was $132.4 million, up from $55.9 million at December 31, 2012, and represented 11.7% and 7.5% of total assets at September 30, 2013 and December 31, 2012, respectively. As part of the mergers, securities with a fair value of $129 million were acquired and as of September 30, 2013 approximately $44 million had been sold in conjunction with planned reductions.

At September 30, 2013, the securities portfolio did not contain securities of any single issuer that were payable from and secured by the same source of revenue or taxing authority where the aggregate carrying value of such securities exceeded 10% of shareholders’ equity.

In addition to securities available for sale, Nicolet had other investments of $8.0 million and $5.2 million at September 30, 2013 and December 31, 2012, respectively, consisting of capital stock in the Federal Reserve and the FHLB (required as members of the Federal Reserve Bank System and the Federal Home Loan Bank System), as well as equity investments in other private companies. The FHLB and Federal Reserve investments are “restricted” in that they can only be sold back to the respective institutions or another member institution at par, and are thus, not liquid, have no ready market or quoted market value, and are carried at cost. The investments in private companies have no quoted market prices, and are carried at cost less other than temporary impairment (“OTTI”) charges, if any. Nicolet’s management evaluates all these other investments periodically for impairment, considering financial condition and other available relevant information. There were no OTTI charges recorded in 2012 or year to date 2013.

Table 13: Investment Securities Portfolio Maturity Distribution


	As of September 30, 2013
	Within One Year					After One but Within Five Years					After Five but Within Ten Years					After Ten Years					Mortgage- related and Equity Securities					Total Amortized Cost						Total Fair Value Amount
(in thousands)	Amount		Yield			Amount		Yield			Amount		Yield			Amount		Yield			Amount		Yield			Amount		Yield				Total Fair Value Amount
U.S. government sponsored enterprises	$	1,293		0.1	%	$	517		0.2	%	$	517		1.7	%	$	—		—	%	$	—		—	%	$	2,327		0.5	%	$	2,323
State and county municipals (1)		9,011		3.0			33,165		1.9			12,000		1.3			958		1.8			—		—			55,134		1.9			55,510
Corporate debt securities		—		—			—		—			—		—			220		7.0			—		—			220		7.0			220
Mortgage-backed securities		—		—			—		—			—		—			—		—			72,592		1.6			72,592		1.6			71,812
Equity securities		—		—			—		—			—		—			—		—			1,131		—			1,131		—			2,491
Total amortized cost	$	10,304		2.6	%	$	33,682		1.9	%	$	12,517		1.3	%	$	1,178		2.8	%	$	73,723		1.6	%	$	131,404		1.7	%	$	132,356
Total fair value and carrying value	$	10,377				$	34,356				$	12,159				$	1,161				$	74,303									$	132,356

(1)	The yield on tax-exempt investment securities is computed on a tax-equivalent basis using a federal tax rate of 34% adjusted for the disallowance of interest expense.

Deposits

Deposits represent Nicolet’s largest source of funds. Nicolet competes with other bank and nonbank institutions for deposits, as well as with a growing number of non-deposit investment alternatives available to depositors, such as mutual funds, money market funds, annuities, and other brokerage investment products. Challenges to deposit growth include price changes on deposit products given movements in the rate environment and other competitive pricing pressures, and customer preferences regarding higher-costing deposit products or non-deposit investment alternatives. Included in total deposits in Table 14 are brokered deposits of $38.2 million at September 30, 2013 and $32.6 million at December 31, 2012.

Table 14: Deposits


	September 30, 2013					December 31, 2012
(in thousands)	Amount		% of Total			Amount		% of Total
Demand	$	173,002		18.0	%	$	108,234		17.6	%
Money market and NOW accounts		425,125		44.3	%		322,507		52.3	%
Savings		95,435		9.9	%		46,907		7.6	%
Time		266,628		27.8	%		138,445		22.5	%
Total deposits	$	960,190		100.0	%	$	616,093		100.0	%

Total deposits were $960 million at September 30, 2013, an increase of $344 million since December 31, 2012, with $346 million and $42 million of deposits from Mid-Wisconsin and Bank of Wausau, respectively, at acquisition. Excluding the $388 million of deposits acquired in 2013, deposits were down $44 million since year end, attributable to $18 million of rate sensitive CDs at Bank of Wausau that redeemed by September 30 and the remainder due to a customary downward pattern that historically follows year ends. On average for the nine months of 2013, total deposits were $777 million, an increase of $245 million over 2012, which includes five months of average deposit balances from Mid-Wisconsin and Bank of Wausau. The mix of average deposits continues to be impacted mostly by a continued shift in customer preferences, predominantly away from time deposits.

Table 15: Average Deposits


	For the nine months ended,
	September 30, 2013					September 30, 2012
(in thousands)	Amount		% of Total			Amount		% of Total
Demand	$	126,420		16.3	%	$	76,460		14.4	%
Money market and NOW accounts		356,197		45.9	%		248,266		46.7	%
Savings		73,353		9.4	%		29,767		5.6	%
Time		220,882		28.4	%		177,302		33.3	%
Total	$	776,852		100	%	$	531,795		100	%

Table 16: Maturity Distribution of Certificates of Deposit


(in thousands)	September 30, 2013
3 months or less	$	33,583
Over 3 months through 6 months		50,818
Over 6 months through 12 months		60,346
Over 12 months		121,881

Total	$	266,628

Other Funding Sources

Other funding sources, which include short-term and long-term borrowings, were $62.3 million and $45.4 million at September 30, 2013 and December 31, 2012, respectively. Short-term borrowings, consisting mainly of customer repurchase agreements maturing in less than three months, totaled $17.7 million at September 30, 2013 and $4.0 million at December 31, 2012. Long-term borrowings include a joint venture note and FHLB advances, totaling $32.5 million at September 30, 2013 compared to $35.2 million at December 31, 2012, attributable to scheduled principal payments on the joint venture note payable and repayment of $10 million of longer term FHLB advances during first quarter 2013 offset by new longer term advances of $7.5 million of which $2.5 million was acquired in the acquisition of Bank of Wausau. All advances acquired in the merger with Mid-Wisconsin were re-paid during the second quarter of 2013. Junior subordinated debentures are another long-term funding source. Junior subordinated debentures of $6.2 million were issued in July 2004 in connection with the $6 million of trust preferred securities. Acquired junior subordinated debentures of $10.3 million in connection with $10 million of trust preferred securities were assumed in the merger and subsequently recorded at the fair market value of $5.8 million. Further information regarding these junior subordinated debentures is located in Note 9 of the unaudited consolidated financial statements.

Off-Balance Sheet Obligations

As of September 30, 2013 and December 31, 2012, Nicolet had the following commitments that did not appear on its balance sheet:

Table 17: Commitments


	September 30,		December 31,
	2013		2012
(in thousands)
Commitments to extend credit — Fixed and variable rate	$	231,335	$	178,676
Standby and irrevocable letters of credit-fixed rate		6,801		4,050

Contractual Obligations

Nicolet is party to various contractual obligations requiring the use of funds as part of its normal operations. Most of these obligations are routinely refinanced into similar replacement obligations. However, renewal of these obligations is dependent on its ability to offer competitive interest rates, liquidity needs, or availability of collateral for pledging purposes supporting the long-term advances.

At the completion of the construction of Nicolet’s headquarters building in 2005 and as part of a joint venture investment related to the building, Nicolet and the other joint venture partners guaranteed a joint venture note to finance certain costs of the building. This note is secured by the building, bears a fixed rate of 5.81% and requires monthly principal and interest payments until its maturity on June 1, 2016. The balance of this joint venture note was $10.0 million and $10.2 million as of September 30, 2013 and December 31, 2012, respectively.

Liquidity and Interest Rate Sensitivity

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 the core deposit base, the repayment and maturity of loans, investment securities sales, and sales of brokered deposits. All investment securities are classified as available for sale and are reported at fair value on the consolidated balance sheet. Approximately $58 million of the $132 million investment securities portfolio on hand at September 30, 2013 was pledged to secure public deposits, short-term borrowings, repurchase agreements and for other purposes as required by law. Other funding sources available include short-term borrowings, federal funds purchased, and long-term borrowings.

Cash and cash equivalents at September 30, 2013 and December 31, 2012 were approximately $50 million and $82 million, respectively. The increased cash and cash equivalents at year end 2012 was predominantly due to strong customer deposit growth outpacing the loan demand. These levels returned to more historical levels during 2013. Nicolet’s liquidity resources were sufficient as of September 30, 2013 to fund loans and to meet other cash needs as necessary.

Interest Rate Sensitivity Gap Analysis

Table 18 represents a schedule of Nicolet’s assets and liabilities repricing over various time intervals. The primary market risk faced by Nicolet is interest rate risk. The static gap analysis starts with contractual repricing information for assets, liabilities, and off-balance sheet instruments. These items are then combined with repricing estimations for administered rate (interest-bearing demand deposits, savings, and money market accounts) and non-rate related products (demand deposit accounts, other assets, and other liabilities) to create a baseline repricing balance sheet. In addition to the contractual information, residential mortgage whole loan products and mortgage-backed securities are adjusted based on industry estimates of prepayment speeds that capture the expected prepayment of principal above the contractual amount based on how far away the contractual coupon is from market coupon rates. At the indicated time intervals the cumulative maturity gap was within Nicolet’s established guidelines of not greater than +25% or -25%.

Table 18: Interest Rate Sensitivity Gap Analysis


	September 30, 2013
(in thousands)	0-90 Days			91-180 Days			181-365 Days			1-5 years			Beyond 5 Years			Total
Earning Assets:
Loans	$	365,156		$	86,295		$	50,268		$	300,410		$	60,616		$	862,745
Securities at fair value		8,969			7,611			1,745			52,291			61,740			132,356
Other earnings assets		39,309			—			—			—			7,982			47,291
Total	$	413,434		$	93,906		$	52,013		$	352,701		$	130,338		$	1,042,392

Cumulative rate sensitive assets	$	413,434		$	507,340		$	559,353		$	912,054		$	1,042,392

Interest-bearing liabilities
Interest bearing deposits (1)	$	382,242		$	79,620		$	31,542		$	120,742		$	173,042		$	787,188
Borrowings		17,849			6,900			3,725			15,710			5,991			50,175
Subordinated debentures		1,510			1,510			3,020			6,039			—			12,079
Total	$	401,601		$	88,030		$	38,287		$	142,491		$	179,033		$	849,442

Cumulative interest sensitive liabilities	$	401,601		$	489,631		$	527,918		$	670,409		$	849,442

Interest sensitivity gap	$	11,833		$	5,876		$	13,726		$	210,210		$	(48,695	)

Cumulative interest sensitivity gap	$	11,833		$	17,709		$	31,435		$	241,645		$	192,950
Cumulative ratio of rate sensitive assets to rate sensitive liabilities		103	%		104	%		106	%		136	%		123	%

(1)

The interest rate sensitivity assumptions for savings accounts, money market accounts, and interest-bearing demand deposits accounts are based on current and historical experiences regarding portfolio retention and interest rate repricing behavior. Based on these experiences, a portion of these balances are considered to be long-term and fairly stable and are, therefore, included in the “1-5 Years” and “Beyond 5 Years” categories.

In order to limit exposure to interest rate risk, management monitors the liquidity and gap analysis on a monthly basis and adjusts pricing, term and product offerings when necessary to stay within applicable guidelines and maximize the effectiveness of asset/liability management.

Along with the static gap analysis, Nicolet’s management also estimates the effect a gradual change and a sudden change in interest rates could have on expected net interest income through income simulation. The simulation is run using the prime rate as the base with the assumption of rates increasing 100, 200, and 300 bps or decreasing 100, 200 and 300 bps. All rates are increased or decreased parallel to the change in prime rate. The simulation assumes a static mix of assets and liabilities. As a result of the simulation, over a 12-month time period ending September 30, 2013, net interest income was estimated to decrease 5.18% if rates increase 100 bps, and was estimated to decrease 5.22% in a 100 bps declining rate environment assumption. These results are in line with Nicolet’s increasing interest rate sensitivity position, relatively short (though extending) loan maturities and level of variable rate loans with interest floors; as rates remain low, asset maturities extend, and deposit maturities contract, this position continues to become more liability-sensitive. These results are based solely on the modeled changes in the market rates and do not reflect the earnings sensitivity that may arise from other factors such as changes in the shape of the yield curve, changes in spreads between key market rates, or changes in consumer or business behavior. Interest rates did increase significantly in the third quarter with longer term rates rising over 100 bps, steepening the yield curve, and there was not a corresponding rise in deposit rates. These results also do not include any management action to mitigate potential income variances within the modeled process. The simulation results are one indicator of interest rate risk, and actual net interest income is largely impacted by the allocation of assets, liabilities and product mix. Nicolet’s management continually reviews its interest rate risk position through the Asset/Liability Committee process, and such Committee reports to the full board of directors on a monthly basis.

Capital

Nicolet’s 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. Nicolet’s management 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 dividends available to shareholders. Nicolet’s management intends to maintain an optimal capital and leverage mix for growth and for shareholder return.

The Small Business Lending Fund (“SBLF”) is a U.S. Treasury program made available to community banks, designed to boost lending to small businesses by providing participating banks with capital and liquidity. In particular, the SBLF program targets commercial, industrial, owner-occupied real-estate and agricultural-based lending to qualifying small businesses, which include businesses with less than $50 million in revenue, and promotes outreach to women-owned, veteran-owned and minority-owned businesses.

On September 1, 2011, under the SBLF, Nicolet received $24.4 million from the Treasury for the issuance of 24,400 shares of Non-Cumulative Perpetual Preferred Stock, Series C, with $1,000 per share liquidation value. The annual dividend rate upon funding and for the following nine calendar quarters is 5%, unless there is growth in qualifying small business loans outstanding over a baseline which could reduce the rate to as low as 1% (as determined under the terms of the Securities Purchase Agreement (the “Agreement”)), adjusted quarterly. The dividend rate is fixed for the tenth quarter after funding through the end of the first four and one-half years at 7% (unless fixed at a lower rate given increased lending as similarly described above); and finally the dividend rate is fixed at 9% after four and one-half years if the preferred stock is not repaid. Nicolet’s weighted average dividend rate has been 5% between funding and September 30, 2013. Under the terms of the Agreement, Nicolet is required to provide various information, certifications, and reporting to the Treasury. At December 31, 2012 and September 30, 2013, Nicolet believes it was in compliance with the requirements set by the Treasury in the Agreement. The preferred stock (under SBLF) qualifies as Tier 1 capital for regulatory purposes.

On April 26, 2013, $9.7 million of common stock was issued as part of the merger with Mid-Wisconsin. Concurrently with the merger, Nicolet also closed a private placement for an aggregate of $2.9 million in proceeds. Approximately $401,000 in direct stock issuance costs for the merger and private placement were incurred and charged against additional paid in capital. Despite the additional equity issued the effect of the merger transactions reduced overall capital ratios as a result of the increased asset size; however, minimum capital levels were maintained and Nicolet maintains sufficient regulatory capital for current and future needs.

On July 9, 2013 banking regulators issued final guidance on how regulatory capital will be calculated going forward. Full provisions of these regulations will go into effect beginning in 2015. Nicolet is determining the effect these regulations will have on future capital needs.

A summary of Nicolet’s and Nicolet National Bank’s regulatory capital amounts and ratios as of September 30, 2013 and December 31, 2012 are presented in the following table.

Table 19: Capital


	Actual					For Capital Adequacy Purposes					To Be Well Capitalized Under Prompt Corrective Action Provisions (2)
(in thousands)	Amount		Ratio (1)			Amount		Ratio (1)			Amount		Ratio (1)
As of September 30, 2013:
Nicolet
Total capital	$	117,367		13.1	%	$	71,592		8.0	%		N/A		N/A
Tier I capital		108,180		12.1	%		35,796		4.0	%		N/A		N/A
Leverage		108,180		9.8	%		44,199		4.0	%		N/A		N/A

Nicolet National Bank
Total capital	$	108,140		12.3	%	$	70,276		8.0	%	$	87,845		10.0	%
Tier I capital		98,953		11.3	%		35,138		4.0	%		52,707		6.0	%
Leverage		98,953		9.1	%		43,690		4.0	%		54,612		5.0	%

As of December 31, 2012:
Nicolet
Total capital	$	85,738		15.2	%	$	45,098		8.0	%		N/A		N/A
Tier I capital		78,691		14.0	%		22,549		4.0	%		N/A		N/A
Leverage		78,691		11.0	%		28,622		4.0	%		N/A		N/A

Nicolet National Bank
Total capital	$	77,500		14.1	%	$	43,984		8.0	%	$	54,981		10.0	%
Tier I capital		70,624		12.8	%		21,992		4.0	%		32,988		6.0	%
Leverage		70,624		10.1	%		27,916		4.0	%		34,895		5.0	%

(1)

The total capital ratio is defined as tier1 capital plus tier 2 capital divided by total risk-weighted assets. The tier 1 capital ratio is defined as tier1 capital divided by total risk-weighted assets. The leverage ratio is defined as tier1 capital divided by the most recent quarter’s average total assets.

(2)	Prompt corrective action provisions are not applicable at the bank holding company level.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Not applicable for smaller reporting companies.

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 Chief Executive Officer and President and Chief Financial Officer, evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as such term 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 Chief Executive Officer and President and the Chief Financial Officer concluded that our disclosure controls and procedures were effective.

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

Not applicable for smaller reporting company.

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

Not applicable.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

Not applicable.

ITEM 4. MINE SAFETY DISCLOSURES

Not applicable.

ITEM 5. OTHER INFORMATION

Not applicable.

ITEM 6. EXHIBITS

The following exhibits are filed herewith:


Exhibit
Number		Description
31.1		Certification of CEO under Section 302 of Sarbanes-Oxley Act of 2002
31.2		Certification of CFO under Section 302 of Sarbanes-Oxley Act of 2002
32.1		Certification of CEO Pursuant to 18 U.S.C Section 1350 as Adopted Pursuant to Section 906 of Sarbanes-Oxley Act of 2002
32.2		Certification of CFO Pursuant to 18 U.S.C Section 1350 as Adopted Pursuant to Section 906 of Sarbanes-Oxley Act of 2002
101*		Interactive data files pursuant to Rule 405 of Regulation S-T: (i) Consolidated Balance Sheets, (ii) Consolidated Statements of Income, (iii) Consolidated Statements of Comprehensive Income, (iv) Consolidated Statements of Stockholders’ Equity, (v) Consolidated Statement of Cash Flows, and (vi) Notes to Consolidated Financial Statements tagged as blocks of text.

*Indicates information that is furnished and not filed or a part of a registration statement or prospectus for purposes of sections 11 or 12 of the Securities Act of 1933, is deemed not filed for purposes of section 18 of the Securities Exchange Act of 1934, and otherwise is not subject to liability under these sections.

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.


		NICOLET BANKSHARES, INC.

November 12, 2013		/s/ Robert B. Atwell
		Robert B. Atwell
		Chairman, President and Chief Executive Officer

November 12, 2013		/s/ Ann K. Lawson
		Ann K. Lawson
		Chief Financial Officer

Nicolet Bankshares - 10-Q quarterly report FY2013 Q3

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