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 March 31, 2017
¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from…………to………………
Commission file number 001-37700
NICOLET BANKSHARES, INC.
(Exact name of registrant as specified in its charter)
WISCONSIN
(State or other jurisdiction of incorporation or organization)
47-0871001
(I.R.S. Employer Identification No.)
111 North Washington Street
Green Bay, Wisconsin 54301
(920) 430-1400
(Address, including zip code, and telephone number, including area code, ofRegistrant’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 ¨
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 ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.
Emerging Growth Company x
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
As of April 25, 2017 there were 8,612,382 shares of $0.01 par value common stock outstanding.
Nicolet Bankshares, Inc.
TABLE OF CONTENTS
Consolidated Balance Sheets
March 31, 2017 (unaudited) and December 31, 2016
Management’s Discussion and Analysis of Financial Condition
and Results of Operations
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PART I – FINANCIAL INFORMATION
Item 1. FINANCIAL STATEMENTS:
NICOLET BANKSHARES, INC. AND SUBSIDIARIES
Consolidated Balance Sheets(In thousands, except share and per share data)
See accompanying notes to unaudited consolidated financial statements.
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ITEM 1. Financial Statements Continued:
Consolidated Statements of Income
(In thousands, except share and per share data) (Unaudited)
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Consolidated Statements of Comprehensive Income
(In thousands) (Unaudited)
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Consolidated Statement of Stockholders’ Equity
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Consolidated Statements of Cash Flows
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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 consolidated financial statements should be read in conjunction with the Company’s audited consolidated financial statements and footnotes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2016.
Critical Accounting Policies and Estimates
Preparation of consolidated financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying disclosures. These estimates are based on management’s best knowledge of current events and actions the Company may undertake in the future. Estimates are used in accounting for, among other items, the allowance for loan losses, 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, the assessment of deferred tax assets and liabilities, and the valuation of loans acquired in the 2013 and 2016 acquisitions; therefore, these are critical accounting policies. Factors that may cause sensitivity to the aforementioned estimates include but are not limited to: external market factors such as market interest rates and employment rates, changes to operating policies and procedures, changes in applicable banking regulations, and changes to deferred tax estimates. Actual results may ultimately differ from estimates, although management does not generally believe such differences would materially affect the consolidated financial statements in any individual reporting period presented.
There have been no material changes or developments with respect to the assumptions or methodologies that the Company uses when applying what management believes are critical accounting policies and developing critical accounting estimates as disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2016.
Recent Accounting Developments Adopted
In December 2016, the Financial Accounting Standards Board (“FASB”) issued updated guidance to Accounting Standards Update (“ASU”) 2016-19 Technical Corrections and Improvements intended to make changes to clarify the Accounting Standards Codification or correct unintended application of guidance that is not expected to have a significant effect on current accounting practice. The ASU is effective for annual periods, including interim periods within those annual periods, beginning after December 15, 2016. The impact of the new guidance did not have a material impact on the Company’s consolidated financial statements.
In March 2016, the FASB issued updated guidance to ASU 2016-09: Stock Compensation Improvements to Employee Share-Based Payment Activity intended to simplify and improve several aspects of the accounting for share-based payment transactions, including the income tax consequences, classification of such awards as either equity or liabilities and classification on the statement of cash flows. The updated guidance is effective for interim and annual reporting periods beginning after December 15, 2016. The consolidated financial statements include the impact of the new guidance. The Company adopted the pronouncement as required on January 1, 2017, prospectively, which included a reduction to income tax expense of $0.1 million in the three months ended March 31, 2017 for deductions attributable to exercised stock options and vesting of restricted stock.
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Note 1 – Basis of Presentation, continued
Operating Segment
While the chief decision makers monitor the revenue streams of the various products and services, and evaluate costs, balance sheet positions and quality, all such products, services and activities are directly or indirectly related to the business of community banking, with no regular, formal or material segment delineations. Operations are managed and financial performance is evaluated on a company-wide basis, and accordingly, all the financial service operations are considered by management to be aggregated in one reportable operating segment.
Reclassifications
Certain amounts in the 2016 consolidated financial statements have been reclassified to conform to the 2017 presentation.
Note 2 – Acquisitions
On April 29, 2016, the Company consummated its merger with Baylake Corp. (“Baylake”), pursuant to the Agreement and Plan of Merger by and between the Company and Baylake dated September 8, 2015, (the “Baylake Merger Agreement”), whereby Baylake was merged with and into the Company, and Baylake Bank, Baylake’s wholly owned commercial bank subsidiary serving northeastern Wisconsin, was merged with and into Nicolet National Bank (the “Bank”). The system integration was completed, and 21 branches of Baylake opened, on May 2, 2016, as branches of the Bank, expanding its presence into Door, Kewaunee, and Manitowoc Counties, Wisconsin. The Company closed one of its Brown County locations concurrently with the Baylake merger, and closed an additional six branches in the fourth quarter of 2016.
The purpose of the Baylake merger was for strategic reasons beneficial to the Company. The acquisition was consistent with its plan to drive growth and efficiency through increased scale, leverage the strengths of each bank across the combined customer base, enhance profitability, and add liquidity and shareholder value.
Pursuant to the terms of the Baylake Merger Agreement, Baylake shareholders received 0.4517 shares of the Company’s common stock for each outstanding share of Baylake common stock (except for Baylake shares pre-owned by the Company at the time of the merger), and cash in lieu of any fractional share. Pre-existing Baylake equity awards (restricted stock units and stock options) immediately vested upon consummation of the merger. The Company issued 0.4517 shares of its common stock for each vesting Baylake restricted stock unit, and Nicolet assumed, after appropriate adjustment by the 0.4517 exchange ratio, all pre-existing Baylake stock options. As a result, the Company issued 4,344,243 shares of the Company’s common stock, for common stock consideration of $163.3 million (based on $37.58 per share, the volume weighted average closing price of the Company’s common stock over the preceding 20 trading day period as defined in the Baylake Merger Agreement), and recorded an additional $1.2 million consideration for the assumed stock options. Approximately $0.3 million in direct stock issuance costs for the merger were incurred and charged against additional paid in capital, bringing the total purchase price to $164.2 million.
The Company accounted for the transaction under the acquisition method of accounting, and thus, the financial position and results of operations of Baylake prior to the consummation date were not included in the accompanying consolidated financial statements. The accounting required assets purchased and liabilities assumed to be recorded at their respective estimated fair values at the date of acquisition. The Company determined the fair value of core deposit intangibles, securities, premises and equipment, loans, OREO, BOLI and other assets, deposits, debt and deferred taxes with the assistance of third party valuations, appraisals, and third party advisors. The estimated fair values may 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.
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Note 2 – Acquisitions, continued
The fair value of the assets acquired and liabilities assumed on April 29, 2016 was as follows:
The following unaudited pro forma information presents the results of operations for three months ended March 31, 2016 as if the acquisition had occurred January 1, 2016. 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 the period presented, nor are they intended to represent or be indicative of future results of operations.
During the first quarter of 2016, Nicolet agreed in a private transaction to hire a select group of financial advisors and purchase their respective books of business, as well as their operating platform, to enhance the leadership and future growth of the Company’s wealth management business. The transaction was effected in phases and completed April 1, 2016. The Company paid $4.9 million total initial consideration, including $0.8 million cash, $2.6 million of Nicolet common stock, and recorded a $1.5 million earn-out liability payable to one principal in the future (which may require adjustment based on change in initial business purchased over a period, but not contingent upon the principal’s employment). The Company initially recorded $0.4 million of goodwill, $0.2 million of fixed assets, and $4.3 million of customer relationship intangibles (a portion amortizing straight-line over 10 years and a portion over 15 years). The transaction will impact the income statement primarily within brokerage income, personnel expense, and intangibles amortization.
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.
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Note 3 – Earnings per Common Share, continued
*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.
There was no anti-dilutive effect of options outstanding at March 31, 2017 and March 31, 2016.
Note 4 – Stock-based Compensation
A Black-Scholes model is utilized to estimate the fair value of stock options and the market price of the Company’s stock at the date of grant is used to estimate the value of restricted stock awards. The weighted average assumptions used in the model for valuing option grants were as follows for the year ended December 31, 2016. There were no options granted during the three months ended March 31, 2017.
Activity in the Company’s Stock Incentive Plans is summarized in the following tables:
*The terms of the stock option agreements permit having a number of shares of stock withheld, the fair market value of which as of the date of exercise is sufficient to satisfy the exercise price and/or tax withholding requirements, and accordingly 2,697 shares were surrendered during the three months ended March 31, 2017 and 10,244 shares were surrendered during the year ended December 31, 2016. These stock options were considered exercised and then surrendered and are included in the Exercise of stock option line.
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Note 4 – Stock-based Compensation, continued
Options outstanding at March 31, 2017 are exercisable at option prices ranging from $9.19 to $38.10. There are 263,400 options outstanding in the range from $9.19 - $20.00, 247,165 options outstanding in the range of $20.01 - $25.00, 157,724 options outstanding in the range of $25.01 - $30.00, and 204,754 options outstanding in the range from $30.01 - $38.10. At March 31, 2017, the exercisable options have a weighted average remaining contractual life of approximately five years and a weighted average exercise price of $20.63.
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 three months of 2017, and full year of 2016 was approximately $1.2 million, and $1.3 million, respectively.
The terms of the restricted stock agreements permit the surrender of shares to the Company upon vesting in order to satisfy applicable tax withholding requirements at the minimum statutory withholding rate, and accordingly, 1,639 shares were surrendered during the three months ended March 31, 2017 and 7,851 shares were surrendered during the year ended December 31, 2016.
The Company recognized approximately $384,000 and $412,000 of stock-based employee compensation expense during the three months ended March 31, 2017 and 2016, respectively, associated with its stock equity awards. As of March 31, 2017, there was approximately $4.1 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 three years.
Note 5 - Securities Available for Sale
Amortized costs and fair values of securities available for sale are summarized as follows:
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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 March 31, 2017 and December 31, 2016.
At March 31, 2017, the Company had $4.8 million of gross unrealized losses related to 499 securities. As of March 31, 2017, the Company does not consider securities with unrealized losses to be other-than-temporarily impaired, as the unrealized losses in each category have occurred as a result of changes in interest rates, market spreads and market conditions subsequent to purchase. 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-month periods ending March 31, 2017 or 2016.
The amortized cost and fair values of securities available for sale at March 31, 2017 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.
There were no sales of securities during the first three months of 2017 or 2016.
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Note 6 – Loans, Allowance for Loan Losses, and Credit Quality
The loan composition as of March 31, 2017 and December 31, 2016 is summarized as follows.
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Note 6 – Loans, Allowance for Loan Losses, and Credit Quality, continued
Practically all of the Company’s loans, commitments, financial letters of credit 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.
The following tables present the balance and activity in the ALLL by portfolio segment and the recorded investment in loans by portfolio at or for the three months ended March 31, 2017:
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The following table presents the balance and activity in the ALLL by portfolio segment and the recorded investment in loans by portfolio at or for the three months ended March 31, 2016.
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The following table presents nonaccrual loans by portfolio segment in total and then as a further breakdown by originated or acquired as of March 31, 2017 and December 31, 2016.
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The following tables present total past due loans by portfolio segment as of March 31, 2017 and December 31, 2016:
30-89 Days Past Due (accruing)
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.
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9 Loss: Assets in this category are considered uncollectible. Pursuing any recovery or salvage value is impractical but does not preclude partial recovery in the future.
The following tables present total loans by loan grade as of March 31, 2017 and December 31, 2016:
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 over $250,000, plus additional loans with impairment risk characteristics. 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.
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The following tables present impaired loans as of March 31, 2017 and December 31, 2016.
There were no originated impaired loans as of March 31, 2017. All loans in the table above were acquired loans.
There were no originated impaired loans as of December 31, 2016. All loans in the table above were acquired loans.
As a further breakdown, impaired loans are also summarized by originated and acquired for the periods presented. In April 2016, the Baylake merger added purchased credit impaired loans at a fair value of $20.8 million, net of an initial $13.9 million non-accretable mark. Including these credit impaired loans acquired in the Baylake merger, total purchased credit impaired loans acquired in aggregate were initially recorded at a fair value of $37.5 million on their respective acquisition dates, net of an initial $26.1 million non-accretable mark and a zero accretable mark. At March 31, 2017, $12.3 million of the $37.5 million remain in impaired loans and $0.4 million of acquired loans have subsequently become impaired, bringing acquired impaired loans to $12.7 million.
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Troubled Debt Restructurings
At March 31, 2017, there were four loans classified as troubled debt restructurings totaling $796,000. These four loans had a combined pre-modification balance of $1,280,000 and a combined outstanding balance of $796,000 at March 31, 2017. There were no other loans which were modified and classified as troubled debt restructurings at March 31, 2017. There were no loans classified as troubled debt restructurings during the previous twelve months that subsequently defaulted as of March 31, 2017. As of March 31, 2017 there were no commitments to lend additional funds to debtors whose terms have been modified in troubled debt restructurings.
Note 7 – Goodwill and Intangible Assets and Mortgage Servicing Rights
The excess of the purchase price in an acquisition over the fair value of net assets acquired consists primarily of goodwill, core deposit intangibles and other identifiable intangibles (primarily related to customer relationships acquired). Management periodically reviews the carrying value of its long-lived and intangible assets to determine if any impairment has occurred, in which case an impairment charge would be recorded as an expense in the period of impairment, or whether changes in circumstances have occurred that would require a revision to the remaining useful life which would impact expense prospectively. In making such determination, management evaluates whether there are any adverse qualitative factors indicating that an impairment may exist, as well as the performance, on an undiscounted basis, of the underlying operations or assets which give rise to the intangible. The Company’s quarterly assessment indicated no impairment charge on goodwill, core deposit intangible or customer list intangible was required for 2016 or the first three months of 2017.
Goodwill: Goodwill was $66.7 million at March 31, 2017 and December 31, 2016. There were additions to the carrying amount of goodwill in 2016 of $0.4 million related to the acquisition of financial advisor business and of approximately $65.5 million related to the Baylake merger. See Note 2 for additional information on the 2016 acquisitions.
Other intangible assets: Other intangible assets, consisting of core deposit intangibles and other intangibles (related to the customer relationships acquired in connection with the 2016 acquisition of financial advisor business), are amortized over their estimated finite lives. Due to the 2016 acquisitions, there was an addition to the core deposit intangibles and to customer list intangibles. See Note 2 for additional information on the 2016 acquisitions.
Mortgage servicing rights: Mortgage servicing rights are amortized in proportion to and over the period of estimated net servicing income, and assessed for impairment at each reporting date, with the amortization recorded in mortgage income, net, in the consolidated income statements. Mortgage servicing rights are carried at the lower of the initial capitalized amount, net of accumulated amortization, or estimated fair value, and are included in other assets in the consolidated balance sheets. Activity in the mortgage servicing rights asset for 2016 and the three months ended March 31, 2017 was as follows:
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Note 7 – Goodwill and Intangible Assets and Mortgage Servicing Rights, continued
The Company periodically evaluates its mortgage servicing rights asset for impairment. At each reporting date, impairment is assessed based on an estimated fair value using estimated prepayment speeds of the underlying mortgage loans serviced and stratifications based on the risk characteristics of the underlying loans serviced (predominantly loan type and note interest rate). No valuation or impairment charge was recorded for the 2016 or 2017 periods.
The following table shows the estimated future amortization expense for amortizing intangible assets. The projections are based on existing asset balances, the current interest rate environment and prepayment speeds as of the March 31, 2017. The actual amortization expense the Company recognizes in any given period may be significantly different depending upon acquisition or sale activities, changes in interest rates, prepayment speeds, market conditions, regulatory requirements and events or circumstances that indicate the carrying amount of an asset may not be recoverable.
Note 8 - Notes Payable
The Company had the following long-term notes payable:
The Company’s FHLB advance is at a fixed rate, requires interest-only monthly payments, and has a maturity of February 2018. The weighted average rates of FHLB advances were 1.17% at both March 31, 2017 and December 31, 2016. 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 $284.7 million and $283.8 million at March 31, 2017 and December 31, 2016, respectively.
The following table shows the maturity schedule of the notes payable as of March 31, 2017:
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Note 8 - Notes Payable, continued
The Company has a $10 million line of credit with a third party bank bearing a variable rate of interest based on one-month LIBOR plus a margin, but subject to a floor rate, with quarterly payments of interest only. At March 31, 2017, the available line was $10 million, the rate was one-month LIBOR plus 2.25% with a 3.25% floor. The outstanding balance was zero at March 31, 2017 and December 31, 2016, and the line was not used in 2017 or 2016.
Note 9 - Junior Subordinated Debentures
At March 31, 2017 and December 31, 2016, the Company’s carrying value of junior subordinated debentures was $24.8 million and $24.7 million, respectively. At March 31, 2017 and December 31, 2016, $23.8 million and $23.7 million, respectively, of trust preferred securities qualify as Tier 1 capital.
In July 2004, Nicolet Bankshares Statutory Trust I (the “Nicolet Trust”) issued $6.0 million of guaranteed preferred beneficial interests (“trust preferred securities”) in the Company’s junior subordinated deferrable interest debentures that qualify as Tier 1 capital under Federal Reserve Board guidelines. All of the common securities of the Nicolet Trust are owned by the Company. The proceeds from the common securities and trust preferred securities were used by the Nicolet Trust to purchase $6.2 million of junior subordinated debentures (the “debentures”) of the Company. The trust preferred securities and debentures pay an 8% fixed rate. The proceeds received by the Company from the sale of the debentures were used for general purposes, primarily to provide capital to the Bank. The Company has the right to redeem the debentures, in whole or in part, on or after July 15, 2009. If the debentures are redeemed prior to maturity, the redemption price will be the principal amount and any accrued but unpaid interest. The maturity date of the debentures, if not redeemed, is July 15, 2034. Interest on the debentures is current.
In April 2013, as part of the Mid-Wisconsin Financial Services, Inc. (“Mid-Wisconsin”) acquisition, the Company assumed $10.3 million of junior subordinated debentures issued in December 2005 by Mid-Wisconsin, related to $10.0 million of trust preferred securities issued by a statutory trust, whose common securities were wholly owned by Mid-Wisconsin. These trust preferred securities and 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 interest rates were 2.56% and 2.39% as of March 31, 2017 and December 31, 2016, respectively. The debentures may be called at par plus any accrued but unpaid interest, in part or in full, on or after December 15, 2010. At acquisition the debentures were recorded at an initial fair market value of $5.8 million, with the initial $4.5 million discount being accreted to interest expense over the remaining life of the debentures. At March 31, 2017, the carrying value of these junior debentures was $6.6 million.
As part of the 2016 acquisition of Baylake, the Company assumed $16.6 million of junior subordinated debentures related to $16.1 million of issued trust preferred securities. The trust preferred securities and the debentures mature on September 30, 2036 and have a floating rate of three-month LIBOR plus 1.35% adjusted quarterly. Interest on these debentures is current. The interest rates were 2.50% and 2.35% as of March 31, 2017 and December 31, 2016, respectively. The debentures may be redeemed on any interest payment date at par in part or in full, on or after June 30, 2011. At acquisition in April 2016 the debentures were recorded at fair value of $11.8 million, with the discount being accreted to interest expense over the remaining life of the debentures. At March 31, 2017, the carrying value of these junior debentures was $12.1 million.
The debentures represent the sole asset of the respective statutory trusts. The statutory trusts are not included in the consolidated financial statements. The net effect of all the documents entered into with respect to the trust preferred securities is that the Company, through payment on its debentures, is liable for the distributions and other payments required on the trust preferred securities.
Note 10 – Subordinated Notes
In 2015, the Company placed an aggregate of $12 million in subordinated Notes in private placements with certain accredited investors. All Notes were issued with 10-year maturities, have a fixed annual interest rate of 5% payable quarterly, are callable on or after the fifth anniversary of their respective issuances dates, and qualify for Tier 2 capital for regulatory purposes. At March 31, 2017, the carrying value of these subordinated Notes was $11.9 million.
The $180,000 debt issuance costs associated with the $12 million Notes are being amortized on a straight line basis over the first five years, representing the no-call periods, as additional interest expense. As of March 31, 2017 and December 31, 2016, $106,000 and $115,000, respectively, of unamortized debt issuance costs remain and are reflected as a deduction to the carrying value of the outstanding debt.
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Note 11 - Fair Value Measurements
As provided for by accounting standards, the Company records and/or discloses financial instruments on a fair value basis. These financial assets and financial liabilities are measured at fair value in three levels, based on the markets in which the assets and liabilities are traded and the observability of the assumptions used to determine fair value. These levels are: Level 1 - 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 other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly; Level 3 – significant 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.
Disclosure of the fair value of financial instruments, whether recognized or not recognized in the balance sheet, is required for those instruments for which it is practicable to estimate that value, with the exception of certain financial instruments and all nonfinancial instruments as provided for by the accounting standards. For financial instruments recognized at fair value in the consolidated balance sheets, the fair value disclosure requirements also apply.
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 following table presents the balances of assets and liabilities measured at fair value on a recurring basis for the periods presented. Two securities classified as Level 3 had a change in fair value during the first quarter of 2017. There were no other changes in Level 3 values to report during the first three months of 2017.
The following is a description of the valuation methodologies used by the Company for the Securities AFS noted in the tables of this footnote. Where quoted market prices on securities exchanges are available, the investment is classified as Level 1. 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 prices obtained from independent pricing vendors who use pricing models (with typical inputs including benchmark yields, reported trades for similar securities, issuer spreads or relationship to other benchmark quoted securities), or discounted cash flows, and are classified as Level 2. Examples of these investments include mortgage-related securities and obligations of state, county and municipals. 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 corporate debt securities, which include trust preferred security investments. At March 31, 2017 and December 31, 2016, 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 and the internal analysis on the corporate debt securities.
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Note 11 - Fair Value Measurements, continued
The following table presents the Company’s impaired loans and other real estate owned (“OREO”) measured at fair value on a nonrecurring basis for the periods presented.
Measured at Fair Value on a Nonrecurring Basis
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 present value of expected future cash flows discounted at the loan’s effective interest rate, the estimated fair value of the underlying collateral for collateral-dependent loans, or the estimated liquidity of the note. For OREO, the fair value is based upon the estimated fair value of the underlying collateral adjusted for the expected costs to sell.
The carrying amounts and estimated fair values of the Company’s financial instruments at March 31, 2017 and December 31, 2016 are shown below.
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Not all the financial instruments listed in the table above are subject to the disclosure provisions of Accounting Standards Codification (“ASC”) 820, as certain assets and liabilities result in their carrying value approximating fair value. These include cash and cash equivalents, other investments, bank owned life insurance, short-term borrowings, and nonmaturing deposits. For those financial instruments not previously disclosed the following is a description of the evaluation methodologies used.
Certificates of deposits in other banks:Fair values are estimated using discounted cash flow analysis based on current interest rates being offered by instruments with similar terms and represents a Level 2 measurement.
Other investments: The carrying amount of Federal Reserve Bank, Bankers Bank, Farmer Mac, and FHLB stock is a reasonably accepted fair value estimate given their restricted nature. Fair value is the redeemable (carrying) value based on the redemption provisions of the instruments which is considered a Level 2 measurement. The carrying amount of the remaining other investments (particularly common stocks of companies or other banks that are not publicly traded) approximates their fair value, determined primarily by analysis of company financial statements and recent capital issuances of the respective companies or banks, if any, and represents a Level 3 measurement.
Loans held for sale: The fair value estimation process for the loans held for sale portfolio is segregated by loan type. The estimated fair value was based on what secondary markets are currently offering for portfolios with similar characteristics and represents a Level 2 measurement.
Loans, net: For variable-rate loans that reprice frequently and with no significant change in credit risk or other optionality, fair values are based on carrying values. Fair values for all other loans are estimated by discounting contractual cash flows using estimated market discount rates, which reflect the credit and interest rate risk inherent in the loan. Collateral-dependent impaired loans are included in loans, net. The fair value of loans is considered to be a Level 3 measurement due to internally developed discounted cash flow measurements.
MSR asset: To estimate the fair value of the MSR asset, the underlying serviced loan pools are stratified by interest rate tranche and term of the loan, and a valuation model is used to calculate the present value of expected future cash flows for each stratum. When the carrying value of the MSR asset related to a stratum exceeds its fair value, the stratum is recorded at fair value, generally through a valuation allowance. The valuation model incorporates assumptions that market participants would use in estimating future net servicing income, such as costs to service, a discount rate, ancillary income, default rates and losses, and prepayment speeds. Although some of these assumptions are based on observable market data, other assumptions are based on unobservable estimates of what market participants would use to measure fair value. As a result, the fair value measurement of mortgage servicing rights is considered a Level 3 measurement and represents an income approach to fair value.
Deposits: The fair value of deposits with no stated maturity (such as demand deposits, savings, interest and non-interest checking, and money market accounts) is, by definition, equal to the amount payable on demand at the reporting date. Fair values for fixed-rate certificates of deposit are estimated using a discounted cash flow calculation that applies interest rates currently being offered in the market place on certificates of similar remaining maturities. Use of internal discounted cash flows provides a Level 3 fair value measurement.
Notes payable: The fair value of the Federal Home Loan Bank advances is obtained from the Federal Home Loan Bank which uses a discounted cash flow analysis based on current market rates of similar maturity debt securities and represents a Level 2 measurement. The fair values of remaining 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 and subordinated notes: The fair values of these debt instruments utilize a discounted cash flow analysis based on an estimate of current interest rates being offered by instruments with similar terms and credit quality. Since the market for these instruments is limited, the internal evaluation represents a Level 3 measurement.
Off-balance-sheet instruments: The estimated fair value of letters of credit at March 31, 2017 and December 31, 2016 was insignificant. Loan commitments on which the committed interest rate is less than the current market rate are also insignificant at March 31, 2017 and December 31, 2016.
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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 12 – Pending Merger Transaction
On November 4, 2016 Nicolet announced the signing of a definitive merger agreement (“First Menasha Merger Agreement”) with First Menasha Bancshares, Inc. (“First Menasha”) under which First Menasha will merge with and into Nicolet to create the largest community bank in the Fox Valley area of Wisconsin. Based upon the financial results as of March 31, 2017, the combined company would have total assets of approximately $2.7 billion, deposits of $2.3 billion and loans of $2.0 billion. The merger transaction is expected to close on April 28, 2017 and is subject to customary closing conditions, including approval by shareholders of First Menasha and regulatory approvals. Since the merger transaction is expected to close on April 28, 2017, the Company is not able to make the disclosures required by purchase accounting standards as management has not yet completed the initial accounting for this business combination.
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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Nicolet Bankshares, Inc. is a bank holding company headquartered in Green Bay, Wisconsin, providing a diversified range of traditional commercial and retail banking services, as well as wealth management services, to individuals, business owners, and businesses in its market area primarily through, as of March 31, 2017, the 34 bank branch offices of its banking subsidiary, Nicolet National Bank (the “Bank”), located within 10 Wisconsin counties (Brown, Door, Outagamie, Kewaunee, Marinette, Taylor, Clark, Marathon, Oneida, and Vilas) and in Menominee, Michigan.
Overview
At March 31, 2017, Nicolet Bankshares, Inc. and its subsidiaries (“Nicolet” or the “Company”) had total assets of $2.3 billion, loans of $1.6 billion, deposits of $1.9 billion and total stockholders’ equity of $285 million, compared to $2.3 billion, $1.6 billion, $2.0 billion, and $276 million, respectively, as of December 31, 2016. Nicolet completed two transactions in the first half of 2016 (the “2016 acquisitions”), which are detailed in Note 2, “Acquisitions” of the notes to unaudited consolidated financial statements. On April 29, 2016, Nicolet completed its transformative stock-for-stock merger with Baylake Corp. (“Baylake”), which added a dominant position in Door County, Wisconsin, based on deposit market share. At the time of the Baylake merger and based on estimated fair values, assets of $1.0 billion, loans of $0.7 billion, deposits of $0.8 billion, core deposit intangible of $17 million and goodwill of $66 million were added to the consolidated balance sheet, for a total purchase price of approximately $164 million, including the issuance of 4.3 million shares of Nicolet common stock and assumption of outstanding Baylake equity awards. On a smaller scale, Nicolet completed on April 1, 2016 its private transaction to hire a select group of financial advisors and to purchase their respective books of business and operating platform, to enhance the leadership and future growth of Nicolet’s wealth management business. In this transaction, Nicolet paid total initial consideration of $4.9 million (including $2.6 million in common stock), accrued an earn-out liability of $1.5 million, recorded $0.4 million of goodwill, $0.2 million of fixed assets and $4.3 million of customer relationship intangibles. Nicolet remains focused on optimizing revenue and cost efficiencies from its acquired scale.
Consistent with Nicolet’s stated interest in strategic growth, Nicolet is nearing the consummation and integration of its previously announced acquisition. Nicolet and First Menasha Bancshares, Inc. (“First Menasha”) announced and signed a definitive merger agreement in November 2016 (the “First Menasha Merger Agreement”), under which First Menasha will merge with and into Nicolet to create the largest community bank in the Fox Valley area of Wisconsin. First Menasha shareholders will receive, at the election of each holder, cash of $131.50 per share of First Menasha common stock or 3.411 shares of Nicolet common stock for each share of First Menasha common stock (the “Exchange Ratio”), subject to proration procedures such that no less than 146,800 shares and no more than 234,900 shares of First Menasha common stock is exchanged for cash. Further, the First Menasha Merger Agreement provides that the Exchange Ratio is fixed at 3.411 unless the Nicolet Common Stock Price is (a) greater than $43.55, to which the Exchange Ratio would become floating at the quotient of $148.55 divided by the Nicolet Common Stock Price, or (b) less than $33.55, to which the Exchange Ratio would become floating at the quotient of $114.44 divided by the Nicolet Common Stock Price. Based upon Nicolet’s Common Stock Price of $47.52 as defined in the First Menasha Merger Agreement and measured as of April 25, 2017, the Exchange Ratio is expected to be 3.126. The acquisition has received all regulatory and shareholder approvals, and is on target for an April 28, 2017 consummation. The merger is expected to improve profitability through efficiency, leverage the strengths of each bank across the combined customer base, and add liquidity and shareholder value. Based upon the financial position as of March 31, 2017, the combined company would have total assets of $2.7 billion, deposits of $2.3 billion and loans of $2.0 billion, and an expanded geography. Appropriately, other than direct merger and integration costs being expensed as incurred, the First Menasha transaction is not included in Nicolet’s financial position or financial results as of March 31, 2017.
Nicolet’s profitability is significantly dependent upon net interest income (interest income earned on loans and other interest-earning assets such as investments, net of interest expense on deposits and other borrowed funds), and noninterest income sources (including but not limited to service charges on deposits, trust and brokerage fees, mortgage income from sales of residential mortgages into the secondary market, and other fees or revenue from financial services provided to customers or ancillary to loans and deposits), offset by the level of the provision for loan losses, noninterest expenses (largely employee compensation and overhead expenses tied to processing and operating the Bank’s business), and income taxes. 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.
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Forward-Looking Statements
Statements made in this document and in any documents that are incorporated by reference which are not purely historical are forward-looking statements, as defined in the Private Securities Litigation Reform Act of 1995, including any statements regarding descriptions of management’s plans, objectives, or goals for future operations, products or services, and forecasts of its revenues, earnings, or other measures of performance. Forward-looking statements are based on current management expectations and, by their nature, are subject to risks and uncertainties. These statements generally may be identified by the use of words such as “believe,” “expect,” “anticipate,” “plan,” “estimate,” “should,” “will,” “intend,” or similar expressions. Shareholders should note that many factors, some of which are discussed elsewhere in this document, could affect the future financial results of Nicolet and could cause those results to differ materially from those expressed in forward-looking statements contained in this document. These factors, many of which are beyond Nicolet’s control, include, but are not necessarily limited to the following:
These factors should be considered in evaluating the forward-looking statements, and you should not place undue reliance on such statements. Nicolet specifically disclaims any obligation to update factors or to publicly announce the results of revisions to any of the forward-looking statements or comments included herein to reflect future events or developments.
Branch Closures
In March 2017, Nicolet closed two branches, one in close proximity to another Nicolet branch and one that was an outlier branch. Since Nicolet implemented its plan in 2015 to eliminate costs associated with branches in overlapping or outlier geographies from its recent acquisitions, Nicolet’s branch count has declined by 12 locations, with two sold, two closed concurrent with the Baylake transaction, and eight additional branches closed through March 31, 2017. As a result, Nicolet operates 34 branches in Northeast and Central Wisconsin and the upper peninsula of Michigan, as of March 31, 2017.
Critical Accounting Policies
The consolidated financial statements of Nicolet 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 consolidated financial statements; accordingly, as this information changes, actual results could differ from the estimates, assumptions and judgments reflected in the consolidated 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 business combinations, as well as the determination of the allowance for loan losses and income taxes and, therefore, are critical accounting policies.
Valuation of Loans Acquired in Business Combinations
Acquisitions accounted for under FASB Accounting Standards Codification (“ASC”) Topic 805, Business Combinations, require 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. 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 the accretable and non-accretable differences, which would have a positive impact on interest income.
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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 (“ALLL”)
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 at March 31, 2017. 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 quarterly 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.
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Management’s Discussion and Analysis
The following discussion is Nicolet management’s analysis of the consolidated financial condition as of March 31, 2017 and December 31, 2016 and results of operations for the three-month periods ended March 31, 2017 and 2016. It should be read in conjunction with Nicolet’s audited consolidated financial statements as of December 31, 2016 and 2015, and for the three years ended December 31, 2016, included in Nicolet’s Annual Report on Form 10-K for the year ended December 31, 2016.
Evaluation of financial performance and average balances between 2017 and 2016 was impacted in general from the timing of the two 2016 acquisitions. Since the balances and results of operations of the acquired entities are appropriately not included in the accompanying consolidated financial statements until their consummation dates, income statement results and average balances for 2017 included full contributions from the 2016 acquisitions versus no or partial contributions in 2016 periods until the respective consummation dates. The inclusion of the Baylake balance sheet (at about 83% of Nicolet’s pre-merger asset size) and operational results for approximately eight months in 2016 analytically explains most of the increase in certain average balances and income statement line items between 2017 and 2016, while the financial advisory business acquisition primarily impacts the brokerage fee income, personnel expense and certain other expense line items. In addition, the 2016 acquisitions and the pending First Menasha transaction impacted pre-tax net income by inclusion of non-recurring direct merger expenses of approximately $1.3 million in 2016 ($0.4 million, $0.4 million, $0.1 million and $0.4 million in first through fourth quarters, respectively) and $0.2 million in the first quarter of 2017, along with a $1.7 million lease termination charge in second quarter 2016 related to a Nicolet branch closed concurrent with the Baylake merger.
Nicolet’s current focus is on the consummation and integration of its pending First Menasha acquisition, gaining efficiencies from increased scale, and organic growth in our expanded markets and in brokerage services. The First Menasha transaction is a cash and stock transaction, subject to proration procedures and other terms and limitations as outlined in the First Menasha Merger Agreement. It is on target for an April 28, 2017 consummation and has received all necessary approvals by regulators and by First Menasha shareholders. Based upon the financial results as of March 31, 2017, the combined company would have approximately $2.7 billion in assets, $2.0 billion in loans and $2.3 billion in deposits, prior to any purchase accounting fair value marks. Appropriately, the transaction will not be included in Nicolet’s financial position or financial results until its consummation date in 2017. Nicolet plans on closing one existing branch concurrent upon consummation of the First Menasha transaction (which will bring in five new branch locations).
Performance Summary
Nicolet reported net income of $6.2 million for the three months ended March 31, 2017, a 134% increase over $2.7 million for the first three months of 2016. Net income available to common shareholders was $6.2 million, or $0.69 per diluted common share for the first quarter of 2017. Comparatively, after $112,000 of preferred stock dividends, net income available to common shareholders was $2.5 million, or $0.57 per diluted common share for the first quarter of 2016. Beginning March 1, 2016, the annual dividend rate on preferred stock moved from 1% to 9% in accordance with the contractual terms. Nicolet redeemed its outstanding preferred stock in full in September 2016, explaining the difference in preferred stock dividends between the first quarter periods.
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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.
Net interest income in the consolidated statements of income (which excludes any taxable equivalent adjustment) was $21.3 million in the first three months of 2017, 99% higher than $10.7 million in the first three months of 2016. 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 $0.6 million for the first three months of 2017 and $0.3 million for the first three months of 2016, resulting in taxable equivalent net interest income of $21.9 million and $11.0 million, respectively.
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 3 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.
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Table 1: Quarterly Net Interest Income Analysis
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Table 2: Quarterly Volume/Rate Variance
Comparison of the three months ended March 31, 2017 versus the three months ended March 31, 2016 follows:
Table 3: Interest Rate Spread, Margin and Average Balance Mix
Taxable-equivalent net interest income was $21.9 million and $11.0 million for the first three months of 2017 and 2016, respectively, up $10.9 million or 99%, with $9.9 million from favorable volume and mix variances (due to the addition of Baylake net interest earning assets, as well as organic growth), and $1.0 million from favorable rate variances (from both a lower cost of funds and higher earning asset yield) between the periods. Taxable equivalent interest income on earning assets increased $11.0 million or 86% between the three-month periods, with $9.6 million more interest from loans ($9.4 million from greater volume and $0.2 million from rates (with $2.1 million in higher aggregate discount accretion income more than offsetting lower underlying loan yields mainly from the acquired Baylake portfolio)), $1.2 million more interest from total investments (mostly volume-based), and $0.2 million more interest from other earning assets. Interest expense increased $0.1 million, led by $0.7 million higher interest on interest-bearing liabilities due to volume variances (mostly acquired deposits), partially offset by $0.6 million of favorable rate variances due to lower cost funding (largely from inclusion of Baylake deposits carrying a lower overall cost).
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The taxable-equivalent net interest margin was 4.32% for the first three months of 2017, up 45 bps versus the first three months of 2016. The interest rate spread increased 50 bps between the first quarter periods, with a favorable increase in the earning asset yield (up 20 bps to 4.67% for first quarter 2017), and an improvement in the cost of funds (down 30 bps to 0.47% for first quarter 2017). The contribution from net free funds decreased by 5 bps, mostly due to lower costs on the funding side of the balance sheet. Since January 1, 2016, the Federal Reserve raised short-term interest rates by 50 bps to 75 bps as of March 31, 2017 (up 25 bps in December 2016 and up 25 bps in March 2017). These increases have impacted the rate earned on cash and the cost of short-term borrowings, but have not significantly influenced rates further out on the yield curve; and thus, have only marginally impacted new investment yields or new loan pricing. Additionally, while both 2017 and 2016 periods are experiencing favorable income from discount accretion on acquired loans, particularly where such loans pay or resolve at better than their carrying values, such favorable interest flow can be sporadic and will diminish over time.
The earning asset yield was influenced largely by the mix of underlying earning assets, particularly carrying a higher proportion of loans and investments (each at higher yields in the 2017 period than the 2016 period) and a lower proportion of low-earning cash. Loans, investments and other interest earning assets (mostly low-earning cash) represented 79%, 18% and 3% of average earning assets, respectively, for the first three months of 2017, and 79%, 14%, and 7%, respectively, for the comparable 2016 quarter. Loans yielded 5.30% and 5.19%, respectively, for the first three months of 2017 and 2016, while non-loan earning assets combined yielded 2.32% and 1.84%, respectively, for the first quarter periods. The 11 bps increase in loan yield between the three-month periods was largely due to the higher aggregate discount accretion on acquired loans between periods, partially offset by continued pricing pressure on new and renewing loans.
Average interest-earning assets were $2.0 billion for the first three months of 2017, $0.9 billion, or 80% higher than the first three months of 2016. The change consisted of an increase in average loans (up 81% to $1.6 billion), a $203 million increase in investment securities (up 123% to $368 million) and a $17 million decrease in other interest-earning assets, predominantly low earning cash.
Nicolet’s cost of funds decreased 30 bps to 0.47% for the first three months of 2017 compared to a year ago. The average cost of interest-bearing deposits (which represent 97% and 95% of average interest-bearing liabilities for the three months ended March 31, 2017 and 2016, respectively), was 0.33% for the first three months of 2017, down 22 bps from the first three months of 2016, largely attributable to inclusion of Baylake deposits carrying a lower overall cost.
Average interest-bearing liabilities were $1.5 billion for the first three months of 2017, up $647 million or 73% from the comparable period in 2016, predominantly attributable to acquired balances. Interest-bearing deposits represented 97% and 95% of average interest-bearing liabilities for the first three months of 2017 and 2016, respectively, while the mix of average interest-bearing deposits moved from higher costing core CDs to lower costing transaction accounts, improving the overall deposit cost between the three-month periods.
Provision for Loan Losses
The provision for loan losses for both the three months ended March 31, 2017 and 2016 was $0.4 million, exceeding net charge-offs of $0.1 million and $0.2 million in the three-month periods ending March 31, 2017 and 2016, respectively. Asset quality trends remained strong with continued resolutions of problem loans. The ALLL was $12.2 million (0.75% of loans) at March 31, 2017, compared to $11.8 million (0.75% of loans) at December 31, 2016 and $10.5 million (1.18% of loans) at March 31, 2016. The decline in this ratio from March 31, 2016 is primarily due to recording the Baylake loan portfolio at fair value with no carryover of its allowance at the time of the merger.
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,” “— Allowance for Loan and Lease Losses,” and “— Impaired Loans and Nonperforming Assets.
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Noninterest Income
Table 4: Noninterest Income
Noninterest income was $6.8 million for the first three months of 2017, compared to $3.9 million for the first three months of 2016, aided largely by the 2016 acquisitions.
The 2017 activity in net loss on sale or write-down of assets consisted of a $0.4 million gain on the sale of a former bank branch, offset by $0.4 million of net losses and write-downs on assets and OREO properties, predominantly the fair market value loss on two closed bank branches transferred to OREO. The 2016 activity was not significant individually or in the aggregate.
Service charges on deposit accounts were $1.0 million for the first three months of 2017, up $0.4 million or 70.0% over the first three months of 2016, resulting from an increased number of accounts mostly from the Baylake acquisition.
Mortgage income represents net gains received from the sale of residential real estate loans service-released and service-retained into the secondary market, capitalized mortgage servicing rights (“MSRs”), servicing fees, offsetting MSR amortization, valuation changes, if any, and to a smaller degree some related income. Net mortgage income increased $0.3 million or 47.5% between the comparable first quarter periods due to greater secondary mortgage production and sales aided by a broader geographic footprint and increased net servicing fees on the growing portfolio of mortgage loans serviced for others.
Trust service fees were up $0.3 million or 26.2% between the first quarter periods due to service fees on additional assets under management. Between the first quarter periods, brokerage fees were up significantly, up $1.0 million or 306.1%, attributable to the new wealth business acquired in the 2016 acquisition of financial advisory personnel and their books of business.
BOLI income was up $0.2 million or 60.4% for the first three months of 2017 when compared to 2016 due to additional insurance purchases in 2016. Other noninterest income was $1.4 million, up $0.7 million or 115.7% over the first quarter of 2016, mostly attributable to an increase in debit and credit card interchange fees, up $0.5 million or 114.4% on higher volume and activity, and income from equity in UFS, a data processing company acquired in the Baylake merger, up $0.1 million.
Noninterest Expense
Table 5: Noninterest Expense
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Total noninterest expense was $18.3 million for the first three months of 2017 (including approximately $0.2 million attributable to non-recurring, merger-based expenses such as legal and conversion processing costs related to the in-process merger), compared to $10.0 million for the comparable period in 2016 (including $0.4 million merger-related expenses). The $8.3 million, or 82.9%, increase between the first quarter periods was primarily attributable to the larger operating base as a result of the 2016 acquisitions. All expense categories showed significant increases from the same period in 2016, though fairly controlled considering the size of Baylake added in April 2016 (at about 83% of Nicolet’s pre-merger asset size) and the expansion of the wealth business platform since early 2016.
Personnel expense was $9.9 million for the first three months of 2017, up $4.6 million or 85.7% compared to the first three months of 2016, largely due to the expanded workforce resulting from the 2016 acquisitions, as well as from merit increases between the periods, incentives timing, and higher health and other benefits costs. Full time equivalent employees were 486 at March 31, 2017 compared to 281 at March 31, 2016, a 73% increase.
Occupancy, equipment and office expense was $2.8 million for the first three months of 2017, up $1.0 million or 57.5% compared to 2016, primarily the result of the larger operating base.
Business development and marketing expense increased $0.4 million, or 60.7%, between the comparable three-month periods, largely due to the expanded operating base influencing additional marketing, promotions and media.
Data processing expenses, which are primarily volume-based, rose $0.8 million or 71.5% between the first quarter periods attributable to the Baylake acquisition. Intangible amortization increased due to the addition of core deposit intangible related to the Baylake acquisition and of customer list intangible acquired as part of the 2016 financial advisor business acquisition. Other noninterest expense increased $0.5 million or 67.8% between the first quarter periods, of which $0.2 million in 2017 was associated with the in-process implementation of a customer relationship system that began in the fourth quarter of 2016.
For the three-month periods ending March 31, 2017 and 2016, income tax expense was $3.0 million and $1.4 million, respectively. Included in the first quarter of 2017 is a tax benefit of $0.1 million related to the exercise of stock options and restricted stock vesting in accordance with ASU 2016-09. U.S. 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 March 31, 2017 or December 31, 2016.
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 on 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 run their daily operations and position their businesses for the future.
Nicolet’s primary lending function is to make 1) commercial loans, consisting of commercial, industrial and business loans and lines of credit, owner-occupied commercial real estate (“owner-occupied CRE”) loans and agricultural (“AG”) production loans; 2) non-owner occupied commercial real estate loans (“CRE investment”), consisting of commercial real estate investment loans, AG real estate, and construction and land development loans; 3) 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 4) retail and other loans . Using these four broad groups the mix of loans at March 31, 2017 was 54% commercial, 19% CRE investment loans, 26% residential real estate, and 1% retail and other loans.
Total loans were $1.61 billion at March 31, 2017 compared to $1.56 billion at December 31, 2016 an increase of $49 million or 3%. Compared to March 31, 2016, loans grew $730 million or 82%. On average, loans were $1.6 billion and $885 million for the first three months of 2017 and 2016, respectively, up 81%.
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Table 6: Period End Loan Composition
Broadly, commercial-based loans (i.e. commercial, AG, owner-occupied CRE, CRE investment and construction loans combined) versus retail-based loans (i.e. residential real estate and other retail loans) were unchanged at approximately 73% commercial-based and 27% retail-based at March 31, 2017 and December 31, 2016. Commercial-based loans are considered to have more inherent risk of default than retail-based loans, in part because of the broader list of factors that could impact a commercial borrower negatively as well as the commercial balance per borrower is typically larger than that for retail-based loans, implying higher potential losses on an individual customer basis.
Commercial and industrial loans consist primarily of commercial loans to small businesses within a diverse range of industries and, to a lesser degree, to municipalities. The credit risk related to commercial and industrial loans is largely influenced by general economic conditions and the resulting impact on a borrower’s operations, or on the value of underlying collateral, if any. Commercial and industrial loans increased $40 million since year end 2016. Commercial and industrial loans continue to be the largest segment of Nicolet’s portfolio and increased to 29.0% of the total portfolio at March 31, 2017, up from 27.3% at December 31, 2016.
Owner-occupied CRE loans decreased to 22.8% of loans at March 31, 2017 from 23.0% at December 31, 2016 and primarily consist of loans within a diverse range of industries secured by business real estate that is occupied by borrowers (i.e. who operate their businesses out of the underlying collateral) and who may also have commercial and industrial loans. The credit risk related to owner-occupied CRE loans is largely influenced by general economic conditions and the resulting impact on a borrower’s operations, as well as on the value of underlying collateral.
Agricultural production and agricultural real estate loans consist of loans secured by farmland and related farming operations. The credit risk related to agricultural loans is largely influenced by the prices farmers can get for their production and/or the underlying value of the farmland. In total, agricultural loans increased $3.5 million since year end 2016, representing 5.2% of total loans at March 31, 2017, versus 5.1% at December 31, 2016.
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. Lending in this segment has been focused on loans that are secured by commercial income-producing properties as opposed to speculative real estate development. The balance of these loans decreased $4.6 million since year end 2016, decreasing as a percent of loans from 12.5% to 11.8% at March 31, 2017.
Loans in the construction and land development portfolio represent 4.7% of total loans at March 31, 2017 and such loans provide financing for the development of commercial income properties, multi-family residential development, and land designated for future development. Nicolet controls the credit risk on these types of loans 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. Credit risk 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. Lending on originated loans in this category has remained steady as a percent of loans. Since December 31, 2016, balances have increased $1.0 million and have decreased slightly as a percent of loans.
On a combined basis, Nicolet’s residential real estate loans represent 25.6% of total loans at March 31, 2017 and 26.4% at year-end 2016, while balances increased slightly, up $0.7 million from December 31, 2016. Residential first mortgage loans include conventional first-lien home mortgages. Residential junior mortgage real estate loans consist mainly of home equity lines and term loans secured by junior mortgage liens. Across the industry, home equities generally involve loans that are in second or junior lien positions, but Nicolet has secured many such loans in a first lien position, further mitigating the portfolio risks. Nicolet has not experienced significant losses in its residential real estate loans; however, if market values in the residential real estate markets decline, particularly in Nicolet’s market area, rising loan-to-value ratios could cause an increase in the provision for loan losses. As part of its management of originating residential mortgage loans, Nicolet’s long-term, fixed-rate residential real estate mortgage loans are sold in the secondary market with or without retaining the servicing rights. Mortgage loans retained in the portfolio are typically of high quality and have historically had low net charge-off rates.
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Loans in the retail and other classification represent less than 1% of the total loan portfolio, and include predominantly short-term and other personal installment loans not secured by real estate. Credit risk is primarily controlled by reviewing the creditworthiness of the borrowers, monitoring payment histories, and taking appropriate collateral and/or guaranty positions. The loan balances in this portfolio remained relatively unchanged from December 31, 2016 to March 31, 2017.
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 March 31, 2017, 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
In addition to the discussion that follows, see also Note 1, “Basis of Presentation,” and Note 6, “Loans, Allowance for Loan Losses and Credit Quality,” in the notes to the unaudited consolidated financial statements and the “Critical Accounting Policies” within management’s discussion and analysis.
Credit risks within the loan portfolio are inherently different for each loan type as described under “Balance Sheet Analysis-Loans.” Credit risk is controlled and monitored through the use of lending standards, a thorough review of potential borrowers, and on-going review of loan payment performance. Active asset quality administration, including early problem loan identification and timely resolution of problems, aids in the management of credit risk and minimization of loan losses.
The 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 off 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.
Management allocates the ALLL by pools of risk within each loan portfolio segment. The allocation methodology consists of the following components. First, a specific reserve for the estimated shortfall is established for all loans determined to be impaired. The specific reserve in the ALLL is equal to the aggregate collateral or discounted cash flow shortfall calculated from the impairment analyses. Loans measured for impairment include nonaccrual loans, non-performing 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. The look-back period on which the average historical loss rates are determined is a rolling 20-quarter (5 year) average. 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. Management conducts its allocation methodology on both the originated loans and on the acquired loans separately to account for differences, such as different loss histories and qualitative factors, between the two segments.
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.
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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, and 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.
At March 31, 2017, the ALLL was $12.2 million compared to $11.8 million at December 31, 2016. The three-month increase was a result of a 2017 provision of $0.4 million offset by 2017 net charge-offs of less than $0.1 million. Comparatively, the provision for loan losses in the first three months of 2016 was $0.4 million and net charge-offs were $0.2 million. Annualized net charge-offs as a percent of average loans were 0.02% in the first three months of 2017 compared to 0.10% for the first three months of 2016 and 0.02% for the entire 2016 year. 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 the ALLL as a percentage of period-end loans was 0.75% at March 31, 2017 and December 31, 2016, and 1.18% at March 31, 2016. The ALLL to loans ratio is impacted by the accounting treatment of the 2016 and 2013 acquisitions, which combined at their acquisition dates added no ALLL to the numerator and $974 million of loans into the denominator at their then estimated fair values ($691 million in 2016 and $283 million in 2013), net of applicable discounts for credit quality. Acquired loans outstanding were $633 million and $667 million at March 31, 2017 and December 31, 2016, respectively. The related allowance for acquired loans was $2.4 million at March 31, 2017 and December 31, 2016, with the ALLL to loans ratio at 0.37% and 0.36%, respectively. Originated loans outstanding, the related allowance and the ALLL to loans ratio at March 31, 2017 were $985 million, $9.9 million and 1.00%, respectively, compared to $902 million, $9.4 million and 1.05%, respectively, at December 31, 2016.
The largest portions of the ALLL were allocated to commercial & industrial loans and owner-occupied CRE loans combined, representing 59.2% and 57.5% of the ALLL at March 31, 2017 and December 31, 2016, respectively. The slight reduction in the allocation to these categories since December 31, 2016 was the result of minor changes to allowance allocations in conjunction with changes in loss histories. These categories combined represented 51.8% and 50.3% of total outstanding loans at March 31, 2017 and December 31, 2016, respectively.
Table 7: Loan Loss Experience
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The allocation of the ALLL is based on Nicolet’s estimate of loss exposure by category of loans and is shown in Table 8 for March 31, 2017 and December 31, 2016.
Table 8: Allocation of the Allowance for Loan Losses
December 31,
2016
Impaired Loans and Nonperforming Assets
As part of its overall credit risk management process, Nicolet’s management has been 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. Nonaccrual loans were $13.7 million (consisting of $0.2 million originated loans and $13.5 million acquired loans) at March 31, 2017 compared to $20.3 million at December 31, 2016 (consisting of $0.3 million originated loans and $20.0 million acquired loans). Nonperforming assets (which include nonperforming loans and other real estate owned “OREO”) were $16.0 million at March 31, 2017 compared to $22.3 million at December 31, 2016. OREO was $2.3 million at March 31, 2017, up slightly from $2.1 million at year end 2016, the majority of which is closed bank branch property. Nonperforming assets as a percent of total assets were 0.70% at March 31, 2017 compared to 0.97% at December 31, 2016.
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 but that are in performing status; however, there are circumstances present which might adversely affect the ability of the borrower to comply with present repayment terms. The decision of management to include performing loans in potential problem loans does not necessarily mean that Nicolet expects losses to occur, but that management recognizes a higher degree of risk associated with these loans. The loans that have been reported as potential problem loans are predominantly commercial-based loans covering a diverse range of businesses and real estate property types. Potential problem loans were $9.0 million (1.0% of loans) and $9.2 million (1.0% of loans) at March 31, 2017 and December 31, 2016, respectively. Potential problem loans require a heightened management review of the pace at which a credit may deteriorate, the duration of asset quality stress, and uncertainty around the magnitude and scope of economic stress that may be felt by Nicolet’s customers and on underlying real estate values.
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Table 9: Nonperforming Assets
Investment Securities
Table 10: Investment Securities Portfolio
At March 31, 2017 the total carrying value of investment securities was $404.4 million, up from $365.3 million at December 31, 2016, largely due to purchases in the first quarter of 2017. Investment securities represented 17.6% and 15.9% of total assets at March 31, 2017 and December 31, 2016, respectively. At March 31, 2017, 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 stockholders’ equity.
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In addition to securities available for sale, Nicolet has other investments, 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, respectively), and the Federal Agricultural Mortgage Corporation, as well as equity investments in other privately-traded 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 remaining investments 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. Other investments totaled $11.7 million at March 31, 2017 and $17.5 million at December 31, 2016, with the decline attributable primarily to redeemed FHLB stock. One equity investment had an OTTI charge of $0.5 million recorded in the fourth quarter of 2016. There were no OTTI charges recorded in 2017.
Table 11: Investment Securities Portfolio Maturity Distribution
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 12 are brokered deposits of $50.6 million at March 31, 2017 and $20.9 million at December 31, 2016.
Table 12: Deposits
Total deposits were $1.95 billion at March 31, 2017, down $24 million or 1% since December 31, 2016. As indicated in the following table, average total deposits were $1.93 billion for the first three months of 2017, up $864 million from the comparable 2016 period, largely attributable to acquired deposits. The mix of average deposits by category between the comparable first quarter periods, with 2017 carrying less in savings and time deposits and more in demand accounts (i.e. noninterest-bearing), money market and NOW accounts.
Table 13: Average Deposits
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Table 14: Maturity Distribution of Certificates of Deposit of $100,000 or More
Other Funding Sources
Other funding sources include short-term borrowings ($6 million at March 31, 2017 and zero at December 31, 2016) and long-term borrowings ($38 million at March 31, 2017 and December 31, 2016). Short-term borrowings consist mainly of customer repurchase agreements maturing in less than three months or federal funds purchased. Short-term borrowings increased $6.0 million at March 31, 2017. Long-term borrowings include notes payable (consisting of FHLB advances), junior subordinated debentures (largely qualifying as Tier 1 capital for regulatory purposes given their long maturity dates, even though they are redeemable in whole or in part at par), and subordinated debt (issued in 2015 with 10-year maturities, callable on or after the fifth anniversary date of their respective issuance dates, and qualifying as Tier 2 capital for regulatory purposes). Junior subordinated debentures totaled $24.8 million at March 31, 2017 and $24.7 million at December 31, 2016. Total subordinated notes of $12 million were issued in 2015, with outstanding balances of $12 million at March 31, 2017 and December 31, 2016. Further information regarding these notes payable, junior subordinated debentures, and subordinated notes is located in “Note 8 – Notes Payable,” “Note 9 – Junior Subordinated Debentures,” and “Note 10 – Subordinated Notes” in the notes to the unaudited consolidated financial statements.
Additional funding sources consist of a $10 million available and unused line of credit at the holding company, $143 million of available and unused federal funds purchased lines, and available total borrowing capacity at the FHLB of $285 million of which $15 million was used at March 31, 2017 (consisting of $1 million in outstanding advances, $6 million of overnight borrowings, and $8 million related to collateralized outstanding letters of credit), and borrowing capacity in the brokered deposit market.
Off-Balance Sheet Obligations
As of March 31, 2017 and December 31, 2016, Nicolet had the following commitments that did not appear on its balance sheet:
Table 15: Commitments
Liquidity Management
Liquidity management refers to the ability to ensure that cash is available in a timely and cost-effective manner to meet cash flow requirements of depositors and borrowers and to meet other commitments as they fall due, including the ability to pay dividends to shareholders, service debt, invest in subsidiaries, repurchase common stock, and satisfy other operating requirements.
Funds are available from a number of basic banking activity sources, including but not limited to the core deposit base, the repayment and maturity of loans, investment securities calls, maturities, and sales, and funds obtained through brokered deposits. All investment securities are classified as available for sale and are reported at fair value on the consolidated balance sheet. Approximately $21 million of the $404 million investment securities portfolio at March 31, 2017 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 March 31, 2017 and December 31, 2016 were approximately $44.3 million and $129.1 million, respectively. The decreased cash and cash equivalents since year-end 2016 was predominantly due to deployment to net loan growth and net investment purchases, as well as a net decline in deposit balances consistent with a customary pattern of seasonal deposit fluctuations. Nicolet’s liquidity resources were sufficient as of March 31, 2017 to fund loans and to meet other cash needs as necessary, including the cash portion of the First Menasha acquisition scheduled to close on April 28, 2017.
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Interest Rate Sensitivity Management and Impact of Inflation
A reasonable balance between interest rate risk, credit risk, liquidity risk and maintenance of yield, is highly important to Nicolet’s business success and profitability. As an ongoing part of its financial strategy and risk management, Nicolet attempts to understand and manage the impact of fluctuations in market interest rates on its net interest income. The consolidated balance sheet consists mainly of interest-earning assets (loans, investments and cash) which are primarily funded by interest-bearing liabilities (deposits and other borrowings). Such financial instruments have varying levels of sensitivity to changes in market rates of interest. Market rates are highly sensitive to many factors beyond our control, including but not limited to general economic conditions and policies of governmental and regulatory authorities. Our operating income and net income depends, to a substantial extent, on “rate spread” (i.e., the difference between the income earned on loans, investments and other earning assets and the interest expense paid to obtain deposits and other funding liabilities).
Asset-liability management policies establish guidelines for acceptable limits on the sensitivity to changes in interest rates on earnings and market value of assets and liabilities. Such policies are set and monitored by management and the board of directors’ Asset and Liability Committee.
To understand and manage the impact of fluctuations in market interest rates on net interest income, Nicolet measures its overall interest rate sensitivity through a net interest income analysis, which calculates the change in net interest income in the event of hypothetical changes in interest rates under different scenarios versus a baseline scenario. Such scenarios can involve static balance sheets, balance sheets with projected growth, parallel (or non-parallel) yield curve slope changes, immediate or gradual changes in market interest rates, and one-year or longer time horizons. The simulation modeling uses assumptions involving market spreads, prepayments of rate-sensitive instruments, renewal rates on maturing or new loans, deposit retention rates, and other assumptions.
Nicolet assessed the impact on net interest income in the event of a gradual +/-100 bps and +/-200 bps decrease in market rates (parallel to the change in prime rate) over a one-year time horizon to a static (flat) balance sheet. The interest rate scenarios are used for analytical purposes only and do not necessarily represent management’s view of future market interest rate movements. Based on this analysis on financial data at March 31, 2017, the projected changes in net interest income over a one-year time horizon, versus the baseline, was -0.4%, -0.2%, -0.6% and -1.1% for the -200, -100, +100 and +200 bps scenarios, respectively; such results are within Nicolet’s guidelines of not greater than -10% for +/- 100 bps and not greater than -15% for +/- 200 bps.
Actual results may differ from these simulated results due to timing, magnitude and frequency of interest rate changes, as well as changes in market conditions and their impact on customer behavior and management strategies.
During the quarter ended March 31, 2017, $26.1 million of Treasury Inflation-Protected Securities (TIPS) were purchased. These securities provide protection against inflation whereby the principal increases with inflation and decreases with deflation, as measured by the Consumer Price Index. When TIPS mature, the greater of the original principal or adjusted principal is paid. Between purchase and maturity, the principal adjustments may vary widely. The interest income and growth in principal are subject to federal income tax but are exempt from state income tax.
Capital
Management regularly reviews the adequacy of its capital to ensure that sufficient capital is available for current and future needs and is in compliance with regulatory guidelines and actively reviews capital strategies in light of perceived business risks associated with current and prospective earning levels, liquidity, asset quality, economic conditions in the markets served, and level of returns available to shareholders. Management intends to maintain an optimal capital and leverage mix for growth and for shareholder return.
At March 31, 2017, Nicolet’s capital structure consists of $285.0 million of common stock equity compared to $275.9 common equity at December 31, 2016. Nicolet’s common equity, representing 12.4% of total assets at March 31, 2017 compared to 12.0% at December 31, 2016, continues to reflect capacity to capitalize on opportunities. Nicolet’s common stock was accepted by shareholders as the primary consideration in the recent predominantly stock-for-stock 2016 acquisitions, as described in Note 2 – “Acquisitions,” in the notes to the unaudited consolidated financial statements. Further, Nicolet’s investors have demonstrated a strong commitment to providing common capital when needed, including a December 2008 private placement raising $9.5 million in common capital as we entered the economic crisis and the April 2013 private placement raising $2.9 million in common capital alongside a predominately stock-for-stock 2013 bank acquisition which added $9.7 million in common capital.
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As shown in Table 16, Nicolet’s regulatory capital ratios remain well above minimum regulatory ratios. At March 31, 2017, Nicolet’s Total, Tier 1, Common Equity Tier 1 (“CET1”) risk-based ratios and its leverage ratio were 14.0%, 12.7%, 11.4% and 10.6%, respectively, compared to the minimum requirements of 8.0%, 6.0%, 4.5% and 4.0%, respectively. Also, at March 31, 2017, the Bank’s Total, Tier 1, CET1 and leverage ratios were 12.2%, 11.6%, 11.6% and 9.6%, respectively, and qualify the Bank as well-capitalized under the prompt-corrective action framework with hurdles of 10.0%, 8.0%, 6.5% and 5.0%, respectively. This strong base of capital has allowed Nicolet to be opportunistic in the current environment and in strategic growth.
The primary source of income and funds for the parent company is dividends from the Bank. Dividends declared by the Bank that exceed the retained net income for the most current year plus retained net income for the preceding two years must be approved by federal regulatory agencies. At March 31, 2017, the Bank could pay dividends of approximately $6.5 million without seeking regulatory approval. During 2016, the Bank paid $35.5 million of dividends (which included a special dividend of $15 million out of Bank surplus), to the parent company, and paid no dividends during the first quarter of 2017.
A summary of Nicolet’s and the Bank’s regulatory capital amounts and ratios as of March 31, 2017 and December 31, 2016 are presented in the following table.
Table 16: Capital
In July 2013, the Federal Reserve Board and the OCC issued final rules implementing the Basel III regulatory capital framework and related Dodd-Frank Act changes. The final rules took effect for Nicolet and the Bank on January 1, 2015, subject to a transition period for certain parts of the rules. The rules permitted certain banking organizations to retain, through a one-time election, the existing treatment for accumulated other comprehensive income, and Nicolet and the Bank made such election in 2015.
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The tables above calculate and present regulatory capital based upon the capital ratio requirements under Basel III that became effective on January 1, 2015. Beginning in 2016, an additional capital conservation buffer was added to the minimum requirements for capital adequacy purposes, subject to a three year phase-in period. The capital conservation buffer will be fully phased-in on January 1, 2019 at 2.5 percent. A banking organization with a conservation buffer of less than 2.5 percent (or the required phase-in amount in years prior to 2019) will be subject to limitations on capital distributions, including dividend payments and certain discretionary bonus payments to executive officers. At the present time, the ratios for the Company and Bank are sufficient to meet the fully phased-in conservation buffer.
Future Accounting Pronouncements
In January 2017, the Financial Accounting Standards Board (“FASB”) issued updated guidance to Accounting Standards Update (“ASU”) 2017-01 Business Combinations (Topic 805): Clarifying the Definition of a Business, clarifying the definition of a business. The amendments affect all companies and other reporting organizations that must determine whether they have acquired or sold a business. The definition of a business affects many areas of accounting including acquisitions, disposals, goodwill, and consolidation. The amendments are intended to help companies evaluate whether transactions should be accounted for as acquisitions (or disposals) of assets or businesses. The amendments provide more consistency in applying the guidance, reduce the costs of application, and make the definition of a business more operable. For public companies, the amendments are effective for annual periods beginning after December 15, 2017, including interim periods within those periods. The Company is currently assessing the impact of the new guidance on its consolidated financial statements.
In January 2017, the FASB issued updated guidance to ASU 2017-04, Intangibles – Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment. To simplify the subsequent measurement of goodwill, the amendments eliminate Step 2 from the goodwill impairment test. The annual, or interim, goodwill impairment test is performed by comparing the fair value of a reporting unit with its carrying amount. An impairment charge should be recognized for the amount by which the carrying amount exceeds the reporting unit’s fair value; however, the loss recognized should not exceed the total amount of goodwill allocated to that reporting unit. In addition, income tax effects from any tax deductible goodwill on the carrying amount of the reporting unit should be considered when measuring the goodwill impairment loss. The amendments should be applied on a prospective basis. For public companies, the amendments are effective for annual periods beginning after December 15, 2019, including interim periods within those periods. The Company is currently assessing the impact of the new guidance on its consolidated financial statements.
In March 2017, the FASB issued updated guidance to ASU 2017-08, Receivables – Nonrefundable Fees and Other Costs (Subtopic 310-20), Premium Amortization on Purchased Callable Debt Securities. The ASU shortens the amortization period for certain callable debt securities held at a premium to the earliest call date. The amendment does not require an accounting change for securities held at a discount; the discount continues to be amortized to maturity. For public companies, the amendments are effective for annual periods beginning after December 15, 2018, including interim periods within those periods. The Company is currently assessing the impact of the new guidance on its consolidated financial statements.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
See section “Interest Rate Sensitivity Management” of Management Discussion & Analysis under Part 1, Item 2.
ITEM 4. CONTROLS AND PROCEDURES
As of the end of the period covered by this report, management, under the supervision, and with the participation, of our 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.
There have been no changes in the Company’s internal controls or, to the Company’s knowledge, in other factors during the quarter covered by this report that have materially affected, or are reasonably likely to materially affect, the Company’s internal controls over financial reporting. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
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PART II – OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
We and our subsidiaries may be involved from time to time in various routine legal proceedings incidental to our respective businesses. Neither we nor any of our subsidiaries are currently engaged in any legal proceedings that are expected to have a material adverse effect on our results of operations or financial position.
ITEM 1A. RISK FACTORS
There have been no material changes in the risk factors previously disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2016.
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
Following are Nicolet’s monthly common stock purchases during the first quarter of 2017.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None.
ITEM 4. MINE SAFETY DISCLOSURES
Not applicable.
ITEM 5. OTHER INFORMATION
ITEM 6. EXHIBITS
The following exhibits are filed herewith:
*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.
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