NICOLET BANKSHARES INC - Quarter Report: 2014 March (Form 10-Q)

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, 2014

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from____________to____________

Commission file number 333-90052

NICOLET BANKSHARES, INC.

(Exact name of registrant as specified in its charter)

WISCONSIN (State or other jurisdiction of incorporation or organization)	47-0871001 (I.R.S. Employer Identification No.)
111 North Washington Street Green Bay, Wisconsin 54301 (920) 430-1400 (Address, including zip code, and telephone number, including area code, of Registrant’s principal executive offices)

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

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

Large accelerated filer £ Accelerated filer £

Non-accelerated filer £ (Do not check if a smaller reporting company) Smaller reporting company S

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

As of April 30, 2014 there were 4,238,911 shares of $0.01 par value common stock outstanding.

Nicolet Bankshares, Inc.

TABLE OF CONTENTS


PART I	FINANCIAL INFORMATION		PAGE

	Item 1.	Financial Statements:

		Consolidated Balance Sheets
		March 31, 2014 (unaudited) and December 31, 2013	3

		Consolidated Statements of Income
		Three Months Ended March 31, 2014 and 2013 (unaudited)	4

		Consolidated Statements of Comprehensive Income
		Three Months Ended March 31, 2014 and 2013 (unaudited)	5

		Consolidated Statement of Changes in Stockholders’ Equity
		Three Months Ended March 31, 2014 (unaudited)	6

		Consolidated Statements of Cash Flows
		Three Months Ended March 31, 2014 and 2013 (unaudited)	7

		Notes to Unaudited Consolidated Financial Statements	8-27

	Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	28-47

	Item 3.	Quantitative and Qualitative Disclosures About Market Risk	48

	Item 4.	Controls and Procedures	48

PART II	OTHER INFORMATION

	Item 1.	Legal Proceedings	48

	Item 1A.	Risk Factors	48

	Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	48

	Item 3.	Defaults Upon Senior Securities	48

	Item 4.	Mine Safety Disclosures	48

	Item 5.	Other Information	48

	Item 6.	Exhibits	49

		Signatures	49-53

PART I – FINANCIAL INFORMATION

Item 1. FINANCIAL STATEMENTS:

NICOLET BANKSHARES, INC. AND SUBSIDIARIES

Consolidated Balance Sheets

(In thousands, except share and per share data)

	March 31, 2014 (Unaudited)			December 31, 2013 (Audited)
Assets
Cash and due from banks	$	24,343		$	26,556
Interest-earning deposits		129,355			119,364
Federal funds sold		2,285			1,058
Cash and cash equivalents		155,983			146,978
Certificates of deposit in other banks		1,960			1,960
Securities available for sale (“AFS”)		133,387			127,515
Other investments		8,015			7,982
Loans held for sale		3,996			1,486
Loans		850,092			847,358
Allowance for loan losses		(9,344	)		(9,232	)
Loans, net		840,748			838,126
Premises and equipment, net		29,776			29,845
Bank owned life insurance		24,010			23,796
Accrued interest receivable and other assets		19,834			21,115
Total assets	$	1,217,709		$	1,198,803
Liabilities and Stockholders’ Equity
Liabilities:
Demand	$	171,140		$	171,321
Money market and NOW accounts		500,267			492,499
Savings		105,787			97,601
Time		265,050			273,413
Total deposits		1,042,244			1,034,834
Short-term borrowings		11,438			7,116
Notes payable		32,360			32,422
Junior subordinated debentures		12,178			12,128
Accrued interest payable and other liabilities		12,211			7,424
Total liabilities		1,110,431			1,093,924

Stockholders’ Equity:
Preferred equity		24,400			24,400
Common stock		42			42
Additional paid-in capital		49,674			49,616
Retained earnings		32,291			30,138
Accumulated other comprehensive income (“AOCI”)		823			666
Total Nicolet Bankshares, Inc. stockholders’ equity		107,230			104,862
Noncontrolling interest		48			17
Total stockholders’ equity and noncontrolling interest		107,278			104,879
Total liabilities, noncontrolling interest and stockholders’ equity	$	1,217,709		$	1,198,803
Preferred shares authorized (no par value)		10,000,000			10,000,000
Preferred shares issued		24,400			24,400
Common shares authorized (par value $0.01 per share)		30,000,000			30,000,000
Common shares outstanding		4,240,484			4,241,044
Common shares issued		4,299,311			4,303,407

See accompanying notes to unaudited consolidated financial statements.

ITEM 1. Financial Statements Continued:

NICOLET BANKSHARES, INC. AND SUBSIDIARIES

Consolidated Statements of Income

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

	Three Months Ended March 31,
	2014		2013
Interest income:
Loans, including loan fees	$	11,007	$	6,781
Investment securities:
Taxable		418		127
Non-taxable		173		173
Other interest income		135		80
Total interest income		11,733		7,161
Interest expense:
Money market and NOW accounts		593		514
Savings and time deposits		688		487
Short-term borrowings		3		1
Junior subordinated debentures		217		124
Notes payable		252		283
Total interest expense		1,753		1,409
Net interest income		9,980		5,752
Provision for loan losses		675		975
Net interest income after provision for loan losses		9,305		4,777
Noninterest income:
Service charges on deposit accounts		494		284
Trust services fee income		1,105		802
Mortgage income		215		872
Brokerage fee income		160		102
Gain on sale of assets, net		750		4
Bank owned life insurance		214		169
Rent income		300		250
Investment advisory fees		110		86
Other		412		187
Total noninterest income		3,760		2,756
Noninterest expense:
Salaries and employee benefits		5,295		3,559
Occupancy, equipment and office		1,898		1,104
Business development and marketing		535		425
Data processing		754		423
FDIC assessments		184		110
Core deposit intangible amortization		335		148
Other		587		571
Total noninterest expense		9,588		6,340

Income before income tax expense		3,477		1,193
Income tax expense		1,232		419
Net income		2,245		774
Less: net income attributable to noncontrolling interest		31		19
Net income attributable to Nicolet Bankshares, Inc.		2,214		755
Less: preferred stock dividends and discount accretion		61		305
Net income available to common shareholders	$	2,153	$	450

Basic earnings per common share	$	0.51	$	0.13
Diluted earnings per common share	$	0.50	$	0.13
Weighted average common shares outstanding:
Basic		4,242,887		3,432,387
Diluted		4,283,888		3,445,664

See accompanying notes to unaudited consolidated financial statements.

ITEM 1. Financial Statements Continued:

NICOLET BANKSHARES, INC. AND SUBSIDIARIES

Consolidated Statements of Comprehensive Income

(In thousands) (Unaudited)

	Three Months Ended March 31,
	2014			2013
Net income	$	2,245		$	774
Other comprehensive income, net of tax:
Securities available for sale:
Net unrealized holding gains arising during the period		599			515
Less: reclassification adjustment for net gains realized in net income		(341	)		-
Net unrealized gains on securities before tax expense		258			515
Income tax expense		(101	)		(201	)
Total other comprehensive income		157			314
Comprehensive income	$	2,402		$	1,088

See accompanying notes to unaudited consolidated financial statements.

ITEM 1. Financial Statements Continued:

NICOLET BANKSHARES, INC. AND SUBSIDIARIES

Consolidated Statement of Stockholders’ Equity

(In thousands) (Unaudited)

	Nicolet Bankshares, Inc. Stockholders’ Equity
	Preferred Equity		Common Stock		Additional Paid-In Capital			Retained Earnings			Accumulated Other Comprehensive Income		Noncontrolling Interest		Total
Balance, December 31, 2013	$	24,400	$	42	$	49,616		$	30,138		$	666	$	17	$	104,879
Net income		-		-		-			2,214			-		31		2,245
Other comprehensive income		-		-		-			-			157		-		157
Stock compensation expense		-		-		154			-			-		-		154
Exercise of stock options		-		-		298			-			-		-		298
Issuance of common stock		-		-		16			-			-		-		16
Purchase and retirement of common stock		-		-		(410	)		-			-		-		(410	)
Preferred stock dividends		-		-		-			(61	)		-		-		(61	)
Balance, March 31, 2014	$	24,400	$	42	$	49,674		$	32,291		$	823	$	48	$	107,278

See accompanying notes to unaudited consolidated financial statements.

ITEM 1. Financial Statements Continued:

NICOLET BANKSHARES, INC. AND SUBSIDIARIES

Consolidated Statements of Cash Flows

(In thousands) (Unaudited)

	Three Months Ended March 31,
	2014			2013
Cash Flows From Operating Activities:
Net income	$	2,245		$	774
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation, amortization, and accretion		829			636
Provision for loan losses		675			975
Provision for deferred taxes		348			-
Increase in cash surrender value of life insurance		(214	)		(169	)
Stock compensation expense		154			198
Gain on sale of assets, net		(750	)		(4	)
Gain on sale of loans held for sale, net		(215	)		(872	)
Proceeds from sale of loans held for sale		10,842			48,338
Origination of loans held for sale		(13,137	)		(42,751	)
Net change in:
Accrued interest receivable and other assets		(159	)		(419	)
Accrued interest payable and other liabilities		(1,478	)		(569	)
Net cash provided (used) by operating activities		(860	)		6,137
Cash Flows From Investing Activities:
Net (increase) decrease in loans		(3,517	)		7,972
Purchases of securities AFS		(6,481	)		(5,992	)
Proceeds from sales of securities AFS		4,021			-
Proceeds from calls and maturities of securities AFS		2,983			1,961
Purchase of other investments		(33	)		(8	)
Purchase of premises and equipment		(513	)		(476	)
Proceeds from sales of other real estate and other assets		1,762			109
Net cash provided (used) by investing activities		(1,778	)		3,566
Cash Flows From Financing Activities:
Net increase (decrease) in deposits		7,540			(52,895	)
Net change in short-term borrowings		4,322			(906	)
Repayments of notes payable		(62	)		(10,059	)
Purchase and retirement of common stock		(410	)		(19	)
Proceeds from issuance of common stock, net		16			-
Proceeds from exercise of common stock options		298			62
Cash dividends paid on preferred stock		(61	)		(305	)
Net cash provided (used) by financing activities		11,643			(64,122	)
Net increase (decrease) in cash and cash equivalents		9,005			(54,419	)
Cash and cash equivalents:
Beginning	$	146,978		$	82,003
Ending	$	155,983		$	27,584
Supplemental Disclosures of Cash Flow Information:
Cash paid for interest	$	1,930		$	1,374
Cash paid for taxes		125			770
Transfer of loans to other real estate owned		601			1,950

See accompanying notes to unaudited consolidated financial statements.

NICOLET BANKSHARES, INC. AND SUBSIDIARIES

Notes to Unaudited Consolidated Financial Statements

Note 1 – Basis of Presentation

General

In the opinion of management, the accompanying unaudited consolidated financial statements contain all adjustments necessary to present fairly Nicolet Bankshares, Inc. (the “Company”) and its subsidiaries, consolidated balance sheets, statements of income, comprehensive income, changes in stockholders’ equity and cash flows for the periods presented, and all such adjustments are of a normal recurring nature. All material intercompany transactions and balances are eliminated. The results of operations for the interim periods are not necessarily indicative of the results to be expected for the entire year.

These interim consolidated financial statements have been prepared according to the rules and regulations of the Securities and Exchange Commission and, therefore, certain information and footnote disclosures normally presented in accordance with generally accepted accounting principles in the United States of America (“U.S. GAAP”) have been omitted or abbreviated. These financial statements should be read in conjunction with the Company’s audited consolidated financial statements and footnotes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2013.

Critical Accounting Policies and Estimates

Preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying disclosures. These estimates are based on management’s best knowledge of current events and actions the Company may undertake in the future. Estimates are used in accounting for, among other items, the allowance for loan losses, useful lives for depreciation and amortization, fair value of financial instruments, deferred tax assets, uncertain income tax positions and contingencies. Estimates that are particularly susceptible to significant change for the Company include the determination of the allowance for loan losses, the assessment of deferred tax assets and liabilities, and the valuation of loans acquired in the 2013 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 within the first twelve months after acquisition as allowed by purchase accounting guidelines. 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, 2013.

Recent Accounting Developments

Accounting Standards Update (“ASU”) 2013-11 Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists. This ASU was issued to clarify the balance sheet presentation of an unrecognized tax benefit when a net operating loss carryforward, a similar tax loss, or a tax credit carryforward exists. ASU 2013-11 is applicable to all entities that have an unrecognized tax benefit due to a net operating loss carryforward, a similar tax loss, or a tax credit carryforward. The ASU is effective for fiscal years, and interim periods within those years, beginning after December 15, 2013. The Company adopted this as required in the first quarter of 2014 with no material impact on the Company’s financial position, results of operations, or disclosures.

Note 2 – Acquisitions

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

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

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

The Company accounted for the transaction under the acquisition method of accounting, and thus, the financial position and results of operations of Mid-Wisconsin prior to the consummation date were not included in the accompanying consolidated financial statements. The accounting required assets purchased and liabilities assumed to be recorded at their respective fair values at the date of acquisition. The estimated fair values will be subject to refinement as additional information relative to the closing date fair values becomes available through the measurement period of approximately one year from consummation.

As of the acquisition date, the transaction added approximately $436 million in assets at fair value, including cash and investments of $133 million, $272 million in loans, of which $15 million were classified as PCI loans, and $31 million of other assets. Deposits of $346 million and junior subordinated debentures, borrowings and other liabilities of $70 million were acquired in the merger. The excess of assets over liabilities acquired of $20 million less the purchase price of $10 million resulted in a bargain purchase gain (“BPG”) of $10 million.

Proforma results for 2014 periods are not necessary as the 2014 actual results fully include both 2013 acquisitions. The following unaudited pro forma information presents the results of operations for three months ended March 31, 2013, including BPG, as if the acquisitions had occurred January 1, 2013, the beginning of the annual period prior to the acquisitions. 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 acquisitions occurred at the beginning of each period presented, nor are they intended to represent or be indicative of future results of operations.

	Three Months Ended March 31, 2013
(in thousands)
Total revenues, net of interest expense	$	24,309
Net income		10,496

Note 3 – Earnings per Common Share

Basic earnings per common share are calculated by dividing net income available to common shareholders by the weighted average number of common shares outstanding during the period. Diluted earnings per share is calculated by dividing net income available to common shareholders by the weighted average number of shares adjusted for the dilutive effect of common stock awards (outstanding stock options and unvested restricted stock), if any. Presented below are the calculations for basic and diluted earnings per common share.

	Three Months Ended March 31,
	2014		2013
(In thousands except per share data)
Net income, net of noncontrolling interest	$	2,214	$	755
Less: preferred stock dividends		61		305
Net income available to common shareholders	$	2,153	$	450
Weighted average common shares outstanding		4,243		3,432
Effect of dilutive stock instruments		41		14
Diluted weighted average common shares outstanding		4,284		3,446
Basic earnings per common share*	$	0.51	$	0.13
Diluted earnings per common share*	$	0.50	$	0.13

*Cumulative quarterly per share performance may not equal annual per share totals due to the effects of the amount and timing of capital increases. When computing earnings per share for an interim period, the denominator is based on the weighted-average shares outstanding during the interim period, and not on an annualized weighted-average basis. Accordingly, the sum of the quarters’ earnings per share data will not necessarily equal the year to date earnings per share data.

Options to purchase approximately 0.5 million shares were outstanding at the three months ending March 31, 2014 and 2013, but excluded from the calculation of diluted earnings per common share as the effect would have been anti-dilutive.

Note 4 – Stock-based Compensation

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

Stock Options	Weighted- Average Fair Value of Options Granted		Option Shares Outstanding			Weighted-Average Exercise Price		Exercisable Shares
Balance – December 31, 2012				825,532		$	17.70		548,623
Granted		-		-			-
Exercise of stock options				(23,625	)		12.96
Forfeited				(8,750	)		15.78
Balance – December 31, 2013				793,157			17.86		600,846
Granted		-		-			-
Exercise of stock options				(18,215	)		16.35
Forfeited				(4,250	)		16.59
Balance – March 31, 2014				770,692		$	17.90		582,381

Options outstanding at March 31, 2014 are exercisable at option prices ranging from $12.50 to $26.00. There are 328,618 options outstanding in the range from $12.50 - $17.00, 396,074 options outstanding in the range from $17.01 - $22.00, and 46,000 options outstanding in the range from $22.01 - $26.00. The exercisable options have a weighted average remaining contractual life of approximately 3 years as of March 31, 2014.

Note 4 – Stock-based Compensation, continued

Intrinsic value represents the amount by which the fair market value of the underlying stock exceeds the exercise price of the stock options. The total intrinsic value of options exercised in the first three months of 2014, and full year of 2013 was approximately $19,000, and $80,000, respectively. The weighted average exercise price of stock options exercisable at March 31, 2014 was $18.31.

Restricted Stock	Weighted- Average Grant Date Fair Value		Restricted Shares Outstanding
Balance – December 31, 2012	$	16.50		54,475
Granted		16.51		26,506
Vested*		16.50		(18,258	)
Forfeited		16.50		(360	)
Balance – December 31, 2013		16.50		62,363
Granted		-		-
Vested *		16.50		(3,536	)
Forfeited		-		-
Balance – March 31, 2014	$	16.50		58,827

*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 1,196 shares were surrendered during the three months ended March 31, 2014 and 5,606 shares were surrendered during 2013.

The Company recognized approximately $154,000 and $198,000 of stock-based employee compensation expense during the three months ended March 31, 2014 and 2013, respectively, associated with its stock equity awards. As of March 31, 2014, there was approximately $1.4 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 four years.

Note 5- Securities Available for Sale

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

	March 31, 2014
(in thousands)	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Fair Value
U.S. government sponsored enterprises	$	2,047	$	3	$	4	$	2,046
State, county and municipals		62,737		1,030		415		63,352
Mortgage-backed securities		66,318		585		1,060		65,843
Corporate debt securities		220		-		-		220
Equity securities		715		1,211		-		1,926
	$	132,037	$	2,829	$	1,479	$	133,387

	December 31, 2013
(in thousands)	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Fair Values
U.S. government sponsored enterprises	$	2,062	$	3	$	8	$	2,057
State, county and municipals		54,594		1,058		613		55,039
Mortgage-backed securities		68,642		585		1,348		67,879
Corporate debt securities		220		-		-		220
Equity securities		905		1,415		-		2,320
	$	126,423	$	3,061	$	1,969	$	127,515

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, 2014 and December 31, 2013.

	March 31, 2014
	Less than 12 months				12 months or more				Total
(in thousands)	Fair Value		Unrealized Losses		Fair Value		Unrealized Losses		Fair Value		Unrealized Losses
U.S. government sponsored enterprises	$	516	$	4	$	-	$	-	$	516	$	4
State, county and municipals		22,294		415		-		-		22,294		415
Mortgage-backed securities		34,860		991		2,845		69		37,705		1,060
	$	57,670	$	1,410	$	2,845	$	69	$	60,515	$	1,479

	December 31, 2013
	Less than 12 months				12 months or more				Total
(in thousands)	Fair Value		Unrealized Losses		Fair Value		Unrealized Losses		Fair Value		Unrealized Losses
U.S. government sponsored enterprises	$	511	$	8	$	-	$	-	$	511	$	8
State, county and municipals		17,697		613		-		-		17,697		613
Mortgage-backed securities		36,687		1,240		2,920		108		39,607		1,348
	$	54,895	$	1,861	$	2,920	$	108	$	57,815	$	1,969

As of March 31, 2014 the Company does not consider securities with unrealized losses to be other-than-temporarily impaired. The unrealized losses in each category have occurred as a result of changes in interest rates, market spreads and market conditions subsequent to purchase. The Company has the ability and intent to hold its securities to maturity. There were no other-than-temporary impairments charged to earnings during the three-month period ending March 31, 2014 or 2013.

The amortized cost and fair values of securities available for sale at March 31, 2014 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.

	March 31, 2014
(in thousands)	Amortized Cost		Fair Value
Due in less than one year	$	5,904	$	5,954
Due in one year through five years		45,685		46,404
Due after five years through ten years		12,330		12,179
Due after ten years		1,085		1,081
		65,004		65,618
Mortgage-backed securities		66,318		65,843
Equity securities		715		1,926
Securities available for sale	$	132,037	$	133,387

Proceeds from sales of securities available for sale during the first three months of 2014 and 2013 were approximately $4.0 million and zero, respectively. Net gains of approximately $341,000 were realized on sales of securities during the first three months of 2014.

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

The loan composition as of March 31, 2014 and December 31, 2013 is summarized as follows.

	Total
	3/31/2014						12/31/2013
(in thousands)	Amount			% of Total			Amount			% of Total
Commercial & industrial	$	255,652			30.1	%	$	253,674			29.9	%
Owner-occupied commercial real estate (“CRE”)		183,056			21.5			187,476			22.1
Agricultural production		15,422			1.8			14,256			1.7
Agricultural real estate		42,392			5.0			37,057			4.4
CRE investment		90,281			10.6			90,295			10.7
Construction & land development		42,817			5.0			42,881			5.1
Residential construction		12,376			1.5			12,535			1.5
Residential first mortgage		155,051			18.2			154,403			18.2
Residential junior mortgage		48,174			5.7			49,363			5.8
Retail & other		4,871			0.6			5,418			0.6
Loans		850,092			100.0	%		847,358			100.0	%
Less allowance for loan losses		9,344						9,232
Loans, net	$	840,748					$	838,126
Allowance for loan losses to loans		1.10	%					1.09	%

	Originated
	3/31/2014					12/31/2013
(in thousands)	Amount		% of Total			Amount		% of Total
Commercial & industrial	$	230,980		36.6	%	$	227,572		36.5	%
Owner-occupied CRE		123,002		19.5			127,759		20.5
Agricultural production		4,515		0.7			3,230		0.5
Agricultural real estate		17,515		2.8			13,596		2.2
CRE investment		61,479		9.8			60,390		9.7
Construction & land development		31,028		4.9			30,277		4.9
Residential construction		12,210		2.0			12,475		2.0
Residential first mortgage		107,513		17.0			104,180		16.7
Residential junior mortgage		38,451		6.1			39,207		6.3
Retail & other		3,997		0.6			4,192		0.7
Loans	$	630,690		100.0	%	$	622,878		100.0	%

	Acquired
	3/31/2014					12/31/2013
(in thousands)	Amount		% of Total			Amount		% of Total
Commercial & industrial	$	24,672		11.2	%	$	26,102		11.6	%
Owner-occupied CRE		60,054		27.4			59,717		26.6
Agricultural production		10,907		5.0			11,026		4.9
Agricultural real estate		24,877		11.3			23,461		10.5
CRE investment		28,802		13.1			29,905		13.3
Construction & land development		11,789		5.4			12,604		5.6
Residential construction		166		0.1			60		0.1
Residential first mortgage		47,538		21.7			50,223		22.4
Residential junior mortgage		9,723		4.4			10,156		4.5
Retail & other		874		0.4			1,226		0.5
Loans	$	219,402		100.0	%	$	224,480		100.0	%

Practically all of the Company’s loans, commitments, and standby letters of credit have been granted to customers in the Company’s market area. Although the Company has a diversified loan portfolio, the credit risk in the loan portfolio is largely influenced by general economic conditions and trends of the counties and markets in which the debtors operate, and the resulting impact on the operations of borrowers or on the value of underlying collateral, if any.

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

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

The allocation methodology used by the Company includes specific allocations for impaired loans evaluated individually for impairment based on collateral values and for the remaining loan portfolio collectively evaluated for impairment primarily based on historical loss rates and other qualitative factors. Loan charge-offs and recoveries are based on actual amounts charged-off or recovered by loan category. Management allocates the ALLL by pools of risk within each loan portfolio. Due to the short period of time since the acquisitions and management’s assessment, no ALLL has been recorded on acquired loans at March 31, 2014.

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


	Total – March 31, 2014
(in thousands) ALLL:	Commercial & industrial			Owner- occupied CRE			AG production			AG real estate			CRE investment			Construction & land development			Residential construction			Residential first mortgage			Residential junior mortgage			Retail & other			Total
Beginning balance	$	1,798		$	766		$	18		$	59		$	505		$	4,970		$	229		$	544		$	321		$	22		$	9,232
Provision		1,847			271			25			200			165			(2,408	)		61			295			116			103			675
Charge-offs		(510	)		-			-			-			-			(12	)		-			(29	)		(9	)		(14	)		(574	)
Recoveries		1			2			-			-			4			-			-			1			-			3			11
Net charge-offs		(509	)		2			-			-			4			(12	)		-			(28	)		(9	)		(11	)		(563	)
Ending balance	$	3,136		$	1,039		$	43		$	259		$	674		$	2,550		$	290		$	811		$	428		$	114		$	9,344
As percent of ALLL		33.6	%		11.1	%		0.5	%		2.8	%		7.2	%		27.2	%		3.1	%		8.7	%		4.6	%		1.2	%		100	%

ALLL:
Individually evaluated	$	214		$	-		$	-		$	-		$	-		$	460		$	-		$	-		$	-		$	-		$	674
Collectively evaluated		2,922			1,039			43			259			674			2,090			290			811			428			114			8,670
Ending balance	$	3,136		$	1,039		$	43		$	259		$	674		$	2,550		$	290		$	811		$	428		$	114		$	9,344

Loans:
Individually evaluated	$	299		$	1,036		$	32		$	459		$	3,729		$	4,856		$	-		$	1,422		$	167		$	-		$	12,000
Collectively evaluated		255,353			182,020			15,390			41,933			86,552			37,961			12,376			153,629			48,007			4,871			838,092
Total loans	$	255,652		$	183,056		$	15,422		$	42,392		$	90,281		$	42,817		$	12,376		$	155,051		$	48,174		$	4,871		$	850,092

Less ALLL	$	3,136		$	1,039		$	43		$	259		$	674		$	2,550		$	290		$	811		$	428		$	114		$	9,344
Net loans	$	252,516		$	182,017		$	15,379		$	42,133		$	89,607		$	40,267		$	12,086		$	154,240		$	47,746		$	4,757		$	840,748

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

	Originated – 3/31/2014
(in thousands) ALLL:	Commercial & industrial			Owner- occupied CRE			AG production			AG real estate			CRE investment			Construction & land development			Residential construction			Residential first mortgage			Residential junior mortgage			Retail & other			Total
Beginning balance	$	1,798		$	766		$	18		$	59		$	505		$	4,970		$	229		$	544		$	321		$	22		$	9,232
Provision		1,847			272			25			200			165			(2,420	)		61			266			107			103			626
Charge-offs		(510	)		-			-			-			-			-			-			-			-			(14	)		(524	)
Recoveries		1			1			-			-			4			-			-			1			-			3			10
Net charge-offs		(509	)		1			-			-			4			-			-			1			-			(11	)		(514	)
Ending balance	$	3,136		$	1,039		$	43		$	259		$	674		$	2,550		$	290		$	811		$	428		$	114		$	9,344
As percent of ALLL		33.6	%		11.1	%		0.5	%		2.8	%		7.2	%		27.2	%		3.1	%		8.7	%		4.6	%		1.2	%		100	%

ALLL:
Individually evaluated	$	214		$	-		$	-		$	-		$	-		$	460		$	-		$	-		$	-		$	-		$	674
Collectively evaluated		2,922			1,039			43			259			674			2,090			290			811			428			114			8,670
Ending balance	$	3,136		$	1,039		$	43		$	259		$	674		$	2,550		$	290		$	811		$	428		$	114		$	9,344

Loans:
Individually evaluated	$	298		$	-		$	-		$	-		$	-		$	3,925		$	-		$	-		$	-		$	-		$	4,223
Collectively evaluated		230,682			123,002			4,515			17,515			61,479			27,103			12,210			107,513			38,451			3,997			626,467
Total loans	$	230,980		$	123,002		$	4,515		$	17,515		$	61,479		$	31,028		$	12,210		$	107,513		$	38,451		$	3,997		$	630,690

Less ALLL	$	3,136		$	1,039		$	43		$	259		$	674		$	2,550		$	290		$	811		$	428		$	114		$	9,344
Net loans	$	227,844		$	121,963		$	4,472		$	17,256		$	60,805		$	28,478		$	11,920		$	106,702		$	38,023		$	3,883		$	621,346

	Acquired – 3/31/2014
(in thousands) ALLL:	Commercial & industrial		Owner- occupied CRE			AG production		AG real estate		CRE investment		Construction & land development			Residential construction		Residential first mortgage			Residential junior mortgage			Retail & other		Total
Provision		-		(1	)		-		-		-		12			-		29			9			-		49
Charge-offs		-		-			-		-		-		(12	)		-		(29	)		(9	)		-		(50	)
Recoveries		-		1			-		-		-		-			-		-			-			-		1
Loans:
Individually evaluated	$	1	$	1,036		$	32	$	459	$	3,729	$	931		$	-	$	1,422		$	167		$	-	$	7,777
Collectively evaluated		24,671		59,018			10,875		24,418		25,073		10,858			166		46,116			9,556			874		211,625
Total loans	$	24,672	$	60,054		$	10,907	$	24,877	$	28,802	$	11,789		$	166	$	47,538		$	9,723		$	874	$	219,402

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

The following table presents the balance and activity in the ALLL by portfolio segment for the three months ended March 31, 2013.

	March 31, 2013
(in thousands) ALLL:	Commercial & industrial			Owner- occupied CRE			AG production			AG real estate			CRE investment			Construction & land development			Residential construction			Residential first mortgage			Residential junior mortgage			Retail & other			Total
Beginning balance	$	1,969		$	1,069		$	-		$	-		$	337		$	2,580		$	137		$	685		$	312		$	31		$	7,120
Provision		7			230			-			-			(144	)		894			(11	)		30			(12	)		(19	)		975
Charge-offs		(475	)		(56	)		-			-			-			(36	)		-			-			-			-			(567	)
Recoveries		5			1			-			-			-			-			-			5			1			-			12
Net charge-offs		(470	)		(55	)		-			-			-			(36	)		-			5			1			-			(555	)
Ending balance	$	1,506		$	1,244		$	-		$	-		$	193		$	3,438		$	126		$	720		$	301		$	12		$	7,540
As percent of ALLL		20.0	%		16.5	%		0.0	%		0.0	%		2.6	%		45.6	%		1.7	%		9.5	%		4.0	%		0.1	%		100	%

ALLL:
Individually evaluated	$	-		$	-		$	-		$	-		$	-		$	-		$	-		$	-		$	-		$	-		$	-
Collectively evaluated		1,506			1,244			-			-			193			3,438			126			720			301			12			7,540
Ending balance	$	1,506		$	1,244		$	-		$	-		$	193		$	3,438		$	126		$	720		$	301		$	12		$	7,540

Loans:
Individually evaluated	$	93		$	1,857		$	-		$	-		$	-		$	-		$	-		$	628		$	-		$	149		$	2,727
Collectively evaluated		193,196			105,666			219			9,866			73,410			22,285			7,445			85,574			39,026			2,710			539,397
Total loans	$	193,289		$	107,523		$	219		$	9,866		$	73,410		$	22,285		$	7,445		$	86,202		$	39,026		$	2,859		$	542,124

Less ALLL	$	1,506		$	1,244		$	-		$	-		$	193		$	3,438		$	126		$	720		$	301		$	12		$	7,540
Net loans	$	191,783		$	106,279		$	219		$	9,866		$	73,217		$	18,847		$	7,319		$	85,482		$	38,725		$	2,847		$	534,584

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

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

The following table presents nonaccrual loans by portfolio segment in total and then as a further breakdown by originated or acquired as of March 31, 2014 and December 31, 2013.

			Total Portfolio
(in thousands)	3/31/2014		% to Total			12/31/2013		% to Total
Commercial & industrial	$	485		5.3	%	$	68		0.7	%
Owner-occupied CRE		1,012		11.1			1,087		10.6
Agricultural production		34		0.4			11		0.1
Agricultural real estate		462		5.1			448		4.3
CRE investment		3,422		37.7			4,631		45.1
Construction & land development		931		10.3			1,265		12.3
Residential construction		-		-			-		-
Residential first mortgage		2,364		26.0			2,365		23.0
Residential junior mortgage		243		2.7			262		2.6
Retail & other		124		1.4			129		1.3
Nonaccrual loans	$	9,077		100.0	%	$	10,266		100.0	%

			Originated
(in thousands)	3/31/2014		% to Total			12/31/2013		% to Total
Commercial & industrial	$	461		33.1	%	$	67		8.9	%
Owner-occupied CRE		-		-			-		-
Agricultural production		-		-			-		-
Agricultural real estate		-		-			-		-
CRE investment		-		-			40		5.3
Construction & land development		-		-			-		-
Residential construction		-		-			-		-
Residential first mortgage		734		52.8			442		58.9
Residential junior mortgage		72		5.2			73		9.7
Retail & other		124		8.9			129		17.2
Nonaccrual loans	$	1,391		100.0	%	$	751		100.0	%

			Acquired
(in thousands)	3/31/2014		% to Total			12/31/2013		% to Total
Commercial & industrial	$	24		0.3	%	$	1		0.1	%
Owner-occupied CRE		1,012		13.2			1,087		11.4
Agricultural production		34		0.4			11		0.1
Agricultural real estate		462		6.0			448		4.7
CRE investment		3,422		44.6			4,591		48.2
Construction & land development		931		12.1			1,265		13.3
Residential construction		-		-			-		-
Residential first mortgage		1,630		21.2			1,923		20.2
Residential junior mortgage		171		2.2			189		2.0
Retail & other		-		-			-		-
Nonaccrual loans	$	7,686		100.0	%	$	9,515		100.0	%

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

The following tables present total past due loans by portfolio segment as of March 31, 2014 and December 31, 2013:

	March 31, 2014
(in thousands)	30-89 Days Past Due (accruing)			90 Days & Over or non- accrual			Current			Total
Commercial & industrial	$	422		$	485		$	254,745		$	255,652
Owner-occupied CRE		1,459			1,012			180,585			183,056
Agricultural production		10			34			15,378			15,422
Agricultural real estate		-			462			41,930			42,392
CRE investment		478			3,422			86,381			90,281
Construction & land development		-			931			41,886			42,817
Residential construction		-			-			12,376			12,376
Residential first mortgage		720			2,364			151,967			155,051
Residential junior mortgage		-			243			47,931			48,174
Retail & other		3			124			4,744			4,871
Total loans	$	3,092		$	9,077		$	837,923		$	850,092
As a percent of total loans		0.3	%		1.1	%		98.6	%		100.0	%

	December 31, 2013
(in thousands)	30-89 Days Past Due (accruing)			90 Days & Over or nonaccrual			Current			Total
Commercial & industrial	$	-		$	68		$	253,606		$	253,674
Owner-occupied CRE		1,247			1,087			185,142			187,476
Agricultural production		-			11			14,245			14,256
Agricultural real estate		-			448			36,609			37,057
CRE investment		491			4,631			85,173			90,295
Construction & land development		-			1,265			41,616			42,881
Residential construction		-			-			12,535			12,535
Residential first mortgage		387			2,365			151,651			154,403
Residential junior mortgage		12			262			49,089			49,363
Retail & other		12			129			5,277			5,418
Total loans	$	2,149		$	10,266		$	834,943		$	847,358
As a percent of total loans		0.3	%		1.2	%		98.5	%		100.0	%

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.

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

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, 2014 and December 31, 2013:


	March 31, 2014
(in thousands)	Grades 1- 4			Grade 5			Grade 6			Grade 7			Grade 8		Grade 9		Total
Commercial & industrial	$	242,326		$	7,475		$	556		$	5,295		$	-	$	-	$	255,652
Owner-occupied CRE		170,768			5,874			2,109			4,305			-		-		183,056
AG production		14,783			258			-			381			-		-		15,422
AG real estate		30,889			10,652			61			790			-		-		42,392
CRE investment		84,465			1,423			-			4,393			-		-		90,281
Construction & land development		31,487			2,107			115			9,108			-		-		42,817
Residential construction		11,872			-			-			504			-		-		12,376
Residential first mortgage		151,026			1,346			-			2,679			-		-		155,051
Residential junior mortgage		47,888			43			-			243			-		-		48,174
Retail & other		4,734			13			-			124			-		-		4,871
Total loans	$	790,238		$	29,191		$	2,841		$	27,822		$	-	$	-	$	850,092
Percent of total		93.0	%		3.4	%		0.3	%		3.3	%		-		-		100	%

	December 31, 2013
(in thousands)	Grades 1- 4			Grade 5			Grade 6			Grade 7			Grade 8		Grade 9		Total
Commercial & industrial	$	240,626		$	7,134		$	722		$	5,192		$	-	$	-	$	253,674
Owner-occupied CRE		174,070			6,605			2,644			4,157			-		-		187,476
AG production		13,631			267			-			358			-		-		14,256
AG real estate		26,058			10,159			62			778			-		-		37,057
CRE investment		83,475			1,202			15			5,603			-		-		90,295
Construction & land development		31,051			2,229			119			9,482			-		-		42,881
Residential construction		12,187			-			-			348			-		-		12,535
Residential first mortgage		150,343			1,365			-			2,695			-		-		154,403
Residential junior mortgage		48,886			215			-			262			-		-		49,363
Retail & other		5,274			15			-			129			-		-		5,418
Total loans	$	785,601		$	29,191		$	3,562		$	29,004		$	-	$	-	$	847,358
Percent of total		92.8	%		3.4	%		0.4	%		3.4	%		-		-		100	%

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. Management instituted the nonaccrual scope criteria in the second quarter of 2013, particularly in response to the higher volume of smaller nonaccrual loans acquired in the 2013 mergers. At the time an individual loan goes into nonaccrual status, however, management evaluates the loan for impairment and possible charge-off regardless of loan size.

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

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

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.

The following tables present impaired loans as of the dates indicated. PCI loans acquired in the 2013 mergers were initially recorded at a fair value of $16.7 million on their respective acquisition dates, net of an initial $12.2 million nonaccretable mark and a zero accretable mark. Included in the March 31, 2014 impaired loans is one troubled debt restructuring totaling $3.9 million described below under “Troubled Debt Restructurings.”


	Total Impaired Loans – March 31, 2014
(in thousands)	Recorded Investment		Unpaid Principal Balance		Related Allowance*		Average Recorded Investment		Interest Income Recognized
Commercial & industrial	$	299	$	310	$	214	$	150	$	1
Owner-occupied CRE		1,036		2,752		-		1,061		34
AG production		32		101		-		21		3
AG real estate		459		561		-		451		11
CRE investment		3,729		7,475		-		4,118		92
Construction & land development		4,856		5,697		460		7,118		62
Residential construction		-		-		-		-		-
Residential first mortgage		1,422		2,934		-		1,565		44
Residential junior mortgage		167		619		-		170		7
Retail & Other		-		31		-		-		1
Total	$	12,000	$	20,480	$	674	$	14,654	$	255

*One commercial and industrial loan with a balance of $298,000 had a specific reserve of $214,000. One construction and land development loan with a balance of $3.9 million had a specific reserve of $460,000. No other loans had a related allowance at March 31, 2014 and therefore the above disclosure was not expanded to include loans with and without a related allowance. These individual loans are identified in a subsequent table.

As a further breakdown, impaired loans as of March 31, 2014 are summarized by originated and acquired as follows:


	Originated – 3/31/2014
(in thousands)	Recorded Investment		Unpaid Principal Balance		Related Allowance*		Average Recorded Investment		Interest Income Recognized
Commercial & industrial	$	298	$	298	$	214	$	149	$	-
Owner-occupied CRE		-		-		-		-		-
AG production		-		-		-		-		-
AG real estate		-		-		-		-		-
CRE investment		-		-		-		-		-
Construction & land development		3,925		3,925		460		6,071		10
Residential construction		-		-		-		-		-
Residential first mortgage		-		-		-		-		-
Residential junior mortgage		-		-		-		-		-
Retail & Other		-		-		-		-		-
Total	$	4,223	$	4,223	$	674	$	6,220	$	10

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

	Acquired – 3/31/2014
(in thousands)	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
Commercial & industrial	$	1	$	12	$	-	$	1	$	1
Owner-occupied CRE		1,036		2,752		-		523		34
AG production		32		101		-		559		3
AG real estate		459		561		-		451		11
CRE investment		3,729		7,475		-		4,118		92
Construction & land development		931		1,772		-		1,047		52
Residential construction		-		-		-		-		-
Residential first mortgage		1,422		2,934		-		1,565		44
Residential junior mortgage		167		619		-		170		7
Retail & Other		-		31		-		-		1
Total	$	7,777	$	16,257	$	-	$	8,434	$	245


	Total Impaired Loans – December 31, 2013
(in thousands)	Recorded Investment		Unpaid Principal Balance		Related Allowance*		Average Recorded Investment		Interest Income Recognized
Commercial & industrial	$	1	$	140	$	-	$	1	$	3
Owner-occupied CRE		1,086		4,151		-		1,268		169
AG production		9		76		-		11		5
AG real estate		443		558		-		443		9
CRE investment		4,507		9,056		-		4,592		451
Construction & land development		9,379		10,580		3,204		9,406		178
Residential construction		-		-		-		-		-
Residential first mortgage		1,708		4,177		-		1,827		215
Residential junior mortgage		172		703		-		198		26
Retail & Other		-		36		-		-		3
Total	$	17,305	$	29,477	$	3,204	$	17,746	$	1,059

*One loan with a balance of $3.9 million and a reserve of $3.2 million is included within the construction and land development category. No other loans had a related allowance at December 31, 2013 therefore the disclosure was not expanded to include loans with and without a related allowance.

As a further breakdown, impaired loans as of December 31, 2013 are summarized by originated and acquired as follows:


	Originated – 12/31/2013
(in thousands)	Recorded Investment		Unpaid Principal Balance		Related Allowance*		Average Recorded Investment		Interest Income Recognized
Commercial & industrial	$	-	$	-	$	-	$	-	$	-
Owner-occupied CRE		-		-		-		-		-
AG production		-		-		-		-		-
AG real estate		-		-		-		-		-
CRE investment		-		-		-		-		-
Construction & land development		8,217		8,217		3,204		8,215		43
Residential construction		-		-		-		-		-
Residential first mortgage		-		-		-		-		-
Residential junior mortgage		-		-		-		-		-
Retail & Other		-		-		-		-		-
Total	$	8,217	$	8,217	$	3,204	$	8,215	$	43

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

	Acquired – 12/31/2013
(in thousands)	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
Commercial & industrial	$	1	$	140	$	-	$	1	$	3
Owner-occupied CRE		1,086		4,151		-		1,268		169
AG production		9		76		-		11		5
AG real estate		443		558		-		443		9
CRE investment		4,507		9,056		-		4,592		451
Construction & land development		1,162		2,363		-		1,191		135
Residential construction		-		-		-		-		-
Residential first mortgage		1,708		4,177		-		1,827		215
Residential junior mortgage		172		703		-		198		26
Retail & other		-		36		-		-		3
Total	$	9,088	$	21,260	$	-	$	9,531	$	1,016

Troubled Debt Restructurings

At March 31, 2014, there were five loans classified as troubled debt restructurings totaling $4.3 million. One loan had a premodification balance of $3.9 million and at March 31, 2014, had a balance of $3.9 million, was in compliance with its modified terms, was not past due, and was included in impaired loans with a specific reserve allocation of approximately $460,000. This loan is performing but is disclosed as impaired as a result of its classification as a troubled debt restructuring. The remaining four loans had a combined premodification balance of $438,000 and a combined outstanding balance of $417,000. Two of these TDRs were modified during the three months ended March 31, 2014. There were no other loans which were modified and classified as troubled debt restructurings at March 31, 2014. There were no loans which were classified as troubled debt restructurings during the previous twelve months that subsequently defaulted during the three months ended March 31, 2014. Loans which were considered troubled debt restructurings by Mid-Wisconsin prior to the acquisition are not required to be classified as troubled debt restructurings in the Company’s financial statements unless or until such loans would subsequently meet criteria to be classified as such, since acquired loans were recorded at their estimated fair values at the time of the acquisition.

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

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

	Three Months ended March 31,
(in thousands)	2014			2013
Balance at beginning of period	$	1,987		$	193
Transfer of loans at net realizable value to OREO		601			1,950
Sale proceeds		(1,762	)		(109	)
Net gain from sale of OREO		409			4
Balance at end of period	$	1,235		$	2,038

Note 8- Notes Payable

The Company had the following long term notes payable:

(in thousands)	March 31, 2014		December 31, 2013
Joint venture note	$	9,860	$	9,922
Federal Home Loan Bank (“FHLB”) advances		22,500		22,500
Notes payable	$	32,360	$	32,422

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

At March 31, 2014 and December 31, 2013, the Company’s fixed-rate FHLB advances totaled $22.5 million, require interest-only monthly payments, and have maturities through February 2018. The weighted average rate of FHLB advances was 1.85% at March 31, 2014 and December 31, 2013. The FHLB advances are collateralized by a blanket lien on qualifying first mortgages, home equity loans, multi-family loans and certain farmland loans which totaled approximately $88.9 million and $85.9 million at March 31, 2014 and December 31, 2013, respectively.

The following table shows the maturity schedule of the notes payable as of March 31, 2014:

Maturing in:	(in thousands)
2014		11,186
2015		5,762
2016		14,412
2017		-
2018		1,000
	$	32,360

Note 9 - Junior Subordinated Debentures

The Company’s carrying value of junior subordinated debentures was $12.2 million at March 31, 2014 and $12.1 million at December 31, 2013. In July 2004, Nicolet Bankshares Statutory Trust I (the “Statutory Trust”), issued $6.0 million of guaranteed preferred beneficial interests (“trust preferred securities”) that qualify as Tier I capital under Federal Reserve Board guidelines. All of the common securities of the Statutory Trust are owned by the Company. The proceeds from the issuance of the common securities and the trust preferred securities were used by the Statutory Trust to purchase $6.2 million of junior subordinated debentures of the Company, which pay an 8% fixed rate. Interest on these debentures is current. The debentures may be redeemed in part or in full, on or after July 15, 2009 at par plus any accrued but unpaid interest. The maturity date of the debenture, if not redeemed, is July 15, 2034.

As part of the Mid-Wisconsin acquisition, the Company assumed $10.3 million of junior subordinated debentures related to $10.0 million of issued trust preferred securities. The trust preferred securities and the debentures mature on December 15, 2035 and have a floating rate of the three-month LIBOR plus 1.43% adjusted quarterly. Interest on these debentures is current. The debentures may be called at par in part or in full, on or after December 15, 2010 or within 120 days of certain events. At acquisition in April 2013, the debentures were recorded at a fair value of $5.8 million, with the discount being accreted to interest expense over the remaining life of the debentures. At March 31, 2014, the carrying value of these junior debentures was $6.0 million and the $5.7 million carrying value of related trust preferred securities qualifies as Tier 1 capital.

Note 10 - 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. There were no changes in Level 3 values to report during the first quarter of 2014.

	Fair Value Measurements Using
Measured at Fair Value on a Recurring Basis:	Total		Level 1		Level 2		Level 3
(in thousands)
U.S. government sponsored enterprises	$	2,046	$	-	$	2,046	$	-
State, county and municipals		63,352		-		62,475		877
Mortgage-backed securities		65,843		-		65,843		-
Corporate debt securities		220		-		-		220
Equity securities		1,926		1,926		-		-
Securities AFS, March 31, 2014	$	133,387	$	1,926	$	130,364	$	1,097

(in thousands)
U.S. government sponsored enterprises	$	2,057	$	-	$	2,057	$	-
State, county and municipals		55,039		-		54,162		877
Mortgage-backed securities		67,879		-		67,879		-
Corporate debt securities		220		-		-		220
Equity securities		2,320		2,320		-		-
Securities AFS, December 31, 2013	$	127,515	$	2,320	$	124,098	$	1,097

The following is a description of the valuation methodologies used by the Company for the items noted in the tables above. 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 auction rate securities available for sale (for which there has been no liquid market since 2008) and corporate debt securities. At March 31, 2014 and December 31, 2013, 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.

Note 10 - Fair Value Measurements, continued

The following table presents the Company’s impaired loans and OREO measured at fair value on a nonrecurring basis for the periods presented.

Measured at Fair Value on a Nonrecurring Basis
	March 31, 2014
			Fair Value Measurements Using
(in thousands)	Total		Level 1		Level 2		Level 3
Impaired loans	$	11,326	$	-	$	-	$	11,326
OREO		1,235		-		-		1,235

	December 31, 2013
			Fair Value Measurements Using
(in thousands)	Total		Level 1		Level 2		Level 3
Impaired loans	$	14,101	$	-	$	-	$	14,101
OREO		1,987		-		-		1,987

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 Company is required under accounting guidance to report the fair value of all financial instruments in the consolidated balance sheets, including those financial instruments carried at cost. The carrying amounts and estimated fair values of the Company’s financial instruments at March 31, 2014 and December 31, 2013 are shown below.

	March 31, 2014
(in thousands)		Carrying Amount		Estimated Fair Value		Level 1		Level 2		Level 3
Financial assets:
Cash and cash equivalents		$	155,983	$	155,983	$	155,983	$	-	$	-
Certificates of deposit in other banks			1,960		1,980		-		1,980		-
Securities AFS			133,387		133,387		1,926		130,364		1,097
Other investments			8,015		8,015		-		5,874		2,141
Loans held for sale			3,996		3,996		3,996		-		-
Loans, net			840,748		842,414		-		-		842,414
Bank owned life insurance			24,010		24,010		24,010		-		-

Financial liabilities:
Deposits		$	1,042,244	$	1,044,434	$	-	$	-	$	1,044,434
Short-term borrowings			11,438		11,438		11,438		-		-
Notes payable			32,360		32,413		-		32,413		-
Junior subordinated debentures			12,178		12,954		-		-		12,954

Note 10 - Fair Value Measurements, continued

	December 31, 2013
(in thousands)		Carrying Amount		Estimated Fair Value		Level 1		Level 2		Level 3
Financial assets:
Cash and cash equivalents		$	146,978	$	146,978	$	146,978	$	-	$	-
Certificates of deposit in other banks			1,960		1,983		-		1,983		-
Securities AFS			127,515		127,515		2,320		124,098		1,097
Other investments			7,982		7,982		-		5,841		2,141
Loans held for sale			1,486		1,486		1,486		-		-
Loans, net			838,126		842,758		-		-		842,758
Bank owned life insurance			23,796		23,796		23,796		-		-

Financial liabilities:
Deposits		$	1,034,834	$	1,036,564	$	-	$	-	$	1,036,564
Short-term borrowings			7,116		7,116		7,116		-		-
Notes payable			32,422		32,548		-		32,548		-
Junior subordinated debentures			12,128		12,704		-		-		12,704

Not all the financial instruments listed in the table above are subject to the disclosure provisions of ASC 820, as certain assets and liabilities result in their carrying value approximating fair value. These include cash and cash equivalents, other investments, loans held for sale, Bank-Owned Life Insurance (“BOLI”), nonmaturing deposits, and short-term borrowings. 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.

Securities AFS and other investments: Fair values for securities are based on quoted market prices on securities exchanges, when available, which is considered a Level 1 measurement. If quoted market prices are not available, fair value is generally determined using pricing models widely used in the industry, quoted market prices of securities with similar characteristics, or discounted cash flows, which is considered a Level 2 measurement, and Level 3 was deemed appropriate for auction rate securities (for which there has been no liquid market since 2008) and corporate debt securities which include trust preferred security instruments. The corporate debt securities were acquired in the Mid-Wisconsin acquisition and valued based on a discounted cash flow analysis and the underlying credit quality of the issuer. The fair value approximates the cost at acquisition. For 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, net: For variable-rate loans that reprice frequently and with no significant change in credit risk or other optionality, fair values are based on carrying values. Fair values for all other loans are estimated by discounting contractual cash flows using estimated market discount rates, which reflect the credit and interest rate risk inherent in the loan. Collateral-dependent impaired loans are included in loans, net. The fair value of loans is considered to be a Level 3 measurement due to internally developed discounted cash flow measurements.

Deposits: The fair value of deposits with no stated maturity (such as demand deposits, savings, interest and non-interest checking, and money market accounts) is, by definition, equal to the amount payable on demand at the reporting date. Fair values for fixed-rate certificates of deposit are estimated using a discounted cash flow calculation that applies interest rates currently being offered in the market place on certificates of similar remaining maturities. Use of internal discounted cash flows provides a Level 3 fair value measurement.

Note 10 - Fair Value Measurements, continued

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: The fair values of junior subordinated debentures are estimated based on an evaluation of current interest rates being offered by instruments with similar terms and credit quality. Since the market for these instruments is limited, the internal evaluation represents a Level 3 measurement.

Off-balance-sheet instruments: The estimated fair value of letters of credit at March 31, 2014 and December 31, 2013 was insignificant. Loan commitments on which the committed interest rate is less than the current market rate are also insignificant at March 31, 2014 and December 31, 2013.

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.

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

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

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

At March 31, 2014, total assets were $1.2 billion and net income for the three months ended March 31, 2014 was $2.2 million. When comparing 2014 results to prior year periods, the timing of Nicolet’s 2013 acquisitions impacts the 2013 financial results. The transactions were accounted for under the acquisition method of accounting, and thus, the results of operations of the acquired entities prior to their respective consummation dates were not included in the accompanying consolidated financial statements. Particularly, the predominantly stock-for-stock acquisition of Mid-Wisconsin Financial Services, Inc. (“Mid-Wisconsin”) consummated on April 26, 2013, and the FDIC-assisted transaction to acquire Bank of Wausau was effective August 9, 2013 (collectively referred to as the “2013 acquisitions”). The eleven banking branches of Mid-Wisconsin and the one branch of Bank of Wausau opened as Nicolet National Bank branches on April 29 and August 10, 2013, respectively. At acquisition, the Mid-Wisconsin transaction increased total assets by $436 million, total liabilities by $416 million, and common equity by approximately $9 million. A bargain purchase gain of $10.4 million was recorded during the second quarter of 2013 and in the third quarter of 2013, a $0.9 million negative adjustment was recorded to that bargain purchase gain relative to a change in estimate of a now settled legal action. The 2013 income statement also included approximately $1.7 million of pre-tax, non-recurring merger related expenses tied to preparation for, consummation of and integration of Mid-Wisconsin into the Company. On a smaller scale, the Bank of Wausau transaction increased total assets by $47 million at acquisition (of which $18 million of cash was used during the month of September 2013 to immediately redeem rate-sensitive certificates of deposit), and resulted in pre-tax bargain purchase gain of $2.4 million and approximately $0.2 million of pre-tax, non-recurring merger related expenses recorded in the third quarter of 2013. Finally, acquisition accounting requires assets purchased and liabilities assumed to be recorded at their respective fair values at the date of acquisition, which impacted various ratios, but most notably asset quality measures (as loans are recorded directly at their estimated fair value and no addition to the allowance for loan losses is recorded at consummation) and taxes. For additional details, see “Note 2 – Acquisitions”, “Note 6 – Loans, Allowance for Loan Losses, and Credit Quality”, and “Income Taxes” within this document.

On November 28, 2012, Nicolet entered into a merger agreement with Mid-Wisconsin. It subsequently filed a Registration Statement on Form S-4 (Regis. No. 333-186401) (the “Registration Statement”) with the Securities and Exchange Commission under the provisions of the Securities Act of 1933, as amended (the “Securities Act”) to register the common stock to be issued in the merger. On March 26, 2013, the Registration Statement became effective and Nicolet became a public reporting company under Section 15(d) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”).

Forward-Looking Statements

Statements made in this document and in documents that are incorporated by reference which are not purely historical are forward-looking statements, as defined in the Private Securities Litigation Reform Act of 1995, including any statements regarding descriptions of management’s plans, objectives, or goals for future operations, products or services, and forecasts of its revenues, earnings, or other measures of performance. Forward-looking statements are based on current management expectations and, by their nature, are subject to risks and uncertainties. These statements generally may be identified by the use of words such as “believe,” “expect,” “anticipate,” “plan,” “estimate,” “should,” “will,” “intend,” or similar expressions. Stockholders should note that many factors, some of which are discussed elsewhere in this document, could affect the future financial results of Nicolet and could cause those results to differ materially from those expressed in forward-looking statements contained in this document. These factors, many of which are beyond Nicolet’s control, include, but are not necessarily limited to the following:

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

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

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

potential difficulties in integrating the operations of Nicolet with those of acquired entities, if any;

compliance or operational risks related to new products, services, ventures, or lines of business, if any, that Nicolet may pursue or implement; and

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

These factors should be considered in evaluating the forward-looking statements, and you should not place undue reliance on such statements. Nicolet specifically disclaims any obligation to update factors or to publicly announce the results of revisions to any of the forward-looking statements or comments included herein to reflect future events or developments.

Critical Accounting Policies

The consolidated financial statements of Nicolet are prepared in conformity with U.S. GAAP and follow general practices within the industry in which it operates. This preparation requires management to make estimates, assumptions and judgments that affect the amounts reported in the consolidated financial statements and accompanying notes. These estimates, assumptions and judgments are based on information available as of the date of the financial statements; accordingly, as this information changes, actual results could differ from the estimates, assumptions and judgments reflected in the financial statements. Certain policies inherently have a greater reliance on the use of estimates, assumptions and judgments and, as such, have a greater possibility of producing results that could be materially different than originally reported. Estimates that are particularly susceptible to significant change include the valuation of loans acquired in the 2013 acquisitions, as well as the determination of the allowance for loan losses and income taxes and, therefore, are critical accounting policies.

Business Combinations and Valuation of Loans Acquired in Business Combinations

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

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

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

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

Allowance for Loan Losses

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

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

Income taxes

The assessment of income tax assets and liabilities involves the use of estimates, assumptions, interpretation, and judgment concerning certain accounting pronouncements and federal and state tax codes. There can be no assurance that future events, such as court decisions or positions of federal and state taxing authorities, will not differ from management’s current assessment, the impact of which could be significant to the consolidated results of operations and reported earnings.

Nicolet files a consolidated federal income tax return and a combined state income tax return (both of which include Nicolet and its wholly owned subsidiaries). Accordingly, amounts equal to tax benefits of those companies having taxable federal losses or credits are reimbursed by the companies that incur federal tax liabilities. Amounts provided for income tax expense are based on income reported for financial statement purposes and do not necessarily represent amounts currently payable under tax laws. Deferred income tax assets and liabilities are computed annually for differences between the financial statement and tax bases of assets and liabilities that will result in taxable or deductible amounts in the future based on enacted tax law rates applicable to the periods in which the differences are expected to affect taxable income. As changes in tax laws or rates are enacted, deferred tax assets and liabilities are adjusted through provision for income tax expense. Valuation allowances are established when it is more likely than not that a portion of the full amount of the deferred tax asset will not be realized. In assessing the ability to realize deferred tax assets, management considers the scheduled reversal of deferred tax liabilities, projected future taxable income and tax planning strategies. Nicolet may also recognize a liability for unrecognized tax benefits from uncertain tax positions. Unrecognized tax benefits represent the differences between a tax position taken or expected to be taken in a tax return and the benefit recognized and measured in the financial statements. Penalties related to unrecognized tax benefits are classified as income tax expense.

The following discussion is Nicolet management’s analysis of the consolidated financial condition as of March 31, 2014 and December 31, 2013 and results of operations for the three-month periods ended March 31, 2014 and 2013. It should be read in conjunction with Nicolet’s audited consolidated financial statements as of December 31, 2013 and 2012, and for the two years ended December 31, 2013, included in Nicolet’s Annual Report on Form 10-K.

Performance Summary

Nicolet reported net income of $2.2 million for the three months ended March 31, 2014, compared to $0.8 million for the first quarter of 2013. After $61,000 of preferred stock dividends, first quarter 2014 net income available to common shareholders was $2.2 million, or $0.50 per diluted common share. Comparatively, after $305,000 of preferred stock dividends, first quarter 2013 net income available to common shareholders was $450,000, or $0.13 per diluted common share. Income statement results and average balances for first quarter 2014 fully include the 2013 acquisitions, while the first quarter of 2013 does not include the 2013 acquisitions at all.

Net interest income was $10.0 million for the first quarter of 2014, an increase of $4.2 million or 74% over the $5.8 million for the first quarter of 2013. The improvement was predominantly volume related, given the timing of the 2013 acquisitions, but was also favorably impacted by an increase in interest rate spread on higher average earning assets. On a tax-equivalent basis, the net interest margin for the first quarter of 2014 was 3.68%, up 18 basis points (“bps”) from 3.50% for the comparable 2013 period. The cost of interest-bearing liabilities was 0.76%, 29 bps lower than first quarter 2013, while the average yield on earning assets was 4.32%, 4 bps lower than first quarter 2013, resulting in a 25 bps improvement in the interest rate spread.

Loans were $850 million at March 31, 2014, up $3 million or 0.3% over $847 million at December 31, 2013, and up $308 million or 57% over $542 million at March 31, 2013. Removing the $284 million of loans added at acquisition (i.e. $272 million from Mid-Wisconsin and $12 million from Bank of Wausau), loans grew organically up 4% between the March 31 periods. Between the comparative first quarter periods, average loans were $847 million in 2014 yielding 5.22%, compared to $547 million in 2013 yielding 4.97%.

Total deposits were $1.0 billion at March 31, 2014, up $7 million or 0.7% over $1.0 billion at December 31, 2013, and up $479 million or 85% over $563 million at March 31, 2013. Removing the $370 million of deposits added at acquisition (i.e. $346 million from Mid-Wisconsin and $24 million net deposits acquired from Bank of Wausau given the quick redemption of $18 million of rate-sensitive certificates of deposit), deposits grew organically 19% between the March 31 periods. Between the comparative first quarter periods, average total deposits were $1.0 billion in 2014, with interest-bearing deposits costing 0.59%, compared to $593 million in 2013, with interest-bearing deposits costing 0.81%.

Asset quality measures remained relatively strong, though were impacted initially by the 2013 acquisitions. Nonperforming assets were 0.85% of total assets at March 31, 2014, compared to 1.02% at year end 2013 and 0.70% at March 31, 2013. The allowance for loan losses was $9.3 million or 1.10% of loans at March 31, 2014 (impacted by the 2013 acquisitions adding no allowance for loan losses while adding $284 million to loans at acquisition), compared to $9.2 million or 1.09%, respectively at year end 2013 and $7.5 million or 1.39%, respectively at March 31, 2013. The provision for loan losses was $0.7 million with net charge offs of $0.6 million for the first quarter of 2014, versus provision of $1.0 million with $0.6 million of net charge offs for the comparable 2013 period.

Noninterest income was $3.8 million for the first three months of 2013, up $1.0 million over the first quarter of 2013, with $0.75 million of this variance attributable to net gains realized in first quarter 2014 on favorable sale resolutions of other real estate owned and of an equity security holding. Other notable increases over prior year, largely due to increased business from the expanded size of the company, were seen in service charges (up $0.2 million or 74%), trust fee income (up $0.3 million or 38%), and other income (up $0.2 million, of which $0.1 million increase is due to income from higher debit card volumes). Mortgage income was $0.2 million or 75% lower than the comparable first quarter of 2013, resulting from a significantly more robust mortgage market a year ago where production was strong until the start of third quarter 2013 when production slowed dramatically largely in response to rising mortgage rates and certain mortgage regulation changes.

Noninterest expense was $9.6 million for the first quarter of 2014, up $3.2 million or 51% over the first quarter of 2013, given the larger operating base from the acquisitions being fully included in 2014, while not included in the first quarter of 2013. Most notably, between the first quarter periods, salaries and benefits were up $1.7 million or 49% (given the larger workforce and merit increases between the years), occupancy was up $0.4 million or 60% (given the operation of 23 branch locations versus 11 branches last year and a harsher winter), office expense was up $0.4 million or 92% (given the larger operating base, but also higher continued integration on systems, system maintenance, phones and postage), processing costs were up $0.3 million or 78% (mostly commensurate with growth in the number of accounts), and core deposit intangible amortization increased $0.2 million, fully attributable to the Mid-Wisconsin merger.

Net Interest Income

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

Comparison of the three months ending March 31, 2014 versus 2013

Net interest income in the consolidated statements of income (which excludes any taxable equivalent adjustment) was $10.0 million in the first three months of 2014, compared to $5.8 million in the first three months of 2013. 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 $157,000 and $120,000 for the first three months of 2014 and 2013, respectively, resulting in taxable equivalent net interest income of $10.1 million for the first three months of 2014 and $5.9 million for the first three months of 2013.

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.

Table 1: Quarterly Net Interest Income Analysis


	For the Three Months Ended March 31,
	2014							2013
(in thousands)	Average Balance		Interest		Average Rate			Average Balance		Interest		Average Rate
ASSETS
Earning assets
Loans (1) (2) (3)(4)	$	846,703	$	11,039		5.22	%	$	547,015	$	6,797		4.97	%
Investment securities
Taxable		88,042		418		1.90	%		25,897		127		1.96	%
Tax-exempt (2)		36,965		298		3.22	%		26,108		275		4.23	%
Other interest-earning assets		128,707		135		0.42	%		69,790		82		0.47	%
Total interest-earning assets		1,100,417	$	11,890		4.32	%		668,810	$	7,281		4.36	%
Cash and due from banks		43,054							15,628
Other assets		65,271							32,802
Total assets	$	1,208,742						$	717,240
LIABILITIES AND STOCKHOLDERS’ EQUITY
Interest-bearing liabilities
Savings	$	100,647	$	61		0.25	%	$	48,986	$	48		0.40	%
Interest-bearing demand		203,213		368		0.73	%		116,385		304		1.06	%
MMA		285,048		211		0.30	%		192,484		198		0.42	%
Core CDs and IRAs		233,954		509		0.88	%		115,923		409		1.43	%
Brokered deposits		51,315		132		1.04	%		29,231		42		0.59	%
Total interest-bearing deposits		874,177		1,281		0.59	%		503,009		1,001		0.81	%
Other interest-bearing liabilities		56,661		472		3.34	%		40,314		408		4.05	%
Total interest-bearing liabilities		930,838		1,753		0.76	%		543,323		1,409		1.05	%
Noninterest-bearing demand		164,438							90,181
Other liabilities		7,099							6,109
Total equity		106,367							77,627
Total liabilities and stockholders’ equity	$	1,208,742						$	717,240
Net interest income and rate spread			$	10,137		3.56	%			$	5,872		3.31	%
Net interest margin						3.68	%						3.50	%

(1)	Nonaccrual loans are included in the daily average loan balances outstanding.

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

(3)	Interest income for the periods ending March 31, includes loan fees of $35,000 in 2014, and $80,000 in 2013.

(4)	Includes accretable yield from acquired loans

Table 2: Volume/Rate Variance

Comparison of the three months ended March 31, 2014 versus 2013 follows:
	Increase (decrease) Due to Changes in
(in thousands)	Volume		Rate			Net
Earning assets
Loans (1)	$	3,898	$	344		$	4,242
Investment securities
Taxable		292		(1	)		291
Tax-exempt (1)		99		(76	)		23
Other interest-earning assets		50		3			53

Total interest-earning assets	$	4,339	$	270		$	4,609

Interest-bearing liabilities
Savings deposits	$	36	$	(23	)	$	13
Interest-bearing demand		178		(114	)		64
MMA		78		(65	)		13
Core CDs and IRAs		301		(201	)		100
Brokered deposits		44		46			90

Total interest-bearing deposits		637		(357	)		280
Other interest-bearing liabilities		115		(51	)		64

Total interest-bearing liabilities		752		(408	)		344
Net interest income	$	3,587	$	678		$	4,265

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

Table 3: Interest Rate Spread, Margin and Average Balance Mix — Taxable-Equivalent Basis


	Three Months Ended March 31,
	2014								2013
(in thousands)	Average Balance		% of Earning Assets			Yield/Rate			Average Balance		% of Earning Assets			Yield/Rate
Total loans	$	846,703		76.9	%		5.22	%	$	547,015		81.8	%		4.97	%
Investment securities and other earning assets		253,714		23.1	%		1.34	%		121,795		18.2	%		1.59	%
Total interest-earning assets	$	1,100,417		100	%		4.32	%	$	668,810		100	%		4.36	%

Interest-bearing liabilities	$	930,838		84.6	%		0.76	%	$	543,323		81.2	%		1.05	%

Noninterest-bearing funds, net		169,579		15.4	%					125,487		18.8	%
Total funds sources	$	1,100,417		100	%		0.64	%	$	668,810		100	%		0.21	%
Interest rate spread							3.56	%							3.31	%
Contribution from net free funds							0.12	%							0.19	%
Net interest margin							3.68	%							3.50	%

Taxable-equivalent net interest income was $10.1 million for the first three months of 2014, an increase of $4.3 million or 73% over the same period in 2013. The $4.3 million increase in taxable-equivalent net interest income was predominantly volume related, given the timing of the acquisitions, but was also favorably impacted by an increase in interest rate spread. Taxable equivalent interest income increased $4.6 million between the three month periods driven by loans (including $3.9 million more interest income from higher loan volumes and $0.3 million from higher loan yields, aided by higher levels of purchase-accounting loan accretion on acquired loans). Interest expense increased $0.3 million between the first quarter periods driven mainly by interest-bearing deposits (including $0.6 million more interest expense from higher volumes, offset by $0.4 million less interest expense from lower deposits rates.)

The taxable-equivalent net interest margin was 3.68% for the first three months of 2014, up 18 bps over the first three months of 2013, with a decrease in the cost of funds to 0.76% (down 29 bps), offset by a lower earning asset yield of 4.32% (down 4 bps) and a 7 bps decrease in net free funds. The cost of funds between the three month periods has benefited from a lower rate structure acquired with the 2013 acquisitions and rate reductions made particularly in commercial deposit products. In general, there has been and will be underlying downward margin pressure as assets mature in this prolonged low-rate environment, with current reinvestment rates substantially lower than previous rates and less opportunity to offset such with similar changes in the already low cost of funds; however, in 2014 such pressure continues to be mitigated by the favorable income from acquired loans.

The earning asset yield was comprised mainly of loans, representing 76.9% of average earning assets and yielding 5.22% for first three months of 2014, compared to 81.8% and 4.97%, respectively, for the first three months of 2013. The 25 bps improvement in loan yield between the three month periods was aided in part by the positive rate profile of acquired loans. All other interest earning assets combined yielded 1.34%, down 25 bps compared to the first three months of 2013, though aided in part by a higher mix of investments (representing 11.4% of average earning assets, versus 7.8% for the comparable 2013 period) that earn more than the other cash-equivalent earning assets.

Nicolet’s cost of funds continued its favorable decline during the low-rate environment, at 0.76% for the first three months of 2014, 29 bps lower than the first three months of 2013. The average cost of interest-bearing deposits (which represent over 90% of average interest-bearing liabilities for both years), was 0.59% for the first three months of 2014, down 22 bps versus the first three months of 2013, with favorable rate variances in all deposit categories, with the exception of brokered deposit balances. Lower-costing transactional deposits (savings, checking and MMA) saw rate declines in response to reductions made across products between the years, while such balances continued to rise. Average brokered deposit balances increased nominally for the comparable three month periods but their cost increased from 0.59% in 2013 to 1.04% in 2014, as longer-term funding replaced maturing shorter-term instruments in the second quarter of 2013. The cost of other interest-bearing liabilities (comprised of short- and long-term borrowings) decreased to 3.34%, down 71 bps between the three month periods, mainly from favorable rates on new advances, the prepayment of $10 million in higher-costing advances during first quarter 2013, and the acquisition at fair value of a lower-rate junior subordinated debenture in the second quarter of 2013.

Average interest-earning assets were $1.1 billion for the first three months of 2014, $432 million or 65% higher than the first three months of 2013, led by a $300 million increase in average loans (to $847 million or 77% of interest earning assets) and a $132 million increase in all other interest-earning assets combined (to $254 million or 23% of earning assets), both heavily influenced by the size and timing of the 2013 acquisitions, and a higher level of low-earning cash balances.

Average interest-bearing liabilities were $931 million, up $388 million or 71% over the first three months of 2013, led by a $349 million increase in non-brokered interest-bearing deposits (to $823 million or 88% of average interest-bearing liabilities), a $22 million increase in average brokered deposits (to $51 million), and a $16 million increase in average other interest-bearing liabilities (to $57 million), both heavily influenced by the size and timing of the acquisitions in 2013.

Provision for Loan Losses

The provision for loan losses for the three months ended March 31, 2014 and 2013 was $0.7 million and $1.0 million, respectively. Asset quality trends remained relatively strong, particularly in the non-acquired portfolio (primarily from work-outs of problem loans and declining net charge-offs). At December 31, 2013, the ALLL was $9.2 million which grew to $9.3 million at March 31, 2014, given the $0.7 million provision for loan losses and net charge offs of $0.6 million during the first three months of 2014. The ratio of the ALLL to total loans was 1.10% at March 31, 2014, up 0.1% from the December 31, 2013 level, but down compared to 1.39% at March 31, 2013. This decline of ALLL to total loans was most notably impacted by the 2013 acquisitions, which added no allowance for loan losses to the numerator at acquisition and $284 million of loans into the denominator as of the dates of their acquisition. As events occur in the acquired loan portfolio, an ALLL will be established for this pool of assets as appropriate.

Nonperforming loans continue to improve. Nonperforming loans were declining prior to the acquisitions, starting at $7.0 million (or 1.3% of total loans) at December 31, 2012, decreasing to $2.7 million (or 0.5% of loans) at March 31, 2013, increasing to a high of $17.4 million (or 2.0% of loans) at September 30, 2013 and then declining to $9.1 million (or 1.1% of loans) at March 31, 2014. Of the nonaccrual loans initially acquired in the 2013 acquisitions, $7.7 million remains included in the $9.1 million of nonaccruals at March 31, 2014.

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.”

Noninterest Income

Table 4: Noninterest Income


	For the three months ended March 31,
	2014		2013		$ Change			% Change
(in thousands)
Service charges on deposit accounts	$	494	$	284	$	210			73.9	%
Trust services fee income		1,105		802		303			37.8
Mortgage income		215		872		(657	)		(75.3	)
Brokerage fee income		160		102		58			56.9
BOLI		214		169		45			26.6
Rent income		300		250		50			20.0
Investment advisory fees		110		86		24			27.9
Gain on sale of assets, net		750		4		746			N/M	*
Other income		412		187		225			120.3
Total noninterest income	$	3,760	$	2,756	$	1,004			36.4	%
Noninterest income without net gains	$	3,010	$	2,752	$	258			9.4	%

*N/M means not meaningful.

Comparison of the three months ending March 31, 2014 versus 2013

Noninterest income was $3.8 million for the first three months of 2014, up $1.0 million or 36.4% over the first three months of 2013, mainly driven by net gains on the sale of assets (up $0.7 million).

During the first three months of 2014, Nicolet recognized $0.75 million of net gains on sales of assets compared to a nominal net gain in the comparable period of 2013. The activity in 2014 consisted of a $0.3 million gain on the sale of an equity security holding and $0.4 million of net gains on sales of OREO (as properties were generally resolved at better than expected terms).

Service charges on deposit accounts were $0.5 million for the first three months of 2014, up $0.2 million (or 73.9%) over the comparable period of 2013. The increase is primarily from increased service charges on deposits given the increase in deposit balances and number of accounts mainly from the acquisitions, and higher non-sufficient funds fees.

Trust service fees increased to $1.1 million for the first three months of 2014, up $0.3 million or 37.8% over the comparable 2013 period. In addition to the larger base of customers acquired through the merger, there was continued market improvement over last year on assets under management, on which fees are based. Similarly, brokerage fees were $0.2 million, up $58,000 or 56.9% over the first three months of 2013, mainly from increased legacy business, market improvements and to a lesser degree from the merger. Management believes the expanded footprint of the bank should provide growth potential for wealth management in future periods.

Mortgage income represents net gains received from the sale of residential real estate loans service-released into the secondary market and to a small degree, some related income. Residential refinancing activity and new purchase activity remained steady for the first six months of 2013; however, mortgage production slowed considerably during the last half of 2013 and into 2014, largely in response to rising mortgage rates and certain mortgage regulation changes. As a result, mortgage income in the first quarter of 2014 was $0.2 million compared to $0.9 million for the first quarter 2013. The change between three-month periods was not significantly impacted by the acquisitions.

The remaining income categories included modest first quarter 2014 increases compared to the first quarter of 2013. BOLI income was $0.2 million for the first three months of 2014, up $45,000 from the comparable period in 2013, or 26.6%, mainly from $4.3 million of BOLI acquired in the Mid-Wisconsin transaction bringing the 2014 three-month average of BOLI investment to $23.9 million, up 27% over the comparable period last year. Rent income, investment advisory fees and other noninterest income combined were $0.8 million for the first three months of 2014 compared to $0.5 million for the comparable 2013 period, with the majority of the increase due to ancillary fees tied to deposit-related products, most particularly debit card, check cashing and wire fee income.

Noninterest Expense

Table 5: Noninterest Expense


	For the three months ended March 31,
	2014		2013		$ Change		% Change
(in thousands)
Salaries and employee benefits	$	5,295	$	3,559	$	1,736		48.8	%
Occupancy, equipment and office		1,898		1,104		794		71.9
Business development and marketing		535		425		110		25.9
Data processing		754		423		331		78.3
FDIC assessments		184		110		74		67.3
Core deposit intangible amortization		335		148		187		126.4
Other		587		571		16		2.8
Total noninterest expense	$	9,588	$	6,340	$	3,248		51.2	%

Comparison of the three months ending March 31, 2014 versus 2013

Total noninterest expense was $9.6 million for the first three months of 2014, up $3.2 million, or 51.2% over the first three months of 2013, as the 2014 period included increased operations from the acquisitions while the first quarter of 2013 did not.

Salaries and employee benefits expense was $5.3 million, up $1.7 million or 48.8%, over the first three months of 2013. The increase was attributable to the growing workforce from the acquisitions (though less than a one-to-one increase as a result of realization of operating efficiencies) and was also impacted by merit increases between the years as well as higher health insurance and 401k expense. Average full time equivalent employees for the first three months of 2014 were 291, up 73% versus 168 for the comparable 2013 period.

Occupancy, equipment and office expense increased $0.8 million to $1.9 million for the first three months of 2014 compared to 2013. This 71.9% increase is in line with the addition of 12 branches in the acquisitions which more than doubled the physical facilities and related expenses. Utilities, rent, snowplowing, and other occupancy expenses increased proportionately in conjunction with the acquisitions, however, a harsher 2014 winter and continued integration costs related to systems, systems maintenance, phones, and postage resulted in higher expense between the first quarter periods.

Business development and marketing expense for the first three months of 2014 increased $0.1 million compared to the same period in 2013. This 25.9% increase includes a greater focus on growth in new markets as well as higher expense on promotional material and television costs between the first quarter periods.

Data processing expenses (which are primarily volume based) rose $0.3 million or 78.3% between the first quarter periods, in line with the larger operating base and continued integration of systems. FDIC assessments increased slightly (up $74,000) given the increased size in assets, on which the assessments are based. Core deposit intangible amortization increased $0.2 million, given the new $4.0 million core deposit intangible recorded at acquisition for Mid-Wisconsin and being amortized on an accelerated basis over 10 years.

Other expense increased minimally between the first quarter periods (up 2.8%). Within this category are foreclosure expenses which were up $121,000 over the first three months of 2013 due to additional OREO properties added from the acquisitions and $96,000 of prepayment expenses related to the early extinguishment of higher costing wholesale debt incurred in the first quarter of 2013 that were not recurring.

Income Taxes

For the first three months of 2014, income tax expense was $1.2 million compared to $0.4 million for the same period of 2013. The effective tax rate was 35% for the first quarter of both 2014 and 2013. 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, 2014 or December 31, 2013.

BALANCE SHEET ANALYSIS

Loans

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

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

Total loans were $850 million at March 31, 2014 compared to $847 million at December 31, 2013. This $3 million increase represented less than 1% of growth in the 3 months after year end 2013, but was favorable compared to the first three months of 2013 which reported an $11 million decrease (or 2%) in total loans since year end 2012.

Table 6: Period End Loan Composition


	March 31, 2014					December 31, 2013					March 31, 2013
	Amount		% of Total			Amount		% of Total			Amount		% of Total
Commercial & industrial	$	255,652		30.1	%	$	253,674		29.9	%	$	193,289		35.7	%
Owner-occupied CRE		183,056		21.5			187,476		22.1			107,523		19.8
Ag production		15,422		1.8			14,256		1.7			219		0.1
Ag real estate		42,392		5.0			37,057		4.4			9,866		1.8
CRE investment		90,281		10.6			90,295		10.7			73,410		13.5
Construction & land development		42,817		5.0			42,881		5.1			22,285		4.1
Residential construction		12,376		1.5			12,535		1.5			7,445		1.4
Residential first mortgage		155,051		18.2			154,403		18.2			86,202		15.9
Residential junior mortgage		48,174		5.7			49,363		5.8			39,026		7.2
Retail & other		4,871		0.6			5,418		0.6			2,859		0.5
Total loans	$	850,092		100	%	$	847,358		100.0	%	$	542,124		100.0	%

Broadly, commercial-based loans (i.e. commercial, agricultural, CRE and construction loans combined) versus retail-based loans (i.e. residential real estate and other retail loans) were 74.0% commercial-based and 26.0% retail-based at March 31, 2014 versus 73.9% and 26.1%, respectively, for December 31, 2013. Commercial-based loans are considered to have more inherent risk of default than retail-based loans, in part because 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 and, to a lesser degree, to municipalities within a diverse range of industries. 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 $2 million since year end 2013. Commercial and industrial loans continue to be the largest segment of Nicolet’s portfolio and increased to 30.1% of the total portfolio at March 31, 2014, up from 29.9% at December 31, 2013.

Owner-occupied CRE loans declined to 21.5% of loans at March 31, 2014 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, or on the value of underlying collateral.

Agricultural production and agricultural real estate loans combined 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, the agricultural loans increased $6.5 million since year end 2013, representing 6.8% of total loans at March 31, 2014, versus 6.1% at December 31, 2013.

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 remained unchanged since year end 2013, declining slightly as a percent of loans from 10.7% to 10.6% at March 31, 2014.

Loans in the construction and land development portfolio represent 5.0% of total loans at March 31, 2014 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 area has declined steadily both in total dollars and as a percentage of the portfolio over the past several years, with the 2013 increase attributable to the 2013 acquisitions.

On a combined basis, Nicolet’s residential real estate loans represent 25.4% of total loans at March 31, 2014, down 0.1% from December 31, 2013. 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 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 declines in market values in the residential real estate markets worsen, particularly in Nicolet’s market area, the value of collateral securing its residential real estate loans could decline further, which could cause an increase in the provision for loan losses. As part of its management of originating residential mortgage loans, the vast majority of Nicolet’s long-term, fixed-rate residential real estate mortgage loans are sold in the secondary market without retaining the servicing rights. Nicolet’s mortgage loans have historically had low net charge off rates and held mortgages typically are of high quality. While mortgage loans normally hold terms of 30 years, Nicolet’s portfolio mortgages have an average contractual life of less than 15 years.

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, 2013 to March 31, 2014 and the portfolio has declined as a percent of total loans.

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, 2014, 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, accounting policies behind loans and the allowance for loan losses are described in Note 1, “Basis of Presentation,” and additional disclosures are included in Note 6, “Loans, Allowance for Loan Losses and Credit Quality,” in the Notes to the Unaudited Consolidated Financial Statements.

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.

Nicolet’s management allocates the ALLL by pools of risk within each loan portfolio segment. The allocation methodology consists of the following components. First, a specific reserve for the estimated 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. Beginning in the first quarter of 2014, management extended the look-back period on which the average historical loss rates are determined, from a prior three-year period to a rolling 20-quarter (5 year) average, as a means of capturing more of a full credit cycle now that recent period loss levels are stabilizing. Contrarily, the three-year average (used by the Company’s methodology during 2009-2013) was considered more appropriate for the severe and prolonged economic downturn particularly evidenced by higher net charge off levels in 2008 through 2011. 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 performs ongoing intensive analyses of its loan portfolio to allow for early identification of customers experiencing financial difficulties, maintains prudent underwriting standards, understands the economy in its markets, and considers the trend of deterioration in loan quality in establishing the level of the ALLL.

Consolidated net income and stockholders’ equity could be affected if Nicolet’s 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, 2014, the ALLL was $9.3 million compared to $9.2 million at December 31, 2013. The increase was a result of a 2014 provision of $0.7 million offset by 2014 net charge offs of $0.6 million. Comparatively, the provision for loan losses in the first three months of 2013 was $1.0 million and net charge offs were $0.6 million. Annualized net charge offs as a percent of average loans were 0.27% in the first quarter of 2014 compared to 0.41% for the first quarter of 2013 and 0.54% for the entire year of 2013. 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 1.10% at March 31, 2014 compared to 1.09% at December 31, 2013 and 1.39% at March 31, 2013. The decrease in the ALLL as a percentage of loans compared to March 31, 2013 was attributable to the 2013 acquisitions since acquired loans are recorded at their estimated fair value at the acquisition dates and no ALLL was initially recorded at acquisition while $284 million was added to loans at acquisition. At March 31, 2014 $9.3 million of the ALLL was reserved against originated loans (representing 1.48% of originated loans) and zero was reserved against acquired loans.

The largest portions of the ALLL were allocated to construction and land development loans and commercial & industrial loans combined, representing 60.8% and 73.3% of the ALLL at March 31, 2014 and December 31, 2013, respectively. The decrease in these categories since December 31, 2013 was the result of changes to allowance allocations as additional qualitative factors related to acquired loans are refined, creating a more ratable distribution of the provision across categories.

Table 7: Loan Loss Experience

	For the three months ended						Year ended
(in thousands)	March 31, 2014			March 31, 2013			December 31, 2013
Allowance for loan losses (ALLL):
Balance at beginning of period	$	9,232		$	7,120		$	7,120
Provision for loan losses		675			975			6,200
Charge-offs		574			567			4,238
Recoveries		11			12			150
Net charge-offs		563			555			4,088
Balance at end of period	$	9,344		$	7,540		$	9,232

Net loan charge-offs (recoveries):
Commercial & industrial	$	509		$	470		$	534
Owner-occupied CRE		(2	)		55			1,851
Agricultural production		-			-			-
Agricultural real estate		-			-			-
CRE investment		(4	)		-			992
Construction & land development		12			36			304
Residential construction		-			-			-
Residential first mortgage		28			(5	)		148
Residential junior mortgage		9			(1	)		189
Retail & other		11			-			70
Total net loans charged-off	$	563		$	555		$	4,088

ALLL to total loans		1.10	%		1.39	%		1.09	%
ALLL to net charge-offs		415	%		340	%		226	%
Net charge-offs to average loans, annualized		0.27	%		0.41	%		0.54	%

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, 2014 and December 31, 2013.

Table 8: Allocation of the Allowance for Loan Losses

(in thousands)	March 31, 2014			% of Loan Type to Total Loans			December 31, 2013			% of Loan Type to Total Loans
ALLL allocation
Commercial & industrial	$	3,136			30.1	%	$	1,798			29.9	%
Owner-occupied CRE		1,039			21.5			766			22.1
Agricultural production		43			1.8			18			1.7
Agricultural real estate		259			5.0			59			4.4
CRE investment		674			10.6			505			10.7
Construction & land development		2,550			5.0			4,970			5.1
Residential construction		290			1.5			229			1.5
Residential first mortgage		811			18.2			544			18.2
Residential junior mortgage		428			5.7			321			5.8
Retail & other		114			0.6			22			0.6
Total ALLL	$	9,344			100	%	$	9,232			100	%

ALLL category as a percent of total ALLL:
Commercial & industrial		33.6	%					19.5	%
Owner-occupied CRE		11.1						8.3
Agricultural production		0.5						0.2
Agricultural real estate		2.8						0.6
CRE investment		7.2						5.5
Construction & land development		27.2						53.8
Residential construction		3.1						2.5
Residential first mortgage		8.7						5.9
Residential junior mortgage		4.6						3.5
Retail & other		1.2						0.2
Total ALLL		100	%					100	%

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 $9.1 million (consisting of $1.4 million originated loans and $7.7 million acquired loans) at March 31, 2014 compared to $10.3 million at December 31, 2013. Nonperforming assets also include OREO and were $10.3 million at March 31, 2014 compared to $12.3 million at December 31, 2013. OREO decreased $0.8 million from year end 2013 to $1.2 million at March 31, 2014. Nonperforming assets as a percent of total assets were 0.85% at March 31, 2014 compared to 1.02% at December 31, 2013.

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 totaled $18.7 million and represented 2.2% of total outstanding loans at both March 31, 2014 and December 31, 2013. Potential problem loans require a heightened management review of the pace at which a credit may deteriorate, the duration of asset quality stress, and uncertainty around the magnitude and scope of economic stress that may be felt by Nicolet’s customers and on underlying real estate values.

Table 9: Nonperforming Assets


(in thousands)	March 31, 2014			December 31, 2013			March 31, 2013
Nonaccrual loans:
Commercial & industrial	$	485		$	68		$	93
Owner-occupied CRE		1,012			1,087			1,857
Agricultural production		34			11			—
Agricultural real estate		462			448			—
CRE investment		3,422			4,631			—
Construction & land development		931			1,265			—
Residential construction		—			—			—
Residential first mortgage		2,364			2,365			628
Residential junior mortgage		243			262			—
Retail & other		124			129			149
Total nonaccrual loans		9,077			10,266			2,727
Accruing loans past due 90 days or more		—			—			—
Total nonperforming loans	$	9,077		$	10,266		$	2,727
CRE investment	$	481		$	935		$	121
Owner-occupied CRE		295			—			—
Construction & land development		429			854			1,917
Residential real estate owned		30			198			—
OREO		1,235			1,987			2,038
Total nonperforming assets	$	10,312		$	12,253		$	4,765
Total restructured loans accruing	$	3,862		$	3,862		$	—
Ratios
Nonperforming loans to total loans		1.07	%		1.21	%		0.50	%
Nonperforming assets to total loans plus OREO		1.21	%		1.44	%		0.88	%
Nonperforming assets to total assets		0.85	%		1.02	%		0.70	%
ALLL to nonperforming loans		102.9	%		89.9	%		158.2	%
ALLL to total loans		1.10	%		1.09	%		1.39	%

Table 10: Investment Securities Portfolio

	March 31, 2014							December 31, 2013
(in thousands)	Amortized Cost		Fair Value		% of Total			Amortized Cost		Fair Value		% of Total
State, county and municipals	$	62,737	$	63,352		47	%	$	54,594	$	55,039		43	%
Mortgage-backed securities		66,318		65,843		49	%		68,642		67,879		53	%
U.S. Government sponsored enterprises		2,047		2,046		2	%		2,062		2,057		2	%
Corporate debt securities		220		220		-			220		220		-
Equity securities		715		1,926		2	%		905		2,320		2	%
Total	$	132,037	$	133,387		100	%	$	126,423	$	127,515		100	%

At March 31, 2014 the total carrying value of investment securities was $133 million, up from $128 million at December 31, 2013, and represented 11.0% and 10.6% of total assets at March 31, 2014 and December 31, 2013, respectively. At March 31, 2014, the securities portfolio did not contain securities of any single issuer that were payable from and secured by the same source of revenue or taxing authority where the aggregate carrying value of such securities exceeded 10% of shareholders’ equity.

In addition to securities available for sale, Nicolet had other investments of $8.0 million at March 31, 2014 and December 31, 2013, 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), and the Federal Agricultural Mortgage Corporation, as well as equity investments in other private companies. The FHLB and Federal Reserve investments are “restricted” in that they can only be sold back to the respective institutions or another member institution at par, and are thus, not liquid, have no ready market or quoted market value, and are carried at cost. The 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. There were no OTTI charges recorded in 2013 or year to date 2014.

Table 11: Investment Securities Portfolio Maturity Distribution


	As of March 31, 2014
	Within One Year					After One but Within Five Years					After Five but Within Ten Years					After Ten Years					Mortgage- related and Equity Securities					Total Amortized Cost					Total Fair Value
(in thousands)	Amount		Yield			Amount		Yield			Amount		Yield			Amount		Yield			Amount		Yield			Amount		Yield			Amount
U.S. government sponsored enterprises	$	1,527		4.5	%	$	—		—	%	$	520		1.9	%	$	—		—	%	$	—		—	%	$	2,047		3.8	%	$	2,046
State and county municipals (1)		4,377		3.3			45,685		2.5			11,810		2.7			865		3.0			—		—			62,737		2.6			63,352
Corporate debt securities		—		—			—		—			—		—			220		2.0			—		—			220		2.0			220
Mortgage-backed securities		—		—			—		—			—		—			—		—			66,318		3.4			66,318		3.4			65,843
Equity securities		—		—			—		—			—		—			—		—			715		—			715		—			1,926
Total amortized cost	$	5,904		3.6	%	$	45,685		2.5	%	$	12,330		2.7	%	$	1,085		2.8	%	$	67,033		3.4	%	$	132,037		3.0	%	$	133,387
Total fair value and carrying value	$	5,954				$	46,404				$	12,179				$	1,081				$	67,769									$	133,387

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

Deposits

Deposits represent Nicolet’s largest source of funds. Nicolet competes with other bank and nonbank institutions for deposits, as well as with a growing number of non-deposit investment alternatives available to depositors, such as mutual funds, money market funds, annuities, and other brokerage investment products. Challenges to deposit growth include price changes on deposit products given movements in the rate environment and other competitive pricing pressures, and customer preferences regarding higher-costing deposit products or non-deposit investment alternatives. Included in total deposits in Table 12 are brokered deposits of $42 million at March 31, 2014 and $50 million at December 31, 2013.

Table 12: Deposits


		March 31, 2014					December 31, 2013
(in thousands)	Amount			% of Total			Amount		% of Total
Demand		$	171,140		16.4	%	$	171,321		16.6	%
Money market and NOW accounts			500,267		48.0	%		492,499		47.6	%
Savings			105,787		10.1	%		97,601		9.4	%
Time			265,050		25.5	%		273,413		26.4	%
Total deposits		$	1,042,244		100	%	$	1,034,834		100	%

Total deposits were $1 billion at March 31, 2014, with no significant increase since December 31, 2013. On average for the first three months of 2014, total deposits were $1.0 billion, an increase of $445 million over the first quarter 2013, which includes organic growth in addition to the balances added from the 2013 acquisitions. The mix of average deposits was impacted by the mix of deposits acquired, but also by a continued shift in customer preferences, predominantly away from time deposits.

Table 13: Average Deposits


	For the three months ended,
	March 31, 2014					March 31, 2013
(in thousands)	Amount		% of Total			Amount		% of Total
Demand	$	164,438		15.8	%	$	90,181		15.2	%
Money market and NOW accounts		501,632		48.3	%		319,912		53.9	%
Savings		101,672		9.8	%		49,748		8.4	%
Time		270,873		26.1	%		133,349		22.5	%
Total	$	1,038,615		100	%	$	593,190		100	%

Table 14: Maturity Distribution of Certificates of Deposit


(in thousands)	March 31, 2014
3 months or less	$	35,150
Over 3 months through 6 months		38,425
Over 6 months through 12 months		64,619
Over 12 months		126,856

Total	$	265,050

Other Funding Sources

Other funding sources, which include short-term and long-term borrowings (notes payable and junior subordinated debentures), were $56 million and $52 million at March 31, 2014 and December 31, 2013, respectively. Short-term borrowings, consisting mainly of customer repurchase agreements maturing in less than three months, totaled $11 million at March 31, 2014 and $7 million at December 31, 2013. Long-term borrowings include a joint venture note and FHLB advances, totaling $32 million at March 31, 2014 and at December 31, 2013. Junior subordinated debentures are another long-term funding source totaling $12 million at March 31, 2014 and December 31, 2013. Junior subordinated debentures of $6.2 million were issued in July 2004 in connection with the $6 million of trust preferred securities. Acquired junior subordinated debentures of $10.3 million in connection with $10 million of trust preferred securities were assumed in the Mid-Wisconsin merger and initially recorded at the fair market value of $5.8 million, with the discount being accreted to interest expense over the remaining life of the debentures. Further information regarding these junior subordinated debentures is located in Note 9 of the unaudited consolidated financial statements.

Off-Balance Sheet Obligations

As of March 31, 2014 and December 31, 2013, Nicolet had the following commitments that did not appear on its balance sheet:

Table 15: Commitments



(in thousands)	March 31, 2014		December 31, 2013
Commitments to extend credit - Fixed and variable rate	$	234,707	$	234,930
Standby and irrevocable letters of credit-fixed rate		6,662		6,371

Liquidity and Interest Rate Sensitivity

Liquidity management refers to the ability to ensure that cash is available in a timely and cost-effective manner to meet cash flow requirements of depositors and borrowers and to meet other commitments as they fall due, including the ability to pay dividends to shareholders, service debt, invest in subsidiaries, repurchase common stock, and satisfy other operating requirements.

Funds are available from a number of basic banking activity sources including 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 $52 million of the $133 million investment securities portfolio on hand at March 31, 2014 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, 2014 and December 31, 2013 were approximately $156 million and $147 million, respectively. The increased cash and cash equivalents at year end 2013 was predominantly due to strong customer deposit growth outpacing the loan demand. These levels have remained high through the first three months of 2014. Nicolet’s liquidity resources were sufficient as of March 31, 2014 to fund loans and to meet other cash needs as necessary.

Interest Rate Sensitivity Gap Analysis

Table 16 represents a schedule of Nicolet’s assets and liabilities repricing over various time intervals. The primary market risk faced by Nicolet is interest rate risk. The static gap analysis below starts with contractual repricing information for assets, liabilities, and off-balance sheet instruments. These items are then combined with repricing estimations for administered rate (interest-bearing demand deposits, savings, and money market accounts) and non-rate related products (demand deposit accounts, other assets, and other liabilities) to create a baseline repricing balance sheet. In addition to the contractual information, residential mortgage whole loan products and mortgage-backed securities are adjusted based on industry estimates of prepayment speeds that capture the expected prepayment of principal above the contractual amount based on how far away the contractual coupon is from market coupon rates. At the indicated time intervals the cumulative gap was within Nicolet’s established guidelines of not greater than +25% or -25% of total assets.

Table 16: Interest Rate Sensitivity Gap Analysis


	March 31, 2014
(in thousands)	0-90 Days			91-180 Days			181-365 Days			1-5 years			Beyond 5 Years			Total
Earning Assets:
Loans	$	353,088		$	51,857		$	115,975		$	263,179		$	65,993		$	850,092
Securities at fair value		16,707			5,352			11,930			69,975			29,423			133,387
Other earnings assets		135,636			—			—			—			8,015			143,651
Total	$	505,431		$	57,209		$	127,905		$	333,154		$	103,431		$	1,127,130

Cumulative rate sensitive assets	$	505,431		$	562,640		$	690,545			1,023,699			1,127,130

Interest-bearing liabilities
Interest bearing deposits (1)	$	469,968		$	38,425		$	64,619		$	126,813		$	342,419		$	1,042,244
Borrowings		15,597			4,306			278			18,687			4,930			43,798
Subordinated debentures		1,510			1,510			3,020			6,138			—			12,178
Total	$	487,075		$	44,241		$	67,917		$	151,638		$	347,349		$	1,098,220

Cumulative interest sensitive liabilities	$	487,075		$	531,316		$	599,233		$	750,871		$	1,098,220

Interest sensitivity gap	$	18,356		$	12,968		$	59,988		$	181,516		$	-243,918

Cumulative interest sensitivity gap	$	18,356		$	31,324		$	91,312		$	272,828		$	28,910
Cumulative ratio of rate sensitive assets to rate sensitive liabilities		104	%		106	%		115	%		136	%		103	%

(1)

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

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

Along with the static gap analysis, Nicolet’s management also estimates the effect a gradual change and a sudden change in interest rates could have on expected net interest income through income simulation. The simulation is run using the prime rate as the base with the assumption of rates increasing 100, 200, and 300 bps or decreasing 100, 200 and 300 bps. All rates are increased or decreased parallel to the change in prime rate. The simulation assumes a static mix of assets and liabilities. As a result of the simulation, over a 12-month time period ending March 31, 2015, net interest income was estimated to decrease 2.89% if rates increase 100 bps in an immediate shock scenario, and was estimated to decrease 2.06% in a 100 bps declining rate environment assumption. These results are in line with Nicolet’s interest rate sensitivity position, including relatively short (though extending) loan maturities and level of variable rate loans with interest floors; as rates remain low, asset maturities extend, and deposit maturities contract, pressuring the position to become more liability-sensitive. These results are based solely on the modeled changes in the market rates and do not reflect the earnings sensitivity that may arise from other factors such as changes in the shape of the yield curve, changes in spreads between key market rates, or changes in consumer or business behavior. These results also do not include any management action to mitigate potential income variances within the modeled process. The simulation results are one indicator of interest rate risk, and actual net interest income is largely impacted by the allocation of assets, liabilities and product mix. Nicolet’s management continually reviews its interest rate risk position through the Asset/Liability Committee process, and such Committee reports to the full board of directors on a monthly basis.

Capital

Nicolet’s management regularly reviews the adequacy of its capital to ensure that sufficient capital is available for current and future needs and is in compliance with regulatory guidelines. Nicolet’s management actively reviews capital strategies in light of perceived business risks associated with current and prospective earning levels, liquidity, asset quality, economic conditions in the markets served, and level of returns available to shareholders. Nicolet’s management intends to maintain an optimal capital and leverage mix for growth and for shareholder return.

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

For participating banks, the annual dividend rate upon funding and for the following nine full calendar quarters is 5%, unless there is growth in qualifying small business loans outstanding over a baseline which could reduce the rate to as low as 1% (as determined under the terms of the Securities Purchase Agreement (the “Agreement”)), adjusted quarterly. The dividend rate fixes for the tenth full quarter after funding through the end of the first four and one-half years based on the amount of qualifying small business loans at that time per the terms of the agreement. The dividend rate is then fixed at 9% after four and one-half years if the preferred stock is not repaid. On September 1, 2011, under the SBLF, Nicolet received $24.4 million from the Treasury for the issuance of 24,400 shares of Non-Cumulative Perpetual Preferred Stock, Series C, with $1,000 per share liquidation value. Nicolet paid an annual dividend rate of 5% from funding through September 30, 2013, paid 1% for the quarter ended December 31, 2013, (i.e. the ninth full quarter after funding) and has qualified beginning in the first quarter of 2014 for the 1% fixed annual dividend rate for the remainder of the first four and one-half years. Nicolet does not have current plans to repay its SBLF funding. Under the terms of the Agreement, Nicolet is required to provide various information, certifications, and reporting to the Treasury. At March 31, 2014, Nicolet believes it was in compliance with the requirements set by the Treasury in the Agreement. The preferred stock (under SBLF) qualifies as Tier 1 capital for regulatory purposes.

On April 26, 2013, through a private placement to accredited investors under Rule 506 of the Securities Act, the Company raised $2.9 million in capital, issuing 174,016 shares of common stock.

On April 26, 2013, in connection with its acquisition of Mid-Wisconsin, the Company issued 589,159 shares of its common stock at a value of $9.7 million. The $0.4 million of incurred issuance costs was charged against additional paid in capital. As a result of this merger, Nicolet became an SEC-reporting company again and listed its common stock on the Over-the-Counter markets (OTCQB) under the trading symbol of “NCBS.”

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

On January 21, 2014, Nicolet’s board of directors approved a resolution authorizing a stock repurchase program whereby Nicolet may utilize up to $6 million to purchase up to 350,000 shares of its outstanding common stock from time to time in the open market or block transactions as market conditions warrant or in private transactions. During the first quarter of 2014, $390,000 was used to repurchase 22,050 shares with a weighted average price of $17.68 per share including commissions.

A summary of Nicolet’s and Nicolet National Bank’s regulatory capital amounts and ratios as of March 31, 2014 and December 31, 2013 are presented in the following table.

Table 17: Capital


	Actual					For Capital Adequacy Purposes					To Be Well Capitalized Under Prompt Corrective Action Provisions (2)
(in thousands)	Amount		Ratio (1)			Amount		Ratio (1)			Amount		Ratio (1)
As of March 31, 2014:
Nicolet
Total capital	$	121,788		14.0	%	$	69,406		8.0	%		N/A		N/A
Tier I capital		112,444		13.0			34,703		4.0			N/A		N/A
Leverage		112,444		9.4			48,058		4.0			N/A		N/A

Nicolet National Bank
Total capital	$	115,235		13.5	%	$	68,434		8.0	%	$	85,543		10.0	%
Tier I capital		105,891		12.4			34,217		4.0			51,326		6.0
Leverage		105,891		8.9			47,576		4.0			59,469		5.0

As of December 31, 2013:
Nicolet
Total capital	$	119,050		13.8	%	$	69,075		8.0	%		N/A		N/A
Tier I capital		109,817		12.7			34,538		4.0			N/A		N/A
Leverage		109,817		9.5			46,322		4.0			N/A		N/A

Nicolet National Bank
Total capital	$	111,343		13.1	%	$	68,110		8.0	%	$	85,138		10.0	%
Tier I capital		102,111		12.0			34,055		4.0			51,083		6.0
Leverage		102,111		8.9			43,858		4.0			57,323		5.0

(1)

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

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

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Not applicable for smaller reporting companies.

ITEM 4. CONTROLS AND PROCEDURES

As of the end of the period covered by this report, management, under the supervision, and with the participation, of our Chief Executive Officer and President and Chief Financial Officer, evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as such term in Rule 13a-15(e) and 15d-15(e) under the Exchange Act pursuant to Exchange Act Rule 13a-15. Based upon, and as of the date of such evaluation, the Chief Executive Officer and President and the Chief Financial Officer concluded that our disclosure controls and procedures were effective.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

PART II – OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

We and our subsidiaries may be involved from time to time in various routine legal proceedings incidental to our respective businesses. Neither we nor any of our subsidiaries are currently engaged in any legal proceedings that are expected to have a material adverse effect on our results of operations or financial position.

ITEM 1A. RISK FACTORS

Not applicable for smaller reporting company.

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

Not applicable.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

Not applicable.

ITEM 4. MINE SAFETY DISCLOSURES

Not applicable.

ITEM 5. OTHER INFORMATION

Not applicable.

ITEM 6. EXHIBITS

The following exhibits are filed herewith:

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

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

SIGNATURES

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


		NICOLET BANKSHARES, INC.

May 9, 2014		/s/ Robert B. Atwell
		Robert B. Atwell
		Chairman, President and Chief Executive Officer

May 9, 2014		/s/ Ann K. Lawson
		Ann K. Lawson
		Chief Financial Officer