NICOLET BANKSHARES INC - Quarter Report: 2015 September (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 September 30, 2015

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

For the transition period from___________to___________

Commission file number 333-90052

NICOLET BANKSHARES, INC.

(Exact name of registrant as specified in its charter)

WISCONSIN

(State or other jurisdiction of incorporation or organization)

47-0871001

(I.R.S. Employer Identification No.)

111 North Washington Street

Green Bay, Wisconsin 54301

(920) 430-1400

(Address, including zip code, and telephone number, including area code, of
Registrant’s principal executive offices)

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

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

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer 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 S

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

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

As of October 31, 2015 there were 3,978,752 shares of $0.01 par value common stock outstanding.

Nicolet Bankshares, Inc.

TABLE OF CONTENTS

PART I	FINANCIAL INFORMATION		PAGE

	Item 1.	Financial Statements:

		Consolidated Balance Sheets September 30, 2015 (unaudited) and December 31, 2014	3

		Consolidated Statements of Income Three Months and Nine Months Ended September 30, 2015 and 2014 (unaudited)	4

		Consolidated Statements of Comprehensive Income Three Months and Nine Months Ended September 30, 2015 and 2014 (unaudited)	5

		Consolidated Statement of Changes in Stockholders’ Equity Nine Months Ended September 30, 2015 (unaudited)	6

		Consolidated Statements of Cash Flows Nine Months Ended September 30, 2015 and 2014 (unaudited)	7

		Notes to Unaudited Consolidated Financial Statements	8-28

	Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	29-55

	Item 3.	Quantitative and Qualitative Disclosures About Market Risk	56

	Item 4.	Controls and Procedures	56

PART II	OTHER INFORMATION

	Item 1	Legal Proceedings	56

	Item 1A.	Risk Factors	56

	Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	56

	Item 3.	Defaults Upon Senior Securities	56

	Item 4.	Mine Safety Disclosures	56

	Item 5	Other Information	56

	Item 6.	Exhibits	57

		Signatures	57-61

PART I – FINANCIAL INFORMATION

Item 1. FINANCIAL STATEMENTS:

NICOLET BANKSHARES, INC. AND SUBSIDIARIES

Consolidated Balance Sheets
(In thousands, except share and per share data)

	September 30, 2015 (Unaudited)			December 31, 2014 (Audited)
Assets
Cash and due from banks	$	9,527		$	23,975
Interest-earning deposits		24,683			43,169
Federal funds sold		425			1,564
Cash and cash equivalents		34,635			68,708
Certificates of deposit in other banks		4,159			10,385
Securities available for sale (“AFS”)		167,572			168,475
Other investments		8,126			8,065
Loans held for sale		3,055			7,272
Loans		884,448			883,341
Allowance for loan losses		(10,005	)		(9,288	)
Loans, net		874,443			874,053
Premises and equipment, net		29,891			31,924
Bank owned life insurance (“BOLI”)		28,228			27,479
Accrued interest receivable and other assets		16,743			18,924
Total assets	$	1,166,852		$	1,215,285

Liabilities and Stockholders’ Equity
Liabilities:
Demand	$	227,610		$	203,502
Money market and NOW accounts		444,616			494,945
Savings		127,827			120,258
Time		212,128			241,198
Total deposits		1,012,181			1,059,903
Notes payable		15,480			21,175
Junior subordinated debentures		12,477			12,328
Subordinated notes		11,840			-
Accrued interest payable and other liabilities		9,862			10,812
Total liabilities		1,061,840			1,104,218

Stockholders’ Equity:
Preferred equity		12,200			24,400
Common stock		40			41
Additional paid-in capital		43,055			45,693
Retained earnings		48,270			39,843
Accumulated other comprehensive income		1,292			1,031
Total Nicolet Bankshares, Inc. stockholders’ equity		104,857			111,008
Noncontrolling interest		155			59
Total stockholders’ equity and noncontrolling interest		105,012			111,067
Total liabilities, noncontrolling interest and stockholders’ equity	$	1,166,852		$	1,215,285

Preferred shares authorized (no par value)		10,000,000			10,000,000
Preferred shares issued and outstanding		12,200			24,400
Common shares authorized (par value $0.01 per share)		30,000,000			30,000,000
Common shares outstanding		3,957,520			4,058,208
Common shares issued		4,010,835			4,124,439

See accompanying notes to unaudited consolidated financial statements.

ITEM 1. Financial Statements Continued:

NICOLET BANKSHARES, INC. AND SUBSIDIARIES

Consolidated Statements of Income

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

	Three Months Ended September 30,				Nine Months Ended September 30,
	2015		2014		2015		2014
Interest income:
Loans, including loan fees	$	11,159	$	11,945	$	33,921	$	34,568
Investment securities:
Taxable		339		379		1,098		1,212
Non-taxable		253		208		788		551
Other interest income		108		91		327		354
Total interest income		11,859		12,623		36,134		36,685
Interest expense:
Money market and NOW accounts		569		544		1,693		1,709
Savings and time deposits		732		790		2,225		2,271
Short-term borrowings		2		2		2		9
Junior subordinated debentures		222		220		658		655
Subordinated notes		159		-		335		-
Notes payable		158		174		488		672
Total interest expense		1,842		1,730		5,401		5,316
Net interest income		10,017		10,893		30,733		31,369
Provision for loan losses		450		675		1,350		2,025
Net interest income after provision for loan losses		9,567		10,218		29,383		29,344
Noninterest income:
Service charges on deposit accounts		631		564		1,752		1,602
Trust services fee income		1,196		1,179		3,636		3,403
Mortgage income, net		811		505		2,670		1,151
Brokerage fee income		170		152		509		478
Bank owned life insurance		252		250		749		684
Rent income		324		292		890		880
Investment advisory fees		98		104		301		316
Gain on sale or writedown of assets, net		91		140		1,042		448
Other		612		459		1,600		1,323
Total noninterest income		4,185		3,645		13,149		10,285
Noninterest expense:
Salaries and employee benefits		5,637		5,366		16,996		16,045
Occupancy, equipment and office		1,745		1,735		5,263		5,370
Business development and marketing		549		548		1,584		1,620
Data processing		864		816		2,585		2,345
FDIC assessments		142		160		469		547
Core deposit intangible amortization		248		284		783		934
Other		664		614		1,695		1,734
Total noninterest expense		9,849		9,523		29,375		28,595

Income before income tax expense		3,903		4,340		13,157		11,034
Income tax expense		1,281		1,552		4,452		3,425
Net income		2,622		2,788		8,705		7,609
Less: net income attributable to noncontrolling interest		28		23		96		76
Net income attributable to Nicolet Bankshares, Inc.		2,594		2,765		8,609		7,533
Less: preferred stock dividends		60		61		182		183
Net income available to common shareholders	$	2,534	$	2,704	$	8,427	$	7,350

Basic earnings per common share	$	0.64	$	0.66	$	2.11	$	1.75
Diluted earnings per common share	$	0.58	$	0.63	$	1.93	$	1.70
Weighted average common shares outstanding:
Basic		3,961,004		4,118,792		3,999,641		4,190,830
Diluted		4,397,906		4,319,975		4,358,082		4,313,298

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						Nine Months Ended
	September 30,						September 30,
	2015			2014			2015			2014
Net income	$	2,622		$	2,788		$	8,705		$	7,609
Other comprehensive income, net of tax:
Unrealized gains (losses) on securities AFS:
Net unrealized holding gains (losses) arising during the period		1,143			(51	)		1,058			994
Reclassification adjustment for net gains included in net income		-			-			(630	)		(341	)
Net unrealized gains (losses) on securities before tax expense		1,143			(51	)		428			653
Income tax (expense) benefit		(446	)		19			(167	)		(255	)
Total other comprehensive income (loss)		697			(32	)		261			398
Comprehensive income	$	3,319		$	2,756		$	8,966		$	8,007

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, 2014	$	24,400		$	41		$	45,693		$	39,843		$	1,031	$	59	$	111,067
Comprehensive income:
Net income		-			-			-			8,609			-		96		8,705
Other comprehensive income		-			-			-			-			261		-		261
Stock compensation expense		-			-			907			-			-		-		907
Exercise of stock options, net		-			-			610			-			-		-		610
Issuance of common stock		-			-			122			-			-		-		122
Purchase and retirement of common stock		-			(1	)		(4,277	)		-			-		-		(4,278	)
Redemption of preferred stock		(12,200	)															(12,200	)
Preferred stock dividends		-			-			-			(182	)		-		-		(182	)
Balance, September 30, 2015	$	12,200		$	40		$	43,055		$	48,270		$	1,292	$	155	$	105,012

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)

	Nine Months Ended September 30,
	2015			2014
Cash Flows From Operating Activities:
Net income	$	8,705		$	7,609
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation, amortization, and accretion		3,083			2,793
Provision for loan losses		1,350			2,025
Increase in cash surrender value of life insurance		(749	)		(684	)
Stock compensation expense		907			459
Gain on sale or writedown of assets, net		(1,042	)		(448	)
Gain on sale of loans held for sale, net		(2,670	)		(1,151	)
Income from branch sale		(123	)		-
Proceeds from sale of loans held for sale		149,509			55,652
Origination of loans held for sale		(142,759	)		(55,585	)
Net change in:
Accrued interest receivable and other assets		(244	)		295
Accrued interest payable and other liabilities		2,330			(639	)
Net cash provided by operating activities		18,297			10,326
Cash Flows From Investing Activities:
Net decrease (increase) in certificates of deposit in other banks		6,226			(6,678	)
Net increase in loans		(14,388	)		(19,175	)
Purchases of securities AFS		(34,238	)		(33,650	)
Proceeds from sales of securities AFS		13,883			515
Proceeds from calls and maturities of securities AFS		17,643			16,693
Purchase of other investments		(61	)		(74	)
Purchases of premises and equipment		(831	)		(4,112	)
Net decrease in premises and equipment		353			10
Proceeds from sales of other real estate and other assets		2,470			3,268
Net cash used in branch sale		(19,865	)		-
Purchase of BOLI		-			(2,750	)
Net cash used by investing activities		(28,808	)		(45,953	)
Cash Flows From Financing Activities:
Net decrease in deposits		(13,728	)		(23,195	)
Net change in short-term borrowings		-			(7,116	)
Repayments of notes payable		(5,695	)		(10,184	)
Proceeds from issuance of subordinated notes, net		11,820			-
Redemption of preferred stock		(12,200	)		-
Purchase of common stock		(4,278	)		(3,998	)
Proceeds from issuance of common stock		122			225
Proceeds from exercise of common stock options		610			380
Noncontrolling interest in joint venture		-			(60	)
Cash dividends paid on preferred stock		(213	)		(183	)
Net cash used by financing activities		(23,562	)		(44,131	)
Net decrease in cash and cash equivalents		(34,073	)		(79,758	)
Cash and cash equivalents:
Beginning	$	68,708		$	146,978
Ending	$	34,635		$	67,220
Supplemental Disclosures of Cash Flow Information:
Cash paid for interest	$	5,458		$	5,562
Cash paid for taxes		2,430			3,535
Transfer of loans and bank premises to other real estate owned		870			1,291

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 consolidated financial statements should be read in conjunction with the Company’s audited consolidated financial statements and footnotes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2014.

Critical Accounting Policies and Estimates

Preparation of consolidated financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying disclosures. These estimates are based on management’s best knowledge of current events and actions the Company may undertake in the future. Estimates are used in accounting for, among other items, the allowance for loan losses, useful lives for depreciation and amortization, fair value of financial instruments, deferred tax assets, uncertain income tax positions and contingencies. Estimates that are particularly susceptible to significant change for the Company include the determination of the allowance for loan losses, the assessment of deferred tax assets and liabilities, and the valuation of loans acquired in the 2013 acquisitions; therefore, these are critical accounting policies. Factors that may cause sensitivity to the aforementioned estimates include but are not limited to: external market factors such as market interest rates and employment rates, changes to operating policies and procedures, changes in applicable banking regulations, and changes to deferred tax estimates. Actual results may ultimately differ from estimates, although management does not generally believe such differences would materially affect the consolidated financial statements in any individual reporting period presented.

There have been no material changes or developments with respect to the assumptions or methodologies that the Company uses when applying what management believes are critical accounting policies and developing critical accounting estimates as disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2014.

Recent Accounting Pronouncements Adopted

In May 2015, Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2015-08 Business Combinations (Topic 805): Pushdown Accounting – Amendments to SEC Paragraphs Pursuant to Staff Accounting Bulletin 115. Amendments in this update amend SEC paragraphs pursuant to Staff Accounting Bulletin (“SAB”) 115, which supersedes several paragraphs in ASC 805-50 in response to the SEC’s November 2014 publication of SAB 115.The SEC issued SAB 115 in connection with the release of FASB ASU 2014-17, “Pushdown Accounting.” This guidance is effective immediately. The adoption of this guidance did not have a significant impact on the consolidated financial condition, results of operations or liquidity of the Company

In April 2015, the FASB issued ASU 2015-03, Simplifying the Presentation of Debt Issuance Costs. The update simplifies the presentation of debt issuance costs by requiring that debt issuance costs be presented in the balance sheet as a direct deduction from the carrying amount of debt liability, consistent with debt discounts or premiums. The recognition and measurement guidance for debt issuance costs are not affected by the amendments in this update. For public companies, this update is effective for interim and annual periods beginning after December 15, 2015, and is to be applied retrospectively. Early adoption is permitted. The Company adopted this update in the first quarter of 2015. See Note 8 for further details on the impact of adopting this accounting update.

In August 2014, the FASB issued ASU 2014-14, Receivables - Troubled Debt Restructurings by Creditors to clarify how creditors are to classify certain government-guaranteed mortgage loans upon foreclosure. This amendment requires that a mortgage loan be derecognized and a separate other receivable be recognized upon foreclosure under certain conditions. Upon foreclosure, the separate other receivable should be measured based on the amount of the loan balance (principal and interest) expected to be recovered from the guarantor. This amendment is effective for annual reporting periods, including interim periods within those annual periods, beginning after December 15, 2014. The Company adopted the accounting standard during the first quarter of 2015 with no material impact.

In June 2014, the FASB issued ASU 2014-11, Transfers and Servicing to clarify the current accounting and disclosures for certain repurchase agreements. The amendments in this update require two accounting changes: (1) change the accounting for repurchase-to-maturity transactions to secured borrowing accounting and (2) require separate accounting for a transfer of a financial asset executed contemporaneously with a repurchase agreement with the same counterparty, which will result in secured borrowing accounting for the repurchase agreement. The amendments in this update also require additional disclosures for certain transactions on the transfer of financial assets, as well as new disclosures for repurchase agreements, securities lending transactions, and repurchase-to-maturity transactions that are accounted for as secured borrowings. This amendment is effective for public business entities for the first interim or annual period beginning after December 15, 2014. The Company adopted the accounting standard during the first quarter of 2015 with no material impact.

Operating Segment

While the chief decision makers monitor the revenue streams of the various products and services, and evaluate costs, balance sheet positions and quality, all such products, services and activities are directly or indirectly related to the business of community banking, with no regular, formal or material segment delineations. Operations are managed and financial performance is evaluated on a company-wide basis, and accordingly, all the financial service operations are considered by management to be aggregated in one reportable operating segment.

Note 2 – Earnings per Common Share

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

	Three Months Ended September 30,				Nine Months Ended September 30,
	2015		2014		2015		2014
(In thousands except per share data)
Net income, net of noncontrolling interest	$	2,594	$	2,765	$	8,609	$	7,533
Less: preferred stock dividends		60		61		182		183
Net income available to common shareholders	$	2,534	$	2,704	$	8,427	$	7,350
Weighted average common shares outstanding		3,961		4,119		4,000		4,191
Effect of dilutive stock instruments		437		201		358		122
Diluted weighted average common shares outstanding		4,398		4,320		4,358		4,313
Basic earnings per common share*	$	0.64	$	0.66	$	2.11	$	1.75
Diluted earnings per common share*	$	0.58	$	0.63	$	1.93	$	1.70

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

For the nine months ended September 30, 2015 and 2014, respectively, there were 0.2 million and 0.4 million outstanding stock options that were not included in the computation of diluted earnings per share because they were considered anti-dilutive.

Note 3 – Stock-based Compensation

The fair value of stock options granted is estimated on the date of grant using a Black-Scholes option pricing model. The fair values of stock options are amortized as compensation expense on a straight-line basis over the vesting period of the grants. Compensation expense recognized is included in salaries and employee benefits expense in the consolidated statements of income. Assumptions are used in estimating the fair value of stock options granted. The weighted average expected life of the 2015 stock options granted were 7 years and represent the period of time that stock options are expected to be outstanding. The risk-free interest rates are based on the U.S. Treasury yield curve in effect at the time of grants and had a weighted average rate of 1.68% for the two grant issuance dates in 2015. The expected volatility was 25% and is based on the implied volatility of the Corporation’s stock, and the dividend yield used in the fair value calculation was 0%. The weighted average per share fair value of the options granted in 2015 was $8.11.

Activity in 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, 2013				793,157		$	17.86		600,846
Granted	$	7.42		221,000			23.80
Exercise of stock options*				(39,548	)		16.01
Forfeited				(6,750	)		16.80
Balance – December 31, 2014				967,859			19.30		630,121
Granted	$	8.11		162,000			26.66
Exercise of stock options*				(33,200	)		18.55
Forfeited				(600	)		16.50
Balance – September 30, 2015				1,096,059		$	20.41		629,284

*The terms of the stock option agreements permit having a number of shares of stock withheld, the fair market value of which as of the date of exercise is sufficient to satisfy the exercise price and/or tax withholding requirements. Accordingly, 170 shares were withheld during the nine months ended September 30, 2015 and no shares were withheld during the twelve months ended December 31, 2014.

Options outstanding at September 30, 2015 are exercisable at option prices ranging from $16.50 to $30.80. There are 672,559 options outstanding in the range from $16.50 - $22.00 and 423,500 options outstanding in the range from $22.01 - $30.80. At September 30, 2015, the exercisable options have a weighted average remaining contractual life of approximately 2 years and a weighted average exercise price of $18.13.

Intrinsic value represents the amount by which the fair market value of the underlying stock exceeds the exercise price of the stock options. The total intrinsic value of options exercised in the first nine months of 2015, and full year of 2014 was approximately $301,000, and $193,000, respectively.

Restricted Stock	Weighted- Average Grant Date Fair Value		Restricted Shares Outstanding
Balance – December 31, 2013	$	16.50		62,363
Granted		23.80		33,136
Vested*		19.26		(29,268	)
Forfeited		-		-
Balance – December 31, 2014		18.94		66,231
Granted		-		-
Vested *		16.50		(12,916	)
Forfeited		-		-
Balance – September 30, 2015	$	19.53		53,315

*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 2,562 shares were surrendered during the nine months ended September 30, 2015 and 5,821 shares were surrendered during the twelve months ended December 31, 2014.

Note 3 – Stock-based Compensation, continued

The Company recognized approximately $907,000 and $459,000 of stock-based employee compensation expense during the nine months ended September 30, 2015 and 2014, respectively, associated with its stock equity awards. As of September 30, 2015, there was approximately $3.5 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 4- Securities Available for Sale

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

	September 30, 2015
(in thousands)	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Fair Value
U.S. government sponsored enterprises	$	286	$	11	$	-	$	297
State, county and municipals		106,763		480		227		107,016
Mortgage-backed securities		54,523		668		284		54,907
Corporate debt securities		1,140		-		-		1,140
Equity securities		2,742		1,507		37		4,212
	$	165,454	$	2,666	$	548	$	167,572

	December 31, 2014
(in thousands)	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Fair Values
U.S. government sponsored enterprises	$	1,025	$	14	$	-	$	1,039
State, county and municipals		102,472		778		474		102,776
Mortgage-backed securities		61,497		639		459		61,677
Corporate debt securities		220		-		-		220
Equity securities		1,571		1,192		-		2,763
	$	166,785	$	2,623	$	933	$	168,475

The following table represents gross unrealized losses and the related fair value of investment securities available for sale, aggregated by investment category and length of time individual securities have been in a continuous unrealized loss position, at September 30, 2015 and December 31, 2014.

	September 30, 2015
	Less than 12 months				12 months or more				Total
(in thousands)	Fair Value		Unrealized Losses		Fair Value		Unrealized Losses		Fair Value		Unrealized Losses
State, county and municipals	$	33,281	$	126	$	12,292	$	101	$	45,573	$	227
Mortgage-backed securities		5,873		42		14,638		242		20,511		284
Equity securities		171		37		-		-		171		37
	$	39,325	$	205	$	26,930	$	343	$	66,255	$	548

	December 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
State, county and municipals	$	48,531	$	288	$	10,338	$	186	$	58,869	$	474
Mortgage-backed securities		5,944		20		19,351		439		25,295		459
	$	54,475	$	308	$	29,689	$	625	$	84,164	$	933

Note 4- Securities Available for Sale, continued

At September 30, 2015 we had $0.5 million of gross unrealized losses related to 123 securities. As of September 30, 2015, the Company does not consider any of its securities with unrealized losses of 12 months or more to be other-than-temporarily impaired as the unrealized losses in each category have occurred as a result of changes in interest rates, market spreads and market conditions subsequent to purchase. The Company has the ability and intent to hold its securities to maturity. There were no other-than-temporary impairments charged to earnings during the nine-month periods ending September 30, 2015 or September 30, 2014.

The amortized cost and fair values of securities available for sale at September 30, 2015 by contractual maturity are shown below. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Fair values of securities are estimated based on financial models or prices paid for the same or similar securities. It is possible interest rates could change considerably, resulting in a material change in estimated fair value.

	September 30, 2015
(in thousands)	Amortized Cost		Fair Value
Due in less than one year	$	4,805	$	4,833
Due in one year through five years		76,769		76,852
Due after five years through ten years		24,914		25,040
Due after ten years		1,701		1,728
		108,189		108,453
Mortgage-backed securities		54,523		54,907
Equity securities		2,742		4,212
Securities available for sale	$	165,454	$	167,572

Proceeds from sales of securities available for sale during the first nine months of 2015 and 2014 were approximately $13.9 million and $0.5 million respectively. Gross gains of approximately $0.6 million and $0.3 million were realized during the first nine months of 2015 and 2014, respectively, and no gross losses were realized on sales of securities during the first nine months of 2015 or 2014.

Note 5 – Loans, Allowance for Loan Losses, and Credit Quality

The loan composition as of September 30, 2015 and December 31, 2014 is summarized as follows.

	Total
	September 30, 2015						December 31, 2014
(in thousands)	Amount			% of Total			Amount			% of Total
Commercial & industrial	$	304,858			34.5	%	$	289,379			32.7	%
Owner-occupied commercial real estate (“CRE”)		179,569			20.3			182,574			20.7
Agricultural (“AG”) production		15,709			1.8			14,617			1.6
AG real estate		39,715			4.5			42,754			4.8
CRE investment		83,278			9.4			81,873			9.3
Construction & land development		39,487			4.5			44,114			5.0
Residential construction		8,106			0.9			11,333			1.3
Residential first mortgage		153,562			17.3			158,683			18.0
Residential junior mortgage		54,170			6.1			52,104			5.9
Retail & other		5,994			0.7			5,910			0.7
Loans		884,448			100.0	%		883,341			100.0	%
Less allowance for loan losses		10,005						9,288
Loans, net	$	874,443					$	874,053
Allowance for loan losses to loans		1.13	%					1.05	%

	Originated
	September 30, 2015						December 31, 2014
(in thousands)	Amount			% of Total			Amount			% of Total
Commercial & industrial	$	294,160			39.9	%	$	268,654			38.3	%
Owner-occupied CRE		146,155			19.8			140,203			20.0
AG production		7,334			1.0			5,580			0.8
AG real estate		21,541			2.9			20,060			2.8
CRE investment		59,894			8.1			53,339			7.6
Construction & land development		28,314			3.8			33,865			4.8
Residential construction		8,106			1.1			11,333			1.6
Residential first mortgage		119,503			16.2			119,866			17.1
Residential junior mortgage		47,096			6.4			43,411			6.2
Retail & other		5,752			0.8			5,395			0.8
Loans		737,855			100.0	%		701,706			100.0	%
Less allowance for loan losses		8,372						9,288
Loans, net	$	729,483					$	692,418
Allowance for loan losses to loans		1.13	%					1.32	%

	Acquired
	September 30, 2015						December 31, 2014
(in thousands)	Amount			% of Total			Amount			% of Total
Commercial & industrial	$	10,698			7.3	%	$	20,725			11.4	%
Owner-occupied CRE		33,414			22.8			42,371			23.3
AG production		8,375			5.7			9,037			5.0
AG real estate		18,174			12.4			22,694			12.5
CRE investment		23,384			16.0			28,534			15.7
Construction & land development		11,173			7.6			10,249			5.6
Residential construction		-			-			-			-
Residential first mortgage		34,059			23.2			38,817			21.4
Residential junior mortgage		7,074			4.8			8,693			4.8
Retail & other		242			0.2			515			0.3
Loans		146,593			100.0	%		181,635			100.0	%
Less allowance for loan losses		1,633						-
Loans, net	$	144,960					$	181,635
Allowance for loan losses to loans		1.11	%					0.00	%

Note 5 – Loans, Allowance for Loan Losses, and Credit Quality, continued

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

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

The allocation methodology used by the Company includes specific allocations for impaired loans evaluated individually for impairment based on collateral values and for the remaining loan portfolio collectively evaluated for impairment primarily based on historical loss rates and other qualitative factors. Loan charge-offs and recoveries are based on actual amounts charged-off or recovered by loan category. Management allocates the ALLL by pools of risk within each loan portfolio. As events have occurred in the acquired loan portfolios, an ALLL has been established for this pool of assets reflecting an increase in risk as some credits migrate to higher grades.

Note 5 – Loans, Allowance for Loan Losses, and Credit Quality, continued

The following tables present the balance and activity in the ALLL by portfolio segment and the recorded investment in loans by portfolio at or for the nine months ended September 30, 2015:

	TOTAL – At or for the Nine Months Ended September 30, 2015
(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	$	3,191		$	1,230		$	53		$	226		$	511		$	2,685		$	140		$	866		$	337		$	49		$	9,288
Provision		781			682			31			76			227			(975	)		(34	)		291			244			27			1,350
Charge-offs		(305	)		(219	)		-			-			-			-			-			(60	)		(104	)		(29	)		(717	)
Recoveries		37			3			-			-			13			-			-			18			1			12			84
Net charge-offs		(268	)		(216	)		-			-			13			-			-			(42	)		(103	)		(17	)		(633	)
Ending balance	$	3,704		$	1,696		$	84		$	302		$	751		$	1,710		$	106		$	1,115		$	478		$	59		$	10,005
As percent of ALLL		37.0	%		17.0	%		0.8	%		3.0	%		7.5	%		17.1	%		1.1	%		11.1	%		4.8	%		0.6	%		100	%

ALLL:
Individually evaluated	$	-		$	-		$	-		$	-		$	-		$	-		$	-		$	-		$	-		$	-		$	-
Collectively evaluated		3,704			1,696			84			302			751			1,710			106			1,115			478			59			10,005
Ending balance	$	3,704		$	1,696		$	84		$	302		$	751		$	1,710		$	106		$	1,115		$	478		$	59		$	10,005

Loans:
Individually evaluated	$	147		$	1,224		$	39		$	392		$	982		$	686		$	-		$	627		$	144		$	-		$	4,241
Collectively evaluated		304,711			178,345			15,670			39,323			82,296			38,801			8,106			152,935			54,026			5,994			880,207
Total loans	$	304,858		$	179,569		$	15,709		$	39,715		$	83,278		$	39,487		$	8,106		$	153,562		$	54,170		$	5,994		$	884,448

Less ALLL	$	3,704		$	1,696		$	84		$	302		$	751		$	1,710		$	106		$	1,115		$	478		$	59		$	10,005
Net loans	$	301,154		$	177,873		$	15,625		$	39,413		$	82,527		$	37,777		$	8,000		$	152,447		$	53,692		$	5,935		$	874,443

	Originated – At or for the Nine Months Ended September 30, 2015
(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	$	3,191		$	1,230		$	53		$	226		$	511		$	2,685		$	140		$	866		$	337		$	49		$	9,288
Provision		160			260			15			4			79			(1,045	)		(34	)		41			149			17			(354	)
Charge-offs		(305	)		(157	)		-			-			-			-			-			(60	)		(91	)		(29	)		(642	)
Recoveries		37			3			-			-			13			-			-			15			-			12			80
Net charge-offs		(268	)		(154	)		-			-			13			-			-			(45	)		(91	)		(17	)		(562	)
Ending balance	$	3,083		$	1,336		$	68		$	230		$	603		$	1,640		$	106		$	862		$	395		$	49		$	8,372
As percent of ALLL		36.8	%		16.0	%		0.8	%		2.7	%		7.2	%		19.6	%		1.3	%		10.3	%		4.7	%		0.6	%		100	%

ALLL:
Individually evaluated	$	-		$	-		$	-		$	-		$	-		$	-		$	-		$	-		$	-		$	-		$	-
Collectively evaluated		3,083			1,336			68			230			603			1,640			106			862			395			49			8,372
Ending balance	$	3,083		$	1,336		$	68		$	230		$	603		$	1,640		$	106		$	862		$	395		$	49		$	8,372

Loans:
Individually evaluated	$	-		$	-		$	-		$	-		$	-		$	-		$	-		$	-		$	-		$	-		$	-
Collectively evaluated		294,160			146,155			7,334			21,541			59,894			28,314			8,106			119,503			47,096			5,752			737,855
Total loans	$	294,160		$	146,155		$	7,334		$	21,541		$	59,894		$	28,314		$	8,106		$	119,503		$	47,096		$	5,752		$	737,855

Less ALLL	$	3,083		$	1,336		$	68		$	230		$	603		$	1,640		$	106		$	862		$	395		$	49		$	8,372
Net loans	$	291,077		$	144,819		$	7,266		$	21,311		$	59,291		$	26,674		$	8,000		$	118,641		$	46,701		$	5,703		$	729,483

Note 5 – Loans, Allowance for Loan Losses, and Credit Quality, continued

	Acquired – At or for the Nine Months Ended September 30, 2015
(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	$	-		$	-		$	-		$	-		$	-		$	-		$	-		$	-		$	-		$	-		$	-
Provision		621			422			16			72			148			70			-			250			95			10			1,704
Charge-offs		-			(62	)		-			-			-			-			-			-			(13	)		-			(75	)
Recoveries		-			-			-			-			-			-			-			3			1			-			4
Net charge-offs		-			(62	)		-			-			-			-			-			3			(12	)		-			(71	)
Ending balance	$	621		$	360		$	16		$	72		$	148		$	70		$	-		$	253		$	83		$	10		$	1,633
As percent of ALLL		38.0	%		22.0	%		1.0	%		4.4	%		9.1	%		4.3	%		-	%		15.5	%		5.1	%		0.6	%		100	%

Loans:
Individually evaluated	$	147		$	1,224		$	39		$	392		$	982		$	686		$	-		$	627		$	144		$	-		$	4,241
Collectively evaluated		10,551			32,190			8,336			17,782			22,402			10,487			-			33,432			6,930			242			142,352
Total loans	$	10,698		$	33,414		$	8,375		$	18,174		$	23,384		$	11,173		$	-		$	34,059		$	7,074		$	242		$	146,593

Less ALLL	$	621		$	360		$	16		$	72		$	148		$	70		$	-		$	253		$	83		$	10		$	1,633
Net loans	$	10,077		$	33,054		$	8,359		$	18,102		$	23,236		$	11,103		$	-		$	33,806		$	6,991		$	232		$	144,960

There was no ALLL allocated to individually evaluated loans at September 30, 2015, therefore the table reflecting the ALLL between individually evaluated loans and collectively evaluated loans was omitted.

The following table presents the balance and activity in the ALLL by portfolio segment and the recorded investment in loans by portfolio at or for the nine months ended September 30, 2014.

	Total – At or for the Nine Months Ended September 30, 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		2,318			1,057			36			213			121			(2,445	)		(73	)		610			129			59			2,025
Charge-offs		(567	)		(468	)		-			-			-			(12	)		-			(191	)		(18	)		(35	)		(1,291	)
Recoveries		50			15			-			-			12			-			-			1			1			7			86
Net charge-offs		(517	)		(453	)		-			-			12			(12	)		-			(190	)		(17	)		(28	)		(1,205	)
Ending balance	$	3,599		$	1,370		$	54		$	272		$	638		$	2,513		$	156		$	964		$	433		$	53		$	10,052
As percent of ALLL		35.8	%		13.6	%		0.5	%		2.7	%		6.3	%		25.0	%		1.6	%		9.6	%		4.3	%		0.6	%		100	%

ALLL:
Individually evaluated	$	238		$	-		$	-		$	-		$	-		$	389		$	-		$	-		$	-		$	-		$	627
Collectively evaluated		3,361			1,370			54			272			638			2,124			156			964			433			53			9,425
Ending balance	$	3,599		$	1,370		$	54		$	272		$	638		$	2,513		$	156		$	964		$	433		$	53		$	10,052

Loans:
Individually evaluated	$	353		$	1,604		$	62		$	394		$	1,740		$	4,778		$	-		$	1,495		$	156		$	-		$	10,582
Collectively evaluated		282,004			177,562			14,570			41,801			75,327			37,684			11,260			156,235			52,367			5,693			854,503
Total loans	$	282,357		$	179,166		$	14,632		$	42,195		$	77,067		$	42,462		$	11,260		$	157,730		$	52,523		$	5,693		$	865,085

Less ALLL	$	3,599		$	1,370		$	54		$	272		$	638		$	2,513		$	156		$	964		$	433		$	53		$	10,052
Net loans	$	278,758		$	177,796		$	14,578		$	41,923		$	76,429		$	39,949		$	11,104		$	156,766		$	52,090		$	5,640		$	855,033

Note 5 – Loans, Allowance for Loan Losses, and Credit Quality, continued

	Originated – At or for the Nine Months Ended September 30, 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		2,261			1,050			36			213			121			(2,457	)		(73	)		457			112			59			1,779
Charge-offs		(510	)		(452	)		-			-			-			-			-			(38	)		-			(35	)		(1,035	)
Recoveries		50			6			-			-			12			-			-			1			-			7			76
Net charge-offs		(460	)		(446	)		-			-			12			-			-			(37	)		-			(28	)		(959	)
Ending balance	$	3,599		$	1,370		$	54		$	272		$	638		$	2,513		$	156		$	964		$	433		$	53		$	10,052
As percent of ALLL		35.8	%		13.6	%		0.5	%		2.7	%		6.3	%		25.0	%		1.6	%		9.6	%		4.3	%		0.6	%		100	%

ALLL:
Individually evaluated	$	238		$	-		$	-		$	-		$	-		$	389		$	-		$	-		$	-		$	-		$	627
Collectively evaluated		3,361			1,370			54			272			638			2,124			156			964			433			53			9,425
Ending balance	$	3,599		$	1,370		$	54		$	272		$	638		$	2,513		$	156		$	964		$	433		$	53		$	10,052

Loans:
Individually evaluated	$	347		$	830		$	-		$	-		$	-		$	3,999		$	-		$	201		$	-		$	-		$	5,377
Collectively evaluated		259,358			130,491			4,882			19,134			50,004			27,942			11,260			116,078			43,923			5,107			668,179
Total loans	$	259,705		$	131,321		$	4,882		$	19,134		$	50,004		$	31,941		$	11,260		$	116,279		$	43,923		$	5,107		$	673,556

Less ALLL	$	3,599		$	1,370		$	54		$	272		$	638		$	2,513		$	156		$	964		$	433		$	53		$	10,052
Net loans	$	256,106		$	129,951		$	4,828		$	18,862		$	49,366		$	29,428		$	11,104		$	115,315		$	43,490		$	5,054		$	663,504

	Acquired – At or for the Nine Months Ended September 30, 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	$	57		$	7		$	-	$	-	$	-	$	12		$	-	$	153		$	17		$	-	$	246
Charge-offs		(57	)		(16	)		-		-		-		(12	)		-		(153	)		(18	)		-		(256	)
Recoveries		-			9			-		-		-		-			-		-			1			-		10
Loans:
Individually evaluated	$	6		$	774		$	62	$	394	$	1,740	$	779		$	-	$	1,294		$	156		$	-	$	5,205
Collectively evaluated		22,646			47,071			9,688		22,667		25,323		9,742			-		40,157			8,444			586		186,324
Total loans	$	22,652		$	47,845		$	9,750	$	23,061	$	27,063	$	10,521		$	-	$	41,451		$	8,600		$	586	$	191,529

Note 5 – Loans, Allowance for Loan Losses, and Credit Quality, continued

The following table presents nonaccrual loans by portfolio segment in total and then as a further breakdown by originated or acquired as of September 30, 2015 and December 31, 2014.

	Total
	September 30, 2015					December 31, 2014
(in thousands)	Amount		% to Total			Amount		% to Total
Commercial & industrial	$	223		5.2	%	$	171		3.2	%
Owner-occupied CRE		1,223		28.4			1,667		30.9
AG production		15		0.3			21		0.4
AG real estate		372		8.7			392		7.3
CRE investment		771		17.9			911		16.9
Construction & land development		686		16.0			934		17.3
Residential construction		-		-			-		-
Residential first mortgage		861		20.1			1,155		21.4
Residential junior mortgage		148		3.4			141		2.6
Retail & other		-		-			-		-
Nonaccrual loans - Total	$	4,299		100.0	%	$	5,392		100.0	%

	Originated
	September 30, 2015					December 31, 2014
(in thousands)	Amount		% to Total			Amount		% to Total
Commercial & industrial	$	47		34.8	%	$	130		11.5	%
Owner-occupied CRE		-		-			673		59.7
AG production		15		11.1			-		-
AG real estate		-		-			-		-
CRE investment		-		-			-		-
Construction & land development		-		-			165		14.6
Residential construction		-		-			-		-
Residential first mortgage		73		54.1			160		14.2
Residential junior mortgage		-		-			-		-
Retail & other		-		-			-		-
Nonaccrual loans - Originated	$	135		100.0	%	$	1,128		100.0	%

	Acquired
	September 30, 2015					December 31, 2014
(in thousands)	Amount		% to Total			Amount		% to Total
Commercial & industrial	$	176		4.2	%	$	41		1.0	%
Owner-occupied CRE		1,223		29.4			994		23.3
AG production		-		-			21		0.5
AG real estate		372		8.9			392		9.2
CRE investment		771		18.5			911		21.4
Construction & land development		686		16.5			769		18.0
Residential construction		-		-			-		-
Residential first mortgage		788		18.9			995		23.3
Residential junior mortgage		148		3.6			141		3.3
Retail & other		-		-			-		-
Nonaccrual loans – Acquired	$	4,164		100.0	%	$	4,264		100.0	%

Note 5 – Loans, Allowance for Loan Losses, and Credit Quality, continued

The following tables present total past due loans by portfolio segment as of September 30, 2015 and December 31, 2014:

	September 30, 2015
(in thousands)	30-89 Days Past Due (accruing)			90 Days & Over or non- accrual			Current			Total
Commercial & industrial	$	61		$	223		$	304,574		$	304,858
Owner-occupied CRE		19			1,223			178,327			179,569
AG production		-			15			15,694			15,709
AG real estate		114			372			39,229			39,715
CRE investment		392			771			82,115			83,278
Construction & land development		-			686			38,801			39,487
Residential construction		-			-			8,106			8,106
Residential first mortgage		170			861			152,531			153,562
Residential junior mortgage		3			148			54,019			54,170
Retail & other		-			-			5,994			5,994
Total loans	$	759		$	4,299		$	879,390		$	884,448
As a percent of total loans		0.1	%		0.5	%		99.4	%		100.0	%

	December 31, 2014
(in thousands)	30-89 Days Past Due (accruing)			90 Days & Over or nonaccrual			Current			Total
Commercial & industrial	$	167		$	171		$	289,041		$	289,379
Owner-occupied CRE		54			1,667			180,853			182,574
AG production		-			21			14,596			14,617
AG real estate		118			392			42,244			42,754
CRE investment		426			911			80,536			81,873
Construction & land development		-			934			43,180			44,114
Residential construction		-			-			11,333			11,333
Residential first mortgage		399			1,155			157,129			158,683
Residential junior mortgage		-			141			51,963			52,104
Retail & other		-			-			5,910			5,910
Total loans	$	1,164		$	5,392		$	876,785		$	883,341
As a percent of total loans		0.1	%		0.6	%		99.3	%		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.

Note 5 – Loans, Allowance for Loan Losses, and Credit Quality, continued

8 Doubtful: Assets with this rating exhibit all the weaknesses as one rated Substandard with the added characteristic that such weaknesses make collection or liquidation in full highly questionable.

9 Loss: Assets in this category are considered uncollectible. Pursuing any recovery or salvage value is impractical but does not preclude partial recovery in the future.

The following tables present total loans by loan grade as of September 30, 2015 and December 31, 2014:

	September 30, 2015
(in thousands)	Grades 1- 4			Grade 5			Grade 6			Grade 7			Grade 8		Grade 9		Total
Commercial & industrial	$	279,955		$	20,594		$	608		$	3,701		$	-	$	-	$	304,858
Owner-occupied CRE		169,669			5,836			1,253			2,811			-		-		179,569
AG production		14,985			686			-			38			-		-		15,709
AG real estate		38,411			443			-			861			-		-		39,715
CRE investment		80,091			1,132			891			1,164			-		-		83,278
Construction & land development		33,936			4,865			-			686			-		-		39,487
Residential construction		7,354			752			-			-			-		-		8,106
Residential first mortgage		150,358			1,019			518			1,667			-		-		153,562
Residential junior mortgage		53,832			167			-			171			-		-		54,170
Retail & other		5,994			-			-			-			-		-		5,994
Total loans	$	834,585		$	35,494		$	3,270		$	11,099		$	-	$	-	$	884,448
Percent of total		94.3	%		4.0	%		0.4	%		1.3	%		-		-		100	%

	December 31, 2014
(in thousands)	Grades 1- 4			Grade 5			Grade 6			Grade 7			Grade 8		Grade 9		Total
Commercial & industrial	$	268,140		$	15,940		$	2,588		$	2,711		$	-	$	-	$	289,379
Owner-occupied CRE		170,544			6,197			2,919			2,914			-		-		182,574
AG production		14,018			244			-			355			-		-		14,617
AG real estate		32,315			9,548			59			832			-		-		42,754
CRE investment		78,229			2,203			-			1,441			-		-		81,873
Construction & land development		35,649			7,417			114			934			-		-		44,114
Residential construction		10,101			1,232			-			-			-		-		11,333
Residential first mortgage		155,916			686			592			1,489			-		-		158,683
Residential junior mortgage		51,843			99			-			162			-		-		52,104
Retail & other		5,904			6			-			-			-		-		5,910
Total loans	$	822,659		$	43,572		$	6,272		$	10,838		$	-	$	-	$	883,341
Percent of total		93.2	%		4.9	%		0.7	%		1.2	%		-		-		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. At the time an individual loan goes into nonaccrual status, however, management evaluates the loan for impairment and possible charge-off regardless of loan size.

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

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

Note 5 – Loans, Allowance for Loan Losses, and Credit Quality, continued

The following tables present impaired loans as of September 30, 2015 and December 31, 2014. As a further breakdown, impaired loans are also summarized by originated and acquired for the periods presented. Purchased credit impaired loans acquired were initially recorded at a fair value of $16.7 million on their respective acquisition dates, net of an initial $12.2 million non-accretable mark and a zero accretable mark. At September 30, 2015, $2.8 million of the $16.7 million remain in impaired loans and $1.4 million of acquired loans have subsequently become impaired, bringing acquired impaired loans to $4.2 million. There were no allowances in excess of the non-accretable marks on acquired loans at December 31, 2014 or September 30, 2015. Included in the December 31, 2014 originated impaired loans is one troubled debt restructuring totaling $3.8 million. This loan was paid off in the third quarter of 2015 and there are no originated impaired loans at September 30, 2015.

	Total Impaired Loans – September 30, 2015
(in thousands)	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
Commercial & industrial	$	147	$	147	$	-	$	147	$	6
Owner-occupied CRE		1,224		2,276		-		1,281		129
AG production		39		55		-		39		3
AG real estate		392		499		-		403		25
CRE investment		982		2,795		-		1,078		110
Construction & land development		686		1,228		-		507		40
Residential construction		-		-		-		-		-
Residential first mortgage		627		1,911		-		673		68
Residential junior mortgage		144		479		-		148		19
Retail & Other		-		13		-		-		1
Total	$	4,241	$	9,403	$	-	$	4,276	$	401

Originated – September 30, 2015

(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

Residential construction

Residential first mortgage

Residential junior mortgage

Retail & Other

Total

	Acquired – September 30, 2015
(in thousands)	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
Commercial & industrial	$	147	$	147	$	-	$	147	$	6
Owner-occupied CRE		1,224		2,276		-		1,281		129
AG production		39		55		-		39		3
AG real estate		392		499		-		403		25
CRE investment		982		2,795		-		1,078		110
Construction & land development		686		1,228		-		507		40
Residential construction		-		-		-		-		-
Residential first mortgage		627		1,911		-		673		68
Residential junior mortgage		144		479		-		148		19
Retail & Other		-		13		-		-		1
Total	$	4,241	$	9,403	$	-	$	4,276	$	401

Note 5 – Loans, Allowance for Loan Losses, and Credit Quality, continued

	Total Impaired Loans – December 31, 2014
(in thousands)	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
Commercial & industrial*	$	35	$	35	$	30	$	36	$	2
Owner-occupied CRE		1,724		2,838		-		2,029		226
AG production		60		126		-		45		10
AG real estate		392		460		-		398		22
CRE investment		1,219		3,807		-		1,344		217
Construction & land development*		4,098		4,641		358		4,236		90
Residential construction		-		-		-		-		-
Residential first mortgage		985		2,723		-		1,107		155
Residential junior mortgage		153		502		-		156		20
Retail & Other		-		22		-		-		2
Total	$	8,666	$	15,154	$	388	$	9,351	$	744

	Originated – December 31, 2014
(in thousands)	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
Commercial & industrial*	$	30	$	30	$	30	$	30	$	-
Owner-occupied CRE		673		673		-		859		47
AG production		-		-		-		-		-
AG real estate		-		-		-		-		-
CRE investment		-		-		-		-		-
Construction & land development*		3,777		3,777		358		3,854		39
Residential construction		-		-		-		-		-
Residential first mortgage		-		-		-		-		-
Residential junior mortgage		-		-		-		-		-
Retail & Other		-		-		-		-		-
Total	$	4,480	$	4,480	$	388	$	4,743	$	86

	Acquired – December 31, 2014
(in thousands)	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
Commercial & industrial	$	5	$	5	$	-	$	6	$	2
Owner-occupied CRE		1,051		2,165		-		1,170		179
AG production		60		126		-		45		10
AG real estate		392		460		-		398		22
CRE investment		1,219		3,807		-		1,344		217
Construction & land development		321		864		-		382		51
Residential construction		-		-		-		-		-
Residential first mortgage		985		2,723		-		1,107		155
Residential junior mortgage		153		502		-		156		20
Retail & other		-		22		-		-		2
Total	$	4,186	$	10,674	$	-	$	4,608	$	658

* One commercial & industrial loan with a balance of $30,000 had a specific reserve of $30,000. One construction & land development loan with a balance of $3.8 million had a specific reserve of $358,000. No other loans had a related allowance at December 31, 2014, and therefore, the above disclosure was not expanded to include loans with and without a related allowance.

Note 5 – Loans, Allowance for Loan Losses, and Credit Quality, continued

Troubled Debt Restructurings

At September 30, 2015, there were eleven loans classified as troubled debt restructurings totaling $0.7 million. The eleven loans had a combined pre-modification balance of $1.8 million and a combined outstanding balance of $696,000 at September 30, 2015. There were no other loans which were modified and classified as troubled debt restructurings at September 30, 2015. There were no loans classified as troubled debt restructurings during the previous twelve months that subsequently defaulted as of September 30, 2015. As of September 30, 2015 and December 31, 2014, there were no commitments to lend additional funds to debtors whose terms have been modified in trouble debt restructurings. At September 30, 2014, there were five loans classified as troubled debt restructurings totaling $4.2 million. One loan had a premodification balance of $3.9 million and at September 30, 2014, had a balance of $3.8 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 $389,000. This loan was performing but was disclosed as impaired as a result of its classification as a troubled debt restructuring. This loan was paid off in the third quarter of 2015. The remaining four loans had a combined premodification balance of $438,000 and a combined outstanding balance of $389,000 at September 30, 2014.

Note 6 - Notes Payable

The Company had the following long-term notes payable:

(in thousands)	September 30, 2015		December 31, 2014
Joint venture note	$	9,480	$	9,675
Federal Home Loan Bank (“FHLB”) advances		6,000		11,500
Notes payable	$	15,480	$	21,175

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.

The Company’s FHLB advances are all fixed rate, require interest-only monthly payments, and have maturities through February 2018. The weighted average rate of FHLB advances was 0.83% and 0.71% at September 30, 2015 and December 31, 2014, respectively. The FHLB advances are collateralized by a blanket lien on qualifying first mortgages, home equity loans, multi-family loans and certain farmland loans which totaled approximately $162.1 million and $164.2 million at September 30, 2015 and December 31, 2014, respectively.

The following table shows the maturity schedule of the notes payable as of September 30, 2015:

Maturing in	(in thousands)
2015	$	68
2016		14,412
2017		-
2018		1,000
	$	15,480

Note 7 - Junior Subordinated Debentures

The Company’s carrying value of junior subordinated debentures was $12.5 million at September 30, 2015 and $12.3 million at December 31, 2014. 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 2013 acquisition of Mid-Wisconsin Financial Services, Inc., 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 September 30, 2015, the carrying value of these junior debentures was $6.3 million, and the $6.0 million carrying value of related trust preferred securities qualifies as Tier 1 capital.

Note 8 – Subordinated Notes

On February 17, April 28, and June 29, 2015, the Company placed an aggregate of $12 million in subordinated Notes in private placements with certain accredited investors. All Notes were issued with 10-year maturities, have a fixed annual interest rate of 5% payable quarterly, are callable on or after the fifth anniversary of their respective issuances dates, and qualify for Tier 2 capital for regulatory purposes.

The Company elected to early adopt ASU 2015-03, Simplifying the Presentation of Debt Issuance Costs, which requires debt issuance costs to be presented in the balance sheet as a direct deduction from the associated debt liability. The $180,000 debt issuance costs associated with the $12 million Notes are being amortized on a straight line basis over the first five years, representing the no-call periods, as additional interest expense. As of September 30, 2015, $160,000 of unamortized debt issuance costs remain and are reflected as a deduction to the carrying value of the outstanding debt.

Note 9 - 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.

Note 9 - Fair Value Measurements, continued

The following table presents the balances of assets and liabilities measured at fair value on a recurring basis for the periods presented. One security classified as Level 3 was purchased at a discount to its par value for $0.9 million during the first nine months of 2015. There were no other changes in Level 3 values to report during the first nine months of 2015.

			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	$	297	$	-	$	297	$	-
State, county and municipals		107,016		-		106,440		576
Mortgage-backed securities		54,907		-		54,907		-
Corporate debt securities		1,140		-		-		1,140
Equity securities		4,212		4,212		-		-
Securities AFS, September 30, 2015	$	167,572	$	4,212	$	161,644	$	1,716

(in thousands)
U.S. government sponsored enterprises	$	1,039	$	-	$	1,039	$	-
State, county and municipals		102,776		-		102,200		576
Mortgage-backed securities		61,677		-		61,677		-
Corporate debt securities		220		-		-		220
Equity securities		2,763		2,763		-		-
Securities AFS, December 31, 2014	$	168,475	$	2,763	$	164,916	$	796

The following is a description of the valuation methodologies used by the Company for the Securities AFS noted in the tables of this footnote. Where quoted market prices on securities exchanges are available, the investment is classified as Level 1. Level 1 investments primarily include exchange-traded equity securities available for sale. If quoted market prices are not available, fair value is generally determined using prices obtained from independent pricing vendors who use pricing models (with typical inputs including benchmark yields, reported trades for similar securities, issuer spreads or relationship to other benchmark quoted securities), or discounted cash flows, and are classified as Level 2. Examples of these investments include mortgage-related securities and obligations of state, county and municipals. Finally, in certain cases where there is limited activity or less transparency around inputs to the estimated fair value, investments are classified within Level 3 of the hierarchy. Examples of these include auction rate securities available for sale (for which there has been no liquid market since 2008) and corporate debt securities, which include trust preferred security investments. At September 30, 2015 and December 31, 2014, 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.

The following table presents the Company’s impaired loans and other real estate owned (“OREO”) measured at fair value on a nonrecurring basis for the periods presented.

Measured at Fair Value on a Nonrecurring Basis
			Fair Value Measurements Using
(in thousands)	Total		Level 1		Level 2		Level 3
September 30, 2015:
Impaired loans	$	4,241	$	-	$	-	$	4,241
OREO		714		-		-		714
December 31, 2014:
Impaired loans	$	8,278	$	-	$	-	$	8,278
OREO		1,966		-		-		1,966

Note 9 - Fair Value Measurements, continued

The following is a description of the valuation methodologies used by the Company for the items noted in the table above, including the general classification of such instruments in the fair value hierarchy. For individually evaluated impaired loans, the amount of impairment is based upon the present value of expected future cash flows discounted at the loan’s effective interest rate, the estimated fair value of the underlying collateral for collateral-dependent loans, or the estimated liquidity of the note. For OREO, the fair value is based upon the estimated fair value of the underlying collateral adjusted for the expected costs to sell.

The carrying amounts and estimated fair values of the Company’s financial instruments at September 30, 2015 and December 31, 2014 are shown below.

September 30, 2015
(in thousands)	Carrying Amount		Estimated Fair Value		Level 1		Level 2		Level 3
Financial assets:
Cash and cash equivalents	$	34,635	$	34,635	$	34,635	$	-	$	-
Certificates of deposit in other banks		4,159		4,172		-		4,172		-
Securities AFS		167,572		167,572		4,212		161,644		1,716
Other investments		8,126		8,126		-		5,985		2,141
Loans held for sale		3,055		3,120		-		3,120		-
Loans, net		874,443		882,543		-		-		882,543
Bank owned life insurance		28,228		28,228		28,228		-		-

Financial liabilities:
Deposits	$	1,012,181	$	1,014,523	$	-	$	-	$	1,014,523
Notes payable		15,480		18,377		-		6,026		12,351
Junior subordinated debentures		12,477		11,853		-		-		11,853
Subordinated notes		11,840		11,554		-		-		11,554

December 31, 2014
(in thousands)	Carrying Amount		Estimated Fair Value		Level 1		Level 2		Level 3
Financial assets:
Cash and cash equivalents	$	68,708	$	68,708	$	68,708	$	-	$	-
Certificates of deposit in other banks		10,385		10,421		-		10,421		-
Securities AFS		168,475		168,475		2,763		164,916		796
Other investments		8,065		8,065		-		5,924		2,141
Loans held for sale		7,272		7,272		-		7,272		-
Loans, net		874,053		881,793		-		-		881,793
Bank owned life insurance		27,479		27,479		27,479		-		-

Financial liabilities:
Deposits	$	1,059,903	$	1,062,262	$	-	$	-	$	1,062,262
Notes payable		21,175		24,212		-		11,526		12,686
Junior subordinated debentures		12,328		11,711		-		-		11,711

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, bank owned life insurance, short-term borrowings, and nonmaturing deposits. For those financial instruments not previously disclosed the following is a description of the evaluation methodologies used.

Certificates of deposits in other banks: Fair values are estimated using discounted cash flow analysis based on current interest rates being offered by instruments with similar terms and represents a Level 2 measurement.

Note 9 - Fair Value Measurements, continued

Other investments: The carrying amount of Federal Reserve Bank, Bankers Bank, Farmer Mac, and FHLB stock is a reasonably accepted fair value estimate given their restricted nature. Fair value is the redeemable (carrying) value based on the redemption provisions of the instruments which is considered a Level 2 measurement. The carrying amount of the remaining other investments (particularly common stocks of companies or other banks that are not publicly traded) approximates their fair value, determined primarily by analysis of company financial statements and recent capital issuances of the respective companies or banks, if any, and represents a Level 3 measurement.

Loans held for sale: The fair value estimation process for the loans held for sale portfolio is segregated by loan type. The estimated fair value was based on what secondary markets are currently offering for portfolios with similar characteristics and represents a Level 2 measurement.

Loans, net: For variable-rate loans that reprice frequently and with no significant change in credit risk or other optionality, fair values are based on carrying values. Fair values for all other loans are estimated by discounting contractual cash flows using estimated market discount rates, which reflect the credit and interest rate risk inherent in the loan. Collateral-dependent impaired loans are included in loans, net. The fair value of loans is considered to be a Level 3 measurement due to internally developed discounted cash flow measurements.

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

Notes payable: The fair value of the Federal Home Loan Bank advances is obtained from the Federal Home Loan Bank which uses a discounted cash flow analysis based on current market rates of similar maturity debt securities and represents a Level 2 measurement. The fair values of remaining notes payable are estimated using discounted cash flow analysis based on current interest rates being offered by instruments with similar terms and credit quality which represents a Level 3 measurement.

Junior subordinated debentures and subordinated notes: The fair values of these debt instruments utilize a discounted cash flow analysis based on an estimate of current interest rates being offered by instruments with similar terms and credit quality. Since the market for these instruments is limited, the internal evaluation represents a Level 3 measurement.

Off-balance-sheet instruments: The estimated fair value of letters of credit at September 30, 2015 and December 31, 2014 was insignificant. Loan commitments on which the committed interest rate is less than the current market rate are also insignificant at September 30, 2015 and December 31, 2014.

Limitations: Fair value estimates are made at a specific point in time, based on relevant market information and information about the financial instrument. These estimates do not reflect any premium or discount that could result from offering for sale at one time the Company’s entire holdings of a particular financial instrument. Fair value estimates may not be realizable in an immediate settlement of the instrument. In some instances, there are no quoted market prices for the Company’s various financial instruments, in which case fair values may be based on estimates using present value or other valuation techniques, or based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of the financial instruments, or other factors. Those techniques are significantly affected by the assumptions used, including the discount rate and estimate of future cash flows. Subsequent changes in assumptions could significantly affect the estimates.

Note 10 – Sale of Branches

On August 7, 2015, the Company completed the sale of its Neillsville and Fairchild, WI branches, which reduced deposits by $34 million, loans by $13 million, fixed assets by $1 million and cash by $20 million, and resulted in $0.1 million recorded in miscellaneous income.

Note 11 – Small Business Lending Fund (“SBLF”) Preferred Stock Redemption

On September 28, 2015, the Company redeemed $12.2 million, or half, of its outstanding SBLF Series C Preferred Stock at par plus accrued dividends.

Note 12 – Pending Merger Transaction

On September 8, 2015 the Company announced the signing of a definitive merger agreement with Baylake Corp. (“Baylake”) (NASDAQ:BYLK) under which Baylake will merge with and into the Company. Based upon the financial position as of September 30, 2015, the combined company would have total assets of approximately $2.2 billion, deposits of $1.8 billion and loans of $1.6 billion. The merger transaction is appropriately not reflected in the Company’s September 30, 2015 financial statements as it is not expected to close until the second quarter of 2016 and is subject to customary closing conditions, including approval by shareholders of each company and regulatory approvals.

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

Nicolet Bankshares, Inc. is a bank holding company headquartered in Green Bay, Wisconsin, providing a diversified range of traditional banking and wealth management services to individuals and businesses in its market area through the 21 branch offices of its banking subsidiary, Nicolet National Bank, in northeastern and central Wisconsin and Menominee, Michigan.

Overview

At September 30, 2015, Nicolet Bankshares, Inc. and its subsidiaries (“Nicolet” or the “Company”) had total assets of $1.2 billion, loans of $884 million, deposits of $1.0 billion and total shareholders’ equity of $105 million. Nicolet’s profitability is significantly dependent upon net interest income (interest income earned on loans and other interest-earning assets such as investments, net of interest expense on deposits and other borrowed funds), and noninterest income sources (including but not limited to service charges on deposits, trust and brokerage fees, mortgage income from sales of residential mortgages into the secondary market, and other fees or revenue from financial services provided to customers or ancillary to loans and deposits), offset by the level of the provision for loan losses, noninterest expenses (largely employee compensation and overhead expenses tied to processing and operating the Bank’s business), and income taxes. Business volumes and pricing drive revenue potential and tend to be influenced by overall economic factors, including market interest rates, business spending, consumer confidence, economic growth and competitive conditions within the marketplace. For the nine months ended September 30, 2015, Nicolet earned net income of $8.6 million, and after $182,000 of preferred stock dividends, net income available to common shareholders was $8.4 million or $1.93 per diluted common share.

During the first nine months of 2015, Nicolet executed on a number of actions. Such actions impact certain comparisons of financial results between 2015 and 2014. During the first half of 2015 through private placements, Nicolet issued $12 million of 5% fixed-rate, 10-year subordinated notes, callable on or after the fifth anniversary of their respective issuance dates, and which qualify as Tier 2 capital for regulatory purposes. On September 28, 2015, Nicolet redeemed $12.2 million, or half, of its outstanding Small Business Lending Fund (“SBLF”) Series C Preferred Stock at par, reducing total equity and regulatory Tier 1 capital. During the nine-month period of 2015, under Nicolet’s existing common stock repurchase program, $4.2 million was used to repurchase approximately 146,400 common shares at a weighted average price of $28.35 per share including commissions. In August 2015, Nicolet completed its sale of two branches, reducing deposits by $34 million, loans by $13 million, fixed assets by $1 million and cash by $20 million.

Finally, consistent with our previously stated interest in strategic growth, on September 8, 2015, Nicolet announced the signing of a definitive merger agreement with Baylake Corp. (“Baylake”) under which Baylake will merge into Nicolet to create the fourth largest bank headquartered in Wisconsin by deposit market share. Based upon the financial position as of September 30, 2015, the combined company would have total assets of $2.2 billion, deposits of $1.8 billion and loans of $1.6 billion, and an expanded geography operating out of 41 bank branches. The merger is expected to drive growth and efficiency through the increased scale, leverage the strengths of each bank across the combined customer base, enhance profitability, and add liquidity and shareholder value. The proposed merger transaction is not reflected in Nicolet’s September 30, 2015, financials as it is not expected to close until the second quarter of 2016, subject to customary closing conditions, including approvals by shareholders of each company and regulatory approvals.

Forward-Looking Statements

Forward Looking Statements “Safe Harbor” Statement Under the Private Securities Litigation Reform Act of 1995. This report contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, which Congress passed in an effort to encourage companies to provide information about their anticipated future financial performance. This act protects a company from unwarranted litigation if actual results are different from management expectations. This report reflects the current views and estimates of future economic circumstances, industry conditions, company performance, and financial results of the management of Nicolet and Baylake. These forward-looking statements are subject to a number of factors and uncertainties which could cause Nicolet’s, Baylake’s or the combined company’s actual results and experience to differ from the anticipated results and expectations expressed in such forward-looking statements, and such differences may be material. Forward-looking statements speak only as of the date they are made and neither Nicolet nor Baylake assumes any duty to update forward-looking statements. There are a number of factors that could cause our actual results to differ materially from those projected in such forward-looking statements.

In addition to factors previously disclosed in Nicolet’s and Baylake’s reports filed with the SEC and those identified elsewhere in this report, these forward-looking statements include, but are not limited to, statements about (i) the expected benefits of the transaction between Nicolet and Baylake and between Nicolet National Bank and Baylake Bank, including future financial and operating results, cost savings, enhanced revenues and the expected market position of the combined company that may be realized from the transaction, and (ii) Nicolet’s and Baylake’s plans, objectives, expectations and intentions and other statements contained in this report that are not historical facts. Other statements identified by words such as “expects,” “anticipates,” “intends,” “plans,” “believes,” “seeks,” “estimates,” “targets,” “projects” or words of similar meaning generally are intended to identify forward-looking statements. These statements are based upon the current beliefs and expectations of Nicolet’s and Baylake’s management and are inherently subject to significant business, economic and competitive risks and uncertainties, many of which are beyond their respective control. In addition, these forward-looking statements are subject to assumptions with respect to future business strategies and decisions that are subject to change. Actual results may differ from those indicated or implied in the forward-looking statements and such differences may be material.

The following risks, among others, could cause actual results to differ materially from the anticipated results or other expectations expressed in the forward-looking statements: (1) the businesses of Nicolet and Baylake may not integrate successfully or the integration may be more difficult, time-consuming or costly than expected; (2) the expected growth opportunities and cost savings from the transaction may not be fully realized or may take longer to realize than expected; (3) revenues following the transaction may be lower than expected as a result of losses of customers or other reasons, including issues arising in connection with integration of the two banks; (4) deposit attrition, operating costs, customer loss and business disruption following the transaction, including difficulties in maintaining relationships with employees, may be greater than expected; (5) governmental approvals of the transaction may not be obtained on the proposed terms or expected timeframe; (6) the terms of the proposed transaction may need to be modified to satisfy such approvals or conditions; (7) Nicolet’s shareholders or Baylake’s shareholders may fail to approve the transaction; (8) reputational risks and the reaction of the companies’ customers to the transaction; (9) diversion of management time on merger related issues; (10) changes in asset quality and credit risk; (11) the cost and availability of capital; (12) customer acceptance of the combined company’s products and services; (13) customer borrowing, repayment, investment and deposit practices; (14) the introduction, withdrawal, success and timing of business initiatives; (15) the impact, extent, and timing of technological changes; (16) severe catastrophic events in our geographic area; (17) a weakening of the economies in which the combined company will conduct operations may adversely affect its operating results; (18) the U.S. legal and regulatory framework, including those associated with the Dodd Frank Wall Street Reform and Consumer Protection Act, could adversely affect the operating results of the combined company; (19) the interest rate environment may compress margins and adversely affect net interest income; and (20) competition from other financial services companies in the companies’ markets could adversely affect operations. Additional factors that could cause Nicolet’s results to differ materially from those described in the forward-looking statements can be found in Nicolet’s reports (such as Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q and Current Reports on Form 8-K) filed with the SEC and available at the SEC’s website (www.sec.gov). Additional factors that could cause Baylake’s results to differ materially from those described in the forward-looking statements can be found in Baylake’s reports (such as Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q and Current Reports on Form 8-K) filed with the SEC and available at the SEC’s website (www.sec.gov). All subsequent written and oral forward-looking statements concerning Nicolet, Baylake or the proposed merger or other matters and attributable to Nicolet, Baylake or any person acting on either of their behalf are expressly qualified in their entirety by the cautionary statements above. Nicolet and Baylake do not undertake any obligation to update any forward-looking statement, whether written or oral, to reflect circumstances or events that occur after the date the forward-looking statements are made.

Merger Agreement

On September 8, 2015, Nicolet, and Baylake entered into an Agreement and Plan of Merger (the “Merger Agreement”), pursuant to which Baylake will merge with and into Nicolet (the “Merger”). Following the Merger, Baylake Bank, the wholly-owned bank subsidiary of Baylake, will merge with and into Nicolet National Bank, Nicolet’s wholly-owned bank subsidiary, with Nicolet National Bank continuing as the surviving bank (the “Bank Merger”), with all bank branches operating under the Nicolet National Bank brand. Nicolet will maintain its corporate office in Green Bay, Wisconsin.

Nicolet and Baylake have agreed to prepare and file with the Securities and Exchange Commission (the “SEC”) a registration statement on Form S-4, which will include a joint proxy statement/prospectus. As soon as practicable following effectiveness of the registration statement on Form S-4, each of Nicolet and Baylake will call a special shareholders meeting to approve the Merger. Subject to the provisions relating to a superior proposal, the parties’ respective boards of directors have agreed to recommend that their respective shareholders approve the Merger.

Merger Consideration. Pursuant to the terms and subject to the conditions set forth in the Merger Agreement, at the effective time of the Merger (the “Effective Time”), each issued and outstanding share of Baylake common stock (other than Baylake common stock held in treasury by Baylake or held directly or indirectly by Nicolet, which shares will be canceled prior to any exchange therefor), will be exchanged for the right to receive 0.4517 of Nicolet common stock and cash in lieu of any fractional shares.

Treatment of Restricted Stock Units and Stock Options. At the effective time, and subject to the exchange ratio outlined in the Merger Agreement, each restricted stock unit and option granted by Baylake, whether vested or unvested, shall be substituted with an equity award issued under a Nicolet stock plan or adjusted under a Baylake stock plan to be exercisable for Nicolet stock.

Board of Directors and Executive Officers. Upon consummation of the Merger, the makeup of the board of directors will consist of sixteen members, eight selected by the Nicolet board of directors and eight selected by the Baylake board of directors. The Nominating Committee of the Nicolet board of directors shall consist of two directors each from Nicolet and Baylake for a period of two years after closing. Nicolet will establish a Co-Chairman and Co-Chief Executive Officer structure for Robert B. Atwell and Robert J. Cera, and deliver an employment agreement to Robert J. Cera as of the closing date.

Closing Conditions. Consummation of the Merger is subject to certain mutual closing conditions, including, without limitation, (i) the approval of the Merger by the shareholders of both Nicolet and Baylake; (ii) Nicolet listing its shares on NASDAQ; (iii) the registration statement on Form S-4 shall become effective; (iv) the absence of any legal proceeding prohibiting the Merger; and (v) the receipt of all required regulatory approvals.

In addition to these mutual conditions, each party’s obligation to consummate the Merger is subject to certain other conditions, including, without limitation, (i) the accuracy of each party’s representations and warranties; and (ii) each party’s compliance with its covenants and agreements contained in the Merger Agreement.

Representations, Warranties and Covenants. The Merger Agreement includes detailed representations, warranties and covenant provisions that are customary for transactions of this type.

No Solicitation. The Merger Agreement restricts the ability of either Nicolet or Baylake to solicit proposals or enter into agreements relating to alternative business combination transactions. However, should either Nicolet or Baylake receive an unsolicited bona fide Acquisition Proposal (as defined in the Merger Agreement), and the receiving entity’s board of directors conclude in good faith that such proposal is superior to that described in the Merger Agreement, such entity may negotiate in good faith with the third party. The receiving party may not terminate the Merger Agreement without providing the other party to the Merger Agreement five business days to respond to such unsolicited offer, during which time the parties to the Merger Agreement shall negotiate in good faith.

Termination. The Merger Agreement contains certain termination rights for both Nicolet and Baylake, including, among others, the right to terminate, by either party, (i) if the required regulatory approvals are not obtained; (ii) if the Merger is not consummated on or before September 8, 2016; (iii) if Nicolet’s shareholders or Baylake’s shareholders fail to approve the Merger; (iv) upon a breach by either Nicolet or Baylake of their respective representations, warranties, covenants or other agreements contained in the Merger Agreement; or (v) if Nicolet or Baylake becomes subject to a law or order that prevents the Merger from being consummated.

The foregoing description of the Merger Agreement does not purport to be complete and is qualified in its entirety by reference to the full text of the Merger Agreement, a copy of which is filed as Exhibit 2.1 to our Current Report on Form 8-K filed on September 10, 2015.

The representations and warranties set forth in the Merger Agreement have been made solely for the benefit of the parties to the Merger Agreement. In addition, such representations and warranties (i) have been made only for the purpose of the Merger Agreement; (ii) have been qualified by the disclosures made to the other party in connection with the Merger Agreement; (iii) are subject to materiality qualifications contained in the Merger Agreement, which may differ from what may be viewed as material by investors; and (iv) have been included in the Merger Agreement for the purpose of allocating risk between the contracting parties and not for purpose of establishing such matters as facts. Based upon the foregoing reasons, you should not rely on the representations and warranties as statements of factual information. Investors should read the Merger Agreement together with the other information concerning Nicolet and Baylake that each publicly file in reports and statements with the SEC.

Critical Accounting Policies

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

Valuation of Loans Acquired in Business Combinations

Acquisitions accounted for under FASB ASC Topic 805, Business Combinations, require the use of the acquisition method of accounting. Assets acquired and liabilities assumed in a business combination are recorded at estimated fair value on their purchase date. In particular, the valuation of acquired loans involves significant estimates, assumptions and judgment based on information available as of the acquisition date. Substantially all loans acquired in the transaction are evaluated either individually or in pools of loans with similar characteristics; and since the estimated fair value of acquired loans includes a credit consideration, no carryover of any previously recorded allowance for loan losses is recorded at acquisition. A number of factors are considered in determining the estimated fair value of purchased loans including, among other things, the remaining life of the acquired loans, estimated prepayments, estimated loss ratios, estimated value of the underlying collateral, estimated holding periods, contractual interest rates compared to market interest rates, and net present value of cash flows expected to be received.

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

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

Allowance for Loan Losses (“ALLL”)

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

The allocation methodology applied by Nicolet is designed to assess the appropriateness of the ALLL and includes allocations for specifically identified impaired loans and loss factor allocations for all remaining loans, with a component primarily based on historical loss rates and a component primarily based on other qualitative factors. The methodology includes evaluation and consideration of several factors, such as, but not limited to, management’s ongoing review and grading of loans, facts and issues related to specific loans, historical loan loss and delinquency experience, trends in past due and nonaccrual loans, existing risk characteristics of specific loans or loan pools, the fair value of underlying collateral, current economic conditions and other qualitative and quantitative factors which could affect potential credit losses. While management uses the best information available to make its evaluation, future adjustments to the allowance may be necessary if there are significant changes in economic conditions or circumstances underlying the collectability of loans. Because each of the criteria used is subject to change, the allocation of the ALLL is made for analytical purposes and is not necessarily indicative of the trend of future loan losses in any particular loan category. The total allowance is available to absorb losses from any segment of the loan portfolio. Management believes the ALLL is appropriate at September 30, 2015. 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.

Management’s Discussion and Analysis

The following discussion is Nicolet management’s analysis of the consolidated financial condition as of September 30, 2015 and December 31, 2014 and results of operations for the three and nine-month periods ended September 30, 2015 and 2014. It should be read in conjunction with Nicolet’s audited consolidated financial statements as of December 31, 2014 and 2013, and for the two years ended December 31, 2014, included in Nicolet’s Annual Report on Form 10-K for the year ended December 31, 2014.

Performance Summary

Nicolet reported net income of $8.6 million for the nine months ended September 30, 2015, a 14% increase over $7.5 million for the first nine months of 2014. After $182,000 of preferred stock dividends, net income available to common shareholders was $8.4 million, or $1.93 per diluted common share for the first nine months of 2015. Comparatively, after $183,000 of preferred stock dividends, net income available to common shareholders was $7.4 million, or $1.70 per diluted common share for the first nine months of 2014.

Net interest income was $30.7 million for the first nine months of 2015, a decrease of $0.6 million or 2% from the first nine months of 2014. The decline was primarily the result of unfavorable rate variances in excess of favorable volume variances. On a tax-equivalent basis, the net interest margin for the first nine months of 2015 was 3.85%, down 6 basis points (“bps”) from 3.91% for the comparable 2014 period. Between the comparable nine-month periods, the earning asset yield decreased 6 bps to 4.51%, while the cost of interest-bearing liabilities increased by 5 bps to 0.84%, resulting in an 11 bps decrease in the interest rate spread between the comparable nine-month periods.

Loans were $884 million at September 30, 2015, up $1 million from $883 million at December 31, 2014, and up $19 million or 2% over $865 million at September 30, 2014. Excluding the impact of the August 2015 branch sale noted earlier, loans grew 4% over September 30, 2014. Between the comparative nine-month periods, average loans grew 3%, to $884 million for 2015 yielding 5.09%, compared to $855 million for 2014 yielding 5.36%. Loan yields declined between the nine-month periods due to $0.7 million lower discount accretion income on acquired loans and continued downward pressure on rates of new and renewing loans.

Total deposits were $1.0 billion at September 30, 2015, down $48 million or 5% from $1.1 billion at December 31, 2014 (following a customary pattern of deposit decline historically following year ends through the first nine months of the year), and unchanged from a year ago. Excluding the impact of the August 2015 branch sale, deposits grew 3% over September 30, 2014. Between the comparative nine-month periods, average total deposits were unchanged at $1.0 billion, with interest-bearing deposits costing 0.65% for the first nine months of 2015, compared to 0.63% for the same period in 2014.

Asset quality measures have been strong in 2015. Nonperforming assets were $5.0 million at September 30, 2015, down 32% from year end 2014 and down 36% from a year ago. Nonperforming assets represented 0.43%, 0.61% and 0.67% of total assets at September 30, 2015, December 31, 2014, and September 30, 2014, respectively. The allowance for loan losses was $10.0 million or 1.13% of loans at September 30, 2015, compared to $9.3 million or 1.05%, respectively at year end 2014, and $10.1 million or 1.16%, respectively at September 30, 2014. The provision for loan losses was $1.4 million, exceeding net charge offs of $0.6 million for the first nine months of 2015, versus provision of $2.0 million with $1.2 million of net charge offs for the comparable 2014 period.

Noninterest income was $13.1 million for the first nine months of 2015 (including $1.0 million net gain on sales or write-downs of assets) compared to $10.3 million for the first nine months of 2014 (which included $0.4 million net gain on sales or write-downs of assets). Removing these net gains, noninterest income was up $2.3 million or 23% between the nine-month periods. The most notable increase over prior year was net mortgage income which was up $1.5 million or 132%, resulting from significantly stronger secondary mortgage production volume between the nine-month periods. Increases in service charges on deposit accounts (up 9%), trust revenues (up 7%) and brokerage income (up 6%), collectively accounted for another $0.4 million increase between the nine-month periods.

Noninterest expense was $29.4 million for the first nine months of 2015, up $0.8 million or 3% over the first nine months of 2014. Between the nine-month periods, salaries and benefits were up $1.0 million or 6% largely a result of merit increases, incentive accruals and higher stock compensation expense. Processing costs were up $0.2 million or 10% mostly commensurate with growth in the number of accounts and enhanced fraud software implemented in 2015. All other noninterest expense categories in the first nine months of 2015 were down compared to the first nine months of 2014, with occupancy, equipment and office expense showing the most notable decrease as a result of a less harsh 2015 winter than the prior year.

Net Interest Income

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

Net interest income in the consolidated statements of income (which excludes any taxable equivalent adjustment) was $30.7 million in the first nine months of 2015, $0.6 million or 2% lower than $31.4 million in the first nine months of 2014. Taxable equivalent adjustments (adjustments to bring tax-exempt interest to a level that would yield the same after-tax income had that been subject to a 34% tax rate) were $0.9 million and $0.5 million for the first nine months of 2015 and 2014, respectively, resulting in taxable equivalent net interest income of $31.6 million and $31.9 million, respectively.

Taxable equivalent net interest income is a non-GAAP measure, but is a preferred industry measurement of net interest income (and its use in calculating a net interest margin) as it enhances the comparability of net interest income arising from taxable and tax-exempt sources.

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

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

	For the Nine Months Ended September 30,
	2015							2014
(in thousands)	Average Balance		Interest		Average Rate			Average Balance		Interest		Average Rate
ASSETS
Earning assets
Loans, including loan fees (1)(2)	$	883,616	$	34,006		5.09	%	$	855,052	$	34,662		5.36	%
Investment securities
Taxable		75,324		1,098		1.94	%		84,747		1,212		1.91	%
Tax-exempt (2)		87,243		1,553		2.37	%		47,923		998		2.78	%
Other interest-earning assets		37,289		327		1.17	%		89,727		354		0.53	%
Total interest-earning assets		1,083,472	$	36,984		4.51	%		1,077,449	$	37,226		4.57	%
Cash and due from banks		30,015							38,657
Other assets		69,319							66,006
Total assets	$	1,182,806						$	1,182,112
LIABILITIES AND STOCKHOLDERS’ EQUITY
Interest-bearing liabilities
Savings	$	125,268	$	231		0.25	%	$	106,958	$	198		0.25	%
Interest-bearing demand		203,359		1,266		0.83	%		206,228		1,141		0.74	%
MMA		250,164		427		0.23	%		263,592		549		0.28	%
Core CDs and IRAs		202,771		1,682		1.11	%		228,945		1,737		1.01	%
Brokered deposits		29,954		312		1.39	%		40,235		355		1.18	%
Total interest-bearing deposits		811,516		3,918		0.65	%		845,958		3,980		0.63	%
Other interest-bearing liabilities		43,100		1,483		4.55	%		48,325		1,336		3.64	%
Total interest-bearing liabilities		854,616		5,401		0.84	%		894,283		5,316		0.79	%
Noninterest-bearing demand		204,106							171,701
Other liabilities		10,201							8,445
Total equity		113,883							107,683
Total liabilities and stockholders’ equity	$	1,182,806						$	1,182,112
Net interest income and rate spread			$	31,583		3.67	%			$	31,910		3.78	%
Net interest margin						3.85	%						3.91	%

(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.

Table 2: Year-To-Date Volume/Rate Variance

Comparison of the nine months ended September 30, 2015 versus the nine months ended September 30, 2014 follows:

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

Loans	$	1,131		$	(1,787	)	$	(656	)
Investment securities
Taxable		(123	)		9			(114	)
Tax-exempt		718			(163	)		555
Other interest-earning assets		(12	)		(15	)		(27	)

Total interest-earning assets	$	1,714		$	(1,956	)	$	(242	)

Interest-bearing liabilities
Savings deposits	$	34		$	(1	)	$	33
Interest-bearing demand		(16	)		141			125
MMA		(27	)		(95	)		(122	)
Core CDs and IRAs		(209	)		154			(55	)
Brokered deposits		(100	)		57			(43	)

Total interest-bearing deposits		(318	)		256			(62	)
Other interest-bearing liabilities		253			(106	)		147

Total interest-bearing liabilities		(65	)		150			85
Net interest income	$	1,779		$	(2,106	)	$	(327	)

Table 3: Quarterly Net Interest Income Analysis

	For the Three Months Ended September 30,
	2015							2014
(in thousands)	Average Balance		Interest		Average Rate			Average Balance		Interest		Average Rate
ASSETS
Earning assets
Loans, including loan fees (1)(2)	$	883,266	$	11,185		4.98	%	$	862,960	$	11,976		5.46	%
Investment securities
Taxable		71,744		339		1.89	%		80,951		379		1.87	%
Tax-exempt (2)		88,842		504		2.27	%		60,483		390		2.57	%
Other interest-earning assets		28,346		108		1.50	%		43,536		91		0.84	%
Total interest-earning assets		1,072,198	$	12,136		4.46	%		1,047,930	$	12,836		4.82	%
Cash and due from banks		29,849							44,550
Other assets		67,886							67,991
Total assets	$	1,169,933						$	1,160,471
LIABILITIES AND STOCKHOLDERS’ EQUITY
Interest-bearing liabilities
Savings	$	127,592	$	81		0.25	%	$	113,065	$	70		0.25	%
Interest-bearing demand		201,362		438		0.86	%		206,764		392		0.75	%
MMA		232,886		131		0.22	%		243,408		152		0.25	%
Core CDs and IRAs		193,893		547		1.12	%		223,740		611		1.09	%
Brokered deposits		28,728		104		1.43	%		33,080		109		1.30	%
Total interest-bearing deposits		784,461		1,301		0.66	%		820,057		1,334		0.65	%
Other interest-bearing liabilities		46,537		541		4.58	%		37,708		396		4.11	%
Total interest-bearing liabilities		830,998		1,842		0.88	%		857,765		1,730		0.80	%
Noninterest-bearing demand		211,414							184,535
Other liabilities		12,599							9,328
Total equity		114,922							108,843
Total liabilities and stockholders’ equity	$	1,169,933						$	1,160,471
Net interest income and rate spread			$	10,294		3.58	%			$	11,106		4.02	%
Net interest margin						3.78	%						4.17	%

(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.

Table 4: Quarterly Volume/Rate Variance

Comparison of the three months ended September 30, 2015 versus the three months ended September 30, 2014 follows:

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

Loans	$	277		$	(1,068	)	$	(791	)
Investment securities
Taxable		(43	)		3			(40	)
Tax-exempt		165			(51	)		114
Other interest-earning assets		18			(1	)		17

Total interest-earning assets	$	417		$	(1,117	)	$	(700	)

Interest-bearing liabilities
Savings deposits	$	10		$	1		$	11
Interest-bearing demand		(11	)		57			46
MMA		(6	)		(15	)		(21	)
Core CDs and IRAs		(83	)		19			(64	)
Brokered deposits		(14	)		9			(5	)

Total interest-bearing deposits		(104	)		71			(33	)
Other interest-bearing liabilities		145			-			145

Total interest-bearing liabilities		41			71			112
Net interest income	$	376		$	(1,188	)	$	(812	)

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

	Nine Months Ended September 30,
	2015								2014
(in thousands)	Average Balance		% of Earning Assets			Yield/Rate			Average Balance		% of Earning Assets			Yield/Rate
Total loans	$	883,616		81.6	%		5.09	%	$	855,052		79.4	%		5.36	%
Securities and other earning assets..		199,856		18.4	%		1.99	%		222,397		20.6	%		1.54	%
Total interest-earning assets	$	1,083,472		100	%		4.51	%	$	1,077,449		100	%		4.57	%

Interest-bearing liabilities	$	854,616		78.9	%		0.84	%	$	894,283		83.0	%		0.79	%

Noninterest-bearing funds, net		228,856		21.1	%					183,166		17.0	%
Total funds sources	$	1,083,472		100	%		0.64	%	$	1,077,449		100	%		0.66	%
Interest rate spread							3.67	%							3.78	%
Contribution from net free funds							0.18	%							0.13	%
Net interest margin							3.85	%							3.91	%

Taxable-equivalent net interest income was $31.6 million for the first nine months of 2015, a decrease of $0.3 million or 1% from the same period in 2014. Taxable equivalent interest income decreased $0.2 million (or 1%) between the nine-month periods driven by loans contributing $0.7 million less interest income ($1.8 million less from lower loan yields and discount accretion income, offset partly by $1.1 million more from higher loan volumes) and by non-loan interest-earning assets combined contributing $0.4 million more interest income (mostly due to increased municipal investment volume). Interest expense increased by $0.1 million (or 2%) between the periods largely from the 5% subordinated debt added in 2015.

The taxable-equivalent net interest margin was 3.85% for the first nine months of 2015, down 6 bps versus the first nine months of 2014. With a unfavorable 6 bps decrease in earning asset yield to 4.51% and a 5 bps rise in the cost of funds to 0.84%, the interest rate spread dropped 11 bps between the nine month periods. 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. Additionally, while both 2015 and 2014 periods are experiencing favorable income from discount accretion on acquired loans, particularly where such loans pay or resolve at better than their carrying values, such favorable interest flow can be sporadic and will likely diminish over time.

The earning asset yield was influenced mainly by asset mix, with more balances in higher-yielding assets. Loans, investments and other interest-earning assets (mostly low-earning cash) represented 82%, 15% and 3% of average earning assets, respectively, for the first nine months of 2015, and 79%, 13% and 8% respectively, for the comparable period in 2014. Loans yielded 5.09% for the first nine months of 2015, compared to 5.36%, for the first nine months of 2014. The 27 bps decrease in loan yield was due to continued downward pressure on rates of new and renewing loans in this low-rate environment, and $0.7 million lower aggregate discount accretion on acquired loans between the nine-month periods. Non-loan earning assets yielded 1.99% versus 1.54% for the nine-month period in 2015 and 2014, respectively. A significantly lower proportion of low-earning cash was the main reason for the 45 bps increase in the non-loan yield between the nine-month periods.

Nicolet’s cost of funds increased 5 bps to 0.84% for the first nine months of 2015 compared to 2014. The average cost of interest-bearing deposits (which represented 95% of average interest-bearing liabilities for both periods), was 0.65% for the first nine months of 2015, up 2 bps over the first nine months of 2014. The cost of interest-bearing demand deposits increased 9 bps as a result of mix changes with average balances remaining steady. Costs associated with money market accounts decreased 5 bps in conjunction with a drop in deposit rates compared to last year. The costs related to time deposits (both CDs and brokered deposits) increased as lower costing time deposits matured leaving a base of higher costing funds but at lower average balances. Average other interest-bearing liabilities (comprised of short- and long-term borrowings) decreased $5.2 million and cost 91 bps more between the nine-month periods as lower cost advances matured and were not renewed and subordinated debt was added to the funding mix in the first nine months of 2015.

Average interest-earning assets were $1.1 billion for the first nine months of 2015 and 2014. While the balance of average interest-earning assets was consistent, the mix improved, led by an increase in total loans of $29 million (to $884 million, up 3%) despite the decrease resulting from the branch sale which would have added an additional $3 million of average loans for the nine-month period. This was offset by a decrease in average non-loan earning assets of $23 million (comprised of a $52 million decline in other interest-earning assets which is predominantly interest-bearing cash and a $29 million increase in investments) to $200 million.

Average interest-bearing liabilities were $855 million, down $40 million or 4% versus the first nine months of 2014, comprised of a $34 million decrease in interest-bearing deposits (to $812 million, representing 95% of average interest-bearing liabilities), and included a $7 million decrease for the nine-month period as a result of the branch sale. The nine-month period ending September 30, 2015 also saw a $5 million decrease in average other interest-bearing liabilities (to $43 million) compared to the same nine-month period in 2014, led by lower repurchase agreements and FHLB advances offset partly by new subordinated debt.

Provision for Loan Losses

The provision for loan losses for the nine months ended September 30, 2015 and 2014 was $1.4 million and $2.0 million, respectively, exceeding net charge offs of $0.6 million and $1.2 million, respectively. Asset quality trends remained strong with continued resolutions of problem loans. The ALLL was $10.0 million (1.13% of loans) at September 30, 2015, compared to $9.3 million (1.05% of loans) at December 31, 2014 and $10.1 million (1.16% of loans) at September 30, 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 6: Noninterest Income

	For the three months ended September 30,										For the nine months ended September 30,
	2015		2014		$ Change			% Change			2015		2014		$ Change			% Change
(in thousands)
Service charges on deposit accounts	$	631	$	564	$	67			11.9	%	$	1,752	$	1,602	$	150			9.4	%
Trust services fee income		1,196		1,179		17			1.4			3,636		3,403		233			6.8
Mortgage income		811		505		306			60.6			2,670		1,151		1,519			132.0
Brokerage fee income		170		152		18			11.8			509		478		31			6.5
Bank owned life insurance (“BOLI”)		252		250		2			0.8			749		684		65			9.5
Rent income		324		292		32			11.0			890		880		10			1.1
Investment advisory fees		98		104		(6	)		(5.8	)		301		316		(15	)		(4.7	)
Gain on sale or write-down of assets, net		91		140		(49	)		(35.0	)		1,042		448		594			132.6
Other income		612		459		153			33.3			1,600		1,323		277			20.9
Total noninterest income	$	4,185	$	3,645	$	540			14.8	%	$	13,149	$	10,285	$	2,864			27.8	%
Noninterest income without net gains	$	4,094	$	3,505	$	589			16.8	%	$	12,107	$	9,837	$	2,270			23.1	%

Comparison of the nine months ending September 30, 2015 versus 2014

Noninterest income was $13.1 million for the first nine months of 2015 (including $1.0 million of net gain on sales of assets), compared to $10.3 million for the first nine months of 2014 (including $0.4 million of net gain on sale of assets). Removing these net gains, noninterest income was up $2.3 million or 23.1% between the nine-month periods.

Net gain on sale or write-down of assets was $1.0 million and $0.4 million for the nine months of 2015 and 2014, respectively. The 2015 activity consisted of $0.6 million net gains on sales of investments and $0.4 million net gains on sales of OREO while the 2014 activity included a $0.3 million gain on the sale of an equity security holding, $0.8 million net gain on sales of OREO offset by a write-down of an acquired former branch building moved to OREO in the second quarter of 2014.

Service charges on deposit accounts were $1.8 million for the first nine months of 2015, up $0.2 million (or 9.4%) over the comparable period of 2014, mainly due to the 6.2% increase in the number of transaction accounts.

Trust service fees increased to $3.6 million for the first nine months of 2015, up $0.2 million (or 6.8%) over the comparable 2014 period. Brokerage fees were $0.5 million, up 6.5% over the first nine months of 2014. Both benefited from continued market improvement over last year and net new business, as well as on rising assets under management on which trust fees are based.

Mortgage income represents predominantly net gains received from the sale of residential real estate loans service-released into the secondary market and, to a smaller degree, some related income. The first nine months of 2015 saw a significantly more robust mortgage market and strong production compared to the first nine months of 2014 (with nine-month originations of $143 million for 2015 versus $56 million for 2014). As a result, mortgage income was $2.7 million for first nine months of 2015 compared to $1.2 million for first nine months of 2014 (up $1.5 million or 132% between the nine-month periods).

The remaining income categories included modest increases. BOLI income was $0.7 million for the first nine months of 2015, up 9.5% over the comparable period in 2014 and in line with the 11% increase in the average BOLI balance. Rent income, investment advisory fees and other noninterest income combined were $2.8 million for the first nine months of 2015 compared to $2.5 million for the comparable 2014 period, with the increase mostly attributable to ancillary fees tied to deposit-related products, such as debit card interchange fees and wire fee income, and the $0.1 million net income from the August 2015 branch sale recorded in other noninterest income.

Noninterest Expense

Table 7: Noninterest Expense

	For the three months ended September 30,										For the nine months ended September 30,
	2015		2014		$ Change			% Change			2015		2014		$ Change			% Change
(in thousands)
Salaries and employee benefits	$	5,637	$	5,366	$	271			5.1	%	$	16,996	$	16,045	$	951			5.9	%
Occupancy, equipment and office		1,745		1,735		10			0.6			5,263		5,370		(107	)		(2.0	)
Business development and marketing		549		548		1			0.2			1,584		1,620		(36	)		(2.2	)
Data processing		864		816		48			5.9			2,585		2,345		240			10.2
FDIC assessments		142		160		(18	)		(11.3	)		469		547		(78	)		(14.3	)
Core deposit intangible amortization		248		284		(36	)		(12.7	)		783		934		(151	)		(16.2	)
Other		664		614		50			8.1			1,695		1,734		(39	)		(2.2	)
Total noninterest expense	$	9,849	$	9,523	$	326			3.4	%	$	29,375	$	28,595	$	780			2.7	%

Comparison of the nine months ending September 30, 2015 versus 2014

Total noninterest expense was $29.4 million for the first nine months of 2015, up $0.8 million, or 2.7% over the first nine months of 2014 in line with a continual focus on expense management. Salaries and employee benefits and data processing were up while all other expense categories were down compared to the same nine-month period in 2014.

Salaries and employee benefits expense was $17.0 million for the first nine months of 2015, up $1.0 million or 5.9% compared to the first nine months of 2014. Base salaries were up 3% between the nine-month periods mainly from merit increases on a minimally changed employee base. The remaining increase is due mostly to higher overtime, incentive accruals and higher stock based compensation. Average full time equivalent employees were 282 and 280 for the first nine months of 2015 and 2014, respectively.

Occupancy, equipment and office expense decreased $0.1 million to $5.3 million for the first nine months of 2015 compared to 2014. This 2.0% decrease was primarily the result of a less harsh 2015 winter than 2014 resulting in lower expenses for utilities and snowplowing. The first nine months of 2014 also included final integration costs on systems and phones early in that year not recurring in 2015.

Business development and marketing expense decreased slightly between the comparable nine-month periods, with similar spending on promotional materials and media advertising.

Data processing expenses, which are primarily volume-based, rose $0.2 million or 10.2% between the nine-month periods, in line with the increase in number of accounts, enhanced fraud software implemented in 2015 and increased services.

Core deposit intangible amortization declined as the intangible has aged under an accelerated amortization schedule. FDIC assessments were lower between the nine-month periods mostly due to a lower assessment rate, and other expense declined mostly from lower OREO and foreclosure costs.

Income Taxes

For the nine-month periods ending September 30, 2015 and 2014, income tax expense was $4.5 million and $3.4 million, respectively. The effective tax rate was 34% for the first nine months of 2015 compared to 31% for the same nine-month period in 2014 (impacted by the $0.5 million tax benefit recorded in the second quarter to the deferred tax asset related to net operating loss utilization potential resulting in an effective tax rate of 20% for second quarter 2014 alone). GAAP requires that deferred income taxes be analyzed to determine if a valuation allowance is required. A valuation allowance is required if it is more likely than not that some portion of the deferred tax asset will not be realized. No valuation allowance was determined to be necessary as of September 30, 2015 or December 31, 2014.

Comparison of the three months ending September 30, 2015 versus 2014

Nicolet reported net income of $2.6 million for the three months ended September 30, 2015, compared to $2.8 million for the comparable period of 2014. Net income available to common shareholders for the third quarter of 2015 was $2.5 million, or $0.58 per diluted common share, compared to net income available to common shareholders of $2.7 million, or $0.63 per diluted common share, for the third quarter of 2014.

Net interest income in the consolidated statements of income (which excludes any taxable equivalent adjustment) was $10.0 million in the third quarter of 2015 versus $10.9 million in the third quarter of 2014. Taxable equivalent adjustments (adjustments to bring tax-exempt interest to a level that would yield the same after-tax income had that been subject to a 34% tax rate) were $0.3 million and $0.2 million for the three months ended September 30, 2015 and 2014, respectively, resulting in taxable equivalent net interest income of $10.3 million and $11.1 million, respectively. Taxable equivalent net interest income for third quarter 2015 was down $0.8 million or 7.3% versus third quarter 2014, with $1.2 million of the decrease due to rate variances (predominately in loans, including $0.7 million lower aggregate discount accretion income on acquired loans as the acquired portfolio ages and resolves, as well as underlying loan yield pressure) offset with a $0.4 million increase from favorable volume variances (especially in earning assets).

The earning asset yield was 4.46% for third quarter 2015, 36 bps lower than third quarter 2014, mainly due to a decline in the yield on loans (as explained above) offset partly by a modest shift in mix from cash balances to higher-yielding investments.

Between the third quarter periods, the cost of funds increased 8 bps to 0.88% in 2015 versus 2014. The increase in cost of funds was driven mainly by the 2015 quarter carrying new 5% subordinated debt in other interest-bearing liabilities which cost 4.58% in 2015, up 47 bps over the 2014 quarter, while the cost of interest-bearing deposits increased 1 bps to 0.66% in the third quarter of 2015 as compared to 2014.

Noninterest income was $4.2 million for third quarter 2015, up $0.5 million or 14.8% over third quarter 2014. Noninterest income without net gains was up $0.6 million or 16.8%, largely due to mortgage income (up $0.3 million given higher production), and other income (up $0.2 million, including $0.1 million net income from the August 2015 branch sale).

Noninterest expense was $9.8 million for the third quarter of 2015, up $0.3 million or 3.4% from third quarter 2014. Salaries and employee benefits for the third quarter of 2015 were $0.3 million or 5.1% higher than the third quarter of 2014 driven mostly by merit increases, overtime and higher stock option expense. All other expenses combined stayed mostly flat between the third quarter periods due to factors consistent with the reduction in year to date expenses noted earlier.

The provision for loan losses for the three months ended September 30, 2015 and 2014 was $0.5 million and $0.7 million respectively. Net charge offs for the quarter ending September 30, 2015 were $0.2 million compared to $0.3 million for the same period in 2014. At September 30, 2015, the ALLL was $10.0 million (or 1.13% of total loans) compared to $10.1 million (or 1.16% of total loans) at September 30, 2014.

Income tax expense was $1.3 million and $1.6 million for the third quarters of 2015 and 2014, respectively. The effective tax rates were 33% for third quarter 2015 and 36% for third quarter 2014.

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 1) commercial loans, consisting of commercial and industrial business loans, agricultural (“AG”) production, and owner-occupied commercial real estate (“CRE”) loans; 2) CRE loans, consisting of commercial investment real estate loans, AG real estate, and construction and land development loans; 3) residential real estate loans, including residential first mortgages, residential junior mortgages (such as home equity loans and lines), and residential construction loans; and 4) retail and other loans. Using these four broad groups the mix of loans at September 30, 2015 was 57% commercial, 18% CRE loans, 24% residential real estate, and 1% retail and other loans; and grouped further the loan mix was 75% commercial-based and 25% retail-based.

Total loans were $884 million at September 30, 2015 compared to $883 million at December 31, 2014 (essentially unchanged but included a $13 million decrease in loans as a result from the branch sale). Compared to September 30, 2014, loans grew $19 million or 2% (or up 4% excluding the impact of the August 2015 branch sale noted earlier). On average, loans were $884 million and $855 million for the first nine months of 2015 and 2014, respectively, up 3%.

Table 8: Period End Loan Composition

	September 30, 2015					December 31, 2014					September 30, 2014
	Amount		% of Total			Amount		% of Total			Amount		% of Total
Commercial & industrial	$	304,858		34.5	%	$	289,379		32.7	%	$	282,357		32.6	%
Owner-occupied CRE		179,569		20.3			182,574		20.7			179,166		20.7
AG production		15,709		1.8			14,617		1.6			14,632		1.7
AG real estate		39,715		4.5			42,754		4.8			42,195		4.9
CRE investment		83,278		9.4			81,873		9.3			77,067		8.9
Construction & land development		39,487		4.5			44,114		5.0			42,462		4.9
Residential construction		8,106		0.9			11,333		1.3			11,260		1.3
Residential first mortgage		153,562		17.3			158,683		18.0			157,730		18.2
Residential junior mortgage		54,170		6.1			52,104		5.9			52,523		6.1
Retail & other		5,994		0.7			5,910		0.7			5,693		0.7
Total loans	$	884,448		100	%	$	883,341		100	%	$	865,085		100	%

Broadly, commercial-based loans versus retail-based loans changed slightly to 75% commercial-based and 25% retail-based at September 30, 2015 as compared to 74% commercial-based and 26% retail-based at December 31, 2014. Commercial-based loans are considered to have more inherent risk of default than retail-based loans, in part because of the broader list of factors that could impact a commercial borrower negatively as well as the commercial balance per borrower is typically larger than that for retail-based loans, implying higher potential losses on an individual customer basis.

Commercial and industrial loans consist primarily of commercial loans to small businesses 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 $15 million since year end 2014. Commercial and industrial loans continue to be the largest segment of Nicolet’s portfolio and increased to 34.5% of the total portfolio at September 30, 2015, up from 32.7% at December 31, 2014.

Owner-occupied CRE loans declined to 20.3% of loans at September 30, 2015 from 20.7% at December 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.

AG production and AG 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, agricultural loans decreased $2 million since year end 2014, representing 6.3% of total loans at September 30, 2015, versus 6.4% at December 31, 2014.

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 increased slightly, up $1.4 million since year end 2014, representing 9.4% of total loans at September 30, 2015 and 9.3% at December 31, 2014.

Loans in the construction and land development portfolio provide financing for the development of commercial income properties, multi-family residential development, and land designated for future development. Nicolet controls the credit risk on these types of loans by making loans in familiar markets, reviewing the merits of individual projects, controlling loan structure, and monitoring the progress of projects through the analysis of construction advances. Credit risk is managed by employing sound underwriting guidelines, lending primarily to borrowers in local markets, periodically evaluating the underlying collateral, and formally reviewing the borrower’s financial soundness and relationships on an ongoing basis. Lending on originated loans in this category has remained relatively steady as a percent of loans. Since December 31, 2014, balances decreased $4.6 million, and this category represented 4.5% and 5.0% of total loans at September 30, 2015 and year end 2014, respectively.

On a combined basis, Nicolet’s residential real estate loans represent 24.3% of total loans at September 30, 2015, down slightly from 25.2% at December 31, 2014. Residential first mortgage loans include conventional first-lien home mortgages. Residential junior mortgage real estate loans consist mainly of home equity lines and term loans secured by junior mortgage liens. Across the industry, home equities generally involve loans that are in second or junior lien positions, but Nicolet has secured many such loans in a first lien position, further mitigating the portfolio risks. Nicolet has not experienced significant losses in its residential real estate loans; however, if market values in the residential real estate markets decline, particularly in Nicolet’s market area, rising loan-to-value ratios could cause an increase in the provision for loan losses. As part of its management of originating residential mortgage loans, 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. Mortgage loans retained in the portfolio are typically of high quality and have historically had low net charge off rates. 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, 2014 to September 30, 2015.

Factors that are important to managing overall credit quality are sound loan underwriting and administration, systematic monitoring of existing loans and commitments, effective loan review on an ongoing basis, early problem loan identification and remedial action to minimize losses, an adequate ALLL, and sound nonaccrual and charge-off policies. An active credit risk management process is used for commercial loans to further ensure that sound and consistent credit decisions are made. The credit management process is regularly reviewed and the process has been modified over the past several years to further strengthen the controls.

The loan portfolio is widely diversified by types of borrowers, industry groups, and market areas. Significant loan concentrations are considered to exist for a financial institution when there are amounts loaned to multiple numbers of borrowers engaged in similar activities that would cause them to be similarly impacted by economic or other conditions. At September 30, 2015, no significant industry concentrations existed in Nicolet’s portfolio in excess of 25% of total loans. Nicolet has also developed guidelines to manage its exposure to various types of concentration risks.

Allowance for Loan and Lease Losses

In addition to the discussion that follows, see also Note 1, “Basis of Presentation,” and Note 5, “Loans, Allowance for Loan Losses and Credit Quality,” in the notes to the unaudited consolidated financial statements and the “Critical Accounting Policies” within management’s discussion and analysis.

Credit risks within the loan portfolio are inherently different for each loan type as described under “Balance Sheet Analysis-Loans.” Credit risk is controlled and monitored through the use of lending standards, a thorough review of potential borrowers, and on-going review of loan payment performance. Active asset quality administration, including early problem loan identification and timely resolution of problems, aids in the management of credit risk and minimization of loan losses.

The ALLL is established through a provision for loan losses charged to expense to appropriately provide for potential credit losses in the existing loan portfolio. Loans are charged off against the ALLL when management believes that the collection of principal is unlikely. The level of the ALLL represents management’s estimate of an amount of reserves that provides for estimated probable credit losses in the loan portfolio at the balance sheet date. To assess the ALLL, an allocation methodology is applied by Nicolet which focuses on evaluation of qualitative and environmental factors, including but not limited to: (i) evaluation of facts and issues related to specific loans; (ii) management’s ongoing review and grading of the loan portfolio; (iii) consideration of historical loan loss and delinquency experience on each portfolio segment; (iv) trends in past due and nonperforming loans; (v) the risk characteristics of the various loan segments; (vi) changes in the size and character of the loan portfolio; (vii) concentrations of loans to specific borrowers or industries; (viii) existing and forecasted economic conditions; (ix) the fair value of underlying collateral; and (x) other qualitative and quantitative factors which could affect potential credit losses. Nicolet’s methodology reflects guidance by regulatory agencies to all financial institutions.

Management allocates the ALLL by pools of risk within each loan portfolio segment. The allocation methodology consists of the following components. First, a specific reserve for the estimated shortfall is established for all loans determined to be impaired. The specific reserve in the ALLL is equal to the aggregate collateral or discounted cash flow shortfall calculated from the impairment analyses. Loans measured for impairment include nonaccrual loans, non-performing troubled debt-restructurings (“restructured loans”), or other loans determined to be impaired by management. Second, Nicolet’s management allocates ALLL with historical loss rates by loan segment. The loss factors applied in the methodology are periodically re-evaluated and adjusted to reflect changes in historical loss levels on an annual basis. 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 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 September 30, 2015, the ALLL was $10.0 million compared to $9.3 million at December 31, 2014. The nine-month increase was a result of a 2015 provision of $1.4 million exceeding 2015 net charge offs of $0.6 million. Comparatively, the provision for loan losses in the first nine months of 2014 was $2.0 million and net charge offs were $1.2 million. Annualized net charge offs as a percent of average loans were 0.10% in the first nine months of 2015 compared to 0.19% for the first nine months of 2014 and 0.31% for the entire 2014 year. Loans charged off are subject to continuous review, and specific efforts are taken to achieve maximum recovery of principal, accrued interest, and related expenses. The level of the provision for loan losses is directly correlated to the assessment of the adequacy of the allowance, including, but not limited to, consideration of the amount of net charge-offs, loan growth, levels of nonperforming loans, and trends in the risk profile of the loan portfolio.

The ratio of the ALLL as a percentage of period-end loans was 1.13% at September 30, 2015 compared to 1.05% at December 31, 2014 and 1.16% at September 30, 2014. The ALLL to loans ratio is impacted by the accounting treatment of Nicolet’s 2013 acquisitions, which combined at their acquisition dates added no ALLL to the numerator and $284 million of loans into the denominator. Acquired loans with no ALLL were $147 million and $182 million at September 30, 2015 and December 31, 2014, respectively. As events have occurred in the acquired loan portfolios, an ALLL has been established beginning in June 30, 2015 for this portfolio of assets reflecting an increase in risk as acquired credits age and several larger and other loans migrate to higher grades. See Note 5 of the Notes to Unaudited Consolidated Financial Statements for a further breakdown of the ALLL between originated and acquired portfolios. Growth in the ALLL to loans ratio is mostly a result of the provision for loan losses exceeding net charge offs.

Table 9: Loan Loss Experience

	For the nine months ended						Year ended
(in thousands)	September 30, 2015			September 30, 2014			December 31, 2014
Allowance for loan losses (ALLL):
Balance at beginning of period	$	9,288		$	9,232		$	9,232
Provision for loan losses		1,350			2,025			2,700
Charge-offs		717			1,291			2,743
Recoveries		(84	)		(86	)		(99	)
Net charge-offs		633			1,205			2,644
Balance at end of period	$	10,005		$	10,052		$	9,288

Net loan charge-offs (recoveries):
Commercial & industrial	$	268		$	517		$	1,868
Owner-occupied CRE		216			453			453
Agricultural production		-			-			-
Agricultural real estate		-			-			-
CRE investment		(13	)		(12	)		(14	)
Construction & land development		-			12			12
Residential construction		-			-			-
Residential first mortgage		42			190			216
Residential junior mortgage		103			17			80
Retail & other		17			28			29
Total net loans charged-off	$	633		$	1,205		$	2,644

ALLL to total loans		1.13	%		1.16	%		1.05	%
Net charge-offs to average loans, annualized		0.10	%		0.19	%		0.31	%

As noted in Table 10, the largest portions of the ALLL were allocated to construction and land development loans, commercial & industrial loans and owner-occupied CRE loans combined, representing 71.1% and 76.5% of the ALLL at September 30, 2015 and December 31, 2014, respectively. While the balances of construction and land development loans have been relatively steady to declining over time, the category carries higher historical loss rates which are coming down with better current performance; hence the allocation fell to 17.1% at September 30, 2015 from 28.9% at year end 2014. The allocations for commercial and industrial loans and owner-occupied CRE loans increased over year end 2014 commensurate with the growth in these portfolios and certain qualitative factors.

The allocation of the ALLL is based on Nicolet’s estimate of loss exposure by category of loans and is shown in Table 10 for September 30, 2015 and December 31, 2014.

Table 10: Allocation of the Allowance for Loan Losses

	September 30, 2015						December 31, 2014
(in thousands)	Amount			% of Loan Type to Total Loans			Amount			% of Loan Type to Total Loans
ALLL allocation
Commercial & industrial	$	3,704			34.5	%	$	3,191			32.7	%
Owner-occupied CRE		1,696			20.3			1,230			20.7
Agricultural production		84			1.8			53			1.6
Agricultural real estate		302			4.5			226			4.8
CRE investment		751			9.4			511			9.3
Construction & land development		1,710			4.5			2,685			5.0
Residential construction		106			0.9			140			1.3
Residential first mortgage		1,115			17.3			866			18.0
Residential junior mortgage		478			6.1			337			5.9
Retail & other		59			0.7			49			0.7
Total ALLL	$	10,005			100	%	$	9,288			100	%

ALLL category as a percent of total ALLL:
Commercial & industrial		37.0	%					34.4	%
Owner-occupied CRE		17.0						13.2
Agricultural production		0.8						0.6
Agricultural real estate		3.0						2.4
CRE investment		7.5						5.5
Construction & land development		17.1						28.9
Residential construction		1.1						1.5
Residential first mortgage		11.1						9.3
Residential junior mortgage		4.8						3.6
Retail & other		0.6						0.6
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 $4.3 million (consisting almost entirely of acquired loans) at September 30, 2015 compared to $5.4 million at December 31, 2014 (consisting of $1.1 million originated loans and $4.3 million acquired loans). Of the $16.7 million nonaccrual loans initially acquired in the 2013 acquisitions, $2.8 million remain which is included in the $4.3 million of nonaccruals within the acquired loan portfolio at September 30, 2015. Purchased credit impaired (“PCI”) loans maintain a non-accretable mark which covers potential losses. At September 30, 2015 no PCI loan has an impairment in excess of the non-accretable mark and therefore no related allowance has been allocated to any PCI loan. Acquired loans are evaluated on a regular basis to determine if an impairment exists in excess of the non-accretable mark and an allowance would be provided as appropriate. Nonperforming assets (which include nonperforming loans and other real estate owned “OREO”) were $5.0 million at September 30, 2015 compared to $7.4 million at December 31, 2014. OREO decreased from $2.0 million at year end 2014 to $0.7 million at September 30, 2015.

OREO at September 30, 2015 included bank land which was moved from active fixed assets to inactive status at its fair value of $0.5 million. Nonperforming assets as a percent of total assets were 0.43% at September 30, 2015 compared to 0.61% at December 31, 2014. Included in the December 31, 2014 originated impaired loans is one troubled debt restructuring totaling $3.8 million. This loan was paid off in the third quarter of 2015 and there are no originated impaired loans at September 30, 2015.

The level of potential problem loans is another predominant factor in determining the relative level of risk in the loan portfolio and in determining the adequacy of the ALLL. Potential problem loans are generally defined by management to include loans rated as Substandard by management but that are in performing status; however, there are circumstances present which might adversely affect the ability of the borrower to comply with present repayment terms. The decision of management to include performing loans in potential problem loans does not necessarily mean that Nicolet expects losses to occur, but that management recognizes a higher degree of risk associated with these loans. The loans that have been reported as potential problem loans are predominantly commercial-based loans covering a diverse range of businesses and real estate property types. Potential problem loans were $6.8 million (0.8% of loans) and $5.4 million (0.6% of loans) at September 30, 2015 and December 31, 2014, respectively. Potential problem loans require a heightened management review of the pace at which a credit may deteriorate, the duration of asset quality stress, and uncertainty around the magnitude and scope of economic stress that may be felt by Nicolet’s customers and on underlying real estate values.

Table 11: Nonperforming Assets

(in thousands)	September 30, 2015			December 31, 2014			September 30, 2014
Nonaccrual loans:
Commercial & industrial	$	223		$	171		$	548
Owner-occupied CRE		1,223			1,667			1,487
AG production		15			21			23
AG real estate		372			392			394
CRE investment		771			911			1,433
Construction & land development		686			934			943
Residential construction		—			—			—
Residential first mortgage		861			1,155			1,845
Residential junior mortgage		148			141			178
Retail & other		—			—			—
Total nonaccrual loans		4,299			5,392			6,851
Accruing loans past due 90 days or more		—			—			—
Total nonperforming loans	$	4,299		$	5,392		$	6,851
OREO:
CRE investment	$	32		$	697		$	352
Owner-occupied CRE		—			139			256
Construction & land development		126			630			38
Residential real estate owned		56			500			117
Bank property real estate owned		500			—			200
Total OREO		714			1,966			963
Total nonperforming assets	$	5,013		$	7,358		$	7,814
Total restructured loans accruing	$	-		$	3,777		$	3,834
Ratios
Nonperforming loans to total loans		0.49	%		0.61	%		0.79	%
Nonperforming assets to total loans plus OREO		0.57	%		0.80	%		0.90	%
Nonperforming assets to total assets		0.43	%		0.61	%		0.67	%
ALLL to nonperforming loans		232.7	%		172.3	%		146.7	%
ALLL to total loans		1.13	%		1.05	%		1.16	%

Table 12: Investment Securities Portfolio

	September 30, 2015							December 31, 2014
(in thousands)	Amortized Cost		Fair Value		% of Fair Value			Amortized Cost		Fair Value		% of Fair Value
U.S. Government sponsored enterprises	$	286	$	297		-	%	$	1,025	$	1,039		1	%
State, county and municipals		106,763		107,016		64			102,472		102,776		61
Mortgage-backed securities		54,523		54,907		33			61,497		61,677		37
Corporate debt securities		1,140		1,140		1			220		220		-
Equity securities		2,742		4,212		2			1,571		2,763		1
Total	$	165,454	$	167,572		100	%	$	166,785	$	168,475		100	%

At September 30, 2015 and December 31, 2014 the total carrying value of investment securities was $168 million, and represented 14.4% and 13.9% of total assets at September 30, 2015 and December 31, 2014, respectively. At September 30, 2015, 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 million at September 30, 2015 and December 31, 2014, 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 privately-traded companies. The FHLB and Federal Reserve investments are “restricted” in that they can only be sold back to the respective institutions or another member institution at par, and are thus, not liquid, have no ready market or quoted market value, and are carried at cost. The remaining investments have no quoted market prices, and are carried at cost less other than temporary impairment (“OTTI”) charges, if any. Nicolet’s management evaluates all these other investments periodically for impairment, considering financial condition and other available relevant information. There were no OTTI charges recorded in 2014 or year to date 2015.

Table 13: Investment Securities Portfolio Maturity Distribution

	As of September 30, 2015
	Within One Year						After One but Within Five Years						After Five but Within Ten Years						After Ten Years						Mortgage- related and Equity Securities						Total Amortized Cost					Total Fair Value
	Amount			Yield			Amount			Yield			Amount			Yield			Amount			Yield			Amount			Yield			Amount		Yield			Amount
(in thousands)
U.S. government sponsored enterprises	$	—			—	%	$	145			1.5	%	$	141			2.1	%	$	—			—	%	$	—			—	%	$	286		1.8	%	$	297
State and county municipals (1)		4,805			2.7			76,624			2.4			24,773			2.6			561			4.4			—			—			106,763		2.4			107,016
Mortgage-backed securities		—			—			—			—			—			—			—			—			54,523			3.2			54,523		3.2			54,907
Corporate debt securities		—			—			—			—			—			—			1,140			6.0			—			—			1,140		6.0			1,140
Equity securities		—			—			—			—			—			—			—			—			2,742			6.2			2,742		6.2			4,212

Total amortized cost	$	4,805			2.7	%	$	76,769			2.4	%	$	24,914			2.6	%	$	1,701			5.5	%	$	57,265			3.3	%	$	165,454		2.8	%	$	167,572
Total fair value and carrying value	$	4,833					$	76,852					$	25,040					$	1,728					$	59,119										$	167,572

As a percent of total fair value		3	%					46	%					15	%					1	%					35	%										100	%

(1)

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

Deposits

Deposits represent Nicolet’s largest source of funds. Nicolet competes with other bank and nonbank institutions for deposits, as well as with a growing number of non-deposit investment alternatives available to depositors, such as mutual funds, money market funds, annuities, and other brokerage investment products. Challenges to deposit growth include price changes on deposit products given movements in the rate environment and other competitive pricing pressures, and customer preferences regarding higher-costing deposit products or non-deposit investment alternatives. Included in total deposits in Table 14 are brokered deposits of $28 million at September 30, 2015 and $31 million at December 31, 2014.

Table 14: Deposits

	September 30, 2015					December 31, 2014
(in thousands)	Amount		% of Total			Amount		% of Total
Demand	$	227,610		22.5	%	$	203,502		19.2	%
Money market and NOW accounts		444,616		43.9	%		494,945		46.7	%
Savings		127,827		12.6	%		120,258		11.3	%
Time		212,128		21.0	%		241,198		22.8	%
Total deposits	$	1,012,181		100	%	$	1,059,903		100	%

Total deposits were $1.0 billion at September 30, 2015, down $48 million or 5% since December 31, 2014 with $34 million of the decline a result of the branch sale in the third quarter. On average for the first nine months of 2015, total deposits were $1.02 billion, almost unchanged from the comparable 2014 period. On average, the mix of deposits changed between the comparable nine-month periods, with 2015 carrying more demand (i.e. noninterest-bearing) and savings deposits and less time, money market, and NOW accounts.

Table 15: Average Deposits

	For the nine months ended
	September 30, 2015					September 30, 2014
(in thousands)	Amount		% of Total			Amount		% of Total
Demand	$	204,106		20.1	%	$	171,701		16.9	%
Money market and NOW accounts		453,523		44.7	%		474,655		46.6	%
Savings		125,268		12.3	%		106,958		10.5	%
Time		232,725		22.9	%		264,345		26.0	%
Total	$	1,015,622		100	%	$	1,017,659		100	%

Table 16: Maturity Distribution of Certificates of Deposit

(in thousands)	September 30, 2015
3 months or less	$	23,618
Over 3 months through 6 months		27,267
Over 6 months through 12 months		41,071
Over 12 months		120,172

Total	$	212,128

Other Funding Sources

Other funding sources, which include short-term and long-term borrowings (notes payable, junior subordinated debentures, and subordinated notes), were $40 million and $34 million at September 30, 2015 and December 31, 2014, respectively. Short-term borrowings consist mainly of customer repurchase agreements maturing in less than nine months or federal funds purchased. There were no short-term borrowings outstanding at September 30, 2015 and December 31, 2014, respectively. Long-term borrowings include notes payable, consisting of a joint venture note and FHLB advances, totaling $15 million and $21 million at September 30, 2015 and December 31, 2014, respectively. Junior debentures are another long-term funding source carried at $12 million at September 30, 2015 and December 31, 2014, with $11.9 million qualifying as Tier 1 capital for regulatory purposes. Further information regarding these notes payable and junior subordinated debentures is located in “Note 6 – Notes Payable” and “Note 7 – Junior Subordinated Debentures” in the notes to the unaudited consolidated financial statements. Subordinated notes provide additional funding and qualify as Tier 2 capital. At September 30, 2015, total subordinated notes were $12 million, with $8 million and $4 million issued in the first and second quarters of 2015, respectively. Further information regarding these subordinated notes is located in “Note 8 – Subordinated Notes” in the notes to the unaudited consolidated financial statements.

Additional funding sources consist of a $10 million available and unused line of credit at the holding company and $75 million of available and unused federal funds purchased lines. Also, available total borrowing capacity at the FHLB was $65 million given the level of FHLB common stock held at September 30, 2015 (of which $6.0 million was outstanding at September 30, 2015).

Off-Balance Sheet Obligations

As of September 30, 2015 and December 31, 2014, Nicolet had the following commitments that did not appear on its balance sheet:

Table 17: Commitments

	September 30,		December 31,
	2015		2014
(in thousands)
Commitments to extend credit — fixed and variable rate	$	276,073	$	269,648
Financial letters of credit		3,046		2,996
Standby letters of credit		4,720		3,629

Liquidity Management

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

Funds are available from a number of basic banking activity sources including but not limited to the core deposit base, the repayment and maturity of loans, investment securities calls, maturities, and sales, and funds obtained through brokered deposits. All investment securities are classified as available for sale and are reported at fair value on the consolidated balance sheet. Approximately $25 million of the $168 million investment securities portfolio on hand at September 30, 2015 was pledged to secure public deposits, short-term borrowings, repurchase agreements, or for other purposes as required by law. Other funding sources available include short-term borrowings, federal funds purchased, and long-term borrowings.

Cash and cash equivalents at September 30, 2015 and December 31, 2014 were approximately $35 million and $69 million, respectively. These levels have declined slightly through the first nine months of 2015 as is typical of Nicolet’s historical deposit behaviors and was further impacted by Nicolet’s completed branch sale in August 2015. Nicolet’s liquidity resources were sufficient as of September 30, 2015 to fund loans, accommodate deposit trends and cycles, and to meet other cash needs as necessary.

Interest Rate Sensitivity Management

A reasonable balance between interest rate risk, credit risk, liquidity risk and maintenance of yield, is highly important to Nicolet’s business success and profitability. As an ongoing part of its financial strategy and risk management, Nicolet attempts to understand and manage the impact of fluctuations in market interest rates on its net interest income. The consolidated balance sheet consists mainly of interest-earning assets (loans, investments and cash) which are primarily funded by interest-bearing liabilities (deposits and other borrowings). Such financial instruments have varying levels of sensitivity to changes in market rates of interest. Market rates are highly sensitive to many factors beyond our control, including but not limited to general economic conditions and policies of governmental and regulatory authorities. Our operating income and net income depends, to a substantial extent, on “rate spread” (i.e., the difference between the income earned on loans, investments and other earning assets and the interest expense paid to obtain deposits and other funding liabilities).

Asset-liability management policies establish guidelines for acceptable limits on the sensitivity to changes in interest rates on earnings and market value of assets and liabilities. Such policies are set and monitored by management and the board of director’s Asset and Liability Committee.

To understand and manage the impact of fluctuations in market interest rates on net interest income, Nicolet measures its overall interest rate sensitivity through a net interest income analysis, which calculates the change in net interest income in the event of hypothetical changes in interest rates under different scenarios versus a baseline scenario. Such scenarios can involve static balance sheets, balance sheets with projected growth, parallel (or non-parallel) yield curve slope changes, immediate or gradual changes in market interest rates, and one-year or longer time horizons. The simulation modeling uses assumptions involving market spreads, prepayments of rate-sensitive instruments, renewal rates on maturing or new loans, deposit retention rates, and other assumptions.

Nicolet assessed the impact on net interest income in the event of a gradual +/-100 bps and +/-200 bps decrease in market rates (parallel to the change in prime rate) over a one-year time horizon to a static (flat) balance sheet. The interest rate scenarios are used for analytical purposes only and do not necessarily represent management’s view of future market interest rate movements. Based on this analysis on financial data at September 30, 2015, the projected changes in net interest income over a one-year time horizon, versus the baseline, was -3.8%, -2.3%, -0.1% and 0.0% for the -200, -100, +100 and +200 bps scenarios, respectively; such results are within Nicolet’s guidelines of not greater than -15% for +/- 100 bps and not greater than -20% for +/- 200 bps.

Actual results may differ from these simulated results due to timing, magnitude and frequency of interest rate changes, as well as changes in market conditions and their impact on customer behavior and management strategies.

Capital

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

At September 30, 2015, Nicolet’s capital structure includes $12.2 million (or 12%) of preferred stock and $92.7 million (or 88%) of common stock equity. Beginning in the fourth quarter of 2013, given growth in qualifying small business loans, Nicolet qualified for a 1% annual dividend rate on its preferred stock issued to the Treasury related to its participation in the SBLF, compared to the previous 5% annual rate paid by Nicolet. This 1% rate will adjust to 9% effective March 1, 2016 according to the terms of the Securities Purchase Agreement, if the preferred stock is not redeemed prior to that time. On September 28, 2015, Nicolet redeemed $12.2 million, or half, of its outstanding Small Business Lending Fund (“SBLF”) Series C Preferred Stock.

Nicolet’s common equity to total assets was 7.94% at September 30, 2015, increased from 7.13% at December 31, 2014 and continues to reflect capacity to capitalize on opportunities. Further, Nicolet’s investors have demonstrated a strong commitment to capital, providing common capital when needed, with the two most recent examples being a December 2008 private placement raising $9.5 million in common capital as we entered the economic crisis and the April 2013 private placement raising $2.9 million in common capital alongside the predominately stock-for-stock Mid-Wisconsin Financial Services, Inc. merger which added $9.7 million in common capital. Book value per common share increased to $23.41 at September 30, 2015 from $21.34 at year end 2014 aided primarily by retained earnings exceeding share reductions. During 2014, a common stock repurchase program was authorized to use up to $12 million to repurchase up to 625,000 shares of Nicolet common stock as an alternative use of capital. On July 21, 2015, a modification to the current stock repurchase program was approved, adding $6 million more to repurchase up to 175,000 more shares of its common stock, bringing the total authorization to up to $18 million to repurchase up to 800,000 shares of outstanding common stock. During the first nine months of 2015, $4.2 million was used to repurchase 146,404 shares at a weighted average price of $28.35 per share including commissions. Since beginning the repurchase program in February 2014, total shares repurchased were 403,695 utilizing $9.8 million for an average cost of $24.27 per share. Given the pending merger with Baylake, Nicolet has suspended its repurchase program.

As shown in Table 18, all of Nicolet’s regulatory capital ratios remain strong and are well above the minimum regulatory ratios. At September 30, 2015, Nicolet’s Total, Tier 1, Common Equity Tier 1 (“CET1”) risk-based ratios and its Leverage ratios were 14.3%, 12.0%, 9.4% and 9.7%, respectively, all above the well-capitalized ratios of 10%, 8%, 6.5% and 5%, respectively. On September 28, 2015, Nicolet redeemed $12.2 million, or half, of its outstanding SBLF Series C Preferred Stock. Nicolet’s Total Capital ratio increased since year end 2014 largely from earnings retained exceeding common stock repurchases, with the inclusion of the $12 million subordinated debt issued in 2015 (Tier 2 capital) offsetting the partial redemption of SBLF preferred stock in 2015 (Tier 1 capital). The reduction in the Tier 1 capital ratio from December 31, 2014 to September 30, 2015 was primarily due to the partial redemption of SBLF preferred stock. Additionally, the Bank’s regulatory ratios at September 30, 2015 and December 31, 2014 qualify the Bank as well-capitalized under the prompt-corrective action framework. This strong base of capital has allowed Nicolet to be opportunistic in the current environment.

A source of income and funds for Nicolet as the parent company of Nicolet National Bank are dividends from the Bank. Dividends declared by the Bank that exceed the retained net income for the most current year plus retained net income for the preceding two years must be approved by federal regulatory agencies. At September 30, 2015, the Bank could pay dividends of approximately $11.0 million without seeking regulatory approval. During 2014, the Bank paid $9 million of dividends to the parent company, and paid $6 million during the first nine months of 2015.

A summary of Nicolet’s and Nicolet National Bank’s regulatory capital amounts and ratios as of September 30, 2015 and December 31, 2014 are presented in the following table.

Table 18: Capital

	Actual					For Capital Adequacy Purposes					To Be Well Capitalized Under Prompt Corrective Action Provisions (2)
(in thousands)	Amount		Ratio (1)			Amount		Ratio (1)			Amount		Ratio (1)
As of September 30, 2015:
Company
Total capital	$	135,223		14.3	%	$	75,782		8.0	%
Tier I capital		113,378		12.0			56,837		6.0
CET1 capital		89,296		9.4			42,627		4.5
Leverage		113,378		9.7			46,643		4.0

Bank
Total capital	$	122,856		13.1	%	$	74,826		8.0	%	$	93,533		10.0	%
Tier I capital		112,851		12.1			56,120		6.0			74,826		8.0
CET1 capital		112,851		12.1			42,090		4.5			60,796		6.5
Leverage		112,851		9.8			46,095		4.0			57,618		5.0

As of December 31, 2014:
Company
Total capital	$	126,336		14.0	%	$	72,045		8.0	%
Tier I capital		117,048		13.0			36,023		4.0
Leverage		117,048		9.7			48,473		4.0

Bank
Total capital	$	115,891		13.0	%	$	71,134		8.0	%	$	88,917		10.0	%
Tier I capital		106,603		12.0			35,567		4.0			53,350		6.0
Leverage		106,603		8.9			47,977		4.0			59,972		5.0

(1)

The total capital ratio is defined as tier 1 capital plus tier 2 capital divided by total risk-weighted assets. The tier 1 capital ratio is defined as tier 1 capital divided by total risk-weighted assets. The leverage ratio is defined as tier 1 capital divided by the most recent quarter’s average total assets, adjusted in accordance with regulatory guidelines.

(2)

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

As disclosed in the Nicolet’s Annual Report on Form 10-K for the year ended December 31, 2014, in July 2013, the Federal Reserve Board and the OCC issued final rules implementing the Basel III regulatory capital framework and related Dodd-Frank Wall Street Reform and Consumer Protection Act changes. The rules revise minimum capital requirements and adjust prompt corrective action thresholds. The final rules revise the regulatory capital elements, add a new common equity Tier I capital ratio, increase the minimum Tier 1 capital ratio requirements and implement a new capital conservation buffer. The rules also permit certain banking organizations to retain, through a one-time election, the existing treatment for accumulated other comprehensive income. The Company and Bank have made the election to retain the existing treatment for accumulated other comprehensive income. The final rules took effect for the Company and Bank on January 1, 2015, subject to a transition period for certain parts of the rules.

For 2015 information only, the table above calculates and presents regulatory capital based upon the new regulatory capital ratio requirements under Basel III that became effective on January 1, 2015. Beginning in 2016, an additional capital conservation buffer will be added to the minimum requirements for capital adequacy purposes, subject to a three year phase-in period. The capital conservation buffer will be fully phased-in on January 1, 2019 at 2.5 percent. A banking organization with a conservation buffer of less than 2.5 percent (or the required phase-in amount in years prior to 2019) will be subject to limitations on capital distributions, including dividend payments and certain discretionary bonus payments to executive officers. At the present time, the ratios for the Company and Bank are sufficient to meet the fully phased-in conservation buffer.

Future Accounting Pronouncements

Recent accounting pronouncements adopted by Nicolet are included in Note 1, “Basis of Presentation” of the Notes to Unaudited Consolidated Financial Statements.

In September 2015, the Financial Accounting Standards Board (“FASB”) issued Accounting Standard Update (“ASU”) 2015-16 Business Combinations: Simplifying the Accounting for Measurement-Period Adjustments. The amendments in this update require that an acquirer recognize adjustments to estimated amounts that are identified during the measurement period in the reporting period in which the adjustment amounts are determined. The amendments require that the acquirer record, in the same period’s financial statements, the effect on earnings of changes in depreciation, amortization or other income effects, if any, as a result of the change to the estimated amounts, calculated as if the account had been completed at the acquisition date. The amendments also require an entity to present separately on the face of the income statement or disclose in the notes the portion of the amount recorded in current-period earnings by line item that would have been recorded in previous reporting periods if the adjustment to the estimated amounts had been recognized as of the acquisition date. This guidance is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2015. The adoption of this guidance is not expected to have a significant impact on the consolidated financial condition, results of operations or liquidity of Nicolet.

In August 2015, the FASB issued ASU 2015-03, Interest - Imputation of Interest: Presentation and subsequent Measurement of Debt Issuance Costs Associated with Line-of-Credit Arrangements-Amendments to SEC Paragraphs Pursuant to Staff Announcement at June 8, 2015 EITF Meeting (SEC Update). The guidance in ASU 2015-03, issued in April of 2015 did not address the presentation or subsequent measurement of debt issuance costs related to line-of- credit arrangements. Given the absence of authoritative guidance within SU 2015-03 for debit issuance costs related to line-of- credit arrangements, the SEC staff stated that they would not object to an entity deferring and presenting debt issuance costs as an asset and subsequently amortizing the deferred debt issuance costs ratably over the term of the line-of-credit arrangement, regardless of whether there are any outstanding borrowings on the line-of-credit arrangement. ASU 2015-15 adds these SEC comments to the “S” section of the codification.

In June 2015, the FASB issued ASU 2015-10: Technical Corrections and Improvements. The amendments in this Update cover a wide range of topics in the Codification including guidance clarification and reference corrections, simplification and minor improvements. Transition guidance varies based on the amendments. The amendments that require transition guidance are effective for all entities for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2015. Early adoption is permitted, including adoption in an interim period. All other amendments will be effective upon issuance. The adoption of this update is not expected to have a material impact on Nicolet’s consolidated financial statements.

In May 2015, the FASB issued ASU 2015-07, Disclosures for Investments in Certain Entities that Calculate Net Asset Value Per Share (or its Equivalent). ASU 2015-07 removes the requirement to categorize within the fair value hierarchy investments for which fair values are estimated using the net asset value practical expedient provided by ASC 820. Disclosures about investments in certain entities that calculate net asset value per share are limited under ASU 2015-07 to those investments for which the entity has elected to estimate the fair value using the net asset value practical expedient. ASU 2015-07 is effective for fiscal years beginning after December 15, 2015, with retrospective application to all periods presented. Early application is permitted. The adoption of this update is not expected to have a material impact on Nicolet’s consolidated financial statements.

In April 2015, the FASB issued ASU 2015-05 Intangibles - Goodwill and Other Internal-Use Software. The amendments in this update provide guidance to customers about whether a cloud computing arrangement includes a software license. If a cloud computing arrangement includes a software license, then the customer should account for the software license element of the arrangement consistent with the acquisition of other software licenses. If a cloud computing arrangement does not include a software license, the customer should account for the arrangement as a service contract. The guidance will not change U.S. GAAP for a customer’s accounting for service contracts. In addition, the guidance in this update supersedes paragraph 350-40-25-16. Consequently, all software licenses within the scope of Subtopic 350-40 will be accounted for consistent with other licenses of intangible assets. This guidance is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2015. The adoption of this guidance is not expected to have a significant impact on the consolidated financial condition, results of operations or liquidity of Nicolet.

In April 2015, the FASB issued ASU 2015-04 Compensation - Retirement Benefits. The amendments in this update provide a practical expedient that permits the entity to measure defined benefit plan assets and obligations using the month-end that is closest to the entity’s fiscal year end and apply that practical expedient consistently from year to year. The amendments in this update also provide a practical expedient that permits the entity to remeasure defined benefit plan assets and obligations using the month-end that is closest to the date of the significant event. This guidance is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2015. The adoption of this guidance is not expected to have a significant impact on the consolidated financial condition, results of operations or liquidity of Nicolet.

In February 2015, the FASB issued ASU No. 2015-02, Consolidation: Amendments to the Consolidation Analysis, effective for fiscal years beginning after December 15, 2015 and interim periods within those years with early adoption permitted. The new standard is intended to improve targeted areas of the consolidation guidance for legal entities such as limited partnerships, limited liability corporations, and securitization structures. The amendments in the ASU affect the consolidation evaluation for reporting organizations. In addition, the amendments in this ASU simplify and improve current GAAP by reducing the number of consolidation models. Nicolet is currently evaluating the impact of this guidance on its consolidated financial statements.

In January 2015, the FASB issued ASU 2015-01 Income Statement - Extraordinary and Unusual Items: Simplifying Income Statement Presentation by Eliminating the Concept of Extraordinary Items. The amendment eliminates from U.S. GAAP the concept of extraordinary items. Subtopic 225-20, Income Statement – Extraordinary and Unusual Items, required that an entity separately classify, present, and disclose extraordinary events and transactions. Presently, an event or transaction is presumed to be an ordinary and usual activity of the reporting entity unless evidence clearly supports its classification as an extraordinary item. If an event or transaction meets the criteria for extraordinary classification, an entity is required to segregate the extraordinary item from the results of ordinary operations and show the item separately in the income statement, net of tax, after income from continuing operations. The entity also is required to disclose applicable income taxes and either present or disclose earnings-per-share data applicable to the extraordinary item. This guidance is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2015. A reporting entity may apply the amendments prospectively or retrospectively to all prior periods presented in the financial statements. Early adoption is permitted provided that the guidance is applied from the beginning of the fiscal year of adoption. The adoption of this guidance is not expected to have a significant impact on the consolidated financial condition, results of operations or liquidity of Nicolet.

In August 2014, the FASB issued ASU 2014-15, Presentation of Financial Statements – Going Concern. In connection with preparing financial statements for each annual and interim reporting periods, an entity’s management should evaluate whether there are conditions or events, considered in the aggregate, that raise substantial doubt about the entity’s ability to continue as a going concern within one year after the date that the financial statements are issued (or within one year after the date that the financial statements are available to be issued when applicable). Management’s evaluation should be based on relevant conditions and events that are known and reasonably knowable at the date that the financial statements are issued (or at the date that the financial statements are available to be issued when applicable). The amendments in this update are effective for the annual period ending after December 15, 2016, and for annual periods and interim periods thereafter. The adoption of this guidance is not expected to have a significant impact on the consolidated financial condition, results of operations or liquidity of Nicolet.

In May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers: Summary and Amendments that Create Revenue from Contracts with Customers and Other Assets and Deferred Costs—Contracts with Customers. The guidance in this update supersedes the revenue recognition requirements in ASC Topic 605, Revenue Recognition, and most industry-specific guidance throughout the industry topics of the codification. For public companies, this update was originally effective for interim and annual periods beginning after December 15, 2016. In July 2015, the FASB voted to delay the effective date of this ASU by one year. Nicolet is currently assessing the impact that this guidance will have on its consolidated financial statements, but does not expect the guidance to have a material impact on Nicolet’s consolidated financial statements.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Not required pursuant to Instruction to Item 305(c) of Regulation S-K.

ITEM 4. CONTROLS AND PROCEDURES

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

There have been no changes in the Company’s internal controls or, to the Company’s knowledge, in other factors during the quarter covered by this report that have materially affected, or are reasonably likely to materially affect, the Company’s internal controls over financial reporting. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

PART II – OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

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

ITEM 1A. RISK FACTORS

There have been no material changes in the risk factors previously disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2014.

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
2.1		Agreement and Plan of Merger by and between Nicolet Bankshares, Inc. and Baylake Corp, dated September 8, 2015 (1)
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.

(1) Incorporated by reference to Exhibit 2.1 to the Registrant’s Current Report on Form 8-K filed on September 10, 2015.

SIGNATURES

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

	NICOLET BANKSHARES, INC.

November 6, 2015	/s/ Robert B. Atwell
	Robert B. Atwell
	Chairman, President and Chief Executive Officer

November 6, 2015	/s/ Ann K. Lawson
	Ann K. Lawson
	Chief Financial Officer