Nicolet Bankshares Inc: Form 10-Q for the period ended Jun 30, 2023

Nicolet Bankshares, Inc. (the “Company” or “Nicolet”) is a bank holding company headquartered in Green Bay, Wisconsin. Nicolet provides a diversified range of traditional banking and wealth management services to individuals and businesses in its market area and through the branch offices of its banking subsidiary, Nicolet National Bank (the “Bank”), in Wisconsin, Michigan, and Minnesota. In this Quarterly Report on Form 10-Q, unless the context indicates otherwise, all references to “we,” “us” and “our” refer to the Company.

Forward-Looking Statements

Statements made in this document and in any documents that are incorporated by reference which are not purely historical are forward-looking statements, as defined in the Private Securities Litigation Reform Act of 1995, including any statements regarding descriptions of management’s plans, objectives, or goals for future operations, products or services, and forecasts of its revenues, earnings, or other measures of performance. Forward-looking statements are based on current management expectations and, by their nature, are subject to risks and uncertainties. These statements are neither statements of historical fact nor assurance of future performance and generally may be identified by the use of words such as “believe,” “expect,” “anticipate,” “plan,” “estimate,” “should,” “will,” “intend,” or similar expressions. Forward-looking statements include discussions of strategy, financial projections, guidance and estimates (including their underlying assumptions), statements regarding plans, objectives, expectations or consequences of various transactions or events, and statements about our future performance, operations, products and services, and should be viewed with caution. Shareholders should note that many factors, some of which are discussed elsewhere in this document, could affect the future financial results of Nicolet and could cause those results to differ materially from those implied or anticipated by the statements. Except as required by law, we expressly disclaim any obligations to publicly update any forward-looking statements whether written or oral, that may be made from time to time, whether as a result of new information, future developments or otherwise. Important factors, many of which are beyond Nicolet’s control, that could cause our actual results and financial condition to differ materially from those indicated in the forward-looking statements, in addition to those described in detail under Item 1A, “Risk Factors” of Nicolet’s 2022 Annual Report on Form 10-K include, but are not necessarily limited to the following:

• operating, legal and regulatory risks, including the effects of legislative or regulatory developments affecting the financial industry generally or Nicolet specifically;
• our ability to maintain liquidity, primarily through deposits, in light of recent events in the banking industry;
• economic, market, political and competitive forces affecting Nicolet’s banking and wealth management businesses;
• changes in interest rates, monetary policy and general economic conditions, which may impact Nicolet’s net interest income;
• potential difficulties in identifying and integrating the operations of future acquisition targets with those of Nicolet;
• the impact of purchase accounting with respect to our merger activities, or any change in the assumptions used regarding the assets purchased and liabilities assumed to determine their fair value;
• cybersecurity risks and the vulnerability of our network and online banking portals, and the systems or parties with whom we contract, to unauthorized access, computer viruses, phishing schemes, spam attacks, human error, natural disasters, power loss and other security breaches that could adversely affect our business and financial performance or reputation;
• changes in accounting standards, rules and interpretations and the related impact on Nicolet’s financial statements;
• compliance or operational risks related to new products, services, ventures, or lines of business, if any, that Nicolet may pursue or implement;
• changes in monetary and tax policies;
• changes occurring in business conditions and inflation and the possibility of a recession;
• our ability to attract and retain key personnel;
• examinations by our regulatory authorities, including the possibility that the regulatory authorities may, among other things, require us to increase our allowance for credit losses, write-down assets, or take other actions;
• risks associated with actual or potential information gatherings, investigations or legal proceedings by customers, regulatory agencies or others;
• the potential effects of events beyond our control that may have a destabilizing effect on financial markets and the economy, such as weather events, natural disasters, epidemics and pandemics (including COVID-19), war or terrorist activities, disruptions in our customers’ supply chains, disruptions in transportation, essential utility outages or trade disputes and related tariffs;
• each of the factors and risks under Item 1A, “Risk Factors” of Nicolet’s 2022 Annual Report on Form 10-K and in subsequent filings we make with the SEC; and
• the risk that Nicolet’s analysis of these risks and forces could be incorrect and/or that the strategies developed to address them could be unsuccessful.

These factors should be considered in evaluating the forward-looking statements, and you should not place undue reliance on such statements.

Overview

The following discussion is management’s analysis of the consolidated financial condition as of June 30, 2023 and December 31, 2022 and results of operations for the three and six-month periods ended June 30, 2023 and 2022. It should be read in conjunction with Nicolet’s audited consolidated financial statements included in Nicolet’s 2022 Annual Report on Form 10-K.

Our financial performance and certain balance sheet line items were impacted by the timing and size of our acquisition of Charter Bankshares, Inc. (“Charter”) on August 26, 2022. Certain income statement results, average balances and related ratios include partial contributions from Charter from the acquisition date. Additional information on our acquisition activity is included in Note 2, “Acquisition” in the Notes to Unaudited Consolidated Financial Statements, under Part I, Item 1.

Economic Outlook and Recent Industry Developments

For year-to-date 2023, economic growth remains stronger than expected, driven by spending within the consumer sector. The labor market remains tighter than expected, which is fueling additional consumer spending through continued demand for goods and services. Inflation has started to come down; however, the progress has been slower than anticipated despite the significant increase in interest rates by the Federal Reserve. In an effort to combat inflation, the Federal Reserve has tightened monetary policy by raising interest rates from a target range of 0.00%-0.25% in early March 2022 to 5.00%-5.25% at the end of June 2023, followed by another 0.25% increase (to a target rate of 5.25%-5.50%) at the end of July 2023. All these factors are indicating a slowing in economic activity is the most likely scenario for the U.S. economy in late 2023.

These macroeconomic challenges are fueling additional concerns within the banking sector. During first quarter 2023, the banking industry experienced significant volatility with high-profile bank failures and industry wide concerns related to liquidity, deposit outflows, unrealized securities losses, and eroding consumer confidence in the banking system. This banking crisis has the potential for tighter lending standards and higher capital requirements, which further complicates the current economic outlook. In addition, the ongoing geopolitical issues also have the potential for further economic disruptions.

(In thousands, except per share data)

Note: Numbers may not sum due to rounding.

(1) Income statement-related ratios for partial-year periods are annualized.

(2) The ratios of tangible book value per common share, return on average tangible common equity, and tangible common equity to tangible assets are non-GAAP financial measures that exclude goodwill and other intangibles, net. These financial ratios have been included as management considers them to be useful metrics with which to analyze and evaluate financial condition and capital strength. See section “Non-GAAP Financial Measures” below.

(3) The adjusted net income measure is a non-GAAP financial measure that provides information that management believes is useful to investors in understanding our operating performance and trends and also aids investors in the comparison of our financial performance to the financial performance of peer banks. See section “Non-GAAP Financial Measures” below.

(4) Provision expense for 2023 is attributable to the expected loss on our investment in Signature Bank sub debt, and the provision expense for 2022 is attributable to the Day 2 allowance from the acquisition of Charter.

Non-GAAP Financial Measures

We identify “tangible book value per common share,” “return on average tangible common equity,” “tangible common equity to tangible assets” “adjusted net income,” and “adjusted diluted earnings per common share” as “non-GAAP financial measures.” In accordance with the SEC’s rules, we identify certain financial measures as non-GAAP financial measures if such financial measures exclude or include amounts in the most directly comparable measures calculated and presented in accordance with generally accepted accounting principles (“GAAP”) in effect in the United States in our statements of income, balance sheets or statements of cash flows. Non-GAAP financial measures do not include operating and other statistical measures, ratios or statistical measures calculated using exclusively financial measures calculated in accordance with GAAP.

Management believes that the presentation of these non-GAAP financial measures (a) are important metrics used to analyze and evaluate our financial condition and capital strength and provide important supplemental information that contributes to a proper understanding of our operating performance and trends, (b) enables a more complete understanding of factors and trends affecting our business, and (c) allows investors to compare our financial performance to the financial performance of our peers and to evaluate our performance in a manner similar to management, the financial services industry, bank stock analysts, and bank regulators. Management uses non-GAAP measures as follows: in the preparation of our operating budgets, monthly financial performance reporting, and in our presentation to investors of our performance. However, we acknowledge that these non-GAAP financial measures have a number of limitations. Limitations associated with non-GAAP financial measures include the risk that persons might disagree as to the appropriateness of items comprising these measures and that different companies might calculate these measures differently. These disclosures should not be considered an alternative to our GAAP results. A reconciliation of non-GAAP financial measures to the most directly comparable GAAP financial measures is presented in the table above.

Performance Summary

Net income was $14 million (or earnings per diluted common share of $0.91) for the six months ended June 30, 2023, compared to net income of $48 million (or earnings per diluted common share of $3.43) for the six months ended June 30, 2022, with 2023 significantly impacted by the first quarter balance sheet repositioning actions (detailed below).

Net income reflected non-core items and the related tax effect of each, including U.S. Treasury securities sale loss, expected loss (provision expense) on the Signature Bank sub debt investment (acquired in an acquisition), merger-related expenses, Day 2 credit provision expense required under the CECL model, as well as gains / (losses) on other assets and investments. These non-core items negatively impacted earnings per diluted common share $2.07 for the six months ended June 30, 2023 and positively impacted earnings per diluted common share $0.12 for the six months ended June 30, 2022.

On March 7, 2023, Nicolet executed the sale of $500 million (par value) U.S. Treasury held to maturity securities for a pre-tax loss of $38 million or an after-tax loss of $28 million to reposition the balance sheet for future growth. The $500 million portfolio yielded approximately 88 bps with scheduled maturities in 2024 and 2025 (or average duration of 2 years). Proceeds from the sale were used to reduce existing FHLB borrowings with the remainder held in investable cash. The following table summarizes the estimated annual impact of this balance sheet repositioning.

$ in Thousands

As a result of the sale of securities previously classified as held to maturity, the remaining unsold portfolio of held to maturity securities, with a book value of $177 million, was reclassified to available for sale with a carrying value of approximately $157 million. The unrealized loss on this portfolio of $20 million (at the time of reclassification) increased the balance of accumulated other comprehensive loss $15 million, net of the deferred tax effect, and is subject to future market changes.

• Net interest income was $116 million for the first six months of 2023, up $7 million (6%) over the first six months of 2022. Interest income grew $62 million attributable to favorable rates from new and renewed loans in a rising interest rate environment, as well as favorable loan volumes (partly from the Charter acquisition). Interest expense increased $55 million between the comparable six-month periods mostly from higher average funding costs. Net interest margin was 3.02% for the six months ended June 30, 2023, compared to 3.29% for the six months ended June 30, 2022. For additional information regarding net interest income, see “Income Statement Analysis — Net Interest Income.”
• Noninterest income was a negative $5 million for the first six months of 2023, a $35 million unfavorable change from the comparable 2022 period, primarily due to the balance sheet repositioning (noted above). Excluding net asset gains (losses), noninterest income for the first six months of 2023 was $34 million, a $7 million increase over the first six months of 2022. For additional information regarding noninterest income, see “Income Statement Analysis — Noninterest Income.”
• Noninterest expense was $90 million, $16 million (21%) higher than the first six months of 2022. Personnel costs increased $7 million, and non-personnel expenses combined increased $8 million (25%) over the comparable 2022 period. For additional information regarding noninterest expense, see “Income Statement Analysis — Noninterest Expense.”
• Nonperforming assets were $27 million, representing 0.32% of total assets at June 30, 2023, compared to $40 million or 0.46% of total assets at December 31, 2022. The reduction in nonperforming assets was due to the sale of select nonaccrual loans (net book value of approximately $13 million). For additional information regarding nonperforming assets, see “Balance Sheet Analysis – Nonperforming Assets.”
• At June 30, 2023, assets were $8.5 billion, down $281 million (3%) from December 31, 2022, mostly due to the sale of investment securities as part of our balance sheet repositioning, partly offset by higher cash balances. For additional balance sheet discussion see “Balance Sheet Analysis.”
• At June 30, 2023, loans were $6.2 billion, up $42 million from December 31, 2022, with growth in residential mortgage loans partly offset by lower commercial-based loans from the sale of specific nonaccrual loans (noted above) as well as the payoff of two larger loan relationships. On average, loans grew $1.5 billion (31%) over the first six months of 2022. For additional information regarding loans, see “Balance Sheet Analysis — Loans.”
• Total deposits of $7.2 billion at June 30, 2023, were minimally changed from December 31, 2022, with growth in customer and brokered time deposits partly offset by lower transaction account balances. Year-to-date average deposits were $711 million (11%) higher than the first six months of 2022. For additional information regarding deposits, see “Balance Sheet Analysis – Deposits.”

INCOME STATEMENT ANALYSIS

Net Interest Income

Tax-equivalent net interest income is a non-GAAP measure, but is a preferred industry measurement of net interest income (and its use in calculating a net interest margin) as it enhances the comparability of net interest income arising from taxable and tax-exempt sources. The tax-equivalent adjustments bring tax-exempt interest to a level that would yield the same after-tax income by applying the effective Federal corporate tax rates to the underlying assets. Tables 2 and 3 present information to facilitate the review and discussion of selected average balance sheet items, tax-equivalent net interest income, interest rate spread and net interest margin.

Table 2: Average Balance Sheet and Net Interest Income Analysis - Tax-Equivalent Basis

(in thousands)

(1) Nonaccrual loans and loans held for sale 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 21% and adjusted for the disallowance of interest expense.

Table 2: Average Balance Sheet and Net Interest Income Analysis - Tax-Equivalent Basis (Continued)

(in thousands)

(1) Nonaccrual loans and loans held for sale 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 21% and adjusted for the disallowance of interest expense.

Table 3: Volume/Rate Variance - Tax-Equivalent Basis

(in thousands)

(1) The change in interest due to both rate and volume has been allocated in proportion to the relationship of dollar amount of change in each.

(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 21% and adjusted for the disallowance of interest expense.

The Federal Reserve raised short-term interest rates a total of 425 bps during 2022, increasing the Federal Funds rate to a range of 4.25% to 4.50% as of December 31, 2022. Additional increases totaling 75 bps were made in the first half of 2023, resulting in a Federal Funds range of 5.00% to 5.25% as of June 30, 2023.

Tax-equivalent net interest income was $117 million for the six months June 30, 2023, an increase of $7 million (7%) over the six months ended June 30, 2022. The $7 million increase in tax-equivalent net interest income was attributable to net favorable volumes (which added $31 million to net interest income, mostly from the Charter acquisition and solid loan growth) and net unfavorable rates (which decreased net interest income $23 million from higher deposit costs and the lag in repricing the loan portfolio to current market interest rates).

Average interest-earning assets increased to $7.7 billion, up $1.0 billion (15%) over the comparable 2022 period, primarily due to the timing of the acquisition of Charter. Between the comparable six-month periods, average loans increased $1.5 billion (31%), mostly due to timing of the Charter acquisition (which added loans of $827 million at acquisition) and strong organic loan growth throughout 2022. Average investment securities decreased $287 million between the comparable six-month periods, while other interest-earning assets declined $150 million, mostly due to lower cash. As a result, the mix of average interest-earning assets shifted to 81% loans, 17% investments and 2% other interest-earning assets (mostly cash) for the first half of 2023, compared to 72%, 24% and 4%, respectively, for the first half of 2022.

Average interest-bearing liabilities were $5.3 billion for the first half of 2023, an increase of $747 million (16%) over the first half of 2022, primarily due to the timing of the acquisition of Charter. Average interest-bearing core deposits increased $404 million and average brokered deposits increased $162 million between the comparable six-month periods, reflecting the impact of the Charter acquisition and brokered funding to support the strong loan growth in 2022. Other interest-bearing liabilities increased $181 million between the comparable six-month periods, partly due to wholesale funding acquired with Charter and partly due to FHLB borrowings to support the strong loan growth in 2022. The mix of average interest-bearing liabilities was 81% core deposits, 11% brokered deposits and 8% wholesale funding for the first half of 2023, compared to 86%, 10%, and 4%, respectively, for the first half of 2022.

The interest rate spread decreased 89 bps between the comparable six-month periods, as our liabilities have repriced faster than our assets in the rapidly rising interest rate environment. The interest-earning asset yield increased 115 bps to 4.69% for the first six months of 2023, due to the changing mix of interest-earning assets (mostly the reduction in cash noted above), as well as the higher interest rate environment. The loan yield improved 87 bps to 5.23% between the comparable six-month periods, largely due to the repricing of new and renewed loans in a rising interest rate environment, while the yield on investment securities increased 51 bps to 2.07%. The cost of funds increased 204 bps to 2.42% for the first half of 2023, also reflecting the rising interest rate environment, a migration of customer deposits into higher rate deposit products, and a shift in the mix of interest-bearing liabilities (mostly the increase in wholesale funding noted above). The contribution from net free funds increased 62 bps, mostly due to the higher value in the rising interest rate environment. As a result, the tax-equivalent net interest margin was 3.02% for the first half of 2023, down 27 bps compared to 3.29% for the first half of 2022.

Tax-equivalent interest income was $181 million for the first half of 2023, up $62 million from comparable period of 2022, comprised of $35 million higher volumes and $27 million higher average rates (mostly in the loan portfolio). Interest income on loans increased $59 million over the first half of 2022, mostly due to higher average balances from the Charter acquisition and strong organic loan growth. Interest expense increased to $64 million for the first half of 2023, up $55 million compared to the first half of 2022, mostly due to a much higher cost of funds. Interest expense on deposits increased $50 million between the comparable six-month periods mostly due to the rapidly rising interest rate environment.

Provision for Credit Losses

The provision for credit losses was $3.5 million for the six months ended June 30, 2023 (comprised of $1.2 million related to the ACL-Loans and $2.3 million for the ACL on securities AFS), compared to $1.1 million for the six months ended June 30, 2022 (comprised of $0.9 million related to the ACL-Loans and the remainder for the ACL on unfunded commitments). The 2023 provision for credit losses on loans was attributable to growth and changes in the underlying loan portfolio, while the provision for credit losses on securities AFS was due to the expected loss on our Signature Bank subordinated debt investment which was fully charged-off during first quarter 2023.

The provision for credit losses is predominantly a function of Nicolet’s methodology and judgment as to qualitative and quantitative factors used to determine the appropriateness of the ACL. The appropriateness of the ACL-Loans is affected by changes in the size and character of the loan portfolio, changes in levels of collateral dependent 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 expected credit losses. The ACL for securities is affected by risk of the underlying issuer, while the ACL for unfunded commitments is affected by many of the same factors as the ACL-Loans, as well as funding assumptions relative to lines of credit. See also Note 6, “Loans, Allowance for Credit Losses - Loans, and Credit Quality” of the Notes to Unaudited Consolidated Financial Statements under Part I, Item 1, for additional disclosures. For additional information regarding asset quality and the ACL-Loans, see “BALANCE SHEET ANALYSIS — Loans,” “— Allowance for Credit Losses - Loans,” and “— Nonperforming Assets.”

Noninterest Income

Table 4: Noninterest Income

(in thousands)

N/M means not meaningful.

Noninterest income was a negative $5.0 million for the first six months of 2023, an unfavorable change of $35.1 million compared to the first six months of 2022, primarily due to the balance sheet repositioning. Excluding net asset gains (losses), noninterest income for first half 2023 was $33.8 million, a $6.6 million (24%) increase over first half 2022.

Wealth management fee income was $11.4 million, up $0.7 million (6%) from the first six months of 2022, including favorable market-related changes, as well as growth in accounts and assets under management.

Mortgage income represents net gains received from the sale of residential real estate loans into the secondary market, capitalized mortgage servicing rights (“MSR”), servicing fees net of MSR amortization, fair value marks on the mortgage interest rate lock commitments and forward commitments (“mortgage derivatives”), and MSR valuation changes, if any. Net mortgage income of $3.3 million, decreased $2.2 million (40%) between the comparable six-month periods, mostly due to the rising interest rate environment reducing secondary market volumes and the related gains on sales. See also Note 7, “Goodwill and Other Intangibles and Servicing Rights” of the Notes to Unaudited Consolidated Financial Statements under Part I, Item 1, for additional disclosures on the MSR asset.

Card interchange income grew $0.8 million (15%) between the comparable six-month periods due to higher volume and activity.

BOLI income was up $0.6 million between the comparable six-month periods, attributable to higher average balances from BOLI acquired with the Charter acquisition.

Loan servicing rights (“LSR”) income increased $2.8 million between the comparable first half periods mostly due to lower LSR amortization from the much slower prepayments speeds in the higher interest rate environment. See also Note 7, “Goodwill and Other Intangibles and Servicing Rights” of the Notes to Unaudited Consolidated Financial Statements under Part I, Item 1, for additional information on the LSR asset.

Other income of $3.7 million for the six months ended June 30, 2023 was up $0.7 million from the comparable 2022 period, largely due to broker fees and card incentive income.

Net asset losses of $38.8 million for the first six months of 2023 were primarily attributable to losses on the sale of approximately $500 million (par value) U.S. Treasury held to maturity securities executed in early March as part of a balance sheet repositioning, while net asset gains of $2.9 million for the first six months of 2022 were primarily attributable to gains on sales of other real estate owned (mostly closed bank branch locations).

Noninterest Expense

Table 5: Noninterest Expense

($ in thousands)

Noninterest expense was $89.8 million, an increase of $15.7 million (21%) over the first six months of 2022. Personnel costs increased $7.4 million (18%), while non-personnel expenses combined increased $8.4 million (25%) compared to the first six months of 2022.

Personnel expense was $48.2 million for the six months ended June 30, 2023, an increase of $7.4 million from the comparable period in 2022. Salary expense increased $6.1 million (18%) over the first six months of 2022, reflecting higher salaries from the larger employee base (with average full-time equivalent employees up 12%, mostly due to the Charter acquisition), investments in our wealth team, and merit increases between the years, partly offset by lower incentive compensation commensurate with the lower current period earnings. Fringe benefits increased $1.3 million (20%) over the first six months of 2022, reflecting higher overall health care expenses as well as the larger employee base. Salary expense was also impacted by the change in the fair value of nonqualified deferred compensation plan liabilities from the recent market improvements. See also “Noninterest Income” for the offsetting fair value change to the nonqualified deferred compensation plan assets.

Occupancy, equipment and office expense was $17.6 million for the first six months of 2023, up $3.8 million (27%) compared to the first six months of 2022, largely due to the expanded branch network with the Charter acquisition, as well as additional expense for software and technology solutions.

Business development and marketing expense was $4.1 million, up $0.2 million (5%) between the comparable first half periods, largely attributable to the timing and extent of marketing donations, promotions, and media to support our expanded branch network and community base.

Data processing expense was $8.2 million, up $1.2 million (18%) between the comparable six-month periods, mostly due to volume-based increases in core and card processing charges, partly from the Charter acquisition.

Intangibles amortization increased $1.5 million between the comparable first half periods due to higher amortization from the intangibles added with the recent acquisitions.

Other expense was $5.7 million, up $1.6 million (39%) between the comparable six-month periods, mostly due to higher professional fees.

Income Taxes

Income tax expense was $3.7 million (effective tax rate of 21.2%) for the first six months of 2023, compared to expense of $15.7 million (effective tax rate of 24.5%) for the comparable period of 2022. The change in income tax expense was largely due to the lower pretax earnings between the years.

Income Statement Analysis – Three Months Ended June 30, 2023 versus Three Months Ended June 30, 2022

Net income was $22.6 million for the three months ended June 30, 2023, compared to $24.0 million for the three months ended June 30, 2022. Earnings per diluted common share was $1.51 for second quarter 2023, compared to $1.73 for second quarter 2022.

Tax-equivalent net interest income was $59.6 million for second quarter 2023, an increase of $4.1 million over second quarter 2022. Interest income increased $32.7 million over second quarter 2022, with $23.5 million from stronger volumes (led by average loans which grew $1.4 billion or 29% over second quarter 2022, mostly due to the Charter acquisition) and $9.2 million from higher yields. Average investment securities decreased $505 million between the comparable second quarter periods, mostly due to the balance sheet repositioning actions in first quarter 2023. Interest expense increased $28.6 million from second quarter 2022, mostly due to $27.2 million higher overall funding costs. For additional information regarding average balances, net interest income and net interest margin, see “INCOME STATEMENT ANALYSIS — Net Interest Income.”

The net interest margin for second quarter 2023 was 3.14%, compared to 3.34% for second quarter 2022, influenced by the rising interest rate environment and the changing balance sheet mix. The mix of average interest-earning assets shifted from 74% loans, 24% investments and 2% other interest-earning assets (mostly cash) for second quarter 2022, to 83%, 14% and 3%, respectively, for second quarter 2023. The yield on interest-earning assets of 4.90% increased 129 bps from second quarter 2022. The yield on loans was 5.35%, 101 bps higher than second quarter 2022, largely due to the impact of the rising interest rate environment. The cost of funds of 2.54% increased 214 bps between the comparable quarters, also due to the rising interest rates.

Provision for credit losses was $0.5 million for second quarter 2023 (all related to the ACL-Loans), compared to $0.8 million provision for credit losses for second quarter 2022 (comprised of $0.6 million related to the ACL-Loans, and $0.2 million for the ACL on unfunded commitments). For additional information regarding the allowance for credit losses-loans and asset quality, see “BALANCE SHEET ANALYSIS — Allowance for Credit Losses - Loans” and “BALANCE SHEET ANALYSIS — Nonperforming Assets.”

Noninterest income was $16.8 million for second quarter 2023, an increase of $2.7 million (19%) from second quarter 2022. Wealth management fee income grew $0.9 million (18%), including favorable market-related changes, as well as growth in accounts and assets under management. Market valuations improved $1.8 million between the comparable second quarter periods from favorable fair value changes on the deferred compensation plan assets. LSR income increased $1.3 million between the comparable second quarter periods mostly due to lower LSR amortization from the much slower prepayments speeds in the higher interest rate environment. Net asset losses of $0.3 million in second quarter 2023 were primarily attributable to unfavorable fair value marks on equity securities, while net asset gains of $1.6 million in second quarter 2022 were primarily attributable to gains on sales of other real estate owned (mostly closed bank branch locations). For additional information regarding noninterest income, see “INCOME STATEMENT ANALYSIS — Noninterest Income.”

Noninterest expense was $45.0 million for second quarter 2023, an increase of $8.4 million (23%) from second quarter 2022, including a $4.2 million increase in personnel expense and a $4.2 million increase in non-personnel expenses. The increase in personnel was due to higher salaries and fringe benefits from the larger employee base (with average full-time equivalent employees up 11%), investments in our wealth team, and merit increases between the years. Occupancy, equipment, and office of $8.8 million was up $2.0 million (28%), largely due to the expanded branch network with the Charter acquisitions as well as additional expense for software and technology solutions. Data processing expense was $4.2 million, up $0.6 million (17%) between the comparable second quarter periods, mostly due to volume-based increases in core and card processing charges, including the larger operating base following the Charter acquisition. Other expense was $2.9 million, an increase of $1.0 million between the comparable second quarter periods, primarily due to higher professional fees and overall higher expenses related to our larger operating base. For additional information regarding noninterest expense, see “INCOME STATEMENT ANALYSIS — Noninterest Expense.”

BALANCE SHEET ANALYSIS

At June 30, 2023, period end assets were $8.5 billion, a decrease of $281 million (3%) from December 31, 2022, mostly due to the sale of investment securities as part of our balance sheet repositioning, partly offset by higher cash balances. Total loans increased $42 million from December 31, 2022, with growth in residential mortgage loans partly offset by lower commercial-based loans from the sale of specific nonaccrual loans as well as the payoff of two larger loan relationships. Total deposits of $7.2 billion at June 30, 2023, were minimally changed from December 31, 2022, with growth in customer and brokered time deposits partly offset by lower transaction account balances. Total borrowings decreased $295 million from December 31, 2022 in FHLB advances (as part of the balance sheet repositioning). Total stockholders’ equity was $978 million at June 30, 2023, an increase of $5 million since December 31, 2022.

Compared to June 30, 2022, assets increased $1.1 billion (15%), largely due to the acquisition of Charter and strong loan growth, partly offset by lower investment securities related to the balance sheet repositioning. Total loans increased $1.2 billion and total deposits increased $912 million from June 30, 2022, also largely due to the acquisition of Charter. Stockholders’ equity increased $138 million from June 30, 2022, primarily due to common stock issued in the Charter acquisition and net income, partially offset by negative net fair value investment changes.

Loans

Nicolet services a diverse customer base throughout Wisconsin, Michigan and Minnesota. We concentrate on originating loans in our local markets and assisting current loan customers. Nicolet actively utilizes government loan programs such as those provided by the U.S. Small Business Administration (“SBA”) and the U.S. Department of Agriculture’s Farm Service Agency (“FSA”).

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

For additional disclosures on loans, see also Note 6, “Loans, Allowance for Credit Losses - Loans, and Credit Quality,” in the Notes to Unaudited Consolidated Financial Statements under Part I, Item 1. For information regarding the allowance for credit losses and nonperforming assets see “BALANCE SHEET ANALYSIS – Allowance for Credit Losses - Loans” and “BALANCE SHEET ANALYSIS – Nonperforming Assets.” A detailed discussion of the loan portfolio accounting policies, general loan portfolio characteristics, and credit risk are described in Note 1, “Nature of Business and Significant Accounting Policies,” of the Notes to Consolidated Financial Statements, included in Part II, Item 8 of the Company’s 2022 Annual Report on Form 10-K.

Table 6: Period End Loan Composition

(in thousands)

As noted in Table 6 above, the loan portfolio at June 30, 2023, was 77% commercial-based and 23% retail-based. Commercial-based loans are considered to have more inherent risk of default than retail-based loans, in part because of the broader list of factors that could impact a commercial borrower negatively. In addition, the commercial balance per borrower is typically larger than that for retail-based loans, implying higher potential losses on an individual customer basis. Credit risk on commercial-based loans is largely influenced by general economic conditions and the resulting impact on a borrower’s operations or on the value of underlying collateral, if any.

Total loans of $6.2 billion at June 30, 2023, increased $42 million from December 31, 2022, with growth in residential mortgage loans partly offset by lower commercial-based loans from the sale of specific nonaccrual loans (net book value of approximately $13 million) as well as the payoff of two larger loan relationships. At June 30, 2023, commercial and industrial loans represented the largest segment of Nicolet’s loan portfolio at 21% of the total portfolio, followed by CRE investment at 18% of the total portfolio. The loan portfolio is widely diversified and included the following industries: manufacturing, wholesaling, paper, packaging, food production and processing, agriculture, forest products, hospitality, retail, service, and businesses supporting the general building industry. The following chart provides the industry distribution of our commercial loan portfolio at June 30, 2023.

Commercial Loan Portfolio by Industry Type (based on NAICS codes)

The following table presents the maturity distribution of the loan portfolio.

Table 7**: Loan Maturity Distribution**

(in thousands)

43

(in thousands)

* The residential construction loans with a loan maturity after five years represent a construction to permanent loan product.

Allowance for Credit Losses - Loans

For additional disclosures on the allowance for credit losses, see Note 6, “Loans, Allowance for Credit Losses - Loans, and Credit Quality,” in the Notes to Unaudited Consolidated Financial Statements under Part I, Item 1. A detailed discussion of the loan portfolio accounting policies, general loan portfolio characteristics, and credit risk are described in Note 1, “Nature of Business and Significant Accounting Policies,” of the Notes to Consolidated Financial Statements, included in Part II, Item 8 of the Company’s 2022 Annual Report on Form 10-K.

Credit risks within the loan portfolio are inherently different for each loan type. Credit risk is controlled and monitored through the use of lending standards, a thorough review of potential borrowers, and ongoing 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. Loans charged off are subject to continuous review, and specific efforts are taken to achieve maximum recovery of principal, interest, and related expenses. For additional information regarding nonperforming assets see also “BALANCE SHEET ANALYSIS – Nonperforming Assets.”

The ACL-Loans represents management’s estimate of expected credit losses in the Company’s loan portfolio at the balance sheet date. To assess the overall appropriateness of the ACL-Loans, management applies an allocation methodology 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 nonaccrual 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 economic conditions; (ix) the fair value of underlying collateral; and (x) other qualitative and quantitative factors which could affect expected credit losses. Assessing these numerous factors involves significant judgment; therefore, management considers the ACL-Loans a critical accounting estimate.

Management allocates the ACL-Loans by pools of risk within each loan portfolio segment. The allocation methodology consists of the following components. First, a specific reserve is established for individually evaluated credit deteriorated loans, which management defines as nonaccrual credit relationships over $250,000, collateral dependent loans, purchased credit deteriorated loans, and other loans with evidence of credit deterioration. The specific reserve in the ACL-Loans for these credit deteriorated loans is equal to the aggregate collateral or discounted cash flow shortfall. Second, management allocates the ACL-Loans with historical loss rates by loan segment. The loss factors are measured on a quarterly basis and applied to each loan segment based on current loan balances and projected for their expected remaining life. Next, management allocates the ACL-Loans using the qualitative and environmental factors mentioned above. Consideration is given to those current qualitative or environmental factors that are likely to cause estimated credit losses at the evaluation date to differ from the historical loss experience of each loan segment. Lastly, management considers reasonable and supportable forecasts to assess the collectability of future cash flows.

At June 30, 2023, the ACL-Loans was $63 million (representing 1.01% of period end loans), minimally changed from $62 million (or 1.00% of period end loans) at December 31, 2022 and up from $51 million (or 1.02% of period end loans) at June 30, 2022. The increase in the ACL-Loans from June 30, 2022 was mostly due to the Charter acquisition, which added $8 million of provision for the Day 2 allowance and $2 million related to purchased credit deteriorated loans. The components of the ACL-Loans are detailed further in Table 8 below.

Table 8: Allowance for Credit Losses - Loans

(in thousands)

Nonperforming Assets

As part of its overall credit risk management process, management is committed to an aggressive problem loan identification philosophy. This philosophy has been implemented through the ongoing monitoring and review of all pools of risk in the loan portfolio to identify problem loans early and minimize the risk of loss. Management continues to actively work with customers and monitor credit risk from the ongoing macroeconomic challenges. For additional disclosures on credit quality, see Note 6, “Loans, Allowance for Credit Losses - Loans, and Credit Quality” of the Notes to Unaudited Consolidated Financial Statements under Part I, Item 1. For additional information on loans see “BALANCE SHEET ANALYSIS – Loans” and for additional information on the ACL-Loans see “BALANCE SHEET ANALYSIS – Allowance for Credit Losses-Loans.”

Nonperforming loans are considered one indicator of potential future loan losses. Nonperforming loans are defined as nonaccrual loans 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. Nonperforming assets include nonperforming loans and other real estate owned (“OREO”). At June 30, 2023, nonperforming assets were $27 million and represented 0.32% of total assets, compared to $40 million or 0.46% of total assets at December 31, 2022. The reduction in nonperforming assets was mostly due to the nonaccrual loan sale (as noted under “BALANCE SHEET ANALYSIS – Loans” above).

The level of potential problem loans is another predominant factor in determining the relative level of risk in the loan portfolio and in determining the appropriate level of the ACL-Loans. 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 $79 million (1% of loans) and $53 million (1% of loans) at June 30, 2023 and December 31, 2022, respectively, with the increase primarily due to the downgrade of one commercial credit relationship. Potential problem loans require heightened management review given the pace at which a credit may deteriorate, the potential duration of asset quality stress, and uncertainty around the magnitude and scope of economic stress that may be felt by Nicolet’s customers and on underlying real estate values.

Table 9: Nonperforming Assets

(in thousands)

Deposits

Deposits represent Nicolet’s largest source of funds, and the strong core deposit base provides a stable funding source. Core deposit balances of $6.5 billion at June 30, 2023 declined $128 million (2%) from December 31, 2022, including lower commercial balances, as well as the seasonal run-off of municipal deposits. Compared to June 30, 2022, core deposits increased $656 million (11%), largely due to the Charter acquisition. The deposit composition is presented in Table 10 below.

Table 10: Period End Deposit Composition

(in thousands)

Total estimated uninsured deposits were $2.0 billion (representing 28% of total deposits) at June 30, 2023, compared to $2.3 billion (representing 32% of total deposits) at December 31, 2022.

Lending-Related Commitments

As of June 30, 2023 and December 31, 2022, Nicolet had the following off-balance sheet lending-related commitments.

Table 11: Commitments

(in thousands)

For additional disclosures on lending-related commitments, see Note 9, “Commitments and Contingencies” of the Notes to Unaudited Consolidated Financial Statements under Part I, Item 1.

Liquidity Management

Liquidity management refers to the ability to ensure that adequate liquid funds are available to meet the current and future cash flow obligations arising in the daily operations of the Company. These cash flow obligations include the ability to meet the commitments to borrowers for extensions of credit, accommodate deposit cycles and trends, fund capital expenditures, pay dividends to stockholders (if any), and satisfy other operating expenses. The Company’s most liquid assets are cash and due from banks and interest-earning deposits, which totaled $505 million and $155 million at June 30, 2023 and December 31, 2022, respectively. Balances of these liquid assets are dependent on our operating, investing, and financing activities during any given period.

The $350 million increase in cash and cash equivalents since year-end 2022 included $48 million net cash provided by operating activities and $581 million net cash provided by investing activities (mostly investment sales from the balance sheet repositioning), partly offset by $279 million net cash used in financing activities (mostly repayment of FHLB borrowings from the balance sheet repositioning). As of June 30, 2023, management believed that adequate liquidity existed to meet all projected cash flow obligations.

Nicolet’s primary sources of funds include the core deposit base, repayment and maturity of loans, investment securities calls, maturities, and sales, and procurement of brokered deposits or other wholesale funding. At June 30, 2023, approximately 43% of the investment securities portfolio was pledged as collateral to secure public deposits and borrowings, as applicable, and for liquidity or other purposes as required by regulation. Liquidity sources available to the Company at June 30, 2023, are presented in Table 12 below.

Table 12: Liquidity Sources

(in millions)

Management is committed to the Parent Company being a source of strength to the Bank and its other subsidiaries, and therefore, regularly evaluates capital and liquidity positions of the Parent Company in light of current and projected needs, growth or strategies. The Parent Company uses cash for normal expenses, debt service requirements and, when opportune, for common stock repurchases, repayment of debt, or investment in other strategic actions such as mergers or acquisitions. At June 30, 2023, the Parent Company had $56 million in cash. Additional cash sources available to the Parent Company include access to the public or private markets to issue new equity, subordinated notes or other debt. Dividends from the Bank and, to a lesser extent, stock option exercises, represent significant sources of cash flows for the Parent Company. The Bank is required by federal law to obtain prior approval of the OCC for payments of dividends if the total of all dividends declared by the Bank in any year will exceed certain thresholds. Management does not believe that regulatory restrictions on dividends from the Bank will adversely affect its ability to meet its cash obligations.

Interest Rate Sensitivity Management and Impact of Inflation

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

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

To understand and manage the impact of fluctuations in market interest rates on net interest income, we measure our 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.

Among other scenarios, we assessed the impact on net interest income in the event of a gradual +/-100 bps and +/-200 bps change in market rates (parallel to the change in prime rate) over a one-year time horizon to a static (flat) balance sheet. The results provided include the liquidity measures mentioned above and reflect the higher interest rate environment. The interest rate scenarios are used for analytical purposes only and do not necessarily represent management’s view of future market interest rate movements. Based on financial data at June 30, 2023 and December 31, 2022, the projected changes in net interest income over a one-year time horizon, versus the baseline, are presented in Table 13 below. The results are within Nicolet’s guidelines of not greater than -10% for +/- 100 bps and not greater than -15% for +/- 200 bps.

Table 13: Interest Rate Sensitivity

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

The effect of inflation on a financial institution differs significantly from the effect on an industrial company. While a financial institution’s operating expenses, particularly salary and employee benefits, are affected by general inflation, the asset and liability structure of a financial institution consists largely of monetary items. Monetary items, such as cash, investments, loans, deposits and other borrowings, are those assets and liabilities which are or will be converted into a fixed number of dollars regardless of changes in prices. As a result, changes in interest rates have a more significant impact on a financial institution’s performance than does general inflation. Inflation may also have impacts on the Bank’s customers, on businesses and consumers and their ability or willingness to invest, save or spend, and perhaps on their ability to repay loans. As such, there would likely be impacts on the general appetite for banking products and the credit health of the Bank’s customer base.

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. The capital position and strategies are actively reviewed 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 shareholder return. For details on the change in capital see “BALANCE SHEET ANALYSIS.”

The Company’s and the Bank’s regulatory capital ratios remain above minimum regulatory ratios, including the capital conservation buffer. At June 30, 2023, the Bank’s regulatory capital ratios qualify the Bank as well-capitalized under the prompt-corrective action framework. This strong base of capital has allowed Nicolet to be opportunistic in strategic growth. A summary of the Company’s and the Bank’s regulatory capital amounts and ratios, as well as selected capital metrics are presented in the following table.

Table 14: Capital

($ in thousands)

In managing capital for optimal return, we evaluate capital sources and uses, pricing and availability of our stock in the market, and alternative uses of capital (such as the level of organic growth or acquisition opportunities, dividends, or repayment of equity-equivalent debt) in light of strategic plans. At June 30, 2023, there remains $46 million authorized under this repurchase program, as modified, to be utilized from time-to-time to repurchase shares in the open market, through block transactions or in private transactions.

Critical Accounting Estimates

The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates, assumptions or judgments that affect the amounts reported in the financial statements and accompanying notes. These estimates and assumptions are based on historical experience, current information, and other factors deemed to be relevant; accordingly, as this information changes, actual results could differ from those estimates. Nicolet considers accounting estimates to be critical to reported financial results if the accounting estimate requires management to make assumptions about matters that are highly uncertain and different estimates that management reasonably could have used for the accounting estimate in the current period, or changes in the accounting estimate that are reasonably likely to occur from period to period, could have a material impact on the financial statements. The accounting estimates we consider to be critical include business combinations and the valuation of loans acquired, the determination of the allowance for credit losses, and income taxes. A discussion of these estimates can be found in the “Critical Accounting Estimates” section in Management’s Discussion and Analysis of Financial Condition and Results of Operations included in the Company’s 2022 Annual Report on Form 10-K. There have been no changes in the Company’s determination of critical accounting policies and estimates since December 31, 2022.

There have been no material changes in our market risk at June 30, 2023, from that presented in our 2022 Annual Report on Form 10-K. See section “Interest Rate Sensitivity Management and Impact of Inflation” within Management’s Discussion and Analysis of Financial Condition and Results of Operations under Part I, Item 2, for our interest rate sensitivity position at June 30, 2023.

(a) Disclosure Controls and Procedures. Management, under the supervision, and with the participation, of our principal executive officer and principal financial officer, evaluated our disclosure controls and procedures (as such term is defined in Exchange Act Rule 13a-15(e)). Based upon that evaluation, our principal executive officer and principal financial officer concluded that our disclosure controls and procedures were effective as of the end of the period covered by this report.

(b) Changes in Internal Control Over Financial Reporting. There were no changes in the Company’s internal control over financial reporting (as such term is defined in Exchange Act Rule 13a-15(f)) during the quarter covered by this report that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

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, 2022.