ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion is management’s analysis to assist in the understanding and evaluation of the consolidated financial condition and results of operations of Nicolet. It should be read in conjunction with the consolidated financial statements and footnotes and the selected financial data presented elsewhere in this report.

The detailed financial discussion that follows focuses on 2018 results compared to 2017 . See “ 2017 Compared to 2016 ” for the summary comparing 2017 and 2016 results. Some tabular information is shown for trends of three years or for five years as required under SEC regulations.

Evaluation of financial performance and average balances between 2018 and 2017 was generally impacted, though to a modest degree, from the timing and size of Nicolet’s 2017 acquisition.  The inclusion of the First Menasha Bancshares, Inc. (“First Menasha”) balance sheet (at about 20% of Nicolet’s then pre-merger asset size) and operational results for 12 months in 2018 and 8 months in 2017, analytically explains a portion of the increase in certain average balances and income statement line items between 2018 and 2017, and there was approximately $0.5 million of non-recurring direct merger expense in 2017 noninterest expense. At consummation in April 2017, First Menasha added $480 million in assets, loans of $351 million, deposits of $375 million, core deposit intangible of $4 million and goodwill of $41 million, for a total purchase price that included $62 million of common equity (or 1.3 million shares) and $19 million of cash. Additionally, the tax expense comparison between 2018 and 2017 was impacted by the Tax Cuts and Jobs Act passed on December 22, 2017, with 2018 tax expense favorably affected by the lower corporate tax rate (from 35% to 21%, effective January 1, 2018), and 2017 tax expense unfavorably affected by $0.9 million related to write-downs associated with the impact of the new tax law on deferred tax assets and investment securities.

Overview

Nicolet provides a diversified range of traditional commercial and retail banking services, as well as wealth management services, to individuals, business owners, and businesses in its market area primarily through, as of year-end 2018 , the 38 bank branch offices of its banking subsidiary, located in northeast and central Wisconsin and Menominee, Michigan.

In 2018 , Nicolet delivered on organic growth, asset quality, capital management and profitability.  At December 31, 2018 , Nicolet had total assets of $3.1 billion , loans of $2.2 billion , deposits of $2.6 billion and stockholders’ equity of $387 million , representing increases over December 31, 2017 of 6% , 4% , 6% and 6% , in assets, loans, deposits and total equity, respectively.  While Nicolet has used acquisitions as part of its growth strategy over the past few years and has successfully integrated and realized cost efficiencies related to scale quickly after each acquisition, the growth between year-end 2018 and 2017 was fully organic. Asset quality improved from an already strong level, with net charge-offs to average loans of 0.05% for 2018 ( 0.08% for 2017 ) and nonperforming assets to assets of 0.19% at December 31, 2018 (down from 0.49% at year-end 2017 ). Nicolet repurchased nearly 408,100 shares of common stock for $22.2 million in 2018 under Nicolet’s common stock repurchase program.  At December 31, 2018 there remained $7.7 million authorized under the repurchase program which Nicolet may from time to time repurchase shares in the open market or through block transactions as market conditions warrant or in private transactions as an alternative use of capital. With total stockholders’ equity to assets of 12.49% at year-end 2018 (largely from earnings exceeding stock repurchases for the year), Nicolet has capacity to act on targets of interest in relevant markets that provide a path to or support our position as the lead-local community bank.

For 2018 , net income attributable to Nicolet was $41.0 million ( 24% higher than 2017 ), and return on average assets was 1.38% (compared to 1.25% for 2017 ). Diluted earnings per common share for 2018 was $4.12 ( $0.79 or 24% higher than 2017 ), with increased earnings and flat diluted average shares, aided by common stock repurchases in 2018 offsetting the acquisition shares issued in mid-2017.

Net income before taxes was $54.8 million ( 10% higher than 2017 ), on overall stronger revenues, lower provision for loan losses and controlled expenses. Net interest income increased $7.9 million or 8% over 2017 , as we exercised discipline in the consistently rising rate environment of 2018 . Interest income grew $16.3 million (overcoming $4.2 million lower aggregate discount income on purchased loans), aided by a 14% increase in average interest-earning assets and the elevated rate environment particularly on new, renewed and variable rate loans. Interest expense increased $8.4 million , primarily due to rising rates on a larger average deposit base, up 13% over 2017 . Noninterest income, excluding net asset gains, increased $5.7 million ( 18% over 2017 ), most notably in trust and brokerage fees combined (up $1.8 million or 15%), card interchange income (up $1.0 million or 22%), and net mortgage income (up $1.0 million or 18%) benefiting from increased business, and BOLI income (up $0.6 million, largely due to a death benefit in third quarter 2018). Noninterest expense increased $8.4 million or 10% , on the larger operating base and given continued investment in people and improvements. Personnel expense increased (up $5.0 million or 11% over 2017 ), partly due to the full period contribution of the expanded workforce (with average full-time equivalent employees up 6% between the years), as well as merit increases, additional competitive market-based wage increases made after tax reform passed, higher cash and equity incentives, and higher health costs. Non-personnel expenses also increased on a combined basis (up $3.4 million or 9% ), mostly due to the larger operating base, but also from $0.6 million higher charitable giving, $0.6 million accelerated

depreciation given branch facility upgrades, and a $0.5 million fraud contingency loss in fourth quarter 2018. Tax expense declined (down $2.8 million or 17% versus 2017 ), despite 10% higher pre-tax earnings. The 2018 effective tax rate was 24.5% , due mostly to the lower corporate tax rate, compared to 32.7% for 2017 , which carried a higher corporate tax rate, an unfavorable $0.9 million adjustment (related to write-downs associated with the impact of the new tax law on deferred tax assets and investment securities), and a favorable $1.9 million benefit (the tax impact of large option exercises, particularly in the fourth quarter).

For 2019, Nicolet’s focus will remain on achieving strong organic growth in loans, deposits, wealth management services and other revenue lines within all our markets, in a cost-effective, profitable manner to sustain a healthy return on average assets. Acquisition growth remains a key goal, and we are well-positioned to capitalize on the opportunities in bank consolidations. That said, when evaluating transactions, quantitative and qualitative factors need to make sense in combination with each other, including but not limited to the economics of the transaction, cultural and strategic fit, geographic and business line relevance, and current or potential talent. Additional resources are planned for innovation preparedness efforts, personnel expenses (in support of growing talent and leadership), and for capital investment related to two existing branch locations in 2019.  Nicolet believes delivering strong earnings, return on assets, and disciplined capital management in 2019 will provide upward pressure on our common stock performance throughout the year.

INCOME STATEMENT ANALYSIS

Net Interest Income

Net interest income in the consolidated statements of income (which excludes any tax-equivalent adjustment) was $106.6 million in 2018, up $7.9 million or 8% compared to $98.7 million in 2017, aided partly by the timing of the 2017 acquisition and overcoming $4.2 million lower aggregate discount accretion between the years. Tax-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 21% tax rate in 2018 and a 35% rate in 2017) were $1.2 million for 2018 and $2.4 million for 2017, resulting in tax-equivalent net interest income of $107.8 million for 2018 and $101.1 million for 2017. Had both years been subject to the 21% tax rate, the tax-equivalent adjustment would have been down $0.1 million or 6%, led mostly by the 7% decline in average tax-exempt investment securities.

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.

Net interest income is the primary source of Nicolet’s revenue, and is the difference between interest income on earning assets, such as loans and investment securities, 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, mix and composition of interest-earning assets and interest-bearing liabilities, including characteristics such as the fixed or variable nature of the financial instruments, contractual maturities, and repricing frequencies.

Tables 1 , 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.