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PALMETTO BANCSHARES, INC.

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PART 1. FINANCIAL INFORMATION

Item 1. Financial Statements

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Notes To Consolidated Interim Financial Statements

1.   GENERAL

Principles of Consolidation and Nature of Operations

The foregoing unaudited consolidated financial statements include accounts of Palmetto Bancshares, Inc. (defined collectively with its subsidiaries as the "Company"), its wholly owned subsidiary, The Palmetto Bank (the "Bank"), and Palmetto Capital, Inc. ("Palmetto Capital"), the Bank's wholly owned subsidiary. The Bank provides a full range of banking services including, but not limited to, taking deposits and making loans. Palmetto Capital offers the brokerage of stocks, bonds, mutual funds and unit investment trusts. Palmetto Capital also offers advisory services and variable rate annuities. The Company's primary market area is the upstate of South Carolina.

In management's opinion, all significant intercompany accounts and transactions have been eliminated, and all adjustments necessary for a fair presentation of the results for interim periods presented have been included.  Any such adjustments are of a normal and recurring nature. The Company operates as one business segment. Assets held by Palmetto Bancshares or its subsidiary in a fiduciary or agency capacity for customers are not included in the consolidated financial statements as such items do not represent assets of Palmetto Bancshares or its subsidiary.

Basis of Presentation

The unaudited consolidated interim financial statements are presented in accordance with the instructions for Form 10-Q.  Accordingly, certain information and footnotes required by generally accepted accounting principles for complete financial statements are not included.  The interim statements should be read in conjunction with the financial statements and footnotes thereto included in Palmetto Bancshares' Annual Report on Form 10-K for the year ended December 31, 2002.

Summary of Significant Accounting Policies

The significant accounting policies used by the Company for interim reporting are consistent with the accounting policies followed for annual financial reporting as described in Note 1 to the Palmetto Bancshares' Annual Report on Form 10-K for the year ended December 31, 2002.  There have been no changes in these policies subsequent to the year ended December 31, 2002.

Accounting Estimates and Assumptions

The accounting and reporting policies of the Company conform to accounting principles generally accepted in the United States of America and to general practices within the banking industry. In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the dates of the consolidated balance sheets for the periods presented. In addition, they affect the reporting amounts of income and expense during the reporting period as of the dates of the consolidated statements of income for the periods presented. Actual results could differ from these estimates and assumptions.  As such, the results of operations for the three months ended June 30, 2003 are not necessarily indicative of the results of operations that may be expected in future periods.

Risks and Uncertainties

In the normal course of its business the Company encounters two significant types of risk: economic and regulatory. There are three main components of economic risk: interest rate risk, credit risk and market risk. The Company is subject to interest rate risk to the degree that its interest-bearing liabilities mature or reprice at different speeds, or on different bases, than its interest-earning assets. Credit risk is the risk of default on the Company's loan portfolio that  

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results from borrowers' inability or unwillingness to make contractually required payments. Market risk reflects changes in the value of collateral underlying loans, the valuation of real estate held by the Company and the valuation of mortgage loans held for sale, investments and mortgage-backed securities available for sale and mortgage servicing rights.

The Company is subject to the regulations of various government agencies. These regulations can and do change significantly from period to period. The Company also undergoes periodic examinations by the regulatory agencies, which may subject it to further changes with respect to asset valuations, amounts of required loss allowances and operating restrictions resulting from the regulators' judgments based on information available to them at the time of their examinations.

Reclassifications

Certain amounts previously presented in the consolidated financial statements for prior periods have been reclassified to conform to current classifications. All such reclassifications had no effect on the prior years' net income or shareholders' equity as previously reported.

2.   PER SHARE INFORMATION

Basic and diluted earnings per share have been computed based on net income in the accompanying consolidated statements of income divided by the weighted average common shares outstanding or assumed to be outstanding as summarized below:

Option shares are excluded from the calculation of diluted earnings when the exercise price is greater than the average market price of the common shares.  At June 30, 2003 there were no option shares that were excluded from the calculation of diluted earnings due to the exercise price being greater than the average market price of the common shares as of that date, based on information available to the Company at that time.

3.  INTANGIBLE ASSETS

In July 2001, the FASB issued SFAS No. 141, "Business Combinations" and SFAS No. 142, "Goodwill and Other Intangible Assets." SFAS No. 141 required that all business combinations initiated after June 30, 2001 be accounted for using the purchase method. Also under SFAS No. 141, identified intangible assets acquired in a purchase business combination must be separately valued and recognized on the balance sheet if they meet certain requirements. Under SFAS No. 142, goodwill and identified intangible assets with indefinite useful lives are not subject to amortization but are to be tested for impairment on an annual basis. The Company adopted SFAS 

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No. 141 and the provisions of SFAS No. 142 relating to non-amortization and amortization of intangible assets on July 1, 2001.

Effective January 1, 2002, the Company adopted SFAS No. 142, which requires that goodwill and intangible assets with indefinite useful lives no longer be amortized; instead they must be tested for impairment at least annually in accordance with the provisions of SFAS No. 142. Goodwill and intangible assets with indefinite useful lives acquired in purchase business combinations completed before July 1, 2001 were subject to amortization through December 31, 2001, at which time amortization ceased. Intangible assets with estimable useful lives are amortized over their respective estimable useful lives to their estimable residual values and reviewed for impairment in accordance with SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets." SFAS No. 141 required the Company to evaluate its existing intangible assets that were acquired in prior purchase business combinations and make any necessary reclassifications in order to conform with the new criteria in SFAS No. 141 in terms of recognition of finite and infinite useful lives intangibles. Upon adoption of SFAS No. 142, the Company reassessed the useful lives and residual values of all intangible assets acquired.

In connection with SFAS No. 142's transitional goodwill impairment evaluation, the statement requires the Company to perform an assessment of whether there was an indication that goodwill was impaired as of the date of adoption. The Company then had six months from the date of adoption to determine the fair value of each reporting unit and compare it to the reporting unit's carrying amount. The Company completed its analysis of the fair value of its reporting units with goodwill by June 30, 2002 and was not required to provide for any transitional impairment losses.

In accordance with SFAS No. 142, the Company plans to review impairment annually and make adjustments as necessary to the carrying amount of goodwill.

The table set forth below illustrates the activity of intangible assets with finite lives, which are comprised of customer list intangibles, presented in "other assets" in the consolidated balance sheets, and the related amortization, presented in "other noninterest expense" in the consolidated statements of income, for the years noted (in thousands).

The table set forth below illustrates the activity of intangible assets with infinite lives, presented in "other assets" in the consolidated balance sheets, and the related amortization, presented in "other noninterest expense" in the consolidated statements of income, for the years noted (in thousands).

In accordance with FASB No. 72, "Accounting for Certain Acquisitions of Banking or Thrift Institutions-an amendment of APB Opinion No. 17, an interpretation of APB Opinions 16 and 17, and an amendment of FASB Interpretation No. 9,"which gave the option to differentiate between intangible assets, the intangible assets acquired in a past transaction were not differentiated 

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between indefinite and definite useful lives prior to the issuance of FASB No. 141 and No. 142 although the information to do so was available. Upon the adoption of these statements, indefinite useful life intangibles were segregated from the total balance as permitted by the pronouncements. The preceding tables have been adjusted to reflect this change.

The Company estimates that its amortization expense related to intangibles with finite lives in fiscal years 2003 through 2009 will range from $144 thousand to $33 thousand.

4.      MORTGAGE SERVICING RIGHTS

Capitalized mortgage servicing rights ("MSRs") totaled $2.1 million, $2.1 million and $2.0 million at June 30, 2003, December 31, 2002, and June 30, 2002, respectively. Amortization expense for MSRs totaled $517 thousand and $163 thousand for the three months ended June 30, 2003 and 2002, respectively. Amortization expense for MSRs totaled $937 thousand and $359 thousand for the six months ended June 30, 2003 and 2002, respectively. Amortization expense for MSRs for the twelve months ended December 31, 2002 totaled $946 thousand. Amortization expense is based on current information regarding loan payments and prepayments. Amortization expense could change in future periods based on changes in the volume of prepayments and other environmental factors. Prepayments could increase as a result of any further decline in market interest rates, leading to an increase in amortization expense.  The impairment adjustments to MSRs for the three months ended June 30, 2003 and 2002 were $87 thousand and $8 thousand, respectively. The impairment adjustments to MSRs for the six months ended June 30, 2003 and 2002 were $133 thousand and $44 thousand, respectively. The impairment adjustment to MSRs for the twelve months ended December 31, 2002 totaled $44 thousand. A valuation allowance for impairment totaling $246 thousand was required at June 30, 2003, increasing from a valuation allowance of $113 thousand required at June 30, 2002. The valuation allowance for impairment required at December 31, 2002 totaled $113 thousand.

5.      STOCK-BASED COMPENSATION

At June 30, 2003, Palmetto Bancshares had a stock-based compensation plan, which was described more fully in Note 12 of the Notes To Consolidated Financial Statements included in Palmetto Bancshares' Annual Report on Form 10-K for the year ended December 31, 2002. The Company accounts for this plan under the recognition and measurement principles of Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued to Employees," and related interpretations. Key Company employees and Company directors are eligible to participate in the stock awards plan. No stock-based compensation cost has been reflected in net income, as all stock options granted under these plans had an exercise price equal to the fair market value of the underlying common stock on the date of grant. The table set forth below illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of SFAS No. 123, "Accounting for Stock-Based Compensation," to stock-based compensation (in thousands, except share data).

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Item 2.  Management's Discussion and Analysis of Financial Condition and Results of Operations

The following discussion and analysis is presented to assist in understanding the financial condition and results of operations of Palmetto Bancshares, Inc..  This discussion should be read in conjunction with the consolidated financial statements and related notes and other financial data appearing in this report as well as the Annual Report of Palmetto Bancshares, Inc. on Form 10-K for the year ended December 31, 2002.  Results of operations for the three month period ended June 30, 2003 are not necessarily indicative of results that may be attained for any other period.  Percentage calculations contained herein have been calculated based upon actual, not rounded, results.

Palmetto Bancshares was organized in 1982 under the laws of South Carolina. Through its wholly-owned subsidiary, The Palmetto Bank, and the Bank's wholly-owned subsidiary, Palmetto Capital, Inc., the Company engages in the general banking business in the upstate South Carolina market of Laurens, Greenville, Spartanburg, Greenwood, Anderson, Cherokee, Abbeville, and Oconee counties (the "Upstate").  The Bank was organized and chartered under South Carolina law in 1906.

The Bank performs a full range of banking activities, including such services as checking, savings, money market, and other time deposits of various types of consumer and commercial depositors; loans for business, real estate, and personal uses; safe deposit box rental and various electronic funds transfer services.  The Bank also offers both individual and commercial trust services through its trust department.  Palmetto Capital is a brokerage subsidiary of the Bank, which offers customers stocks, treasury and municipal bonds, mutual funds and insurance annuities, and college and retirement planning.

FORWARD LOOKING STATEMENTS

This report contains certain forward-looking statements (as defined in the Private Securities Litigation Reform Act of 1995) to assist in the understanding of anticipated future operating and financial performance, growth opportunities, growth rates, and other similar forecasts and statements of expectations. These forward-looking statements reflect current views, but are based on assumptions and are subject to risks, uncertainties, and other factors, which may cause actual results to differ materially from those in such statements. These factors include, but are not limited to, the following:

•          risks from changes in economic, monetary policy and industry conditions;
•          changes in interest rates, deposit rates, the net interest margin and funding sources;
•          market risk and inflation;
•          risks inherent in making loans, including repayment risks and value of collateral;
•          loan growth;
•          the adequacy of the allowance for loan losses and the assessment of problem loans;
•          the Company's ability to meet its contractual obligations;
•          fluctuations in consumer spending;
•          competition in the banking industry and demand for the Company's products and services;
•          dependence on senior management;
•          level,  composition,  and repricing  characteristics of the securities portfolio;
•          technological changes;
•          ability to increase market share;
•          expense projections;
•          risks associated with income taxes, including the potential for adverse adjustments;
•          changes in accounting policies and practices;
•          costs and effects of litigation; and
•          recently-enacted or proposed legislation.
  
  

Should one or more of these risks or uncertainties materialize, or should underlying assumptions 

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prove incorrect, actual results may vary materially from those expected or projected. Any forward-looking statements speak only as of the date on which they are made. The Company undertakes no obligation to update any forward looking statement to reflect events or circumstances after the date on which such statement is made to reflect the occurrence of unanticipated events. In addition, certain statements in future filings by the Company with the Securities Exchange Commission, in press releases and in oral and written statements made by or with the approval of the Company, which are not statements of historical fact, constitute forward-looking statements.

SIGNIFICANT ACCOUNTING POLICIES

The Company considers its policies regarding its allowance for loan losses to be its most critical accounting policy due to the significant degree of management judgment exercised in relation to this estimate. The Company has developed policies and procedures for assessing the adequacy of the allowance, which requires a number of assumptions and estimates with respect to its loan portfolio. The adequacy of the allowance is analyzed on a monthly basis using an internal analysis model. For purposes of this analysis, adequacy is defined as a level sufficient to absorb probable losses in the portfolio. The Company's allowance model takes into account factors such as the composition of the loan portfolio (including risk grade classifications, based on an internally developed grading system), historical asset quality trends (including, but not limited to, previous loss experience ratios), and reviews of specific high risk sectors of the portfolio. Loans are graded at inception and are reviewed on a periodic basis to ensure that assigned risk grades are proper based on the definition of such classification. The value of underlying collateral is also considered during such analysis.  These assessments may be impacted in future periods by changes in economic conditions, the impact of regulatory examinations, and the discovery of information with respect to borrowers, which is not known to management at the time of the issuance of the consolidated financial statements.

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BALANCE SHEET REVIEW

Overview

Total assets increased by $35.0 million, or 4.2%, at June 30, 2003 as compared with December 31, 2002 and increased by $96.4 million, or 12.6%, at June 30, 2003 as compared with June 30, 2002. Liquid assets, which include cash, federal funds sold, and investments available for sale, decreased by $7.4 million, or 4.8%, at June 30, 2003 from December 31, 2002 and decreased by $10.6 million, or 6.7%, at June 30, 2003 from June 30, 2002. Total liabilities increased $30.4 million, or 4.0%, at June 30, 2003 from December 31, 2002 and increased $87.9 million, or 12.6%, at June 30, 2003 from June 30, 2002. Total shareholders' equity increased $4.6 million, or 6.8%, at June 30, 2003 from December 31, 2002 and $8.5 million, or 13.3%, at June 30, 2003 from June 30, 2002.

Securities

At June 30, 2003, the Company's investment portfolio totaled $117.2 million compared with $116.8 million and $103.8 million at December 31, 2002 and June 30, 2002, respectively.  This represents an increase of 0.3% from December 31, 2002 and a 12.9% increase from June 30, 2002. The composition of the investment portfolio at June 30, 2003 was as follows: agencies 21%, municipalities 33%, treasuries 2%, and mortgage-backed securities and other securities 44%. 

During the first six months of 2003, the Bank purchased $44.5 million of investment securities (available for sale), $32.5 million of the investment portfolio matured or was sold, resulting in a gain of $281 thousand, and $11.3 million was paid down on mortgage-backed securities.  The June 30, 2003 securities balance included $3.0 million in pre-tax unrealized gains in the portfolio.

During the first six months of 2002, the Bank purchased $50.1 million of investment securities (available for sale), $41.7 million of the investment portfolio matured or was sold, resulting in a gain of $235 thousand, and $2.9 million was paid down on mortgage-backed securities. The June 30, 2002 securities balance included $1.9 million in pre-tax unrealized losses in the portfolio.

Loans

At June 30, 2003, the Company had total loans outstanding, including held for investment loans net of related allowance and held for sale mortgage loans, of $672.6 million, which equaled 87% of total deposits, including retail repurchase agreements and commercial paper, and 78% of total assets.  Loans are the largest category of the Company's earning assets and have generally produced higher yields than other earning assets. The Company's loan portfolio consists principally of commercial loans, commercial real estate loans, consumer loans, sales finance loans, and mortgage loans.

Mortgage loans held for sale were $13.0 million at June 30, 2003 compared with $11.9 million and $4.1 million at December 31, 2002 and June 30, 2002, respectively.  This represents an increase of 9.4% from December 31, 2002 and an increase of 212.6% from June 30, 2002.  As a result of the favorable interest rate environment for mortgage loans and refinances, the Bank originated approximately $92.4 million in mortgage loans during the first six months of 2003, with substantially all being sold during the same period. The Company originates the substantial majority of its loans in its primary market area located in Upstate South Carolina. 

Loans, net of unearned income and excluding those mortgage loans held for sale, were $666.6 million at June 30, 2003 compared with $625.5 million and $570.3 million at December 31, 2002 and June 30, 2002, respectively. This represents increases of 6.6% from December 31, 2002 and 16.9% from June 30, 2002.

See "Credit Quality" for additional discussion of loan portfolio performance. 

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Allowance for Loan Losses

The adequacy of the allowance is analyzed on a monthly basis.  For purposes of this analysis, adequacy is defined as a level sufficient to absorb probable losses in the portfolio. The Bank uses an allowance model that takes into account loan risk grades, delinquency trends, and charge-off ratios as well as loan growth. Assessing the adequacy of the allowance requires considerable judgment. See "Significant Accounting Policies" for additional discussion related to the allowance for loan losses.  Management's judgments are based on numerous assumptions about current events, which management believes to be reasonable.  The allowance is subject to examination and adequacy testing by regulatory agencies. 

The allowance for loan losses totaled $7.0 million at June 30, 2003 compared with $6.4 million and $5.9 million at December 31, 2002 and June 30, 2002, respectively.  This represents an increase of 9.7% from December 31, 2002 and 19.7% from June 30, 2002.  Table 1 summarizes the changes in the allowance.

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The allowance for loan losses as a percentage of loans, excluding mortgage loans held for sale, increased to 1.05% at June 30, 2003 from 1.02% and 1.03% at December 31, 2002 and June 30, 2002, respectively. During mid-1999 management noted deterioration in the performance of the sales finance portfolio, resulting in increased charge-offs in 1999 and 2000. In the years since the discovery of the deterioration in the portfolio and these heightened charge-offs, charge-off levels have declined. In 2001 net charged-off loans declined $970 thousand from 2000.  Net charged-off loans in 2002 declined $282 thousand from 2001. Annualized (where applicable) net charge-offs as a percentage of average loans excluding mortgage loans held for sale have declined from .61% for the six month period ended June 30, 2002 to .37% for the six month period ended June 30, 2003.  Additionally, the sales finance portfolio has had relatively little growth with a balance of $16.1 million at June 30, 2003, $14.7 million at December 31, 2002 and $14.2 million at June 30, 2002.

Net charge-offs for the six months ended June 30, 2003 totaled $1.2 million, a decline from $1.7 million for the six months ended June 30, 2002.  The majority of the decline in net charge-offs over these periods was the result of a decline of $314 thousand in the commercial and industrial loan category as well as a decline in the installment loan category (excluding credit cards) of $462 thousand.  Offsetting these declines was an increase in charge-offs related to loans secured by real estate of $208 thousand.  Comparing the same periods, net charge-offs related to credit card loans remained relatively unchanged.  The decrease in charge-off activity within the commercial / industrial and installment portfolios can be attributed to the low interest rates environment, which has led to increased consumer debt incurrence and refinancing.  Additionally, the decline in charge-off activity related to the installment portfolio can also be attributed to the increased performance related to the quality of the sales finance portfolio.  The increase in charge-offs related to loans secured by real estate stems from the high levels of mortgages in the foreclosure process. The rise in foreclosures paralleled mounting job losses and personal bankruptcies in the first six months of 2003.

See "Credit Quality" for additional discussion of factors contributing to the allowance for loan losses. 

Other Assets

At June 30, 2003, other assets totaled $15.9 million compared with $15.2 million and $12.5 million at December 31, 2002 and June 30, 2002, respectively.  This represents an increase of 4.8% from December 31, 2002 and 27.4% from June 30, 2002.

At June 30, 2003, major components of other assets included the Travelers Express reserve (described below) totaling $1.9 million, net mortgage servicing rights totaling $1.9 million, pension plan assets totaling $2.8 million, other real estate owned totaling $2.2 million, and $4.2 million of intangible assets. 

At December 31, 2002, major components of other assets included the Travelers Express reserve totaling $1.9 million, net mortgage servicing rights which totaled $2.0 million, pension plan assets totaling $2.4 million, other real estate owned totaling $2.5 million, and $4.3 million of intangible assets. 

At June 30, 2002, large components contributing to the balance of $12.5 million of other assets included net mortgage servicing rights totaling $1.9 million, pension plan assets totaling $2.0 million, other real estate owned totaling $1.9 million, and $4.2 million of intangible assets.

In August 2002, the Bank established a reserve account with Travelers Express, its third party official check vendor.  Before then, Travelers Express paid checks and the Bank remitted the forwarded balance the following day, which resulted in payment of one day's interest to Travelers Express on the forwarded monies.  Establishing this reserve account eliminated the need for forwarded monies and therefore the interest payments to Travelers Express.

The recent favorable interest rate environment as well as the addition of mortgage loan originators 

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has contributed to the increase in the loan portfolio at June 30, 2003 from December 31, 2002 as well as June 30, 2002.  As noted in the "Loans" section above, originations of mortgage loans held for sale in the six months ended June 30, 2003 have totaled $92.4 million.  Since loans are typically sold servicing retained, the increase in loans originated results in increased additions to the mortgage servicing rights portfolio.  Amortization and impairment of the rights as well as loan payoffs offset these additions. 

Due to the low volume of properties within the other real estate owned portfolio, the foreclosure of new property or the sale of an existing property can cause the balance to fluctuate greatly on a monthly basis.  The other real estate owned portfolio is often reviewed in terms of lending relationships, which may contain of more than one parcel of real estate. During the first six months of 2002, six relationships were added to the portfolio totaling $1.8 million while four properties were sold totaling $135 thousand.  At June 30, 2003 there were 9 relationships within the portfolio totaling $1.9 million.  At December 31, 2002 the other real estate owned portfolio contained 12 relationships totaling $2.5 million.  From December 31, 2002 to June 30, 2003, six relationships were added to the portfolio totaling $608 thousand and five properties were sold totaling $821 thousand bringing the portfolio total to $2.2 million at June 30, 2003. 

As noted above in the "Allowance for Loan Losses" section, during mid-1999 management noted deterioration in the performance of the sales finance portfolio. In the periods following these findings, charge-offs increased and collateral was repossessed, in some cases, in conjunction with a portion of these sales finance loans. Since this discovery and the related charge-offs, the Bank has begun to experience a decrease in charge-offs (in part related to this portfolio).  In addition, the balance of repossessed automobiles has begun to decline.  Resulting from the review of the loans within the portfolio, repossessed automobiles have declined from $472 thousand at June 30, 2002 to $181 thousand at December 31, 2002 and to $151 thousand at June 30, 2003. Additionally growth within the sales finance loan portfolio has been low during this time frame.

See Note 3 of Notes To Consolidated Interim Financial Statements contained herein for a summary of intangible assets.

Deposits

At June 30, 2003, traditional deposits totaled $744.4 million compared with $722.0 million and $664.4 million at December 31, 2002 and June 30, 2002, respectively.  This represents an increase of 3.1% from December 31, 2002 and 12.0% from June 30, 2002.  Deposits remain the Bank's primary source of funds for loans and investments.  Traditional deposits provided funding for 95% of average earning assets for the six month periods ended June 30, 2003 and 2002.  Although deposit pricing competition remains very stiff, the Company feels as though it is in a good competitive position. The composition of the traditional deposit portfolio at June 30, 2003 follows: time deposits 45%, interest-bearing demand deposits 33%, noninterest-bearing deposits 16%, and savings 6%. 

Borrowed Funds

At June 30, 2003, total securities sold under agreement to repurchase totaled $12.8 million compared with $12.8 million and $17.3 million at December 31, 2002 and June 30, 2002, respectively. This represents a decrease of 0.6% from December 31, 2002 and a decrease of 26.3% from June 30, 2002.

At June 30, 2003, total commercial paper totaled $19.7 million compared with $14.8 million and $14.4 million at December 31, 2002 and June 30, 2002, respectively.  This represents an increase of 32.6% from December 31, 2002 and 36.6% from June 30, 2002.

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Other Liabilities

At June 30, 2003, other liabilities totaled $5.2 million compared with $7.8 million and $3.9 million at December 31, 2002 and June 30, 2002, respectively.  This represents a decrease of 34.5% from December 31, 2002 and an increase of 32.9% from June 30, 2002.

The decrease in other liabilities at June 30, 2003 compared with December 31, 2002 of $2.7 million is the result of fluctuations in several accounts with the majority of the change accumulated within two accounts.  Accrued expenses decreased $730 thousand from December 31, 2002 to June 30, 2003 due to the higher than usual occurrence of expenses at the end of the year as compared to typical expenses incurred during the year.  The mortgage servicing clearing account decreased $1.9 million at June 30, 2003 from December 31, 2002 constituting the majority of the fluctuation in the "other liabilities" category.  When mortgage loans are sold, funds are recorded in this account until all information is received for loan system entry.  Once all items have been received, the loan is booked on the loan system and the resulting funds are simultaneously transferred from this clearing account to the proper loan account.  Therefore, fluctuations in this account are impacted by the volume of mortgage loans held for sale, the timing of funding loans sold, and clearing backlog. 

The increase in other liabilities at June 30, 2003 compared with June 30, 2002 of $1.3 million results from the fluctuations in several accounts with the majority of the change accumulated within three accounts. Taxes relating to the unrealized gain on available for sale securities increased approximately $442 thousand due to an increase in the unrealized gain on available for sale securities at June 30, 2003 from June 30, 2002. The remaining increase in other liabilities between these two periods relates for the most part to increases in mortgage lending related accounts.  The mortgage servicing clearing account increased $450 thousand at June 30, 2003 from June 30, 2002.  As noted in the preceding paragraph, the fluctuations in this account are due to timing.  Additionally, the mortgage servicing remittance account increased $524 thousand from June 30, 2002 to June 30, 2003.  The increase in this account is also due to timing as the remittance of payments is dependent on the timing of customer payments.  The increase in this account is also due in part to the increase in serviced loans at June 30, 2003 over June 30, 2002 resulting in an increase of remittances.

Capital Resources and Dividends

Shareholders' equity totaled $72.1 million, $67.5 million, and $63.6 million at June 30, 2003, December 31, 2002, and June 30, 2002, respectively.  Shareholders' equity as a percentage of total assets was 8.38% at June 30, 2003, 8.18% at December 31, 2002 and 8.33% at June 30, 2002.   Increases in shareholders' equity resulted from retention of earnings, unrealized gains in the available for sale security portfolio, and stock option exercises offset by dividends paid. 

Book value per share was $11.35 at June 30, 2003 compared with $10.68 and $10.11 at December 31, 2002 and June 30, 2002, respectively. 

As of June 30, 2003, the Company and the Bank were in compliance with each of the applicable regulatory capital requirements and met or exceeded the "well-capitalized" regulatory guidelines.  Table 2 sets forth various capital ratios for the Company and the Bank.  The Company and the Bank are subject to certain regulatory restrictions on the amount of dividends they are permitted to pay.

At June 30, 2003, the Bank had $2.8 million of excess capital available for payment of dividends and still be considered "well-capitalized" related to the total risk based capital ratio.

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For a complete discussion of capital matters see related topics in Palmetto Bancshares' Annual Report on Form 10-K for the year ended December 31, 2002.

During May 2003 Palmetto Bancshares' Board of Directors approved a stock repurchase transaction to acquire 100 thousand shares of Common Stock. During July 2003 the transaction was consummated with Palmetto Bancshares repurchasing 100 thousand shares at a cost of $2.9 million.

Off-Balance Sheet Arrangements

The Company's off-balance sheet arrangements, which principally include lending commitments, are described below. At June 30, 2003, December 31, 2002 and June 30, 2002, the Company had no interests in non-consolidated special purpose entities. Neither Palmetto Bancshares nor the Bank is involved in other off-balance sheet contractual relationships, unconsolidated related entities that have off-balance sheet arrangements or transactions that could result in liquidity needs or other commitments or significantly impact earnings.

Lending commitments include loan commitments, standby letters of credit, and unused credit card lines. These instruments are not recorded in the consolidated balance sheet until funds are advanced under the commitments. The Company provides these lending commitments to customers in the normal course of business. The Company applies essentially the same credit policies and standards as it does in the lending process when making these commitments.

For commercial customers, loan commitments generally take the form of revolving credit arrangements to finance customer's working capital requirements. For retail customers, loan commitments are generally lines of credit secured by residential property. Unused credit card lines are generally used for short-term borrowings. At June 30, 2003, these commitments totaled $119.4 million.

Standby letters of credit represent an obligation of the Company to a third party contingent upon the 

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failure of the Company's customer to perform under the terms of an underlying contract with the third party or obligates the Company to guarantee or stand as surety for the benefit of the third party.  The underlying contract may entail either financial or nonfinancial obligations and may involve such things as the customer's delivery of merchandise, completion of a construction contract, release of a lien, or repayment of an obligation.  Under the terms of a standby letter of credit, generally, drafts will be drawn only when the underlying event fails to occur as intended.  The Company can seek recovery of the amounts paid from the borrower; however, standby letters of credit are generally not collateralized. In recent months the Company has reflected in its policy regarding such commitments that collateral is encouraged with exceptions requiring approvals. Commitments under standby letters of credit are usually for one year or less.  At June 30, 2003, the Company has recorded no liability for the current carrying amount of the obligation to perform as a guarantor and no contingent liability is considered necessary, as such amounts are not considered material.  The maximum potential amount of undiscounted future payments related to standby letters of credit at June 30, 2003 was $1.7 million.  Past experience indicates that many of these standby letters of credit will expire unused. However, through its various sources of liquidity, the Company believes that it has the necessary resources to meet these obligations should the need arise.  Additionally, current fair value of such guarantees are deemed immaterial at June 30, 2003.

The table set forth below represents the Bank's issued commitments to extend credit and unused credit card lines at June 30, 2003 (in thousands).

Generally, mortgage loan commitments are at adjustable rates that fluctuate with prime rate or are at fixed rates that approximate market rates. The current amounts of these commitments approximate their fair value and are not deemed material.

Liquidity

Liquidity management ensures that adequate funds are available to meet deposit withdrawals, fund loan and capital expenditure commitments, maintain reserve requirements, pay operating expenses, provide funds for dividends, and manage operations on an ongoing basis.  Funds are primarily provided by the Bank through customer deposits, principal and interest payments on loans, loan sales, securities available for sale, maturities of securities, and earnings.

Proper liquidity management is crucial to facilitate the Company's ability to take advantage of new opportunities as well as meet the demands of its customers.  In this process, the Company focuses on assets and liabilities and on the manner in which they combine to provide adequate liquidity to meet the Company's needs.

Investment securities are an important tool to the Company's liquidity management.  Securities classified as available for sale may be sold in response to changes in interest rates, liquidity needs, and/or significant prepayment risk.

Net cash provided by operations and deposits from customers have been the primary sources of liquidity for the Company.  Liquidity is also enhanced by the ability to acquire new deposits through the Bank's established network of 30 branches in South Carolina.

The Bank has access to borrowings from the FHLB and maintains short-term lines of credit. At June 30, 2003, the Bank had approximately $85 million of unused borrowing capacity from the FHLB. The Bank has pledged assets to be used as collateral if the Bank takes advantage of the FHLB line of credit.  At June 30, 2003, the Bank had unused short-term lines of credit totaling approximately $31.1 

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million (which are withdrawable at the lender's option). Management believes that these sources are adequate to meet its liquidity needs and to maintain the liquidity ratio within policy guidelines.

The Company's cash needs include general operating expenses and the payment of dividends and interest on borrowings.  The Company currently has no long-term debt outstanding and has declared and paid cash dividends totaling $0.12 per share in the three month period ended June 30, 2003 and $0.24 per share in the six month period ended June 30, 2003.  Although there can be no guarantee that additional dividends will be paid in 2003, the Company plans to continue its quarterly dividend payments.

In the normal course of business, to meet the financial needs of its customers, the Company, principally through the Bank, enters into agreements to extend credit. For amounts and types of such agreements at June 30, 2003, see "Off-Balance Sheet Arrangements." Increased demand for funds under these agreements would reduce the Company's liquidity and could require additional sources of liquidity.

Credit Quality

A willingness to take credit risk is inherent in the decision to grant credit. Prudent risk-taking requires a credit risk management system based on sound policies and control processes that ensure compliance with those policies. Adherence to underwriting standards is managed through a multi-layered credit approval process and review of loans approved by lenders. Through loan review, reviews of exception reports, and ongoing analysis of asset quality trends, compliance with loan monitoring policies is managed.

Table 3 presents information pertaining to nonperforming assets.

Similar to other parts of the country, in recent years the markets served by the Company have experienced a moderately slowing economy with higher bankruptcy filings and higher delinquency 

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rates.  Although there have been signs of a recovery, the rise in foreclosures of the first six months of 2003 paralleled mounting job losses and personal bankruptcies. Until sectors of the economy improve (employment, consumer spending, etc), credit quality indicators will remain volatile. While current economic data seems to be signaling improvement (The Consumer Confidence Index remained steady at 83.5 in June, following a revised 83.6 in May and two previous monthly increases), the outlook remains uncertain.

Other real estate owned increased $340 thousand at June 30, 2003 from June 30, 2002.  This increase is attributed to several properties acquired in settlement of loans that have not yet been sold due to market conditions. Additionally, nonaccrual loans have increased $1.4 million over the same time frame. Prior to recent times that have seen increased bankruptcies and job losses, more flexibility was given for borrowers to make payments when they became delinquent. Since that time, the Company has been applying more strict collection policies to such loans.  The Company believes in most of these nonaccrual loan cases, collateral is sufficient to cover any potential losses.  As a result, the Company has been more proactive in advancing loans to nonaccrual status as a step toward foreclosure, and has ceased payment negotiations that typically took place in the past.  

The Bank uses an allowance model that takes into account loan risk grades, delinquency trends, and charge-off ratios as well as loan growth. Assessing the adequacy of the allowance requires considerable judgment. Management's judgments are based on numerous assumptions about current events, which management believes to be reasonable. Management believes, however, that, although the Company has seen an increase in both nonaccrual loans and other real estate owned at June 30, 2003 from June 30, 2002, loss exposure in the Company's loan portfolio is identified, adequately reserved in a timely manner, and closely monitored to ensure that changes are promptly addressed in its analysis of allowance adequacy. Accordingly, management believes the allowance as of June 30, 2003 is adequate, based on its assessment of probable losses, and available facts and circumstances then prevailing. Additionally, management believes that there will always remain a core level of delinquent loans and real estate and personal property acquired in settlement of loans from normal lending operations.  With this in mind, long term Bank goals include the management of problem assets.

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EARNINGS REVIEW

COMPARISON OF THE RESULTS OF OPERATIONS FOR THE THREE MONTHS ENDED JUNE 30, 2003 AND 2002

Overview

Net income for the three months ended June 30, 2003 totaled $2.7 million, up 9.0% compared with $2.5 million for the second quarter of 2002. Earnings per diluted share for second quarter 2003 were $0.42, a 10.5% increase from $0.38 per diluted share in the second quarter 2002. Earnings per basic share for the second quarter 2003 were $0.43, a 7.5% increase from $0.40 per basic share for second quarter 2002.

Average common shares outstanding on a diluted basis were 6,498,919 for second quarter 2003, up 0.52% from 6,465,218 for second quarter 2002. Average common shares outstanding on a basic basis were 6,346,105 for second quarter 2003, up slightly from 6,293,765 for second quarter 2002.

Net interest income after the provision for loan losses for the three months ended June 30, 2003 and 2002 was $8.1 million and $7.4 million, respectively, an increase of 8.4%.  Noninterest income for the three months ended June 30, 2003 totaled $3.8 million, up 6.6% compared with $3.6 million for second quarter 2002. Noninterest expense for the three months ended June 30, 2003 increased $551 thousand from the three month period ended June 30, 2002.

Net Interest Income

Net interest income is the difference between gross interest and fees on earning assets, primarily loans and investment securities and interest paid on deposits and other interest-earning liabilities. The net interest margin measures how effectively a company manages the difference between the yield on earning assets and the rate paid on funds to support those assets. Fully tax-equivalent net interest income adjusts the yield for assets earning tax exempt income to a comparable yield on a taxable basis.  Table 4 presents average balance sheets and a net interest income analysis on a tax-equivalent basis for the three months ended June 30, 2003 and 2002.

Fully tax-equivalent net interest income for second quarter 2003 increased $461 thousand, or 5.3%, to $9.2 million from $8.7 million for second quarter of 2002. The fully tax-equivalent net interest margin decreased to 4.64% in the second quarter of 2003 from 4.93% in the second quarter of 2002.

Average earning assets grew $84.3 million, or 11.9%, to $791.4 million for second quarter 2003 from $707.1 million for second quarter of 2002, primarily from the growth of loans and investment securities offset by a decline in federal funds sold. Average loans, including mortgage loans held for sale, were $668.6 million for second quarter 2003 compared with $567.4 million for second quarter 2002. Average investment securities, including the average net unrealized securities gains, increased from $101.9 million for second quarter of 2002 to $111.5 million for second quarter 2003.

Average earning traditional deposits increased from $560.1 million for second quarter 2002 to $622.0 million for second quarter 2003. Average other interest-earning liabilities increased to $36.0 million for second quarter 2003 from $33.6 million for second quarter 2002.

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The underlying factor for the changes in the yields and rates on earning assets and costing liabilities has been the action of the Federal Reserve Open Market Committee during the past 30 months. From January 2001 through the end of June 2003, the Federal Reserve cut interest rates 5.50%.  Variable rate loans typically repriced immediately following changes in interest rates by the Federal Reserve. During second quarter 2003 as compared with second quarter 2002, the net interest margin declined  primarily from decreasing yields of the loan and securities portfolios which was a direct result of the interest rate environment only partially offset by repricing certificates of deposits at lower rates.   The weighted average yield of the loan portfolio decreased from 7.28% for second quarter 2002 to 6.46% for second quarter 2003. The weighted average yield of the securities portfolio decreased from 5.06% for second quarter 2002 to 3.79% for second quarter 2003.   As the Company reduced its interest rates during the year, the decline in the earning asset yield outpaced the decline in the funding source rate.

Provision for Loan Losses

The allowance for loan losses is increased by charges to current period operations, through the provision for loan losses, when, based on the Company's allowance model, the balance is deemed insufficient to absorb probable losses in the portfolio at the balance sheet date.  The provision for loan losses was $900 thousand for second quarter 2003 as compared with $1.0 million for second quarter 2002. The provision is adjusted each month to reflect loan volume growth and allow for loan charge‑offs, recoveries and other factors that impact management's assessment of the adequacy of the allowance for loan losses.  Management's objective is to maintain the allowance for loan losses at an adequate level to cover probable losses in the portfolio.  Additions to the allowance for loan losses are based on management's evaluation of the loan portfolio under current economic conditions, past loan loss experience, and such other factors, which in management's judgment deserve recognition in estimating loan losses.

During mid-1999 management noted deterioration in the performance of the sales finance portfolio that resulted in increased charge-offs during 1999 and 2000. Higher charge-offs in this portfolio contributed to the increase in the provision for loan losses in recent years. However, annualized second quarter net charge-offs as a percentage of average loans excluding mortgage loans held for sale have begun to decline and were .40% for the quarter ended June 30, 2003 compared with .63% for the quarter ended June 30, 2002.  This decline in charge-offs effects historical charge-off ratios, which are factors within the Company's allowance model. See "Allowance for Loan Losses" for discussion of such factors and their effects on the allowance for loan losses and the provision for loan losses.

While management uses the best information available to make evaluations, future adjustments to the allowance in the form of provisions through the income statement may be necessary if economic conditions differ substantially from the assumptions used in making the evaluation.  The allowance for loan losses is subject to periodic evaluation by various regulatory authorities and may be subject to adjustment, based upon information that is available to them at the time of their examination.

NonInterest Income and Expense

Noninterest income for second quarter 2003 increased $235 thousand, or 6.6%, to $3.8 million from $3.6 million for second quarter 2002.  Noninterest expense for second quarter 2003 increased $551 thousand, or 7.5%, to $7.9 million at the end of second quarter 2003.

Major contributors to the increase in noninterest income for the three months ended June 30, 2003 from the same period ended 2002 were increases in service changes on deposit accounts totaling $235 thousand and gains on sales of mortgage loans totaling $142 thousand.  The increase in gains on sales of loans in second quarter 2003 as well as higher levels of gains in recent previous quarters are attributable to the increased originations and refinances of mortgage loans resulting from low mortgage loan interest rates.  Should interest rates increase, the level of originations and refinances of mortgage loans may decline which may result in gains on sales of mortgage loans being lower than

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recent results.  Offsetting these increases was a decline in other noninterest income totaling $297 thousand.  The main component of the decline in other noninterest income was the increase in mortgage servicing rights amortization, which reduces servicing fee income, during second quarter 2003 from the same period of 2002.  Due to several factors including, but not limited to, the increased prepayment speeds attributable to current market interest rates, amortization expense on servicing rights increased $354 thousand in the quarter ended June 30, 2003 from the quarter ended June 30, 2002.  Additionally, the Company recorded an impairment reserve against the carrying value of servicing rights during the 2003 quarter of $87 thousand, an increase of $79 thousand from the second quarter 2002 impairment of $8 thousand.

The increase within noninterest expense for the three months ended June 30, 2003 from the three months ended June 30, 2002 was the result of fluctuations in several accounts with the majority of the change accumulated within two financial statement line items, salaries and other personnel expense and furniture and equipment expense, which increased $455 thousand and $170 thousand, respectively for the three months ended June 30, 2003 from the same period ended June 30, 2002.

The increase in salaries and other personnel expense for the three month period ended June 30, 2003 compared with the same period of 2002 is due to increased staffing in various operation and retail areas as well as annual raises. The increase in furniture and equipment expense is due to additional expense related to new item processing hardware, software, and the related installations the first payment of which was made in July 2002.

Income Taxes

Income tax expense attributable to income from continuing operations increased to $1.3 million for second quarter 2003 from $1.2 million for second quarter 2002. The effective income tax rate was 32% for second quarter 2003 and 33% for second quarter 2002.

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COMPARISON OF THE RESULTS OF OPERATIONS FOR THE SIX MONTHS ENDED JUNE 30, 2003 AND 2002

Overview

Net income for the six month period ended June 30, 2003 totaled $5.6 million, up 13.6% compared with $4.9 million for the same six month period of 2002. Earnings per diluted share for the six month period ended June 30, 2003 were $0.87, a 14.5% increase from $0.76 per diluted share in the same period of 2002. Earnings per basic share for the six month period ended June 30, 2003 were $0.89, a 12.7% increase from $0.79 per basic share for the same six month period of 2002.

Average common shares outstanding on a diluted basis were 6,483,582 for the six month period ended June 30, 2003, up 0.34% from 6,461,727 for the same six month period of 2002. For the six month period ended June 30, 2003 average common shares outstanding on a basic basis were 6,336,455, up slightly from 6,290,529 for the first six months of 2002.

Net interest income after the provision for loan losses for the six months ended June 30, 2003 and 2002 was $16.1 million and $14.9 million, respectively, an increase of 8.3%.  Noninterest income for the six months ended June 30, 2003 totaled $7.3 million, up 4.9 % compared with $6.9 million for the first six months of 2002. Noninterest expense for the six months ended June 30, 2003 increased $607 thousand from the six month period ended June 30, 2002.

Net Interest Income

Net interest income is the difference between gross interest and fees on earning assets, primarily loans and investment securities and interest paid on deposits and other interest-earning liabilities. The net interest margin measures how effectively a company manages the difference between the yield on earning assets and the rate paid on funds to support those assets. Fully tax-equivalent net interest income adjusts the yield for assets earning tax exempt income to a comparable yield on a taxable basis.  Table 5 presents average balance sheets and a net interest income analysis on a tax-equivalent basis for the six months ended June 30, 2003 and 2002.

Fully tax-equivalent net interest income for the first six months of 2003 increased $937 thousand, or 5.4%, to $18.3 million from $17.3 million for the first six months of 2002. The fully tax-equivalent net interest margin decreased to 4.73% for the first half of 2003 from 5.02% for the first half of 2002.

Average earning assets grew $83.5 million, or 12.0%, to $779.8 million for the first six months of 2003 from $696.2 million for the first six months of 2002, primarily from the growth of loans and investment securities offset by a decline in federal funds sold. Average loans, including mortgage loans held for sale, were $655.6 million for the first six months of 2003 compared with $566.5 million for same period of 2002. Average investment securities, including the average net unrealized securities gains, increased from $102.7 million for the first half of 2002 to $111.7 million for the same period of 2003.

Average earning traditional deposits increased from $556.0 million for first six months of 2002 to $616.5 million for first six months of 2003. Average other interest-earning liabilities increased to $35.0 million for the six months ended June 30, 2003 from $31.8 million for the same period of 2002.

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The underlying factor for the changes in the yields and rates on earning assets and costing liabilities has been the action of the Federal Reserve Open Market Committee during the past 30 months. From January 2001 through the end of June 2003, the Federal Reserve cut interest rates 5.50%.  Variable rate loans typically repriced immediately following changes in interest rates by the Federal Reserve. During the six months ended June 30, 2003 as compared with the same period of 2002, the net interest margin declined primarily from decreasing yields of the loan and securities portfolios which was a direct result of the interest rate environment only partially offset by repricing certificates of deposits at lower rates. The weighted average yield of the loan portfolio decreased from 7.41% for the six month period ended June 30, 2002 to 6.61% for the same period of 2003. The weighted average yield of the securities portfolio decreased from 5.26% for the six month period ended June 30, 2002 to 4.05% for the same period of 2003.   As the Company reduced its interest rates during the year, the decline in the earning asset yield outpaced the decline in the funding source rate.

Provision for Loan Losses

The allowance for loan losses is increased by charges to current period operations, through the provision for loan losses, when, based on the Company's allowance model, the balance is deemed insufficient to absorb probable losses in the portfolio at the balance sheet date.  The provision for loan losses was $1.8 million for first six months of 2003 as compared with $1.9 million for the first six months of 2002. The provision is adjusted each month to reflect loan volume growth and allow for loan charge‑offs, recoveries and other factors that impact management's assessment of the adequacy of the allowance for loan losses.  Management's objective is to maintain the allowance for loan losses at an adequate level to cover probable losses in the portfolio.  Additions to the allowance for loan losses are based on management's evaluation of the loan portfolio under current economic conditions, past loan loss experience, and such other factors, which in management's judgment deserve recognition in estimating loan losses.

During mid-1999 management noted deterioration in the performance of the sales finance portfolio that resulted in increased charge-offs during 1999 and 2000. Higher charge-offs in this portfolio contributed to the increase in the provision for loan losses in recent years. However, annualized year-to-date net charge-offs as a percentage of average loans excluding mortgage loans held for sale have begun to decline and were .61% for the six month period ended June 30, 2002 compared with .37% for the six month period ended June 30, 2003.  This decline in charge-offs effects historical charge-off ratios, which are factors within the Company's allowance model. See "Allowance for Loan Losses" for discussion of such factors and their effects on the allowance for loan losses and the provision for loan losses.

NonInterest Income and Expense

Noninterest income for the six month period ended June 30, 2003 increased $338 thousand, or 4.9%, to $7.3 million from $6.9 million for the six month period ended June 30, 2002.  Noninterest expense for first six months of 2003 increased $607 thousand, or 4.2%, to $15.1 million at the end of the six month period ended June 30, 2003.

Major contributors to the increase in noninterest income for the six months ended June 30, 2003 from the same period ended 2002 were increases in service changes on deposit accounts totaling $414 thousand and gains on sales of mortgage loans totaling $256 thousand.  The increase in gains on sales of loans during the first six months of 2003 as well as higher levels of gains in recent previous quarters are attributable to the increased originations and refinances of mortgage loans resulting from low mortgage loan interest rates.  Should interest rates increase, the level of originations and refinances of mortgage loans may decline which may result in gains on sales of mortgage loans being lower than recent results.  Offsetting these increases was a decline in other noninterest income totaling $467 thousand.  The main component of the decline in other noninterest income was the increase in mortgage servicing rights amortization, which reduces servicing fee income, during the first six months of 2003 from the same period of 2002.  Due to several factors including, but not 

30

limited to, the increased prepayment speeds attributable to current market interest rates, amortization expense on servicing rights increased $578 thousand in the six month period ended June 30, 2003 from the six month period ended June 30, 2002.  Additionally, the Company recorded an impairment reserve against the carrying value of servicing rights during the first six months of 2003 of $133 thousand, an increase of $89 thousand from the same period of 2002 impairment of $44 thousand.

The increase within noninterest expense for the six month period ended June 30, 2003 from the six month period ended June 30, 2002 was the result of increases in several accounts with the majority of the change accumulated within two financial statement line items, salaries and other personnel expense and furniture and equipment expense, offset by a decrease in other noninterest expense.  Salaries and other personnel expense increased $446 thousand during the six month period ended June 30, 2003 compared with the same of period of 2002. Furniture and equipment expense increased $348 thousand during the six month period ended June 30, 2003 compared with the same of period of 2002.   Offsetting these increases was a decrease in other noninterest expense of $156 thousand when comparing the same periods. The increase in salaries and other personnel expense for the six month period ended June 30, 2003 compared with the same period of 2002 is due to increased staffing in various operation and retail areas as well as annual raises.  The increase in furniture and equipment expense is due to additional expense related to new item processing hardware, software, and the related installations the first payment of which was made in July 2002.

Income Taxes

Income tax expense attributable to income from continuing operations increased to $2.7 million for the six months ended June 30, 2003 from $2.4 million for same period of 2002. The effective income tax rate was 32% for six months ended June 30, 2003 and 33% for same period of 2002.

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ACCOUNTING AND REPORTING MATTERS

In November 2002, the FASB issued FASB Interpretation ("FIN") No. 45, "Guarantors Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others." This Interpretation elaborates on the disclosures to be made by a guarantor in its interim and annual financial statements about its obligations under certain guarantees that it has issued. It also clarifies that a guarantor is required to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. This Interpretation does not prescribe a specific approach for subsequently measuring the guarantor's recognized liability over the term of the related guarantee. This Interpretation also incorporates, without change, the guidance in FASB Interpretation No. 34, "Disclosure of Indirect Guarantees of Indebtedness of Others," which is being superseded. FIN No. 45 requires that the initial recognition and initial measurement provisions of the Interpretation be applied on a prospective basis to guarantees issued or modified after December 31, 2002. Disclosure requirements of the Interpretation are effective for financial statements of interim or annual periods ending after December 15, 2002. The Company adopted the initial recognition and initial measurement provisions of FIN 45 effective as of January 1, 2003 and adopted the disclosure requirements effective as of December 31, 2002. No contingent liability was determined to be necessary relating to Company's obligation to perform as a guarantor, since such amounts are not considered material.

In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based Compensation-Transition and Disclosure-an amendment of FASB Statement No. 123." This Statement amends FASB Statement No. 123, "Accounting for Stock-Based Compensation," to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, this statement amends the disclosure requirements of Statement 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The Company adopted this standard effective December 31, 2002 and has included the required disclosures in this Quarterly Report on Form 10-Q for the quarter ended June 30, 2003. As of June 30, 2003, the Company has not elected the fair value treatment of stock-based compensation. Therefore, the adoption of this standard had no impact on the financial position or the results of operations of the Company.

In January 2003, the FASB issued FASB Interpretation No. 46, "Consolidation of Variable Interest Entities" ("FIN 46"), which addresses consolidation by business enterprises of variable interest entities. Under FIN 46, an enterprise that holds significant variable interest in a variable interest entity but is not the primary beneficiary is required to disclose the nature, purpose, size, and activities of the variable interest entity, its exposure to loss as a result of the variable interest holder's involvement with the entity, and the nature of its involvement with the entity and date the involvement began. The primary beneficiary of a variable interest entity is required to disclose the nature, purpose, size, and activities of the variable interest entity, the carrying amount and classification of consolidated assets that are collateral for the variable interest entity's obligations, and any lack of recourse by creditors (or beneficial interest holders) of a consolidated variable interest entity to the general creditors (or beneficial interest holders) of a consolidated variable interest entity to the general creditor of the primary beneficiary. FIN 46 is effective for the first fiscal year or interim period beginning after June 15, 2003. The impact to the Company upon adoption is currently not known.

In April 2003, the FASB issued SFAS No. 149, "Amendment of Statement 133 on Derivative Instruments and Hedging Activities." This Statement amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts (collectively referred to as derivatives) and for hedging activities under SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities." This Statement amends Statement 133 for decisions made (1) as part of the Derivatives Implementation Group process that effectively required amendments to Statement 133, (2) in connection with other Board projects dealing with

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 financial instruments, and (3) in connection with implementation issues raised in relation to the application of the definition of a derivative, in particular, the meaning of an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors, the meaning of underlying, and the characteristics of a derivative that contains financing components. The changes in this Statement improve financial reporting by requiring that contracts with comparable characteristics be accounted for similarly. This Statement is effective for contracts entered into or modified after June 30, 2003, except as stated below and for hedging relationships designated after June 30, 2003. In addition, except as stated below, all provisions of this Statement should be applied prospectively. The provisions of this Statement that relate to Statement 133 Implementation Issues that have been effective for fiscal quarters that began prior to June 15, 2003, should continue to be applied in accordance with their respective effective dates. In addition, provisions of the statement which relate to forward purchases or sales of when-issued securities or other securities that do not yet exist, should be applied to both existing contracts and new contracts entered into after June 30, 2003. At June 30, 2003, the Company has no embedded derivative instruments.  The Company has freestanding derivative instruments consisting of fixed rate conforming loan commitments.  The commitments to originate fixed rate conforming loans were not material at June 30, 2003. The Company does not currently engage in hedging activities.  The Company adopted the provisions of SFAS No. 149 on June 30, 2003, which had no impact on the financial position or results of operations of the Company.

In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity." SFAS No. 150 establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances.) Many of those instruments were previously classified as equity. SFAS No. 150 is generally effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. The Company adopted the provisions of SFAS No. 150, which did not have a material impact on the financial position or results of operations of the Company.

In June 2003, the American Institute of Certified Public Accountants (AICPA) issued an exposure draft of a proposed Statement of Position (SOP), "Allowance for Credit Losses." The proposed SOP addresses the recognition and measurement by creditors of the allowance for credit losses related to all loans, as that term is defined in SFAS No. 114, "Accounting by Creditors for Impairment of a Loan." The proposed SOP provides that the allowance for credit losses reported on a creditor's balance sheet should consist only of (1) a component for individual loan impairment recognized and measured pursuant to FASB Statement No. 114 and (2) one or more components of collective loan impairment recognized pursuant to FASB Statement No. 5, "Accounting for Contingencies," and measured in accordance with the guidance in the proposed SOP. The provisions of the proposed SOP would be effective for financial statements for fiscal years beginning after December 15, 2003, with earlier application permitted. The effect of initially applying the provisions of the proposed SOP would be reported as a change in accounting estimate.  Comments on the exposure draft are due by September 19, 2003.  Although the effect on the financial position or results of operations of the Company related to the adoption of this proposed SOP have not been determined, adoption is expected to have a material impact on the Company.

Other accounting standards that have been issued or proposed by the FASB or other standards-setting bodies that do not require adoption until a future date are not expected to have a material impact on the financial position or the results of operations of the Company upon adoption.

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Item 3.  Quantitative and Qualitative Disclosures about Market Risk

Market risk is the risk of loss from adverse changes in market prices and rates.  The Company's market risk arises principally from interest rate risk inherent in its lending, deposit, borrowing and investing activities.  Management actively monitors and manages its inherent rate risk exposure. Although the Company manages other risks, such as credit quality and liquidity risk, in the normal course of business, management considers interest rate risk to be its most significant market risk. This risk could potentially have the largest material effect on the Company's financial condition and results of operations.  Other types of market risks, such as foreign currency exchange rate risk and commodity price risk, do not arise in the normal course of the Company's business activities.

The Company's profitability is affected by fluctuations in interest rates.  Management's goal is to maintain a reasonable balance between exposure to interest rate fluctuations and earnings.  A sudden and substantial increase or decrease in interest rates may adversely impact the Company's earnings to the extent that the interest rates on interest-earning assets and interest-bearing liabilities do not change at the same speed, to the same extent or on the same basis.  The Company monitors the impact of changes in interest rates on its net interest income using several tools.

At June 30, 2003, management believes that there have been no significant changes in market risk as disclosed in Palmetto Bancshares' Annual Report on Form 10-K for the year ended December 31, 2002.

The Bank's goal is to minimize interest rate risk between interest-bearing assets and liabilities at various maturities through its Asset-Liability Management ("ALM").  ALM involves managing the mix and pricing of assets and liabilities in the face of uncertain interest rates and an uncertain economic outlook.  It seeks to achieve steady growth of net interest income with an acceptable amount of interest rate risk and sufficient liquidity.  The process provides a framework for determining, in conjunction with the profit planning process, which elements of the Company's profitability factors can be controlled by management.  Understanding the current position and implications of past decisions is necessary in providing direction for the future financial management of the Company.  The Company uses an asset-liability model to determine the appropriate strategy for current conditions.

Interest sensitivity management is part of the asset-liability management process.  Interest sensitivity gap ("GAP") is the difference between total rate sensitive assets and rate sensitive liabilities in a given time period.  The Company's rate sensitive assets are those repricing within one year and those maturing within one year.  Rate sensitive liabilities include insured money market accounts, savings accounts, interest-bearing transaction accounts, time deposits and borrowings.  The profitability of the Company is influenced significantly by management's ability to manage the relationship between rate sensitive assets and liabilities.

The following table is a summary of the Company's one year gap (dollars in thousands):

The above analysis does not take in to account any prepayments on mortgages, consumer or other loans, or securities.  All maturities are stated in contractual terms.  The Company's current GAP analysis reflects that in periods of increasing or decreasing interest rates, rate sensitive assets will reprice slower than rate sensitive liabilities. The Company's GAP analysis also shows that at the interest repricing of one year, the Company's net interest margin would be adversely impacted by an increase in market interest rates. This analysis, however, does not take into account the dynamics of the marketplace.  GAP is a static measurement that assumes that if the prime rate increases by 1.00%, all assets and liabilities that are due to reprice will increase by 1.00% at the next opportunity.

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Because the Company's management feels that GAP analysis is a static measurement, it manages its interest income through its asset/liability strategies that focus on a net interest income model based on management's projections.  The Company has a targeted net interest income range of plus or minus twenty percent based on a 3.00% change over twelve months.   The asset/liability committee meets weekly to address interest pricing issues, and this model is reviewed monthly.  Management will continue to monitor its liability sensitive position in times of increasing interest rates, which might adversely affect its net interest margin. 

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Item 4.  Controls and Procedures

Under the supervision and with the participation of the Company's management, including the Chief Executive Officer and Chief Accounting Officer, the effectiveness of the design and operation of the Company's disclosure controls and procedures has been evaluated within 90 days of the filing date of this quarterly report, and, based on such evaluation, our Chief Executive Officer and Chief Accounting Officer have concluded that these controls and procedures are effective. There were no significant changes in the Company's internal controls or in other factors that could significantly affect these controls subsequent to the date of their evaluation.

Disclosure controls and procedures are controls and procedures that are designed to ensure that information required to be disclosed by the Company in the reports that are filed or submitted under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission's rules and forms.  Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by the Company in the reports that are filed or submitted under the Exchange Act is accumulated and communicated to the Company's management, including the Chief Executive Officer and Chief Accounting Officer, as appropriate to allow timely decisions regarding required disclosure.

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Item 1.  Legal Proceedings

The Company is currently subject to various legal proceedings and claims that have arisen in the ordinary course of its business. In the opinion of management based on consultation with external legal counsel, any reasonably foreseeable outcome of such current litigation would not materially affect the Company's consolidated financial position or results of operations.

Item 2.  Changes in Securities and Use of Proceeds

None

Item 3.  Defaults Upon Senior Securities

None

Item 4.  Submission of Matters to a Vote of Securities Holders

The annual shareholders' meeting of Palmetto Bancshares, Inc. was held on April 22, 2003.  5,275,326 shares were present in person or by proxy of the shares of common stock entitled to vote at the Annual Meeting. 

Proposal #1 - Election of Directors.  The shareholders elected L. Leon Patterson, J. David Wasson, Jr., Sam B. Phillips, Jr., and William S. Moore as directors of the Company for three year terms ending in 2006.  At the meeting the following directors were elected for the terms specified:

Proposal #2 - Proposal to Adopt the Amendment to Palmetto Bancshares, Inc. 1997 Stock Compensation Plan.  The shareholders approved an amendment to Palmetto Bancshares, Inc. 1997 Stock Compensation Plan to increase the shares available for issuance by 100,000 shares with 4,738,715 shares voting in favor, 490,546 shares voting against, and 46,065 shares abstaining.

Item 5.  Other Information

None

Item 6.  Exhibits and Reports on Form 8‑K

(a)  Exhibits

31.1      L. Leon Patterson's Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

31.2      Paul W. Stringer's Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

32         Certifications Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

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(b)  Reports on Form 8-K

On July 16, 2003, the Company filed a Form 8-K announcing the earnings release dated July 14, 2003, which included selected financial data for the quarter ended June 30, 2003 and for select other previously reported periods. 

On July 31, 2003, the Company filed a Form 8-K announcing the mailing of its quarterly earnings overview to shareholders dated August 7, 2003, which included selected financial data for the quarter ended June 30, 2003 and for select other previously reported periods. 

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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.

PALMETTO BANCSHARES, INC.

By:

/s/      L. Leon Patterson                          

 L. Leon Patterson
 Chairman and Chief Executive Officer

/s/      Paul W. Stringer                                 

 Paul W. Stringer

 President and Chief Operating Officer
(Chief Accounting Officer)

Date:   August 14, 2003

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