1ST STATE BANCORP INC - 10-Q Quarterly Report

Back to GetFilings.com

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended December 31, 2004

OR

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

For the transition period from ______ to ______

Commission file number: 0-25859
-------

1st STATE BANCORP, INC.
------------------------------------------------------
(Exact Name of Registrant as Specified in Its Charter)

Virginia 56-2130744
- ------------------------------- ------------------
(State or Other Jurisdiction of (I.R.S. Employer
Incorporation or Organization) Identification No.)

445 S. Main Street, Burlington, North Carolina 27215
- ---------------------------------------------- ----------
(Address of Principal Executive Offices) (Zip Code)

(336) 227-8861
--------------------------------------------------
Registrant's Telephone Number, Including Area Code

Not Applicable
----------------------------------------------------
(Former Name, Former Address and Former Fiscal Year,
if Changed Since Last Report)

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

Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes |_| No |X|

As of February 8, 2005, the issuer had 2,940,119 shares of common stock
issued and outstanding.

CONTENTS

PAGE
----

PART I. FINANCIAL INFORMATION
---------------------

Item 1. Financial Statements

Consolidated Balance Sheets as of December 31, 2004 (unaudited)
and September 30, 2004 ....................................... 2

Consolidated Statements of Income for the Three Months Ended
December 31, 2004 and 2003 (unaudited) ....................... 3

Consolidated Statements of Stockholders' Equity and Comprehensive
Income for the Three Months Ended December 31, 2004 and 2003
(unaudited) .................................................. 4

Consolidated Statements of Cash Flows for the Three Months Ended
December 31, 2004 and 2003 (unaudited) ....................... 5

Notes to Consolidated Financial Statements ........................ 7

Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations ........................................ 10

Item 3. Quantitative and Qualitative Disclosures About Market Risk ........ 18

Item 4. Controls and Procedures ........................................... 18

PART II. OTHER INFORMATION
-----------------

Item 1. Legal Proceedings ................................................. 19

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds ....... 19

Item 3. Defaults Upon Senior Securities ................................... 20

Item 4. Submission of Matters to a Vote of Security Holders ............... 20

Item 5. Other Information ................................................. 20

Item 6. Exhibits .......................................................... 20

SIGNATURES

1

1st State Bancorp, Inc. and Subsidiary
Consolidated Balance Sheets
December 31, 2004 and September 30, 2004
(In Thousands, except share data)

At At
December 31, September 30,
2004 2004
------------ -------------
(Unaudited)

ASSETS

Cash and cash equivalents $ 11,162 $ 9,854
Investment securities:
Held to maturity (fair value of $20,765 and $22,884
at December 31, 2004 and September 30, 2004, respectively) 20,902 22,919
Available for sale (cost of $91,388 and $97,386
at December 31, 2004 and September 30, 2004, respectively) 90,499 96,693
Loans held for sale, at lower of cost or fair value 913 930
Loans receivable (net of allowance for loan losses of $3,985
and $3,956 at December 31, 2004 and September 30, 2004,
respectively) 231,942 231,763
Real estate owned 17 17
Federal Home Loan Bank stock, at cost 2,227 2,325
Premises and equipment 7,749 7,884
Accrued interest receivable 2,243 2,124
Other assets 5,293 3,205
--------- ---------
Total assets $ 372,947 $ 377,714
========= =========

LIABILITIES AND STOCKHOLDERS' EQUITY

Liabilities:
Deposit accounts 268,432 262,734
Advances from Federal Home Loan Bank 33,500 44,000
Advance payments by borrowers for property taxes and insurance 123 39
Dividend payable 296 296
Other liabilities 4,219 4,731
--------- ---------
Total liabilities 306,570 311,800
--------- ---------

Stockholders' Equity:
Preferred stock, $0.01 par value, 1,000,000 shares authorized;
none issued -- --
Common stock, $0.01 par value, 7,000,000 shares authorized;
2,956,373 and 2,962,323 shares issued and outstanding
at December 31, 2004 and September 30, 2004, respectively 33 33
Additional paid-in capital 36,096 36,038
Unallocated ESOP shares (2,430) (2,571)
Deferred compensation payable in treasury stock 6,700 6,440
Treasury stock (14,512) (14,086)
Retained income - substantially restricted 41,031 40,462
Accumulated other comprehensive loss - net unrealized
loss on investment securities available for sale (541) (402)
--------- ---------
Total stockholders' equity 66,377 65,914
--------- ---------
Total liabilities and stockholders' equity $ 372,947 $ 377,714
========= =========

See accompanying notes to the consolidated financial statements.

2

1st State Bancorp, Inc. and Subsidiary
Consolidated Statements of Income
For the Three Months Ended December 31, 2004 and 2003
(In Thousands, Except per Share Data)

(Unaudited)

For the Three Months Ended
December 31
--------------------------
2004 2003
------- -------

Interest income:
Interest and fees on loans $ 3,121 $ 2,854
Interest and dividends on investments 1,198 1,184
Overnight deposits 18 9
------- -------
Total interest income 4,337 4,047
------- -------

Interest expense:
Deposit accounts 914 919
Borrowings 356 316
------- -------
Total interest expense 1,270 1,235
------- -------

Net interest income 3,067 2,812

Provision for loan losses 330 60
------- -------
Net interest income after provision for loan losses 2,737 2,752
------- -------

Other income:
Customer service fees 298 205
Commissions from sales of annuities and mutual funds 67 72
Mortgage banking income, net 123 98
Securities gains, net -- 97
Other 160 54
------- -------
Total other income 648 526
------- -------

Operating expenses:
Compensation and related benefits 1,283 1,332
Occupancy and equipment 355 342
Real estate operations, net (5) (3)
Other expenses 433 432
------- -------
Total operating expenses 2,066 2,103
------- -------

Income before income taxes 1,319 1,175

Income taxes 467 417
------- -------

Net income $ 852 $ 758
======= =======

Earnings per share:

Basic $ 0.30 $ 0.27
Diluted $ 0.29 $ 0.26

See accompanying notes to the consolidated financial statements.

3

1st State Bancorp, Inc. and Subsidiary
Consolidated Statements of Stockholders' Equity and Comprehensive Income
For the Three Months Ended December 31, 2004 and 2003 (Unaudited)
(In Thousands)

Deferred
compensation
Additional Unallocated payable in
Common paid-in ESOP treasury
stock capital shares stock
------- ---------- ----------- ------------

Balance at September 30, 2003 $ 33 35,778 (3,141) 5,466

Comprehensive income:
Net income -- -- -- --
Other comprehensive income-unrealized
Gain on securities available-for-sale, net
of income taxes of $88 -- -- -- --

Total comprehensive income
Allocation of ESOP shares -- 61 144 --
Acquisition of treasury stock -- -- -- --
Cash dividends declared ($0.10 per share) -- -- -- --
Cash dividends on unallocated ESOP shares -- -- -- --
------- ------- ------- -------
Balance at December 31, 2003 $ 33 35,839 (2,997) 5,466
======= ======= ======= =======

Balance at September 30, 2004 $ 33 36,038 (2,571) 6,440

Comprehensive income:
Net income -- -- -- --
Other comprehensive loss-unrealized
loss on securities available for sale net
of income tax benefit of $57 -- -- -- --

Total comprehensive income
Allocation of ESOP shares -- 58 141 --
Acquisition of treasury stock -- -- -- --
Deferred compensation 260
Cash dividends declared ($0.10 per share) -- -- -- --
Cash dividends on unallocated ESOP shares -- -- -- --
------- ------- ------- -------

Balance at December 31, 2004 $ 33 36,096 (2,430) 6,700
======= ======= ======= =======

Accumulated
other Total
Treasury Retained comprehensive stockholders'
stock Income income (loss) equity
-------- -------- ------------- -------------

Balance at September 30, 2003 (12,785) 38,118 (768) 62,701

Comprehensive income:
Net income -- 758 -- 758
Other comprehensive income-unrealized
Gain on securities available-for-sale, net
of income taxes of $88 -- -- 135 135
-------
Total comprehensive income 893
Allocation of ESOP shares -- -- -- 205
Acquisition of treasury stock (161) -- -- (161)
Cash dividends declared ($0.10 per share) -- (297) -- (297)
Cash dividends on unallocated ESOP shares -- 17 -- 17
------- ------- ------- -------
Balance at December 31, 2003 (12,946) 38,596 (633) 63,358
======= ======= ======= =======

Balance at September 30, 2004 (14,086) 40,462 (402) 65,914

Comprehensive income:
Net income -- 852 -- 852
Other comprehensive loss-unrealized
loss on securities available for sale net
of income tax benefit of $57 -- -- (139) (139)
-------
Total comprehensive income 713
Allocation of ESOP shares -- -- -- 199
Acquisition of treasury stock (166) -- -- (166)
Deferred compensation (260) --
Cash dividends declared ($0.10 per share) -- (296) -- (296)
Cash dividends on unallocated ESOP shares -- 13 -- 13
------- ------- ------- -------

Balance at December 31, 2004 (14,512) 41,031 (541) 66,377
======= ======= ======= =======

See accompanying notes to the consolidated financial statements.

4

1st State Bancorp, Inc. and Subsidiary
Consolidated Statements of Cash Flows
For the Three Months Ended December, 2004 and 2003
(Unaudited)
(In Thousands)

For the Three Months Ended
December 31,
--------------------------
2004 2003
-------- --------

Cash flows from operating activities:
Net income $ 852 $ 758
Adjustment to reconcile net income to net cash used in
operating activities:
Provision for loan losses, net of writeoffs 30 12
Depreciation 164 227
Deferred tax expense (benefit) (153) 2
Amortization of premiums and discounts, net (19) (2)
Deferred compensation 60 60
Release of ESOP shares 199 205
Loan origination fees and unearned discounts
deferred, net of current amortization (5) (16)
Gain on sale of other real estate (6) --
Gain on sale of investment securities available for sale -- (97)
Net (gain) loss on sale of loans (1) 28
Proceeds from loans held for sale 6,056 6,845
Originations of loans held for sale (6,038) (7,399)
Increase in other assets (1,878) (320)
Increase in accrued interest receivable (119) (85)
Decrease in other liabilities (306) (1,241)
-------- --------
Net cash used in operating activities (1,164) (1,023)
-------- --------

Cash flows provided by investing activities:
Proceeds from redemption of FHLB stock 2,335 1,025
Purchases of FHLB stock (2,237) (1,250)
Purchases of investment securities held to maturity (966) (2,373)
Purchases of investment securities available for sale -- (15,828)
Proceeds from sales of investment securities available for sale -- 3,979
Proceeds from maturities and issuer calls of investment securities
available for sale 6,000 17,019
Proceeds from maturities and issuer calls of investment securities
held to maturity 3,000 1
Net increase in loans receivable (204) (669)
Purchase of real estate acquired in settlement of loans -- (108)
Purchases of premises and equipment net of disposals (29) (180)
-------- --------

Net cash provided by investing activities 7,899 1,616
-------- --------

(Continued)

5

1st State Bancorp, Inc. and Subsidiary
Consolidated Statements of Cash Flows - Continued
For the Three Months Ended December 31, 2004 and 2003
(Unaudited)
(In Thousands)

For the Three Months Ended
December 31,
--------------------------
2004 2003
-------- --------

Cash flows from financing activities:
Net increase (decrease) in deposits $ 5,698 $ (6,333)
Advances from the Federal Home Loan Bank 38,000 32,000
Repayments of advances from the Federal Home Loan Bank (48,500) (25,500)
Purchase of treasury stock (426) (161)
Dividends paid on common stock (283) (280)
Increase in advance payments by borrowers for
property taxes and insurance 84 72
-------- --------

Net cash used in financing activities (5,427) (202)
-------- --------

Net increase in cash and cash equivalents 1,308 391

Cash and cash equivalents at beginning of period 9,854 9,359
-------- --------

Cash and cash equivalents at end of period $ 11,162 $ 9,750
======== ========

Payments are shown below for the following:
Interest $ 1,272 $ 1,591
======== ========

Income taxes $ 350 $ 269
======== ========

Noncash investing and financing activities:

Unrealized gains (losses) on investment securities
available for sale $ (196) $ 223
======== ========

Cash dividends declared but not paid $ 296 $ 280
======== ========

Cash dividends on unallocated ESOP shares $ 13 $ 17
======== ========

Transfer from loans to real estate acquired in settlement of loans $ -- $ 70
======== ========

See accompanying notes to the consolidated financial statements.

6

1st State Bancorp, Inc. and Subsidiary
Notes to Consolidated Financial Statements
December 31, 2004 (unaudited) and September 30, 2004

Note 1. Nature of Business

1st State Bancorp, Inc. (the "Company") was incorporated under the laws of
the Commonwealth of Virginia for the purpose of becoming the holding company for
1st State Bank (the "Bank") in connection with the Bank's conversion from a
North Carolina-chartered mutual savings bank to a North Carolina-chartered stock
savings bank (the "Converted Bank") pursuant to its Plan of Conversion (the
"Stock Conversion"). Upon completion of the Stock Conversion, the Converted Bank
converted from a North Carolina-chartered stock savings bank to a North Carolina
commercial bank (the "Bank Conversion"), retaining the name 1st State Bank (the
"Commercial Bank"), and the Commercial Bank succeeded to all of the assets and
liabilities of the Converted Bank. The Stock Conversion and the Bank Conversion
were consummated on April 23, 1999. The common stock of the Company began
trading on the Nasdaq National Market System under the symbol "FSBC" on April
26, 1999.

Note 2. Basis of Presentation

The accompanying consolidated financial statements (which are unaudited,
except for the consolidated balance sheet at September 30, 2004, which is
derived from the September 30, 2004 audited consolidated financial statements)
have been prepared in accordance with accounting principles generally accepted
in the United States of America and with the rules and regulations of the
Securities and Exchange Commission. Accordingly, they do not include all of the
information and footnotes required by accounting principles generally accepted
in the United States of America for complete financial statements. In the
opinion of management, all adjustments (none of which were other than normal
recurring accruals) necessary for a fair presentation of the financial position
and results of operations for the periods presented have been included.

The results of operations for the three month period ended December 31,
2004 are not necessarily indicative of the results of operations that may be
expected for the year ending September 30, 2005. The preparation of consolidated
financial statements in accordance with accounting principles generally accepted
in the United States of America requires management to make certain estimates.
These amounts may be revised in future periods because of changes in the facts
and circumstances underlying their estimation.

Note 3. Earnings Per Share

For purposes of computing basic and diluted earnings per share, weighted
average shares outstanding excludes unallocated ESOP shares that have not been
committed to be released. The deferred compensation obligation discussed in Note
5 that is funded with shares of the Company's common stock has no net impact on
the Company's earnings per share computations. Diluted earnings per share
include the potentially dilutive effects of the Company's stock-based benefit
plans. There were no anti-dilutive stock options for the three months ended
December 31, 2004 and 2003. A reconciliation of the denominators of the basic
and diluted earnings per share computations is as follows:

Three Months Ended
December 31,
--------------------------
2004 2003
---------- ----------

Average shares issued and outstanding 2,959,899 2,969,258
Less: Unallocated ESOP shares (127,764) (156,807)
---------- ----------
Average basic shares for earnings per share 2,832,135 2,812,451
Add: Potential common stock pursuant to stock option plan 147,440 149,240
---------- ----------
Average dilutive shares for earnings per share 2,979,575 2,961,691
========== ==========

7

Note 4. Employee Stock Ownership Plan ("ESOP")

The Company sponsors an employee stock ownership plan (the "ESOP") whereby
an aggregate number of shares amounting to 253,050 or 8% of the stock issued in
the conversion was purchased for future allocation to employees. The ESOP was
funded by an 11-year term loan from the Company in the amount of $4,899,000. The
loan is secured by the shares of stock purchased by the ESOP. During the three
months ended December 31, 2004 and 2003, 7,176 and 7,360 shares of stock were
committed to be released and approximately $199,000 and $205,000, respectively,
of compensation expense was recognized.

Note 5. Deferred Compensation

Directors and certain executive officers participate in a deferred
compensation plan, which was approved by the Board of Directors on September 24,
1997. This plan generally provides for fixed payments beginning after the
participant retires. Each participant is fully vested in his account balance
under the plan. Directors may elect to defer their directors' fees and executive
officers may elect to defer 25% of their salary and 100% of bonus compensation.

Prior to the Stock Conversion, amounts deferred by each participant
accumulated interest at a rate equal to the highest rate of interest paid on the
Bank's one-year certificates of deposit. In connection with the Stock
Conversion, participants in the plan were given the opportunity to prospectively
elect to have their deferred compensation balance earn a rate of return equal to
the total return of the Company's stock. All participants elected this option
concurrent with the Stock Conversion, so the Company purchases its common stock
to fund this obligation. Refer to the Company's notes to consolidated financial
statements, incorporated by reference in the Company's 2004 Annual Report on
Form 10-K for a discussion of the Company's accounting policy with respect to
this deferred compensation plan and the related treasury stock purchased by the
Company to fund this obligation.

The expense related to this plan for each of the three months ended
December 31, 2004 and 2003 was $60,000. This expense is included in compensation
expense.

Note 6. Stock Option and Incentive Plan

On June 6, 2000, the Company's stockholders approved the 1st State
Bancorp, Inc. 2000 Stock Option and Incentive Plan (the "Plan"). The purpose of
this plan is to advance the interests of the Company through providing select
key employees and directors of the Bank with the opportunity to acquire shares.
By encouraging such stock ownership, the Company seeks to attract, retain and
motivate the best available personnel for positions of substantial
responsibility and to provide incentives to the key employees and directors.
Under the Plan, the Company granted 316,312 options to purchase its $0.01 par
value common stock. The exercise price per share is equal to the fair market
value per share on the date of the grant. Options granted under the Stock Option
Plan are 100% vested on the date of the grant, and all options expire 10 years
from the date of the grant. As a result of the one-time cash dividend of $5.17
paid on October 2, 2000, the exercise price for the options repriced from $18.44
to $14.71. No options were exercised or granted during the three months ended
December 31, 2004 and 2003. At December 31, 2004, 314,235 options are
outstanding, all of which are exercisable.

Note 7. Mortgage Servicing Rights

The rights to service mortgage loans for others are included in other
assets on the consolidated balance sheet. Mortgage servicing rights ("MSRs") are
capitalized based on the allocated cost that is determined when the underlying
loans are sold. MSRs are amortized over a period that approximates the life of
the underlying loan as an adjustment of servicing income. Impairment reviews of
MSRs are performed on a quarterly basis. As of December 31, 2004 and September
30, 2004, MSRs totaled $488,000 and $493,000, respectively, and no valuation
allowance was required.

Amortization expense totaled $23,000 and $29,000 for the three months
ended December 31, 2004 and 2003, respectively.

8

Note 8. Standby Letters of Credit

In November 2002, the FASB issued Interpretation No. 45 (FIN 45),
"Guarantor's Accounting and Disclosure Requirements for Guarantees, Including
Indirect Guarantees of Indebtedness of Others", which addressed the disclosure
to be made by a guarantor in its interim and annual financial statements about
its obligations under guarantees. FIN 45 requires the guarantor to recognize a
liability for the non-contingent component of the guarantee, such as the
obligation to stand ready to perform in the event that specified triggering
events or conditions occur. The initial measurement of this liability is the
fair value of the guarantee at inception. The recognition of the liability is
required even if it is not probable that payments will be required under the
guarantee or if the guarantee was issued with a premium payment or as part of a
transaction with multiple events. The initial recognition and measurement
provisions are effective for all guarantees within the scope of FIN 45 issued or
modified after June 30, 2003. The Company issues standby letters of credit
whereby the Company guarantees performance if a specified triggering event or
condition occurs (primarily nonperformance under construction contracts entered
into by construction customers). The guarantees generally expire within one year
and may be automatically renewed depending on the terms of the guarantee. The
maximum potential amount of undiscounted future payments related to standby
letters of credit at December 31, 2004 is $1.9 million. At December 31, 2004,
the Company has recorded no liability for the obligation to perform as a
guarantor. In addition, no contingent liability is considered necessary as such
amounts are not deemed probable. Substantially all standby letters of credit are
secured by real estate and/or guaranteed by third parties in the event the
Company had to advance funds to fulfill the guarantee.

9

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

Forward-Looking Statements

When used in this Form 10-Q, the words or phrases "will likely result,"
"are expected to," "will continue," "is anticipated," "estimate," "project" or
similar expressions are intended to identify "forward-looking statements" within
the meaning of the Private Securities Litigation Reform Act of 1995. Such
statements are subject to certain risks and uncertainties including changes in
economic conditions in our market area, changes in policies by regulatory
agencies, fluctuations in interest rates, demand for loans in our market area,
and competition that could cause actual results to differ materially from
historical earnings and those presently anticipated or projected. We wish to
caution you not to place undue reliance on any such forward-looking statements,
which speak only as of the date made. We wish to advise you that the factors
listed above could affect our financial performance and could cause our actual
results for future periods to differ materially from any opinions or statements
expressed with respect to future periods in any current statements.

We do not undertake, and specifically disclaim any obligation, to publicly
release the result of any revisions which may be made to any forward-looking
statements to reflect events or circumstances after the date of such statements
or to reflect the occurrence of anticipated or unanticipated events.

General

1st State Bancorp, Inc. was formed in November 1998 and became the holding
company for 1st State Bank on April 23, 1999.

Our business consists principally of attracting deposits from the general
public and investing these funds in loans secured by single-family residential
and commercial real estate, secured and unsecured commercial loans and consumer
loans. Our profitability depends primarily on our net interest income, which is
the difference between the income we receive on our loan and investment
securities portfolios and our cost of funds, which consists of interest paid on
deposits and borrowed funds. Net interest income also is affected by the
relative amounts of interest-earning assets and interest-bearing liabilities.
When interest-earning assets approximate or exceed interest-bearing liabilities,
any positive interest rate spread will generate net interest income. Our
profitability is also affected by the level of other income and operating
expenses. Other income consists of miscellaneous fees related to our loans and
deposits, mortgage banking income and commissions from sales of annuities and
mutual funds. Operating expenses consist of compensation and benefits, occupancy
related expenses, federal deposit insurance premiums, data processing,
advertising and other expenses.

Our operations are influenced significantly by local economic conditions
and by policies of financial institution regulatory authorities. Our cost of
funds is influenced by interest rates on competing investments and by rates
offered on similar investments by competing financial institutions in our market
area, as well as general market interest rates. These factors can cause
fluctuations in our net interest income and other income. Lending activities are
affected by the demand for financing of real estate and other types of loans,
which in turn is affected by the interest rates at which such financing may be
offered. In addition, local economic conditions can impact the credit risk of
our loan portfolio, in that local employers may be required to eliminate
employment positions of many of our borrowers, and small businesses and other
commercial borrowers may experience a downturn in their operating performance
and become unable to make timely payments on their loans. Management evaluates
these factors in estimating its allowance for loan losses, and changes in these
economic conditions could result in increases or decreases to the provision for
loan losses.

Our business emphasis has been to operate as a well capitalized,
profitable and independent community-oriented financial institution dedicated to
providing quality customer service. We are committed to meeting the financial
needs of the communities in which we operate. We believe that we can be more
effective in servicing our customers than many of our nonlocal competitors
because of our ability to quickly and effectively provide senior management
responses to customer needs and inquiries. Our ability to provide these services
is enhanced by the stability of our senior management team.

Over the years, we have sought to gradually increase the percentage of our
assets invested in commercial real estate loans, commercial loans and home
equity lines of credit, which have shorter terms and adjust more frequently to

10

changes in interest rates than single-family residential mortgage loans. These
loans generally carry added risk when compared to a single-family residential
mortgage loan, so we have concurrently increased our allowance for loan losses
as we have originated these loans.

Due to a general slowdown in the economy beginning in 2000, the Federal
Reserve acted to provide a stimulus through a series of interest rate reductions
that lowered the prime rate from 9.50% in January 2001 to 4.00% in June 2003.
These reductions in prime tended to negatively impact the Company's net interest
margin and net interest spread which resulted in lower net interest income for
the Company. The Company's asset growth has been slower as a result of heavy
refinancing as customers have taken advantage of these attractive interest
rates. The fee income associated with the heavy refinancing volume has replaced
some of the lost net interest income. Now as the refinancing activity has
slowed, the Company is looking to replace lost net interest income possibly with
leverage strategies. During periods of slow loan demand, the Company purchases
more investments, and the Company uses short-term borrowings as an alternative
to deposits for funding certain assets. The Company's balance sheet is currently
asset sensitive, that is, rate sensitive assets exceed rate sensitive
liabilities. We expect an increase in net interest income during periods of
rising interest rates and decreased net interest income during periods of
falling interest rates.

Critical Accounting Policies

The Company's significant accounting policies are set forth in Note 1 of
the consolidated financial statements as of September 30, 2004, which was filed
on the Company's Annual Report on Form 10-K for the fiscal year ended September
30, 2004. Of these significant accounting policies, the Company considers its
policy regarding the allowance for loan losses to be its most critical
accounting policy, because it requires management's most subjective and complex
judgments. In addition, changes in economic conditions can have a significant
impact on the allowance for loan losses and therefore the provision for loan
losses and results of operations. The Company has developed appropriate policies
and procedures for assessing the adequacy of the allowance for loan losses,
recognizing that this process requires a number of assumptions and estimates
with respect to its loan portfolio. The Company's 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 that is
not known to management at the time of the issuance of the consolidated
financial statements.

Comparison of Financial Condition at December 31, 2004 and September 30, 2004

Total assets decreased $4.8 million from $377.7 million at September 30,
2004 to $372.9 million at December 31, 2004. During the quarter ended December
31, 2004, loan growth was flat and the Company shrank its investment portfolio
by applying proceeds from investment calls to reduce overnight borrowings. The
Company grew deposits by $5.7 million during the quarter, the proceeds of which
were also applied to reduce overnight borrowings.

Investment securities available for sale decreased $6.2 million from $96.7
million at September 30, 2004 to $90.5 million at December 31, 2004. During the
three months ended December 31, 2004, we received $6.0 million in proceeds from
maturities and issuer calls of investment securities available for sale and
purchased no investments available for sale during this time. Interest rates
increased during the three months ended December 31, 2004 which caused the
Company's gross unrealized loss on investment securities available for sale to
increase from $693,000 at September 30, 2004 to $889,000 at December 31, 2004.
Investment securities held to maturity decreased $2.0 million from $22.9 million
at September 30, 2004 to $20.9 million at December 31, 2004. During the three
months ended December 31, 2004, we purchased $966,000 of securities and received
$3.0 million in proceeds from maturities and issuer calls of investment
securities held to maturity. As interest rates have increased, the Company has
purchased fewer fixed rate securities.

Loans held for sale decreased to $913,000 at December 31, 2004 from
$930,000 at September 30, 2004. The decrease in loans held for sale resulted
from timing differences in the funding of loan sales. Loans receivable, net
increased from $231.8 million at September 30, 2004 to $231.9 million at
December 31, 2004. During the three months ended December 31, 2004, mortgage
originations were considerably slower than in previous quarters as refinance
activity continues to slow.

11

Stockholders' equity increased by $463,000 from $65.9 million at September
30, 2004 to $66.4 million at December 31, 2004 as a result of net income of
$852,000 and the release of ESOP shares of $199,000. These increases were
partially offset by cash dividends to stockholders declared of $283,000,
purchases of treasury stock of $166,000, and an increase in the net unrealized
loss on available for sale securities of $139,000. The increase in the net
unrealized loss on available for sale securities was a result of increases in
interest rates which caused bond prices to decrease.

Comparison of Operating Results for the Three Months Ended December 31, 2004 and
2003

Net Income. We recorded net income of $852,000 for the quarter ended
December 31, 2004, as compared to $758,000 for the quarter ended December 31,
2003, representing an increase of $94,000, or 12.4%. For the three months ended
December 31, 2004, basic and diluted earnings per share were $0.30 and $0.29,
respectively, compared to the basic and diluted earnings per share for the
quarter ended December 31, 2003 of $0.27 and $0.26, respectively. The increase
in net income resulted primarily from increased net interest income and
increased other income that were offset partially by increased provision for
loan losses and increased income tax expense. The increase in net interest
income resulted from higher net interest margins and increased net earning
assets. The average prime interest rate for the quarter ended December 31, 2004
was 4.93%, an increase of 93 basis points from 4.00% which was the average prime
for the quarter ended December 31, 2003. The repricing of loans increased the
Company's average asset yield by 15 basis points whereas the average cost of
funds increased only 1 basis point during the quarter ended December 31, 2004.

Net Interest Income. Net interest income, the difference between interest
earned on loans and investments and interest paid on interest-bearing
liabilities, increased by $255,000 or 9.1% for the three months ended December
31, 2004, compared to the same quarter in the prior year. This increase results
from a $290,000 increase in interest income that was partially offset by the
$35,000 increase in total interest expense. The average net interest rate spread
increased 14 basis points from 2.98% for the three months ended December 31,
2003 to 3.12% for the quarter ended December 31, 2004.

Interest Income. The increase in interest income for the three months
ended December 31, 2004 was the result of an increase in yield on
interest-earning assets of 15 basis points from 4.77% for the three months ended
December 31, 2003 to 4.92% for the three months ended December 31, 2004. Average
interest-earning assets increased $12.6 million compared to the same quarter in
the prior year. Average loans receivable and average investment securities
increased $6.9 million and $6.0 million, respectively, while interest-bearing
overnight funds decreased $234,000. The increase in average interest-earning
assets increased interest income by approximately $150,000 and the increase in
the average asset yield increased interest income by approximately $140,000.

Interest Expense. Interest expense increased in the three months ended
December 31, 2004 due to an increase in average interest-bearing liabilities of
$5.5 million and an increase in the cost of interest-bearing liabilities of 1
basis point from 1.79% for the three months ended December 31, 2003 to 1.80% for
the three months ended December 31, 2004. Average interest-bearing deposits
increased by $4.5 million while average FHLB advances increased $946,000 for the
three months ended December 31, 2004 compared to the same quarter in the prior
year. The increase in average interest-bearing liabilities increased interest
expense by approximately $26,000 and the increase in the average cost of
interest-bearing liabilities increased interest expense by approximately $9,000.

12

The following table presents average balances and average rates
earned/paid by the Company for the quarter ended December 31, 2004 compared to
the quarter ended December 31, 2003.

Three Months Ended Three Months Ended
December 31, 2004 December 31, 2003
----------------------------------- ----------------------------------
(Dollars in Thousands)
Average Average Average Average
Balance Interest Yield/Cost Balance Interest Yield/Cost
-------- -------- ---------- -------- -------- ----------

Assets:
Loans receivable (1) $232,575 $ 3,121 5.37% $225,723 $ 2,854 5.06%
Investment securities (2) 115,919 1,198 4.13 109,942 1,184 4.31
Interest-bearing overnight deposits 3,779 18 1.92 4,013 9 0.91
-------- -------- -------- -------- -------- --------
Total interest-earning assets (4) 352,273 4,337 4.92 339,678 4,047 4.77
Non interest-earning assets 19,896 20,406
-------- --------
Total assets 372,169 $360,084
======== ========

Liabilities and stockholders' equity
Interest bearing checking 36,205 23 0.26 36,102 19 0.21
Money market investment accounts 18,630 43 0.92 19,599 33 0.68
Passbook and statement savings 30,306 50 0.66 30,352 47 0.62
Certificates of deposit 162,560 798 1.96 157,108 820 2.09
FHLB advances 34,375 356 4.14 33,429 316 3.78
-------- -------- -------- -------- -------- --------
Total interest-bearing liabilities 282,076 1,270 1.80 276,590 1,235 1.79
Non interest-bearing liabilities 23,863 20,594
-------- --------
Total liabilities 305,939 297,184
Stockholders' equity 66,230 62,900
-------- --------
Total liabilities and stockholders' equity $372,169 $360,084
======== ========

Net interest income $ 3,067 $ 2,812
======== ========
Interest rate spread 3.12% 2.98%
======== ========
Net interest margin (3) 3.48% 3.31%
======== ========
Ratio of average interest-earning assets to
average interest-bearing liabilities 124.89% 122.81%
======== ========

- ----------
(1) Includes nonaccrual loans and loans held for sale, net of discounts and
allowance for loan losses.

(2) Includes FHLB of Atlanta stock.

(3) Represents net interest income divided by the average balance of
interest-earning assets.

(4) Due to immateriality, the interest income and yields related to certain
tax exempt assets have not been adjusted to reflect a fully taxable
equivalent yield.

Provision for Loan Losses. We charge provisions for loan losses to
earnings to maintain the total allowance for loan losses at a level we consider
adequate to provide for probable loan losses, based on existing loan levels and
types of loans outstanding, nonperforming loans, prior loss experience, general
economic conditions and other factors. We estimate the allowance using an
allowance for loan losses model which takes into consideration all of these
factors. Our policies require the review of assets on a regular basis, and we
assign risk grades to loans based on the relative risk of the credit,
considering such factors as repayment experience, value of collateral,
guarantors, etc. Our credit management systems have resulted in low loss
experience; however, there can be no assurances that such experience will
continue. We believe we use the best information available to make a
determination with respect to the allowance for loan losses, recognizing that
future adjustments may be necessary depending upon a change in economic
conditions.

13

The provision for loan losses was $330,000 and net charge-offs were
$300,000 for the three months ended December 31, 2004 compared with a provision
of $60,000, and net charge-offs of $8,000 for the three months ended December
31, 2003. Nonperforming loans at December 31, 2004 and September 30, 2004 were
$3.6 million and $4.0 million, respectively. The majority of the non-performing
loans resulted from two unrelated, distinct credits which are not necessarily
indicative of the credit quality of the entire portfolio. See "- Asset Quality"
for further information.

Other Income. Other income increased $122,000 from $526,000 for the three
months ended December 31, 2003 to $648,000 for the three months ended December
31, 2004. Mortgage banking income, net increased $25,000 from $98,000 for the
three months ended December 31, 2003 to $123,000 for the three months ended
December 31, 2004 despite lower loan volumes. We sold loans totaling $6.1
million in the three months ended December 31, 2004 compared with sales of $6.8
million in the previous year for the comparable period. Given the current level
of mortgage interest rates, the Company believes that mortgage banking income
will continue to decrease in future quarters due to lower refinancing activity.
Customer fees increased $93,000 or 45.4% to $298,000 for the quarter ended
December 31, 2004 compared with the $205,000 reported in the prior year. This
increase was the result of increased deposit service charges compared with the
prior year. The Company recorded gains on sales of investments of $97,000 in the
three months ended December 31, 2003 which were not present in the current year.
Included in other income for the quarter ended December 31, 2004 is a recovery
of $85,000 for a non-credit loss that had been charged to earnings in a prior
year that did not result in any loss to the Company. Other income increased from
$54,000 for the quarter ended December 31, 2003 to $160,000 for the quarter
ended December 31, 2004 primarily as a result of this recovery.

Operating Expenses. Total operating expenses were $2.1 million for each of
the three months ended December 31, 2004 and 2003, respectively. The Company has
been able to control expenses during this period of slower asset growth.

Income Tax Expense. Income tax expense increased $50,000 from tax expense
of $417,000 for the three months ended December 31, 2003 to $467,000 for the
three months ended December 31, 2004. The effective tax rates were 35.4% and
35.5% for the three months ended December 31, 2004 and 2003, respectively.

Commitments, Contingencies and Off-Balance Sheet Risk

The Company is a party to financial instruments with off-balance sheet
risk including commitments to extend credit under existing lines of credit and
commitments to sell loans. These instruments involve, to varying degrees,
elements of credit and interest rate risk in excess of the amount recognized in
the consolidated balance sheets.

Off-balance sheet financial instruments whose contract amounts represent
credit and interest rate risk are summarized as follows:

December 31, 2004 September 30, 2004
----------------- ------------------
(In thousands)

Commitments to originate new loans $ 8,150 $ 2,177
Commitments to originate new loans held for sale 113 --
Unfunded commitments to extend credit under existing
equity line and commercial lines of credit 54,335 55,357
Commercial letters of credit 1,904 2,055
Commitments to sell loans held for sale 1,132 2,174

Commitments to originate new loan include three unrelated commercial real
estate loans totaling $6.3 million. The Company does not have any special
purpose entities or other similar forms of off-balance sheet financing
arrangements.

Commitments to originate new loans or to extend credit are agreements to
lend to a customer as long as there is no violation of any condition established
in the contract. Loan commitments generally expire within 30 to 45 days. Most
equity line commitments are for a term of 15 years, and commercial lines of
credit are generally renewable on an annual basis. Commitments generally have
fixed expiration dates or other termination clauses and may require payment of a
fee. Since many of the commitments are expected to expire without being drawn
upon, the total commitment amounts do not necessarily represent future cash
requirements. The Company evaluates each customer's creditworthiness

14

on a case-by-case basis. The amount of collateral obtained, if deemed necessary
by the Company upon extension of credit, is based on management's credit
evaluation of the borrower.

Commitments to sell loans held for sale are agreements to sell loans to a
third party at an agreed upon price. At December 31, 2004, the aggregate fair
value of these commitments exceeded the book value of the loans to be sold.

Contractual Obligations

As of December 31, 2004:

Payments Due by Period
----------------------
(Dollars in thousands)

Less than
1 year 1-3 years 4-5 years Over 5 years Total
--------- --------- --------- ------------ --------

Deposits $235,201 $ 22,938 $ 10,293 $ -- $268,432
Advances from
Federal Home Loan Bank 13,500 -- 20,000 -- 33,500
Lease obligations 20 42 42 5 109
-------- -------- -------- -------- --------
Total contractual cash
obligations $248,721 $ 22,980 $ 30,335 $ 5 $302,041
======== ======== ======== ======== ========

Asset Quality

At December 31, 2004, the Company had approximately $3.7 million in
nonperforming assets (nonaccrual loans and real estate owned) or 0.98% of total
assets. At September 30, 2004, nonperforming assets were $4.0 million or 1.05%
of total assets. At December 31, 2004 and September 30, 2004, impaired loans
totaled $3.0 million and $3.8 million, respectively, as defined by Statement of
Financial Accounting Standards No. 114, "Accounting by Creditors for Impairment
of a Loan." The impaired loans at December 31, 2004 and September 30, 2004
result from two unrelated commercial loan customers, each of which have loans
secured by commercial real estate and business assets in Alamance County. At
December 31, 2004, the entire $3.0 million of the impaired loans are on
non-accrual status, and their related reserve for loan losses totaled $300,000.
The average carrying value of impaired loans was $3.4 million during the three
months ended December 31, 2004. Interest income of $30,000 has been recorded on
impaired loans in the three months ended December 31, 2004. The Bank's net
chargeoffs for the three months ended December 31, 2004 were $300,000. The
Bank's allowance for loan losses was $4.0 million at December 31, 2004 and
September 30, 2004, and the ratio of the allowance for loan losses to total
loans, net of loans in process and deferred loan fees was 1.69% and 1.68% at
December 31, 2004 and September 30, 2004, respectively.

The following table presents an analysis of our nonperforming assets:

Dollars in thousands

At At At
December 31, September 30, December 31,
2004 2004 2003
------------ ------------- ------------

Nonperforming loans:
Nonaccrual loans $3,644 $3,962 $4,057
Loans 90 days past due and accruing -- -- --
Restructured loans -- -- --
------ ------ ------
Total nonperforming loans 3,644 3,962 4,057
Other real estate 17 17 273
------ ------ ------
Total nonperforming assets 3,661 $3,979 $4,330
====== ====== ======

Nonperforming loans to loans receivable, net 1.57% 1.72% 1.79%
Nonperforming assets as a percentage
of loans and other real estate owned 1.58% 1.72% 1.91%
Nonperforming assets to total assets 0.98% 1.05% 1.19%

15

Included in nonperforming assets at December 31, 2004 were loans totaling
$748,000 to a local borrower secured by real estate and loans to his
transportation business secured by operating assets. These loans are in default,
and the Company is working with the borrower and their business on a voluntary
liquidation. The Company charged off $300,000 on this relationship during the
current quarter and has a specific reserve of $300,000 for these loans at
December 31, 2004. We project the resolution of these nonperforming loans during
the next several months with minimal additional loss, if any.

Regulations require that we classify our assets on a regular basis. There
are three classifications for problem assets: substandard, doubtful and loss. We
regularly review our assets to determine whether any assets require
classification or re-classification. At December 31, 2004, we had $4.1 million
in classified assets consisting of $4.0 million in substandard loans and $17,000
in real estate owned. At September 30, 2004, we had $4.7 million in classified
assets consisting of $4.7 million in substandard loans and $17,000 in real
estate owned. At December 31, 2003, we had $4.6 million in substandard loans and
$273,000 in real estate owned.

In addition to regulatory classifications, we also classify as "special
mention" and "watch" assets that are currently performing in accordance with
their contractual terms but may become classified or nonperforming assets in the
future. At December 31, 2004, we have identified approximately $5.3 million in
assets classified as special mention and $24.1 million as watch. At December 31,
2003, we had identified approximately $935,000 in assets classified as special
mention and $34.7 million as watch.

Liquidity and Capital Resources

The Bank must meet certain liquidity requirements established by the State
of North Carolina Office of the Commissioner of Banks (the "Commissioner"). At
December 31, 2004, the Bank's liquidity ratio exceeded such requirements.
Liquidity generally refers to the Bank's ability to generate adequate amounts of
funds to meet its cash needs. Adequate liquidity guarantees that sufficient
funds are available to meet deposit withdrawals, fund loan commitments, maintain
adequate reserve requirements, pay operating expenses, provide funds for debt
service, pay dividends to stockholders and meet other general commitments.

Our primary sources of funds are deposits, principal and interest payments
on loans, proceeds from the sale of loans, and to a lesser extent, advances from
the FHLB of Atlanta. While maturities and scheduled amortization of loans are
predictable sources of funds, deposit flows and mortgage prepayments are greatly
influenced by general interest rates, economic conditions and local competition.

Our most liquid assets are cash and cash equivalents. The levels of these
assets are dependent on our operating, financing, lending and investing
activities during any given period. At December 31, 2004, cash and cash
equivalents totaled $11.2 million. We have other sources of liquidity should we
need additional funds. During the three months ended December 31, 2004, we sold
loans totaling $6.1 million. Additional sources of funds include FHLB of Atlanta
advances. Other sources of liquidity include loans and investment securities
designated as available for sale, which totaled $90.5 million at December 31,
2004.

We anticipate that we will have sufficient funds available to meet our
current commitments. At December 31, 2004, we had $8.3 million in commitments to
originate new loans, $54.3 million in unfunded commitments to extend credit
under existing equity lines and commercial lines of credit and $1.9 million in
standby letters of credit. At December 31, 2004, certificates of deposit, which
are scheduled to mature within one year, totaled $134.6 million. We believe that
a significant portion of such deposits will remain with us.

The Federal Deposit Insurance Corporation ("FDIC") requires the Bank to
meet a minimum leverage capital requirement of Tier I capital to assets ratio of
4%. The FDIC also requires the Bank to meet a ratio of total capital to
risk-weighted assets of 8%, of which 4% must be in the form of Tier I capital.
The Commissioner requires the Bank at all times to maintain certain minimum
capital levels. The Bank was in compliance with all capital requirements of the
FDIC and the Commissioner at December 31, 2004 and is deemed to be "well
capitalized."

The Federal Reserve also mandates capital requirements on all bank holding
companies, including 1st State Bancorp, Inc. These capital requirements are
similar to those imposed by the FDIC on the Bank. At December 31, 2004, the
Company was in compliance with the capital requirements of the Federal Reserve.

16

The Company's equity to asset ratio at December 31, 2004 was 17.8%. The
Company's capital level is sufficient to support future growth.

The Company has declared cash dividends per common share of $0.10 for each
of the three months ended December 31, 2004, September 30, 2004 and June 30,
2004. The Company's ability to pay dividends is dependent upon earnings. The
Company's dividend payout ratio for the three months ended December 31, 2004,
September 30, 2004 and December 31, 2003 was 34.5%, 31.3% and 38.5%,
respectively.

Accounting Matters

In March 2004, the SEC released Staff Accounting Bulletin No. 105 -
Application of Accounting Principles to Loan Commitments. This bulletin requires
all registrants to begin accounting for their issued loan commitments (including
interest rate lock commitments) subject to Statement 133 as written options.
Treatment as a written option would require those loan commitments to be
reported as liabilities until either they are exercised (and a loan is made) or
they expire unexercised. Staff Accounting Bulletin No. 105 must be applied to
loan commitments that are issued after March 31, 2004. The adoption of Staff
Accounting Bulletin No. 105 did not have a material impact on the consolidated
financial statements.

In January 2003, FASB Interpretation No. 46, "Consolidation of Variable
Interest Entities, an interpretation of ARB No. 51", (Interpretation 46) was
issued. Interpretation 46 addresses the consolidation by business enterprises of
variable interest entities as defined in the Interpretation. Interpretation 46
applies immediately to variable interests in variable interest entities created
after January 31, 2003, and to variable interests in variable interest entities
obtained after January 31, 2003. In December 2003, the FASB issued FASB
Interpretation No. 46 (revised December 2003), "Consolidation of Variable
Interest Entities", which addresses how a business enterprise should evaluate
whether it has a controlling financial interest in an entity through means other
than voting rights and accordingly should consolidate the entity. FIN 46R
replaces FASB Interpretation No. 46, "Consolidation of Variable Interest
Entities", which was issued in January 2003. The Company will be required to
apply FIN 46R to variable interests in VIEs created after December 31, 2003.
FASB deferred the effective date of FIN 46 to no later than the end of the first
reporting period that ends after March 15, 2004. The application of this revised
interpretation is not expected to have a material effect on the consolidated
financial statements.

On September 30, 2004, the FASB issued FASB Staff Position ("FSP")
Emerging Issues Task Force ("EITF") Issue No. 03-1-1 delaying the effective date
of paragraphs 10-20 of EITF 03-1, "The meaning of Other-Than-Temporary
Impairment and Its Application to Certain Investments", which provides guidance
for determining the meaning of "other-than-temporarily impaired" and its
application to certain debt and equity securities within the scope of SFAS No.
115, "Accounting for Certain Investments in Debt and Equity Securities", and
investments accounted for under the cost method. The guidance requires that
investments which have declined in value due to credit concerns or solely due to
changes in interest rates must be recorded as other than temporarily impaired
unless the Company can demonstrate its intention to hold the security for a
period of time sufficient to allow for a recovery of fair value up to or beyond
the cost of the investment which might mean maturity. The delay of the effective
date of EITF 03-1 will be superceded concurrent with the final issuance of
proposed FSP Issue 03-1-a. Proposed FSP Issue 03-1-a is intended to provide
implementation guidance with respect to all securities analyzed for impairment
under paragraphs 10-20 of EITF 03-1. Management continues to closely monitor and
evaluate how the provisions of EITF 03-1 and proposed Issue 03-1-a will affect
the Company.

On December 16, 2004, the FASB issued SFAS No. 123R, "Share-Based
Payment," which is an Amendment of FASB Statement Nos. 123 and 95. SFAS No. 123R
changes, among other things, the manner in which share-based compensation, such
as stock options, will be accounted for and will be effective as of the
beginning of the first interim or annual reporting period that begins after June
15, 2005. The cost of employee services received in exchange for equity
instruments including options and restricted stock awards generally will be
measured at fair value at the grant date. The grant date fair value will be
estimated using option-pricing models adjusted for the unique characteristics of
those options and instruments, unless observable market prices for the same or
similar options are available. The cost will be recognized over the requisite
service period, often the vesting period, and will be remeasured subsequently at
each reporting date through settlement date.

The changes in accounting will replace existing requirements under SFAS
No. 123, "Accounting for Stock-Based Compensation," and will eliminate the
ability to account for share-based compensation transactions using

17

ABP Opinion No. 25, "Accounting for Stock Issued to Employees," which does not
require companies to expense options if the exercise price is equal to the
trading price at the date of grant. The accounting for similar transactions
involving parties other than employees or the accounting for employee stock
ownership plans that are subject to American Institute of Certified Public
Accountants ("AICPA") Statement of Position 93-6, "Employers' Accounting for
Employee Stock Ownership Plans," would remain unchanged.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

Market risk is the possible chance of loss from unfavorable changes in
market prices and rates. These changes may result in a reduction of current and
future period net interest income, which is the favorable spread earned from the
excess of interest income on interest-earning assets over interest expense on
interest-bearing liabilities.

The Company considers interest rate risk to be its most significant market
risk, which could potentially have the greatest impact on operating earnings.
The structure of the Company's loan and deposit portfolios is such that a
significant decline in interest rates may adversely impact net market values and
net interest income.

The Company monitors whether material changes in market risk have occurred
since September 30, 2004. The Company does not believe that any material adverse
changes in market risk exposures have occurred since September 30, 2004.

Item 4. Controls and Procedures

As of the end of the period covered by this report, management of the
Company carried out an evaluation, under the supervision and with the
participation of the Company's principal executive officer and principal
financial officer, of the effectiveness of the Company's disclosure controls and
procedures. Based on this evaluation, the Company's principal executive officer
and principal financial officer concluded that the Company's disclosure controls
and procedures are effective in ensuring that information required to be
disclosed by the Company in reports that it files or submits under the
Securities Exchange Act of 1934, as amended, is recorded, processed, summarized
and reported, within the time periods specified in the Securities and Exchange
Commission's rules and forms. It should be noted that the design of the
Company's disclosure controls and procedures is based in part upon certain
reasonable assumptions about the likelihood of future events, and there can be
no reasonable assurance that any design of disclosure controls and procedures
will succeed in achieving its stated goals under all potential future
conditions, regardless of how remote, but the Company's principal executive and
financial officers have concluded that the Company's disclosure controls and
procedures are, in fact, effective at a reasonable assurance level.

In addition, there have been no changes in the Company's internal control
over financial reporting identified in connection with the evaluation described
in the above paragraph that occurred during the Company's last fiscal quarter,
that has materially affected, or is reasonably likely to materially affect, the
Company's internal control over financial reporting.

18

PART II. OTHER INFORMATION

Item 1. Legal Proceedings

From time to time, we are a party to various legal proceedings incident to
our business. There currently are no legal proceedings to which we are a party,
or to which any of our property was subject, except as described in the
following paragraph and none which are expected to result in a material loss.
There are no pending regulatory proceedings to which we are a party or to which
any of our properties is subject which are expected to result in a material
loss.

A civil action was filed against 1st State Bank and Brokers, Incorporated
by Michael Locklar in Davidson County Superior Court, in the State of North
Carolina on May 16, 2003. Mr. Locklar has alleged in the action that 1st State
Bank granted him an option to purchase certain real property located in Davidson
County, North Carolina, which 1st State Bank wrongfully sold to Brokers,
Incorporated for $150,000 in breach of the option granted to Mr. Locklar. Mr.
Locklar is seeking to set aside the conveyance of property to Brokers,
Incorporated and to purchase the property from 1st State Bank for the option
price. Brokers, Incorporated has filed a cross-claim against 1st State Bank
seeking indemnification in the form of return of the purchase price they paid
for the property, damages and attorneys fees should Locklar be successful in
setting aside the real estate conveyance. 1st State Bank intends to vigorously
contest Mr. Locklar's allegations. Management does not anticipate that this
lawsuit will have a material adverse impact on the Company's financial condition
or results of operations.

The Bank has been named as a co-defendant in a lawsuit brought by minority
stockholders of a corporation against the majority stockholders of the
corporation. A director of the Company and the Bank, along with family members,
is the majority stockholder of the corporation, which had previously had loans
outstanding from the Bank. During the quarter ended December 31, 2004, these
loans were paid off in full. Included in part of plaintiffs' complaint are
allegations related to loans made by the Bank to the borrowers. The Bank will
vigorously defend the lawsuit and seek its dismissal by the court. Management
does not anticipate that this lawsuit will have a material adverse impact on the
Company's financial condition or results of operations.

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

(a) Not applicable

(b) Not applicable

(c) The following table sets forth information regarding the Company's
repurchases of its Common Stock during the quarter ended December
31, 2004.

19

(d)
(c) Maximum
(a) Total Number of Number of Shares
Total (b) Shares Purchased that May Yet Be
Number of Average as Part of Publicly Purchased Under
Shares Price Paid Announced Plans the Plans or
Period Purchased per Share or Programs Programs
------ --------- --------- ----------- --------

October 2004 -- -- -- --
Beginning date: October 1
Ending date: October 31

November 2004 3,500 $ 27.50 3,500 292,732(1)
Beginning date: November 1
Ending date: November 30

December 2004 2,450 $ 28.52 2,450 290,282(1)
Beginning date: December 1
Ending date: December 31

Total 5,950 $ 27.92 5,950

(1) On November 17, 2004, the Company announced a 10% stock repurchase program
to acquire up to 296,232 shares of the Company's common stock over a
period of 24 months. These share purchases were part of this repurchase
program.

Item 3. Defaults Upon Senior Securities

None.

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

None.

Item 5. Other Information

None.

Item 6. Exhibits

The following exhibits are filed herewith:

31.1 Rule 13a-14(a) Certification of Chief Executive Officer

31.2 Rule 13a-14(a) Certification of Chief Financial Officer

32 Section 1350 Certification

20

SIGNATURES

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

1st STATE BANCORP, INC.

Date: February 11, 2005 /s/ James C. McGill
----------------------------------------
James C. McGill
President and Chief Executive Officer
(Principal Executive Officer)

Date: February 11, 2005 /s/ A. Christine Baker
----------------------------------------
A. Christine Baker
Executive Vice President
Treasurer and Secretary
(Principal Financial and Accounting
Officer)