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Item 1.   Financial Statements

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See accompanying notes to consolidated interim financial statements. 

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PALMETTO BANCSHARES, INC. AND SUBSIDIARY
Notes To Interim Consolidated Financial Statements (unaudited)

Palmetto Bancshares, Inc. is a regional financial services company with assets totaling approximately $966 million and is the holding company for The Palmetto Bank (the "Bank").  The Bank is a full-service bank and trust company and engages in the general banking business through 30 retail branch offices in the Upstate South Carolina markets of Laurens, Greenville, Spartanburg, Greenwood, Anderson, Cherokee, Abbeville, and Oconee counties (the "Upstate"). The Bank also engages in investment services through its wholly-owned subsidiary, Palmetto Capital, Inc. ("Palmetto Capital"). Throughout these Notes, the "Company" shall refer to Palmetto Bancshares, Inc. and its subsidiary, the Bank.

The industry in which the Bank operates exists primarily to provide an intermediary service to the general public with funds to deposit and, by using these funds, to originate loans in the markets served. The Bank provides a full range of banking activities, including, but not limited to, checking, savings, money market, and other time deposits for a wide range of consumer and commercial depositors, loans for business, real estate, and personal uses, safe deposit box rental, electronic funds transfer services, telephone banking, and bank card services. The Bank's indirect lending department establishes relationships with Upstate automobile dealers to provide customer financing on qualifying automobile purchases, and its mortgage banking operation meets a range of customers' financial service needs by originating, selling, and servicing mortgage loans. The Bank also offers both individual and commercial trust services through an active trust department. Palmetto Capital offers customers stocks, treasury and municipal bonds, mutual funds, and insurance annuities, as well as college and retirement planning.

Palmetto Bancshares is headquartered in Laurens, South Carolina and was organized in 1982 under the laws of South Carolina. The Bank was organized and chartered under South Carolina law in 1906. 

1.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

The accompanying consolidated financial statements include the accounts of the Company.  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 periods presented have been included.  Any such adjustments are of a normal and recurring nature. Assets held in a fiduciary or agency capacity for customers are not included in the consolidated financial statements, as such assets do not represent assets of the Company. The Company primarily operates through its wholly-owned subsidiary bank, the Bank, which represents its only reportable segment. 

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 included hereto, which are unaudited with the exception of those as of the year ended December 31, 2003, 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 date of the consolidated financial statements for the periods presented. Actual results could differ from these estimates and assumptions. As such, the results of operations for the three and nine month periods ended September 30, 2004 are not necessarily indicative of the results of operations that may be expected in future periods.

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The consolidated financial statements and related notes included hereto are prepared in conformity with the Securities and Exchange Commission's instructions for Quarterly Reports on Form 10-Q. Accordingly, certain information and footnotes required by generally accepted accounting principles ("GAAP") for complete financial statements are not included.  As such, the information contained in this report should be read in conjunction with the financial statements and footnotes thereto included in the Company's Annual Report on Form 10-K for the year ended December 31, 2003.

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 period net income or retained earnings as previously reported.

Accounting policies followed by the Company for reporting within this quarterly report are consistent with the accounting policies followed for annual financial reporting as described in Note 1 of Notes to Consolidated Financial Statements included in the Company's Annual Report on Form 10-K for the year ended December 31, 2003. With the exception of the Company's policy regarding Federal Home Loan Bank ("FHLB") borrowings, these polices have not materially changed from the year ended December 31, 2003.

During the second quarter of 2004, the Company began to utilize short term and long term borrowings from the FHLB.  FHLB borrowings are a source of funding which the Company utilizes depending on the current level of deposits, management's willingness to raise deposits through market promotions, the Company's unused FHLB borrowing capacity, and the availability of collateral to secure FHLB borrowings. Such borrowings are used to fund increases in interest earning assets in times of declines in alternative funding sources. Short term borrowings typically represent overnight funds sweeps used to fully utilize the Company's supply of excess lendable funds with maturities of one year or less when made. Access to alternate short-term funding sources allows the Company to meet funding needs without relying on increasing deposits on a short-term basis. Long term borrowings have maturities greater than one year when made. FHLB borrowings are collateralized by a blanket lien on certain qualifying commercial and single-family loans held in the Company's loan portfolio. The Company may, at its discretion, collateralize such borrowings with securities from the Company's investment portfolio. FHLB borrowings are an alternative to other funding sources with similar maturities.

During the three month and nine month periods ended September 30, 2004, increases in FHLB borrowings were used to support earning asset growth including increases in investment securities. The following table reports information regarding the Company's long term FHLB borrowing portfolio at September 30, 2004 (dollars in thousands).   

2.       INVESTMENT SECURITIES AVAILABLE FOR SALE

The following tables summarize the amortized cost, gross unrealized gains, gross unrealized losses, and fair values of investment securities available for sale at the dates indicated (in thousands).

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Securities with an aggregate carrying value of $72.0 million at September 30, 2004 were pledged to secure public deposits. Investment securities available for sale were impacted by purchases, proceeds from the sale, maturity, and / or call of such maturities as well as principal paydowns of mortgage-backed securities, which is reflected in the Consolidated Statement of Cash Flows.

During the three months ended September 30, 2004, the Company had no realized gains and realized losses of $18 thousand on the sales of investment securities available for sale.  During the same quarter of 2003, the Company had realized gains of $81 thousand and no realized losses on sales of investment securities available for sale. During the nine months ended September 30, 2004, the Company had realized gains of $141 thousand and realized losses of $51 thousand on sales of investment securities available for sale.  During the same period of 2003, the Company had realized gains of $362 thousand and no realized losses on sales of investment securities available for sale.  Specific identification is the basis on which cost was determined in computing realized gains and losses.

3.       LOANS

The Company's primary market area is the Upstate region of South Carolina. Management closely monitors its credit concentrations and attempts to diversify the portfolio within its primary market area. At September 30, 2004, except for the fact that the majority of the loan portfolio is located in the Company's primary market area, there were no concentrations of loans in any type of industry, type of property, or to one borrower.

The following table illustrates loans, including deferred fees and costs and in process accounts (excluding those mortgage loans held for sale), by classification at September 30, 2004 and December 31, 2003 (dollars in thousands).

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Loans included in the above table are net of whole loans and participations sold and mortgage loans serviced for others. Mortgage loans serviced for the benefit of others amounted to $267.3 million and $269.9 million at September 30, 2004 and December 31, 2003, respectively. Most of these mortgage loans are serviced for the Federal Home Loan Mortgage Corporation.

As reflected in the table above, there were no significant fluctuations in the mix of the loan portfolio when comparing balances at December 31, 2003 with those at September 30, 2004.   Management has continued its emphasis on loans secured by real estate during the third quarter of 2004 due to the reduced amount of inherent risk within such loans compared with those secured by collateral other than real estate or loans that are unsecured. Additionally, as was the case during the year ended December 31, 2003, the loan portfolio has continued to experience increases in prime access loans over the periods presented primarily resulting from the no closing costs promotional offering for such loans.

The table set forth below illustrates the activity impacting the allowance for loan losses ("Allowance") for the three and nine month periods ended September 30, 2004 and 2003 (in thousands).

The Allowance was $8.2 million or 1.09% of loans, excluding mortgage loans held for sale, at September 30, 2004 compared with $7.5 million or 1.08% of loans at December 31, 2003. Although improved asset quality trends impacted the historical loss factors used in the Allowance model contributing to the decline in provision for loan losses of 27.8% for the three months ended September 30, 2004 over the same quarter of 2003, net charged-off loans over the same period declined 32.0%.  Likewise, the provision for loan losses declined 20.4% for the nine months ended September 30, 2004 over the period of 2003, while net charged-off loans over the same period declined 22.5%.  As a result, the Allowance as a percentage of loans, excluding mortgage loans held for sale, increased for both the three and nine month periods ended September 30, 2004 over the respective periods of 2003.

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The following table summarizes the Company's nonperforming assets and loans 90 days or more past due and still accruing interest as of the dates indicated (in thousands).

(1) Substantially all of these loans are credit card loans

4.       MORTGAGE SERVICING RIGHTS

On a quarterly basis, a third party is utilized to determine the value of mortgage servicing rights ("MSRs") as well as the related amortization and impairment of such rights. The external valuation utilizes estimates for the amount and timing of mortgage loan repayments, estimated prepayment rates, credit loss experience, costs to service loans, and discount rates to determine an estimate of the fair value of mortgage servicing rights. In regard to the valuation obtained at September 30, 2004, management believes that the modeling techniques and assumptions used in conjunction with the valuation are reasonable.

In accordance with Statement of Financial Accounting Standards ("SFAS") No. 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities -a replacement of SFAS No.125," mortgage servicing assets are stratified based on predominant risk factors in order to evaluate impairment. Impairment is recognized and reported through a valuation allowance. Impairment is the difference between the period end book value and the market value at the same point in time.

Amortization expense is calculated based on current available 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.

The following tables summarize the changes in gross mortgage servicing rights during the three and nine month periods ended September 30 (in thousands).

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The following tables summarize the activity impacting the valuation allowance for impairment of mortgage servicing rights during the three and nine month periods ended September 30 (in thousands).

Gross mortgage servicing rights and the related valuation allowance are included in "other assets" on the Consolidated Balance Sheets.

As management projected in its Annual Report on Form 10-K for the year ended December 31, 2003, due to the interest rate environment, residential mortgage production during the first nine months of 2004 has declined compared with recent years, resulting in reduced loan sales.  As a result, mortgage servicing rights capitalized during the first nine months of 2004 have also declined when compared with the same period of 2003. Activity impacting the Company's mortgage servicing right portfolio, including mortgage loans originated to be sold and sales, are reflected in the Consolidated Statement of Cash Flows. Management expects lower origination and sales figures to continue due to higher mortgage loan rates. Although existing mortgage servicing rights continued to be amortized and evaluated for impairment, changes in current available market information regarding such facets of the portfolio as loan payments and prepayments have caused a decline in amortization and impairment during the nine months ended September 30, 2004 when compared with the same period of 2003.  As noted above, during the three and nine month periods ended September 30, 2004 amortization of mortgage servicing rights has outpaced the capitalization of new rights. During the same periods of 2003 the opposite was true.

5.       OTHER INTANGIBLE ASSETS

The following table summarizes the carrying amount of other intangible assets, included in "other assets" on the Consolidated Balance Sheets at the periods noted (in thousands).

Intangible assets with infinite lives are subject to periodic impairment tests in accordance with SFAS No. 142, "Goodwill and Other Intangible Assets," on an annual basis, or more often if events or circumstances indicate that there may be impairment. Impairment valuations as of June 30, 2004 indicated that no impairment charge was required as of that test date, as the carrying amount of reporting units did not exceed implied fair value. As a result, no impairment loss was recorded. 

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The following tables summarize the activity of intangible assets with finite lives and the related amortization, included in "other assets" on the Consolidated Statements of Income, during the three and nine month periods ended September 30 (in thousands).

Amortization expense related to intangible assets with finite lives is expected to total $144 thousand for the year ended December 31, 2004.  In addition, amortization expense related to intangibles of $144 thousand is expected to be recorded for fiscal year 2005, $48 thousand for fiscal years 2006 and 2007, $45 thousand for fiscal year 2008, and $33 thousand for fiscal year 2009.

6.       NET INCOME PER COMMON SHARE

Basic and diluted earnings per share have been computed based on net income presented 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 as of that date.  At September 30, 2004, there were no option shares that were excluded from the calculation of diluted earnings, based on information available to management at that time.

The Company paid cash dividends of $0.14 per share for the quarter ended September 30, 2004 and $0.12 per share for the same quarter of 2003.  The Company paid cash dividends of $0.42 per share for the nine months ended September 30, 2004 and $0.36 per share for the same period of 2003. 

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7.  EMPLOYEE BENEFIT PLANS

Postretirement Benefits
The tables set forth below present the components of the Company's net period benefit cost during the three and nine month periods ended September 30 (in thousands).

The Company disclosed in its Annual Report on Form 10-K for the year ended December 31, 2003 that it expected to contribute $1.3 million to its noncontributory defined benefit pension plan during 2004. During the three and nine month periods ended September 30, 2004, $323 thousand and $982 thousand was contributed, respectively.

Stock Based Compensation
At September 30, 2004, the Company had a stock-based employee and director option plan, which is described more fully in Note 12 of Notes to Consolidated Financial Statements included in its Annual Report on Form 10-K for the year ended December 31, 2003.  SFAS No. 123, "Accounting for Stock-Based Compensation," allows a company to either adopt the fair value method of valuation or continue using the intrinsic valuation method presented under Accounting Principles Bulletin ("APB") Opinion 25, "Accounting for Stock Issued to Employees," to account for stock-based compensation. The Company has elected to continue following APB Opinion 25 and provide pro forma net income and pro forma earnings per share disclosures for employee stock option grants as if the fair value-based method defined in SFAS No. 123 had been applied. As such, no stock-based employee 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.

In December 2002, the Financial Accounting Standards Board ("FASB") issued SFAS No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure - an amendment of FASB Statement No. 123." This Statement amends SFAS No. 123 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 SFAS No. 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 transition and disclosure provisions were required for financial statements for fiscal periods ending after December 15, 2002. The Company adopted this standard effective December 31, 2002 and has included the required interim disclosures herein.

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The tables set forth below illustrate the impact the fair value recognition provisions of SFAS No. 123 to stock-based compensation would have had on net income and earnings per share if the Company had applied them for the three and nine month periods ended September 30 (in thousands, except share data).

In accordance with its 1997 Stock Compensation Plan, the Company granted 44,000 options during second quarter 2003 and 34,000 options during first quarter 2004. The fair value of each option granted is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions used for grants during 2004 and 2003, respectively: dividend yield of 2.7% and 2.6%, expected volatility of 18% for grants during both years, average risk-free interest rate of 4% for grants during both years, expected lives of 10 years, and a vesting period of five years. The weighted average fair value of options granted approximated $4.58 in 2004 and $4.38 in 2003. For purposes of the pro forma calculation, compensation expense is recognized on a straight-line basis over the vesting period.

In November 2003, the FASB issued a tentative decision related to fair value accounting of stock options requiring that all unvested options begin being expensed in 2005 financial statements, which included guidance on how equity-based awards will be valued, expensed, and classified. The Company anticipated at that time that the adoption of such decisions would have an impact on its financial position or results of operations although such impact could not be determined at that time.

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In March 2004, the FASB formally proposed to require companies to recognize the fair value of stock options and other stock-based compensation to employees for 2005 reporting periods, a policy consistent with the related international standard released and with convergence between the two sets of standards. The question then followed regarding how "share based payments" (to use the International Accounting Standard Board's ("IASB") term adopted by the FASB) should be valued and classified and the related implementation difficulties. The exposure draft addressed only accounting for share-based awards to employees, including employee-stock-purchase-plans (ESPPs). Accounting for employee-stock-ownership-plan transactions (ESOPs) and awards to nonemployees were to be taken up in a later phase of the project. Comments on the exposure draft were due by June 30, 2004.

On July 20, 2004, the House passed a bill that would prevent the Securities and Exchange Commission from putting into effect the FASB proposal to require companies to expense employee stock options. The legislation proposed requiring public companies to report only employee stock options granted to their CEOs and four highest-paid officers. Small businesses would be exempted from expensing options, and new public companies would be able to delay expensing for top executives during their first three years. The House also approved an amendment to the legislation to clarify that companies wishing to expense stock options voluntarily may continue to do so. At the time, a similar bill was in the Senate under consideration.

On October 16, 2004, the FASB voted to delay for six months the effective date by which companies would be required to expense stock options. The new FASB rule will require all stock options granted, modified or settled after June 15, 2005 to be expensed in income, effective for periods beginning after June 15, 2005. The previous effective date was January 1, 2005. The FASB plans to issue a final rule by December 31, 2004 and will require that companies begin disclosing in their financial statements the expected impact of adoption of this rule for December 31, 2004 financial statements. The Company anticipates that the adoption of such decisions would have an impact on its financial position or results of operations beginning in 2005.

Due to the continually evolving nature of stock option and other stock-based compensation accounting, the Company will stay abreast of the issue and comply with any requirements that become applicable to it. 

8.       BUSINESS SEGMENTS

The Company has one principal operating subsidiary, The Palmetto Bank, which is evaluated regularly by the chief operating decision makers in deciding how to allocate resources and assess performance. This subsidiary, by virtue of exceeding certain quantitative thresholds, is the Company's only reportable segment. The reportable segment also provides demand transaction accounts and time deposit accounts to businesses and individuals. The Bank offers products and services primarily to customers in South Carolina. Revenues for the Bank are derived primarily from interest and fees on loans, interest on investment securities, service charges on deposits, and other customer service fees. No single customer accounts for a significant amount of the revenues of the reportable segment.

9.       COMMITMENTS, CONTINGENCIES, AND OFF-BALANCE SHEET RISK

Lending Commitments and Off-Balance Sheet Risk
In the normal course of business, the Company engages in a variety of financial transactions that, in accordance with generally accepted accounting principles, are not recorded in the financial statements or are recorded in amounts that differ from the notional amounts. These transactions involve elements of credit, interest rate, and liquidity risk. Such transactions are used for general corporate purposes or to meet customer needs. Corporate purpose transactions are those used to manage customers' requests for funding.

Off-balance sheet arrangements, which principally include commitments to extend credit, are described below. At September 30, 2004, the Company had no interests in non-consolidated special purpose entities nor is it involved in other off-balance sheet contractual relationships (other than those discussed herein), unconsolidated related entities that have off-balance sheet arrangements, or transactions that could result in liquidity needs.

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The Company makes contractual commitments to extend credit, which are legally binding agreements to lend money to customers at predetermined interest rates for a specific period of time. The Company also provides standby letters of credit. These lending commitments are provided to customers in the normal course of business and the Company's credit policies and standards are applied when making these commitments.

For commercial customers, loan commitments generally take the form of revolving credit arrangements to finance customers' 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.

Generally, unused loan commitments are at adjustable rates that fluctuate with the prime rate or are at fixed rates that approximate market rates.

The following table summarizes issued commitments to extend credit loan commitments and unused credit card lines at September 30, 2004 (in thousands).

Outstanding commitments on mortgage loans not yet closed, the majority of which include interest rate lock commitments, amounted to approximately $3.7 million at September 30, 2004. These were principally single-family loan commitments. Commitments to extend credit are agreements to lend to borrowers as long as there is no violation of any condition established by the commitment letter. Commitments generally have fixed expiration dates or other termination clauses. The majority of the commitments will be funded within a 12-month period. Each customer's creditworthiness is evaluated on a case-by-case basis. The amount of collateral obtained, if deemed necessary upon extension of credit, is based on management's credit evaluation of the borrower. Collateral held consists of residential properties.

Standby letters of credit represent an obligation to a third party contingent upon the failure of a 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 September 30, 2004, 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 the Company believes the likelihood that it will have to perform under such contracts is not likely. The maximum potential amount of undiscounted future payments related to standby letters of credit at September 30, 2004 was $1.6 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 values of such guarantees are deemed immaterial at September 30, 2004.

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The Company originates, sells, and services mortgage loans. All of the loan sales within the first nine months of 2004 were without provision for recourse. Mortgage loans serviced for the benefit of others, which are not owned by the Company and therefore are not recorded on the Consolidated Balance Sheets, amounted to $267.3 million and $269.9 million at September 30, 2004 and December 31, 2003, respectively.

Contingencies
The Company is currently the defendant in certain 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.

On May 18, 2004, Glen Meadows, LLC, WACC, LLC, and BC Ventures, LLC filed a complaint against The Palmetto Bank and two other financial institutions claiming that a dishonest employee (of the plaintiffs) deposited checks drawn on company accounts at the latter two institutions and deposited these funds into the employee's account at The Palmetto Bank. Although The Palmetto Bank contended that we had no obligation to the drawer of the checks due to the extended period of time between the occurrences and the claim, the compliant was settled during the third quarter of 2004 for $75,000.

Lease Agreements
The Company has not entered into any material property and equipment leases during the nine month period ended September 30, 2004.

10.   RELATED PARTY TRANSACTIONS

In the ordinary course of business, the company engages in business transactions with certain of its directors and employees. Such transactions are competitively negotiated at arms-length by the Company and are not considered to include terms that are unfavorable to the Company.

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

WEBSITE AVAILABILITY OF REPORTS FILED WITH THE SECURITIES AND EXCHANGE COMMISSION

The Bank's website, www.palmettobank.com, includes a link to the Securities and Exchange Commission's Electronic Data Gathering, Analysis, and Retrieval ("EDGAR") system which makes various reports filed with the Securities and Exchange Commission by the Company, including, but not limited to, its Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, Ownership Reports filed in conjunction with Section 16, and amendments to such reports, available, free of charge.  These reports are made available as soon as reasonably practicable after these reports are filed with, or furnished to, the Securities and Exchange Commission.  The Securities and Exchange Commission's EDGAR database may also be accessed through its website, www.sec.gov.

FORWARD-LOOKING STATEMENTS

In this report and in other reports and proxy statements filed with the Securities and Exchange Commission (the "SEC"), forward-looking statements (as defined in the Private Securities Litigation Reform Act of 1995) are made. In addition, management may make forward-looking statements orally. Broadly speaking, forward-looking statements include, but are not limited to, projections of the revenues, income, earnings per share, capital expenditures, dividends, capital structure, or other financial items, descriptions of plans or objectives for future operations, products or services, forecasts of future economic performance, and descriptions of assumptions underlying or relating to any of the foregoing.

Forward-looking statements discuss matters that are not historical facts. Because they discuss future events or conditions, forward-looking statements often include words such as "anticipate," "believe," "estimate," "expect," "intend," "plan," "project," "target," "can," "could," "may," "should," "will," "would," or similar expressions. Do not unduly rely on forward-looking statements. Such statements give management's expectations about the Company's future and are not guarantees. Forward-looking statements speak only as of the date they are made, and no obligation is undertaken 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 included in future filings of the Company with the SEC, in press releases, and/or 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.

There are several factors, many beyond the Company's and its management's control, that could cause results to differ from expectations. Some of these factors include, but are not limited to,

• changes in economic and / or industry conditions and monetary policy;
• changes in interest rates, deposit rates, the net interest margin, and / or funding sources;
• market risk and inflation;
• risks inherent in making loans including repayment and collateral risk;
• volume of loan growth;
• the adequacy of the allowance for loan losses (the "Allowance") and the assessment of problem loans;
• the ability of the Company to meet its contractual obligations;
• fluctuations in consumer spending;
• competition in the banking industry and the related demand for banking products and services;
• dependence on senior management;
• technological changes;

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• the ability to maintain and / or increase market share;
• the reliability of expense projections;
• risks associated with income taxes, including the potential for adverse adjustments;
• changes in accounting policies and practices;
• potential cost and impact of litigation; and
• the impact of recently-enacted or proposed legislation.

Many of these factors, as well as other factors, such as credit, market, operational, liquidity, interest rate, and other risks, are discussed in more detail in the Company's Annual Report on Form 10-K for the year ended December 31, 2003. Any factor described in this Quarterly Report on Form 10-Q or in that Annual Report on Form 10-K could by itself, or together with one or more factors, adversely affect the business, financial condition, and / or results of operations of the Company. Additionally, there are factors that may not be described in this report that could cause actual results to differ from expectations.

COMPANY OVERVIEW

Palmetto Bancshares is a bank holding company organized under the laws of South Carolina in 1982. The Palmetto Bank (the "Bank"), a wholly-owned subsidiary of Palmetto Bancshares, was organized and chartered under South Carolina law in 1906.  The Company's corporate offices are located at 301 Hillcrest Drive, Laurens, South Carolina. The Bank is a full-service bank and trust company.  At September 30, 2004, the Bank had thirty full-service branches in the Upstate region of South Carolina within the following counties: Laurens County (4), Greenville County (10), Spartanburg County (5), Greenwood County (5), Anderson County (3), Cherokee County (2), and Oconee County (1).  In addition to branch locations, at September 30, 2004, the Bank has 27 automatic teller machine ("ATM") locations (including two at non-branch locations) and five limited service branches located in retirement centers in the Upstate. The Company added a new ATM to its Simpsonville market in October 2004. The Bank engages in investment services through its wholly-owned subsidiary, Palmetto Capital, Inc. ("Palmetto Capital"). Throughout this report, the "Company" shall refer to Palmetto Bancshares, Inc. and its subsidiary.

The Company's primary market area is located within South Carolina in the foothills region of Greenville, including Greenville County and its surrounding counties. Primary business sectors in the region include banking and finance, manufacturing, health care, retail, telecommunications, government services, and education. The Company believes that it is not dependent on any one or a few types of commerce due to the area's diverse economic base.

The Upstate is a designated foreign trade zone area, and boasts the highest level of foreign capital investment per capita in the nation, and is home to more than 240 international firms from 23 nations, including BMW, Hitachi, and Michelin. While commercial real estate lending has not returned to the levels seen before the economic downturn of recent years, activity in this sector has increased. Having recently annexed more than 724 acres of prime development property, the Upstate is believed to be the cutting edge of new industrial opportunities. Along with the creation of the Millennium Campus and an automotive research park at the site, part of a joint venture with Clemson University and BMW, developers are ready to bring many new industries to the area.

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No new branches were opened during the twelve month period ended September 30, 2004, although management continually reviews opportunities for Upstate expansion that it believes to be in the best interest of the Company, its customers, and its shareholders. Expansion opportunities are currently being evaluated in the market areas in which the Company currently serves. During the second quarter of 2004, the Company closed on a real estate site in Easley, South Carolina that will introduce the Company's presence into Pickens County. Easley is a culturally diverse community with approximately 20,000 residents living within the city limits. Maintaining the Company's focus on serving Upstate South Carolina, ground will be broken on the new office in Easley in December 2004, with the branch opening scheduled for third quarter 2005.

In addition to traditional banking services, the Company's offers brokerage and trust services. Community banking includes the retail and commercial distribution network consisting of 30 branches, telephone banking, and internet banking. Community banking provides a variety of depository accounts including interest-bearing and noninterest-bearing checking accounts, savings accounts, certificates of deposit and money market accounts. In addition, community banking offers a variety of loan products, including commercial, consumer, real estate and home equity loans as well as credit card services. The Bank also maintains 27 ATMs and allows customers to access their accounts on-line. The mortgage business provides both fixed-rate and variable-rate mortgage products and loan servicing. Mortgage lenders are located in the community bank branches. Palmetto Capital offers full service and discount brokerage, annuity sales and financial planning services through a third party arrangement with Raymond James. The Company also offers trust services for companies and individuals. Investment advisors are based in branch locations in community bank branches.  In addition, separate investment facilities are maintained in Greenville and Laurens Counties.  Trust professionals are located in the community bank branches as well as in the Company's operations center.

The Company derives interest income through traditional banking activities such as generating loans and earning interest on securities. Income is also earned from fees on deposit accounts and mortgage, brokerage, and trust services. Also, as a part of the Company's management of its securities portfolio, income is recognized on the sale of securities. Improving the net interest margin is critical to the Company's strategy to grow earnings. However, the recent interest rate environment has continued to pressure loan yields. Although the lending environment continues to be challenging due to economic conditions, loan growth continues to be a primary focus for the Company. 

Lowering funding costs is essential to improving the Company's net interest margin. The Company continues its focus on growing deposits balances while remaining cognizant of pricing dilemmas resulting from the recent interest rate environment. In addition to traditional funding sources, during 2004, the Company began to utilize Federal Home Loan Bank ("FHLB") borrowings to support earning asset growth, including increases in investment securities. Although often obtained at rates higher than those obtained through traditional funding sources, borrowings represent a source of funding diversification, which can be used for leverage in deposit pricing. In addition, they help an institution avoid overpaying for deposits. Among other tools, the Company uses marginal cost analyses when considering funding options.  Management believes that marginal cost analysis is the key to incorporating borrowings in deposit pricing. Although alternative funding sources, such as FHLB borrowings, do not always result in lower interest expense, management believes that such funding alternatives can increase net interest income by employing these funds in higher yield assets.

Since asset quality is tied to profitability and capital adequacy, maintaining sound asset quality continues to be a primary focus for the Company. As a result of this focus and the initiatives taken during recent years, our asset quality ratios have improved significantly and remain strong as of and for the periods ended September 30, 2004. Activities designed to monitor and improve asset quality typically have a positive impact on earnings by reducing the credit risk profile of the Company and reducing future collection costs. Nevertheless, certain risks are inherent within any loan portfolio particularly portfolios containing commercial, commercial real estate, and consumer loans, which must be continually managed. Management monitors asset quality and credit risk on an ongoing basis.

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The Company is focused on retaining existing customers and attracting new customers. The Company feels that it sets itself apart from its competitors by providing superior personal service. This is accomplished through a variety of delivery channels marketing a full range of high quality financial products and services. The Company sets strategic targets for net growth in deposit accounts annually in an effort to cross-sell, thereby increasing the products per banking relationship. Traditional marketing techniques are employed to attract new customers including, but not limited to, direct mailings and advertising, as the Company recognizes that attracting new customers provides, in addition to interest opportunities, a new avenue for the generation of fee income.  In addition, new deposit customers are key to providing a mix of lower-cost funding sources. To meet the convenience needs of existing and potential customers, the Company offers early bird hours at select branch locations, Saturday banking at select branch locations, a telephone banking call center, as well as Internet banking options. The Company will continue to expand into new areas as both market and economic conditions warrant.

Consistent with the United States banking industry's increased reliance on nontraditional business activities to generate fee income, trading revenue, and other types of noninterest income, the Company continues to place emphasis on noninterest income for possible growth opportunities. These sources of income typically provide a boost to revenue while being less dependent on overall business conditions than traditional interest income. As a result of the Company's emphasis increases have been experienced related to service charges on deposit accounts, brokerage and trust services, and mortgage banking services in the first nine months of 2004.  The Company continuously reviews opportunities for new products, services, and expansion opportunities as conditions warrant.

The following discussion and analysis is presented to assist in understanding the financial condition and results of operations of the Company.  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 in the Company's Annual Report on Form 10-K for the year ended December 31, 2003.  Results of operations for the three and nine month periods ended September 30, 2004 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.

FINANCIAL SUMMARY

Net income totaled $3.1 million, or $0.49 per diluted share, for the three months ended September 30, 2004, compared to net income of $2.9 million or $0.45 per diluted share for the same period in 2003. For the nine months ended September 30, 2004, net income amounted to $9.0 million, or $1.41 per diluted share, compared with net income of $8.5 million or $1.32 per diluted share for the same period in 2003. Net income for the three months and nine months ended September 30, 2004 increased due primarily to higher net interest income as well as a decline in the provision for loan losses.  This decline in the provision for loan losses is primarily attributable to improved asset quality trends that directly impact the historical loss factors used in the Allowance model.  The increase in net interest income resulted from an increase in volume offset by a decline in rates as well as the results of certain asset-liability management transactions entered into during the second and third quarters of 2004.

During the third quarter of 2004, the Company's nontraditional banking services continued to generate strong revenue growth consistent with the third quarter of 2003. In the aggregate, noninterest expense remained relatively unchanged during the three months ended September 30, 2004 when compared with the same period of 2003 primarily due to a reduction in salaries and other personnel expense being absorbed through slight increases in marketing and professional services expense.  Salaries and other personnel expense, the largest component of noninterest expense, accounted for approximately 54.3% of total noninterest expenses for the quarter ended September 30, 2004. Income tax expense increased $247 thousand due to an increase in projected taxable income relative to nontaxable adjustments.

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During the first nine months of 2004, the Company's nontraditional banking services continued to generate strong revenue growth compared to the first nine months of 2003, with net fees for trust and brokerage services up 8.4%, mortgage banking income up 76.7% and other noninterest income up 6.7%. These increases were offset slightly by a 75.1% decline in gains on investment security sales. Noninterest expense increased 1.5% primarily due to increases in marketing and professional services expense. These increases were offset slightly by declines in postage and supplies expense. Salaries and other personnel expense, the largest component of noninterest expense, accounted for approximately 56.1% and 57.1% of total noninterest expenses for the nine months ended September 30, 2004 and 2003, respectively. Income tax expense increased $302 thousand due to an increase in projected taxable income relative to nontaxable adjustments.

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CRITICAL ACCOUNTING POLICIES

The Company's accounting and financial reporting policies are in conformity with generally accepted accounting principles ("GAAP") and with general practice within the banking industry. The preparation of financial statements in conformity with such principles requires management to make estimates and assumptions that impact the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. During the annual financial reporting process, management, in conjunction with the Company's independent auditors, discusses the development and selection of the critical accounting estimates with the Audit Committee of the Board of Directors.  Additionally, the Audit Committee reviews the Company's Quarterly Reports on Form 10-Q and the Annual Reports on Form 10-K including all related disclosures.

In order to understand the Company's financial position and results of operations, it is important to understand the Company's critical accounting policies and the extent to which judgment and estimates are used in applying such policies. The Company's significant accounting policies are discussed in Item 7 and Note 1 of Notes to Consolidated Financial Statements of its Annual Report on Form 10-K for the year ended December 31, 2003. Of these significant accounting policies, policies regarding the accounting for its allowance for loan losses, pension plan, mortgage servicing rights, and income taxes, are considered to be the most critical accounting policies due to the valuation techniques used and the sensitivity of these financial statement amounts to the methods, assumptions, and estimates underlying these balances. Accounting for these critical areas requires a significant degree of management judgment that could be subject to revision as current information becomes available. In order to assist in the determination of critical accounting policies, management considers whether the accounting estimate requires assumptions about matters that were highly uncertain at the time the accounting estimate was made and whether different estimates that reasonably could have been used in the current period, or changes in the accounting estimate that are reasonably likely to occur from period to period, would have a material impact on the Company's financial condition or results of operations.

Based on a critical assessment of its accounting policies and the underlying judgments and uncertainties impacting the application of these policies, management believes that the Company's consolidated financial statements provide a meaningful and fair presentation of its current financial condition. This is not to suggest that risk factors, some of which are described in Forward-Looking Statements, could not adversely impact this condition.

NON-GAAP FINANCIAL INFORMATION

This report contains financial information determined by methods other than in accordance with GAAP. The Company's management uses these non-GAAP measures to analyze performance. In particular, certain designated net interest income amounts are presented on a tax-equivalent basis. Management believes that the presentation of net interest income on a tax-equivalent basis aids in the comparability of net interest income arising from both taxable and tax-exempt sources. These disclosures should not be viewed as a substitute for GAAP measures, and furthermore, the Company's non-GAAP measures may not necessarily be comparable to non-GAAP performance measures of other companies.

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EARNINGS REVIEW

Net Interest Income and Margin
Net interest income is the difference between gross interest and fees on interest-earning assets, primarily loans and investment securities, and interest paid on deposits and other interest-bearing liabilities and represents the largest component of earnings for the Company. The net yield on interest-earning assets measures how effectively a company manages the difference between the yield on interest-earning assets and the rate paid on funds to support those assets. Fully tax-equivalent net interest income is a non-GAAP performance measure used by management in operating the business which management believes provides investors with a more accurate picture of the interest margin for comparative purposes.  This measure adjusts the yield for assets earning tax-exempt income to a comparable yield on a taxable basis. Balances of interest-earning assets and successful management of the net interest margin determine the level of net interest income. Changes in interest rates earned and paid on assets and liabilities, the rate of growth of the asset and liability base, the ratio of interest-earning assets to interest-bearing liabilities, and the management of interest rate sensitivity cause changes in net interest income.

The following tables present the Company's analysis of net interest income on a fully tax-equivalent basis and average balance sheets for the three and nine months ended September 30, 2004 (dollars in thousands).

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