10-Q 1 form10q-65810_firststate.txt 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)

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)

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)

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)

(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)

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:

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.

---------- (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:

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:

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:

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

(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)

1ST STATE BANCORP INC 10-Q