form10-q.htm

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect reported amounts of assets and liabilities and the reported amounts of revenues and expenses during the reporting period. The more significant estimates that are particularly susceptible to significant change relate to the determination of the allowance for loan losses, valuation of goodwill and intangible assets, valuation of investments, and tax assets, liabilities and expense. Actual results could differ from those estimates.

In the opinion of management, all adjustments necessary for a fair presentation of the financial position and results of operations for the periods presented have been included, and all significant intercompany transactions have been eliminated in consolidation. All such adjustments are of a normal and recurring nature. Certain amounts reported in prior periods have been reclassified to conform to the current presentation. Such reclassifications have no effect on net income or shareholders’ equity as previously reported. The results of operations for the three and six months ended June 30, 2007 are not necessarily indicative of the results of operations that may be expected for the year ended December 31, 2007.

The condensed consolidated balance sheet at December 31, 2006 has been derived from the audited consolidated financial statements contained in the Company’s Annual Report on Form 10-K for the year ended December 31, 2006.

The accounting policies followed are as set forth in Note 1 of the Notes to Consolidated Financial Statements in the Company’s Annual Report on Form 10-K for the year ended December 31, 2006.

The Company adopted the provisions of FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109,” (“FIN 48”) effective January 1, 2007. FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 clarifies the accounting for uncertain tax positions and requires the Company to recognize management’s best estimate of the impact of a tax position only if it is considered “more likely than not,” as defined in Statement of Financial Accounting Standards (“SFAS”) No. 5, Accounting for Contingencies, of being sustained on audit based solely on the technical merits of the tax position. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. The Company does not anticipate any changes in its current accounting policies associated with the adoption of FIN 48. The adoption of FIN 48 has not had a material financial impact on the Company’s financial condition or results of operations.

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS No. 157”), which defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007. The Company is currently in the process of evaluating the provisions of SFAS No. 157 and determining how this framework for measuring fair value will affect the Company’s current accounting policies and procedures and our financial statements, but does not expect the adoption of SFAS No. 157 to have a material impact on the Company’s financial condition or results of operations.

In February 2007, the FASB issued SFAS No. 159,“The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS No. 159”), which permits entities to choose to measure financial instruments and certain other financial assets and financial liabilities at fair value. SFAS No. 159 is effective for fiscal years beginning after November 15, 2007. The Company is currently assessing the impact SFAS No. 159 will have on the Company’s financial position and results of operations, but does not expect the adoption of SFAS No. 159 to have a material impact on the Company’s financial condition or results of operations.

- 8 -

INDEX

Capital Bank Corporation – Notes to Condensed Consolidated Financial Statements (Unaudited)

From time to time, the FASB issues exposure drafts for proposed statements of financial accounting standards. Such exposure drafts are subject to comment from the public, to revisions by the FASB and to final issuance by the FASB as statements of financial accounting standards. The Company considers the effect of the proposed statements on the financial statements of the Company and monitors the status of changes to, and proposed effective dates of, exposure drafts.

2. Comprehensive Income

Comprehensive income includes net income and all other changes to the Company’s equity, with the exception of transactions with shareholders (“other comprehensive income”). The Company’s comprehensive income (loss) for the six month periods ended June 30, 2007 and 2006 are as shown in the Company’s Condensed Consolidated Statements of Changes in Shareholders’ Equity (unaudited).

The Company’s other comprehensive income (loss) and accumulated other comprehensive income (loss) are comprised of unrealized gains and losses on certain investments in debt securities and derivatives that qualify as cash flow hedges to the extent that the hedge is effective. Information concerning the Company’s other comprehensive income (loss) for the three and six month periods ended June 30, 2007 and 2006 is as follows:

Three Month Period Ended June 30, 2007 and 2006 (Unaudited)
	2007			2006
(Dollars in thousands)

Unrealized losses on available-for-sale securities	$	(4,766	)	$	(2,346	)
Unrealized loss on change in fair value of cash flow hedge		(877	)		–
Income tax benefit		2,176			94
Other comprehensive loss	$	(3,467	)	$	(1,442	)

Six Month Period Ended June 30, 2007 and 2006 (Unaudited)
	2007			2006
(Dollars in thousands)

Unrealized losses on available-for-sale securities	$	(4,516	)	$	(2,585	)
Unrealized loss on change in fair value of cash flow hedge		(942	)		–
Income tax benefit		2,055			996
Other comprehensive loss	$	(3,403	)	$	(1,589	)

3. Earnings Per Share

The Company is required to report both basic and diluted earnings per share (“EPS”). Basic EPS excludes dilution and is computed by dividing income available to common shareholders by the weighted average number of common shares outstanding for the period. Diluted EPS assumes the conversion, exercise or issuance of all potential common stock instruments, such as stock options, unless the effect is to reduce a loss or increase earnings per share. For the Company, EPS is adjusted for outstanding stock options using the treasury stock method in order to compute diluted EPS. The following tables provide a computation and reconciliation of basic and diluted EPS for the three and six month periods ended June 30, 2007 and 2006, respectively.

Three Month Period Ended June 30, 2007 and 2006 (Unaudited)
	2007		2006
(Dollars in thousands except share data)

Income available to shareholders – basic and diluted	$	2,676	$	3,051
Shares used in the computation of earnings per share:
Weighted average number of shares outstanding – basic		11,503,441		11,639,014
Incremental shares from assumed exercise of stock options		70,669		87,570
Weighted average number of shares outstanding – diluted		11,574,110		11,726,584

- 9 -

INDEX

Capital Bank Corporation – Notes to Condensed Consolidated Financial Statements (Unaudited)

Six Month Period Ended June 30, 2007 and 2006 (Unaudited)
	2007		2006
(Dollars in thousands except share data)

Income available to shareholders – basic and diluted	$	5,060	$	5,814
Shares used in the computation of earnings per share:
Weighted average number of shares outstanding – basic		11,498,125		11,628,015
Incremental shares from assumed exercise of stock options		75,507		87,495
Weighted average number of shares outstanding – diluted		11,573,632		11,715,510

For the three and six month periods ended June 30, 2007 and 2006, options to purchase approximately 299,000 shares and 383,000 shares, respectively, of common stock were used in the diluted calculation. For the three and six month periods ended June 30, 2007 and 2006, options to purchase approximately 64,000 shares and 74,000 shares, respectively, of common stock were not included in the diluted calculation because the option price exceeded the average fair market value of the associated shares of common stock.

4. Stock-Based Compensation

The Company accounts for stock-based compensation in accordance with SFAS No. 123R, “Share-Based Payments” (“SFAS No. 123R”). The Company has stock option plans providing for the issuance of up to 650,000 options to purchase shares of the Company’s common stock to officers and directors. As of June 30, 2007, options for 183,209 shares of common stock remained available for future issuance. In addition, there were approximately 567,000 options, which were assumed under various plans from previously acquired financial institutions, of which approximately 131,015 remain outstanding.

The Company also administers the Capital Bank Corporation Deferred Compensation Plan for Outside Directors (the “Deferred Compensation Plan”). Under the Deferred Compensation Plan, eligible directors may elect to defer all or part of their directors’ fees for a calendar year, in exchange for common stock of the Company, based on the year end share price. The amount deferred, if elected, is equal to 125 percent of the total director’s fees. Each participant is fully vested in his or her account balance. The Deferred Compensation Plan generally provides for payment of share units either in shares of Company common stock or cash (at the Company’s discretion). The Deferred Compensation Plan is classified as a liability-based plan under SFAS No. 123R. For the six month periods ended June 30, 2007 and 2006, the Company recognized ($47,000) and $86,000, respectively, of share-based expense related to the Deferred Compensation Plan.

The following is a summary of stock option information and the weighted average exercise price (“WAEP”) for the six months ended June 30, 2007.

	Number of Shares			Weighted Average Exercise Price		Weighted Average Remaining Contractual Term in Years		Aggregate Intrinsic Value
(Dollars in thousands except share data)

Outstanding at January 1, 2007		389,715		$	11.75
Granted		9,000			16.89
Exercised		(35,597	)		8.59
Outstanding at June 30, 2007		363,118		$	12.18		4.53	$	1,766

Options exercisable at June 30, 2007		354,118		$	12.06		4.39	$	1,766

- 10 -

INDEX

Capital Bank Corporation – Notes to Condensed Consolidated Financial Statements (Unaudited)

The following table summarizes information about the Company’s stock options at June 30, 2007.

Exercise Price	Number Outstanding	Weighted Average Remaining Contractual Life in Years	Number Exercisable

$6.62 – $9.00	107,165	2.91	107,165
$9.01 – $12.00	87,702	4.17	87,702
$12.01 – $15.00	33,750	1.53	33,750
$15.01 – $18.00	67,751	6.28	67,751
$18.01 – $18.37	57,750	7.49	57,750
	354,118	4.53	354,118

The fair values of the options granted prior to January 1, 2006 were estimated on the date of grant using the Black-Scholes option-pricing model. Option pricing models require the use of highly subjective assumptions, including expected stock volatility, which when changed can materially affect fair value estimates. The expected life of the options used in this calculation was the period the options are expected to be outstanding. Expected stock price volatility was based on the historical volatility of the Company’s common stock for a period approximating the expected life; the expected dividend yield was based on the Company’s historical annual dividend payout; and the risk-free rate was based on the implied yield available on U.S. Treasury issues.

5. Investment Securities

The following table shows the gross unrealized losses and fair value of the Company’s investments with unrealized losses that are not deemed to be other-than-temporarily impaired, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at June 30, 2007.

	Less than 12 Months				12 Months or Greater				Total
(Dollars in thousands)	Fair Value		Unrealized Losses		Fair Value		Unrealized Losses		Fair Value		Unrealized Losses

Available for Sale
U.S. agency securities	$	37,439	$	408	$	36,441	$	890	$	73,880	$	1,298
Municipal bonds		63,277		3,038		8,060		244		71,337		3,282
Mortgage-backed securities		14,628		192		51,199		2,543		65,827		2,735
		115,344		3,638		95,700		3,677		211,044		7,315
Held to Maturity
U.S. agency securities		–		–		3,909		90		3,909		90
Municipal bonds		–		–		288		12		288		12
Mortgage-backed securities		–		–		5,769		248		5,769		248
		–		–		9,966		350		9,966		350
Total at June 30, 2007	$	115,344	$	3,638	$	105,666	$	4,027	$	221,010	$	7,665

The unrealized losses on the Company’s investments were primarily the result of interest rate changes. The Company has the ability and intent to hold these investments until a recovery of fair value, which may be maturity. Accordingly, the Company does not consider these investments to be other-than-temporarily impaired at June 30, 2007.

- 11 -

INDEX

Capital Bank Corporation – Notes to Condensed Consolidated Financial Statements (Unaudited)

6. Loans

The composition of the loan portfolio by loan classification at June 30, 2007 and December 31, 2006 was as follows:

	June 30, 2007		December 31, 2006
(Dollars in thousands)	(Unaudited)

Commercial	$	608,813	$	593,410
Construction		249,443		250,308
Consumer		34,188		30,806
Home equity lines		80,580		83,231
Mortgage		48,896		50,099
		1,021,920		1,007,854
Plus deferred loan costs, net		227		198
	$	1,022,147	$	1,008,052

Loans held for sale as of June 30, 2007 and December 31, 2006 were $11.1 million and $7.2 million, respectively, and were included in the mortgage category.

7. Financial Instruments with Off-Balance-Sheet Risk

To meet the financial needs of its customers, the Company is party to financial instruments with off-balance-sheet risk in the normal course of business. These financial instruments are comprised of unused lines of credit, overdraft lines and standby letters of credit. These instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized in the balance sheet.

The Company’s exposure to credit loss in the event of nonperformance by the other party is represented by the contractual amount of those instruments. The Company uses the same credit policies in making these commitments as it does for on-balance-sheet instruments. 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. Collateral held varies but may include trade accounts receivable, property, plant and equipment, and income-producing commercial properties. Since many unused lines of credit expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements.

The Company’s exposure to credit risk as of June 30, 2007 and December 31, 2006 was as follows:

	June 30, 2007		December 31, 2006
(Dollars in thousands)	(Unaudited)

Unused lines of credit and overdraft lines	$	208,303	$	187,163
Standby letters of credit		2,394		12,698
Total commitments	$	210,697	$	199,861

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

The following discussion presents an overview of the unaudited financial statements for the three and six months ended June 30, 2007 and 2006 for Capital Bank Corporation (the “Company”) and it’s wholly owned subsidiary, Capital Bank (the “Bank”). This discussion and analysis is intended to provide pertinent information concerning financial condition, results of operations, liquidity, and capital resources for the periods covered and should be read in conjunction with the unaudited financial statements and related footnotes contained in Part I, Item 1 of this report.

- 12 -

INDEX

Information set forth below contains various forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), which statements represent the Company’s judgment concerning the future and are subject to risks and uncertainties that could cause the Company’s actual operating results to differ materially. Such forward-looking statements can be identified by the use of forward-looking terminology, such as “may,” “will,” “expect,” “anticipate,” “estimate,” “believe,” or “continue,” or the negative thereof or other variations thereof or comparable terminology. The Company cautions that such forward-looking statements are further qualified by important factors that could cause the Company’s actual operating results to differ materially from those in the forward-looking statements, as well as the factors set forth in Part II, Item 1A of this report, and the Company’s periodic reports and other filings with the Securities and Exchange Commission (“SEC”).

Overview

The Bank is a full-service state chartered community bank conducting business throughout North Carolina. The Bank’s business consists principally of attracting deposits from the general public and investing these funds in loans secured by commercial real estate, secured and unsecured commercial and consumer loans, single-family residential mortgage loans, and home equity lines. As a community bank, the Bank’s profitability depends primarily upon its levels of net interest income, which is the difference between interest income from interest-earning assets and interest expense on interest-bearing liabilities. When interest-earning assets approximate or exceed interest-bearing liabilities, any positive interest rate spread will generate net interest income. The Bank’s profitability is also affected by its provision for loan losses, noninterest income, and other operating expenses. Noninterest income primarily consists of miscellaneous service charges, interchange income and ATM fees, fees generated from originating mortgage loans that are sold, and the increase in cash surrender value of bank-owned life insurance. Operating expenses primarily consist of compensation and benefits, occupancy related expenses, advertising, data processing, professional fees and other expenses.

The Bank’s operations are influenced significantly by local economic conditions and by policies of financial institution regulatory authorities. The Bank’s cost of funds is influenced by interest rates on competing investments and by rates offered on similar investments by competing financial institutions in its market area, as well as general market interest rates. Lending activities are affected by the demand for financing, which in turn is affected by the prevailing interest rates.

Critical Accounting Policies and Estimates

The Company’s critical accounting policies are described in Note 1 of the Company’s Annual Report on Form 10-K for the year ended December 31, 2006. These policies are important in understanding management’s discussion and analysis. Some of the Company’s accounting policies require the Company to make estimates and judgments regarding uncertainties that may affect the reported amounts of assets, liabilities, revenues and expenses.

The Company has identified five accounting policies as being critical in terms of significant judgments and the extent to which estimates are used: allowance for loan losses, investments, valuation allowances, goodwill and the impairment of long-lived assets. In many cases, there are several alternative judgments that could be used in the estimation process. The Company bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. For more information on the Company’s critical accounting policies, refer to Part II, Item 7 of the Company’s Annual Report on Form 10-K for the year ended December 31, 2006.

- 13 -

INDEX

Executive Summary

As discussed in more detail below, the following is a summary of our significant results for the quarter ended June 30, 2007.

	•	The Company reported net income for the quarter ended June 30, 2007 of $2.7 million compared to $3.1 million for the quarter ended June 30, 2006. Fully diluted earnings per share were $0.23 and $0.26 for the quarter ended June 30, 2007 and 2006, respectively. The decrease in net income was primarily due to a $354,000 decrease in net interest income, which reflects a 39 basis point (“bp”) decrease in the net interest margin as a result of the rising cost of funds and a $447,000 increase in noninterest expense, primarily due to higher compensation costs, offset by a $391,000 decrease in income tax expense due to an increase in tax-exempt investment income.

	•	The provision for loan losses for the quarter ended June 30, 2007 was a credit of ($91,000) compared to $249,000 for the quarter ended June 30, 2006. The decrease in the provision for loan losses is primarily due to revisions to the Company’s loan loss allowance estimation methodology.

	•	Net interest income for the quarter ended June 30, 2007 decreased to $11.3 million, a 3.1% decline from the $11.6 million earned in the quarter ended June 30, 2006. The decrease in net interest income is primarily due to a 71 bps increase in the cost of funds compared to a 22 bps increase in the yield on earning assets.

	•	Noninterest income for the quarter ended June 30, 2007 decreased $305,000 to $2.3 million compared to $2.6 million in the quarter ended June 30, 2006. This decrease is primarily due to lower mortgage fees and revenues as a result of decreased volume and a $138,000 gain realized on the sale of a closed branch location in the quarter ended June 30, 2006.

	•	Noninterest expense was $9.8 million for the quarter ended June 30, 2007 compared to $9.3 million for the quarter ended June 30, 2006. The increase is primarily due to higher salaries and employee benefits, which increased by $463,000 in the quarter ended June 30, 2007 compared to the quarter ended June 30, 2006. The increase in salaries and employee benefits was primarily due to the addition of sales associates during 2007.

Financial Condition

Total consolidated assets of the Company at June 30, 2007 were $1.44 billion compared to $1.42 billion at December 31, 2006, an increase of $17.9 million. The increase in total consolidated assets for the six months ended June 30, 2007 is primarily due to a $14.1 million increase in the Bank’s loan portfolio, net of the allowance for loan losses, since December 31, 2006. Total deposits as of June 30, 2007 were $1.07 billion, which represents growth of $17.8 million from December 31, 2006.

Total earning assets were $1.29 billion at June 30, 2007 compared to $1.27 billion at December 31, 2006. Earning assets represented 89.2% and 89.1% of total assets as of June 30, 2007 and December 31, 2006, respectively. At June 30, 2007, investment securities were $241.7 million, compared to $239.1 million at December 31, 2006. Interest-earning cash, federal funds sold and short term investments were $21.9 million at June 30, 2007 compared to $20.8 million at December 31, 2006.

The allowance for loan losses as of June 30, 2007 and December 31, 2006 was $13.3 million and represented approximately 1.31% and 1.32%, respectively, of total loans as of both dates. Management believes that the amount of the allowance is adequate to absorb the estimated probable losses inherent in the current loan portfolio. See “Asset Quality” below for further discussion of the allowance for loan losses.

Total deposits as of June 30, 2007 were $1.07 billion, an increase of $17.8 million, or 1.9%, from December 31, 2006. The increase was primarily due to a $42.9 million increase in money market deposits offset by a $35.0 million decrease in time deposits. Total time deposits represented 49.6% of total deposits at June 30, 2007 compared to 53.8% at December 31, 2006. The Company’s high yield checking account product, Smart Checking, which is designed to generate higher debit card interchange income to offset the higher yield offered, added over 1,300 new accounts during the quarter ended June 30, 2007. As of June 30, 2007, there were over 5,800 Smart Checking accounts and $28.1 million of deposits associated with this product.

- 14 -

INDEX

Noninterest-bearing demand deposit accounts (“DDA”) were $123.6 million at June 30, 2007, an increase of $2.7 million from December 31, 2006. The average balance of noninterest DDA accounts was $112.5 million during the quarter ended June 30, 2007 compared to $105.5 million during the quarter ended June 30, 2006.

Total consolidated shareholders’ equity was $162.4 million as of June 30, 2007, an increase of $721,000 from December 31, 2006. Retained earnings increased by $3.2 million, reflecting $5.1 million of net income for the six months ended June 30, 2007 less $1.9 million of dividends paid during the six months ended June 30, 2007. Accumulated other comprehensive loss, which represents the unrealized loss on available-for-sale securities and derivatives accounted for as cash flow hedges, net of related tax benefits, was $5.0 million and $1.6 million as of June 30, 2007 and December 31, 2006, respectively. The decrease is primarily due to the decline in the fair value of the Company’s available-for-sale security portfolio as a result of changing interest rate conditions in the bond market. See Item 1. Financial Statements – Condensed Consolidated Statements of Changes in Shareholders’ Equity for additional information.

Results of Operations

Quarter ended June 30, 2007 compared to quarter ended June 30, 2006

For the quarter ended June 30, 2007, the Company reported net income of $2.7 million, or $0.23 per diluted share, compared to net income of $3.1 million, or $0.26 per diluted share, for the quarter ended June 30, 2006. Net income decreased by $375,000, primarily due to margin compression as a result of the rising costs of funds. The Company’s net interest margin, on a fully taxable equivalent basis, for the quarter ended June 30, 2007 decreased by 39 bps compared to the net interest margin for the quarter ended June 30, 2006. The Company expects continued pressures on its net interest margin in the near term, primarily from increased competition for funds in the Company’s primary markets.

Net interest income decreased $354,000, or 3.1%, from $11.6 million for the quarter ended June 30, 2006, to $11.3 million for the quarter ended June 30, 2007. Average earning assets increased $121.0 million to $1.29 billion for the quarter ended June 30, 2007 from $1.17 billion for the quarter ended June 30, 2006. Average interest-bearing liabilities increased $98.5 million to $1.15 billion for the quarter ended June 30, 2007 from $1.05 billion for the quarter ended June 30, 2006. The net interest margin on a fully taxable equivalent basis decreased by 39 bps to 3.65% for the quarter ended June 30, 2007 from 4.04% for the quarter ended June 30, 2006. The earned yield on average interest-earning assets was 7.51% and 7.29% for the quarter ended June 30, 2007 and 2006, respectively, while the interest rate on average interest-bearing liabilities for those periods was 4.34% and 3.63%, respectively. The decrease in the net interest margin is primarily attributed to interest-bearing liabilities repricing at a faster rate than interest-earning assets as a result of the current static interest rate environment and competitive pressures in the Company’s primary markets. The majority of the Company’s loans are prime based, which has remained flat while the interest-bearing deposits are impacted more by rates paid by competitors.

The following table shows the Company’s effective yield on earning assets and cost of funds. Yields and costs are computed by dividing income or expense for the year by the respective daily average asset or liability balance.

- 15 -

INDEX

Average Balances, Interest Earned or Paid, and Interest Yields/Rates

Three Months Ended June 30, 2007 and 2006 (Unaudited)

Taxable Equivalent Basis ¹

	June 30, 2007								June 30, 2006
(Dollars in thousands)	Average Balance			Amount Earned/Paid		Average Rate			Average Balance			Amount Earned/Paid		Average Rate

Assets
Loans receivable ²	$	1,021,517		$	20,519		8.06	%	$	954,420		$	18,648		7.84	%
Investment securities ³		248,850			3,382		5.45	%		190,045			2,345		4.95	%
Federal funds sold and other interest on short term investments		22,284			291		5.24	%		27,183			308		4.94	%
Total interest earning assets		1,292,651		$	24,192		7.51	%		1,171,648		$	21,301		7.29	%
Cash and due from banks		27,489								32,202
Other assets		129,972								133,222
Allowance for loan losses		(13,528	)							(14,291	)
Total assets	$	1,436,584							$	1,322,781

Liabilities and Equity
Savings deposits	$	33,664		$	44		0.52	%	$	41,477		$	52		0.50	%
Interest-bearing demand deposits		377,274			3,264		3.47	%		279,029			1,981		2.85	%
Time deposits		554,979			6,610		4.78	%		564,025			5,296		3.77	%
Total interest-bearing deposits		965,917			9,918		4.12	%		884,531			7,329		3.32	%
Borrowed funds		119,978			1,567		5.24	%		107,724			1,287		4.79	%
Subordinated debt		30,930			592		7.68	%		30,930			596		7.73	%
Repurchase agreements		31,696			337		4.26	%		26,884			289		4.31	%
Total interest-bearing liabilities		1,148,521		$	12,414		4.34	%		1,050,069		$	9,501		3.63	%
Noninterest-bearing deposits		112,513								105,506
Other liabilities		10,673								5,885
Total liabilities		1,271,707								1,161,460
Shareholders’ equity		164,877								161,321
Total liabilities and shareholders’ equity	$	1,436,584							$	1,322,781

Net interest spread ⁴							3.17	%							3.66	%
Tax equivalent adjustment				$	524							$	192
Net interest income and net interest margin ⁵				$	11,778		3.65	%				$	11,800		4.04	%

¹	The fully taxable equivalent basis is computed using a blended federal and state tax rate of approximately 36% and 38% in 2007 and 2006, respectively.

²	Loans receivable include nonaccrual loans for which accrual of interest has not been recorded and mortgage loans held for sale.

³	The average balance for investment securities excludes the effect of their mark-to-market adjustment, if any.

⁴	Net interest spread represents the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities.

⁵	Net interest margin represents net interest income divided by average interest-earning assets.

- 16 -

INDEX

Interest income on loans increased from $18.6 million for the quarter ended June 30, 2006 to $20.5 million for the quarter ended June 30, 2007. The increase is primarily due to higher average loan balances, which increased by $67.1 million, primarily due to organic net loan growth, and higher loan yields. Higher yields in 2007 reflect the increase in the prime rate charged by the Bank between the quarters ended June 30, 2007 and 2006. The Company’s prime rate was 8.25% as of June 30, 2007 and as of June 30, 2006, however the last change in the prime rate was in late June 2006. In November 2006, the Company entered into a $100 million (notional) interest rate swap to help mitigate its exposure to interest rate volatility. This swap reduced the overall yield on loans and the net interest margin by 5 bps and 4 bps, respectively, for the quarter ended June 30, 2007.

Interest income on investment securities increased from $2.2 million for the quarter ended June 30, 2006 to $2.9 million for the quarter ended June 30, 2007. The increase is primarily due to a $58 million increase in average balances outstanding between the periods, with approximately $47.0 million of the increase related to investments in tax-exempt municipal bonds acquired in the second half of 2006. The yield on investment securities on a fully taxable equivalent basis increased from 4.95% for the quarter ended June 30, 2006 to 5.45% for the quarter ended June 30, 2007.

Interest expense on deposits increased from $7.3 million for the quarter ended June 30, 2006 to $9.9 million for the quarter ended June 30, 2007. The increase is primarily due to a $81.4 million increase in the average balance of interest-bearing deposits outstanding, due to organic deposit growth and higher deposit rates. The average rate paid on total interest-bearing deposits increased from 3.32% for the quarter ended June 30, 2006 to 4.12% for the quarter ended June 30, 2007, a 80 bps rise. The rate paid on time deposits, which represented 57.5% and 63.8% of total average interest-bearing deposits for the quarters ended June 30, 2007 and 2006, respectively, increased from 3.77% for the quarter ended June 30, 2006 to 4.78 % for the quarter ended June 30, 2007, primarily as a result of the rising interest rate environment and increased competition in the Company’s primary markets.

Interest expense on borrowings increased from $2.2 million for the quarter ended June 30, 2006 to $2.5 million for the quarter ended June 30, 2007, primarily due to an increase in overall borrowing rates. The rate on borrowings and subordinated debentures for the quarter ended June 30, 2007 was 5.24% and 7.68%, respectively, compared to 4.79% and 7.73%, respectively, for the quarter ended June 30, 2006. In July of 2003, the Bank entered into interest rate swap agreements on $25.0 million of its outstanding Federal Home Loan Bank advances to swap fixed rate borrowings to a variable rate. The net effect of the swaps was an increase in interest expense of $126,000 and $100,000 for the quarters ended June 30, 2007 and 2006, respectively.

For the quarter ended June 30, 2007, the provision for loan losses was a credit of ($91,000) compared to $249,000 for the quarter ended June 30, 2006, a decrease of $340,000. The decrease in the provision for loan losses reflects slower net loan growth in the quarter and the effects of revisions made to the Company’s allowance for loan loss estimation methodology as discussed more fully below under “Asset Quality.” Net charge-offs for the quarter ended June 30, 2007 were $101,000, or 0.04% of average loans, compared to $523,000, or 0.22% of average loans for the quarter ended June 30, 2006. Total nonperforming assets and past due loans decreased from $9.3 million and $16.2 million, respectively, as of March 31, 2007 to $8.5 million and $13.0 million, respectively, as of June 30, 2007. Past due loans consists of all loans past due 30 days or more.

Noninterest income for the quarter ended June 30, 2007 was $2.3 million compared to $2.6 million for the quarter ended June 30, 2006, a decrease of $305,000. This decrease was primarily due to a $74,000 decrease in mortgage fees and revenues as a result of a lower volume of mortgage originations. Service charges and other fees decreased $63,000, primarily due to lower service charges and nonsufficient fund fees, offset partially by an increase in interchange income from the Smart Checking product. The Company also recognized a $138,000 gain from the sale of a consolidated branch location in the quarter ended June 30, 2006.

Noninterest expense for the quarter ended June 30, 2007 was $9.8 million compared to $9.3 million for the quarter ended June 30, 2006. Salaries and employee benefits, representing the largest noninterest expense category, increased to $5.3 million for the quarter ended June 30, 2007, from $4.9 million for the quarter ended June 30, 2006. The increase in salaries and employee benefits was primarily due to salary increases and staff additions. As of June 30, 2007, the Company had 340 full-time equivalent employees compared to 326 at June 30, 2006.

- 17 -

INDEX

Occupancy costs, the second largest component of noninterest expense, increased $35,000 from $938,000 for the quarter ended June 30, 2006 to $973,000 for the quarter ended June 30, 2007. The increase is primarily due to the higher rent expenses related to the Company’s new headquarters. Furniture and equipment expenses for the quarter ended June 30, 2007 increased $85,000 from the same period in 2006, primarily due to higher depreciation expenses associated with computer equipment acquired for the Company’s operations center. Data processing expenses for the quarter ended June 30, 2007 increased $215,000 from the same period in 2006, primarily due to the Company’s implementation of an internet-based phone system, which increased network expenses but reduced telecommunication costs. Directors’ fees for the quarter ended June 30, 2007 decreased $54,000 from the same period in 2006, primarily due to lower share-based compensation expense associated with the Deferred Compensation Plan. Advertising expenses for the quarter ended June 30, 2007 decreased $74,000 from the same period in 2006, primarily due to the state wide marketing campaign associated with the introduction of Smart Checking in 2006. Other expenses for the quarter ended June 30, 2007 decreased $204,000 from the same period in 2006, primarily due to lower costs associated with telecommunications, operational losses and office supplies, which decreased by $138,000, $77,000 and $68,000, respectively, partially offset by an increase of $51,000 in the provision for off-balance-sheet credit risk associated with unfunded commitments.

Income tax expense for the quarters ended June 30, 2007 and 2006 was $1.2 million and $1.6 million, respectively. The Company’s effective tax rate for the quarter ended June 30, 2007 was 30.7 % compared to 34.1% for the quarter ended June 30, 2006. The decrease in the effective tax rate is primarily due to greater proportion of tax-exempt income to taxable income for the quarter ended June 30, 2007 compared to the same period in 2006 as a result of municipal bonds acquired during the quarter ended December 31, 2006. The Company forecasts its taxable and nontaxable income and calculates the effective tax rate for the entire year, which is then applied to the three month period.

Results of Operations

Six month period ended June 30, 2007 compared to six month period ended June 30, 2006

For the six month period ended June 30, 2007, the Company reported net income of $5.1 million, or $0.44 per diluted share, compared to net income of $5.8 million, or $0.50 per diluted share, for the six month period ended June 30, 2006. Net income decreased by $754,000, primarily due to lower net interest income, which decreased due to a lower net interest margin and higher noninterest expense.

Net interest income decreased $1.0 million, or 4.4%, from $23.0 million for the six month period ended June 30, 2006, to $22.0 million for the six month period ended June 30, 2007. Average earning assets increased $127.4 million to $1.29 billion for the six month period ended June 30, 2007 from $1.17 billion for the six month period ended June 30, 2006. Average interest-bearing liabilities increased $113.0 million to $1.15 billion for the six month period ended June 30, 2007 from $1.04 billion for the six month period ended June 30, 2006. The net interest margin on a fully taxable equivalent basis decreased 46 bps to 3.59% for the six month period ended June 30, 2007 from 4.05% for the six month period ended June 30, 2006. The earned yield on average interest-earning assets was 7.47% and 7.12% for the six month periods ended June 30, 2007 and 2006, respectively, while the interest rate on average interest-bearing liabilities for those same periods was 4.35% and 3.44%, respectively. The decrease in the net interest margin is primarily due to the cost of funds rising at a faster rate than the yield on earning assets as a result of the current interest rate environment. The average interest rate on interest-bearing deposits increased from 3.11% for the six month period ended June 30, 2006 to 4.13% for the six month period ended June 30, 2007, an increase of 102 bps. However, the average yield on the loan portfolio increased from 7.66% for the six month period ended June 30, 2006 to 8.01% for the six month period ended June 30, 2007, an increase of 35 bps. The Company expects its net interest margin will continue to experience compression in the second half of 2007 based on Fed Funds rate projections for the remainder of 2007.

- 18 -

INDEX

Average Balances, Interest Earned or Paid, and Interest Yields/Rates

Six Months Ended June 30, 2007 and 2006

Taxable Equivalent Basis ¹

	2007								2006
(Dollars in thousands)	Average Balance			Amount Earned/Paid		Average Rate			Average Balance			Amount Earned/Paid		Average Rate

Assets
Loans receivable ²	$	1,017,000		$	40,402		8.01	%	$	939,185		$	35,666		7.66	%
Investment securities ³		246,291			6,685		5.47	%		192,290			4,648		4.87	%
Federal funds sold and other interest on short term investments		29,440			776		5.32	%		33,830			850		5.07	%
Total interest-earnings assets		1,292,731		$	47,863		7.47	%		1,165,305		$	41,164		7.12	%
Cash and due from banks		27,541								31,788
Other assets		130,049								135,454
Allowance for loan losses		(13,412	)							(15,723	)
Total assets	$	1,436,909							$	1,316,824

Liabilities and Equity
Savings deposits	$	34,017		$	86		0.51	%	$	42,646			112		0.53	%
Interest-bearing demand deposits		360,044			6,186		3.46	%		272,357			3,530		2.61	%
Time deposits		577,922			13,652		4.76	%		556,121			9,797		3.55	%
Total interest-bearing deposits		971,983			19,924		4.13	%		871,124			13,439		3.11	%
Borrowed funds		116,832			3,070		5.30	%		111,043			2,613		4.75	%
Subordinated debt		30,930			1,178		7.68	%		31,752			1,193		7.58	%
Repurchase agreements		33,012			694		4.24	%		25,868			536		4.18	%
Total interest-bearing liabilities		1,152,757		$	24,866		4.35	%		1,039,787			17,781		3.44	%
Noninterest-bearing deposits		109,441								102,741
Other liabilities		10,627								13,715
Total liabilities		1,272,825								1,156,243
Shareholders’ equity		164,084								160,581
Total liabilities and shareholders’ equity	$	1,436,909							$	1,316,824

Net interest spread ⁴							3.12	%							3.68	%
Tax equivalent adjustment				$	1,020							$	385
Net interest income and net interest margin ⁵				$	22,997		3.59	%				$	23,383		4.05	%

¹	The taxable equivalent basis is computed using a blended federal and state tax rate of approximately 36% and 38% in 2007 and 2006, respectively.

²	Loans receivable include nonaccrual loans for which accrual of interest has not been recorded and mortgage loans held for sale.

³	The average balance for investment securities excludes the effect of their mark-to-market adjustment, if any.

⁴	Net interest spread represents the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities.

⁵	Net interest margin represents net interest income divided by average interest-earning assets.

- 19 -

INDEX

For the six month period ended June 30, 2007, the provision for loan losses was $246,000 compared to $661,000 for the six month period ended June 30, 2006, a decrease of $415,000. The decrease in 2007 was primarily due to the slower net growth of the loan portfolio and revisions made to the Company’s allowance for loan loss estimation methodology. See “Asset Quality” below for further discussion of the allowance for loan losses and the revisions to estimation methodology. Net charge-offs for the six month period ended June 30, 2007 were $254,000 compared to $3.9 million for the six month period ended June 30, 2006. Net charge-offs for the six month period ended June 30, 2006 includes $2.9 million related to one 1st State Bank loan relationship that had been fully reserved by 1st State Bank as of December 31, 2005. See “Asset Quality” below for further discussion of the allowance for loan losses.

Noninterest income for the six month period ended June 30, 2007, was $4.5 million compared to $4.7 million for the six month period ended June 30, 2006, a decrease of $130,000. Service charges and other fees decreased by $100,000 as a result of an increase in waived service charges and lower nonsufficient fund fees. Mortgage fees and revenues increased by $103,000, primarily due to higher loan volumes in the first quarter of 2007. Other noninterest income decreased by $133,000, primarily due to a gain of $138,000 realized on the sale of a consolidated branch location in 2006.

Noninterest expense for the six month period ended June 30, 2007 was $19.0 million compared to $18.2 million for the six month period ended June 30, 2006. Salaries and employee benefits, representing the largest noninterest expense category, increased by $1.0 million to $10.4 million for the six month period ended June 30, 2007, from $9.4 million for the six month period ended June 30, 2006. This increase reflects an increase in the number of personnel employed by the Company as well as higher benefit and incentive compensation costs.

Occupancy costs and furniture and equipment expenses for the six month period ended June 30, 2007 increased by $255,000 and $208,000, respectively, compared to the six month period ended June 30, 2006, primarily due to higher expenses associated with the Company’s new headquarters and data processing equipment depreciation associated with the Company’s operations center. Directors’ fees decreased $162,000 for the six month period ended June 30, 2007 compared to the same period in 2006, primarily due to a reduction in share-based compensation expense associated with the Deferred Compensation Plan as a result of a decrease in the Company’s share price. Data processing expenses increased $22,000 for the six month period ended June 30, 2007 compared to the same period in 2006, primarily due to network costs associated with implementing an internet-based phone system, partially offset by a reduction in external item processing costs as a result of bringing operations in house during 2006.

Advertising expenses for the six month period ended June 30, 2007 decreased by $80,000 compared to the same period in 2006, primarily due to the promotional campaign associated with the May 2006 introduction of Smart Checking. Professional fees for the six month period ended June 30, 2007 increased by $21,000 compared to the same period in 2006, primarily due to higher legal and accounting fees, partially offset by reduced consulting expenses. Other expenses for the six month period ended June 30, 2007 decreased $324,000 from the same period in 2006, primarily due to lower costs associated with telecommunications, operational losses and office supplies, which decreased by $222,000, $87,000 and $86,000, respectively, partially offset by higher insurance costs, which increased by $57,000.

The Company’s effective tax rate for the six month periods ended June 30, 2007 and 2006 was 29.8% and 34.0%, respectively. The change in the effective tax rate was due to changes in forecasted levels of taxable and tax-exempt income and the decrease for these comparable periods primarily reflects a higher mix of tax-exempt income as a result of municipal bonds acquired during the quarter ended December 31, 2006.

Asset Quality

Determining the allowance for loan losses is based on a number of factors, many of which are subject to judgments made by management. At the origination of each commercial loan, management assesses the relative risk of the loan and assigns a corresponding risk grade. To ascertain that the credit quality is maintained after the loan is booked, a loan review officer performs an annual review of all unsecured loans over a predetermined loan amount, a sampling of loans within a lender’s authority, and a sampling of the entire loan pool. Loans are reviewed for credit quality, sufficiency of credit and collateral documentation, proper loan approval, covenant, policy and procedure adherence, and continuing accuracy of the loan grade. This officer reports directly to the Chief Credit Officer and the Audit Committee of the Company’s Board of Directors. On an as needed basis, the Bank hires an outside third party firm to review the Bank’s loan portfolio to ensure quality standards and reasonableness of risk assessment.

- 20 -

INDEX

The Company estimates the amount of allowance needed to cover inherent losses in the portfolio by applying a loss allowance factor to each risk grade. Consumer loans and mortgages are not risk graded, but a loss allocation factor is utilized for these loans based on historical losses. The loss allocation factors have been developed based on the Bank’s historical losses and industry trends. In addition to this quantitative analysis, a qualitative assessment of the general economic trends, portfolio concentration and the trend of delinquencies are taken into consideration. The loan loss allowance is adjusted to an amount that management believes is adequate to absorb probable losses inherent in the loan portfolio as of the balance sheet date presented.

The Company provides a specific allowance for loan losses associated with certain commercial loans rated special mention and/or classified with outstanding balances greater than $750,000. Management determines the level of specific allowance based on the facts and circumstances of each loan, including among other factors, payment history, collateral values, guarantor liquidity, and net worth. Of the $13.3 million allowance for loan losses as of June 30, 2007, $3.0 million has been allocated to specific loans, including loans considered to be impaired. As of June 30, 2007 and December 31, 2006, there were $8.1 million and $6.2 million, respectively, of impaired loans. As of June 30, 2007 and December 31, 2006, $2.5 million and $1.1 million, respectively, was included in the allowance for loan losses for impaired loans. At June 30, 2007 and December 31, 2006, there were no impaired loans that did not have an allowance for loan losses.

A loan is considered impaired, based on current information and events, if it is probable that the Bank will be unable to collect the scheduled payments of principal and interest when due according to the contractual terms of the loan agreement. The Bank uses several factors in determining if a loan is impaired. Internal asset classification procedures include a review of significant loans and lending relationships by both management and third-party credit review firms. The loan reviews include the accumulation of related data on loan payment status, borrowers’ financial data and borrowers’ operating factors such as cash flows, operating income or loss. Uncollateralized loans are measured for impairment based on the present value of expected future cash flows discounted at the historical effective interest rate, while all collateral-dependent loans are measured for impairment based on the fair value of the collateral. Impaired loans at June 30, 2007 includes $1.9 million related to a developer who has been accused of engaging in fraudulent marketing and financing practices in Western North Carolina by the North Carolina Attorney General. The Company has established an $800,000 specific loan loss allocation for this exposure, which management believes is adequate.

The allowance for loan losses is established through a provision for loan losses charged to expense. Loans are charged against the allowance for loan losses when management believes that the collectibility of the principal is unlikely. Based on this allowance calculation, management recorded a credit provision of ($91,000) for the quarter ended June 30, 2007 compared to a provision of $249,000 for the quarter ended June 30, 2006. The decrease in the provision was primarily due to revisions made to the allowance for loan loss estimation methodology as a result of recent regulatory guidance, which emphasized that institutions should incorporate historical loss experience into the allowance for loan loss estimation methodology. The Company’s former estimation methodology was based primarily on a standard loss percentage for loan categories. The revised estimation methodology takes into consideration the Company’s historical loss experience, as well as several other factors, and utilizes a greater dispersion of risk rating classifications based on the collateral backing of the loans. The revised estimation methodology shifts a portion of the unallocated loan loss allowance to specific allocation loans and, in the quarter ended June 30, 2007, resulted in a provision for loan losses that was $2.5 million lower than would have occurred under the Company’s previous methodology.

The Company also experienced favorable developments in key risk metrics and trends associated with the credit quality of the loan portfolio during the quarter ended June 30, 2007. Past due loans as a percentage of average loans decreased from 1.60% at March 31, 2007 to 1.27% at June 30, 2007. Past dues greater than 90 days as a percentage of total loans decreased from 0.63% at March 31, 2007 to 0.61% at June 30, 2007. Nonperforming assets as a percentage of total assets were 0.59% and 0.63% at June 30, 2007 and March 31, 2007, respectively. Management believes the allowance for loan losses as of June 30, 2007 is adequate to absorb the probable losses on existing loans that may become uncollectible, based on evaluations of the collectibility of loans and prior loan loss experience.

The following table presents an analysis of changes in the allowance for loan losses for the three and six month periods ended June 30, 2007 and 2006, respectively.

- 21 -

INDEX

	Three Months Ended June 30,						Six Months Ended June 30,
(Dollars in thousands)	2007			2006			2007			2006

Allowance for loan losses, beginning of period	$	13,531		$	14,209		$	13,347		$	9,592
1st State Bank loan loss allowance acquired		–			–			–			7,637
Net charge-offs:
Loans charged off:
Commercial		94			531			165			3,847	¹
Construction		–			–			–			–
Consumer		59			30			109			136
Home equity lines		–			26			25			26
Mortgage		36			3			53			34
Total charge-offs		189			590			352			4,043
Recoveries of loans previously charged off:
Commercial		35			117			35			125
Construction		–			–			–			–
Consumer		51			22			59			26
Home equity lines		2			–			4			4
Mortgage		–			–			–			5
Total recoveries		88			139			98			160
Total net charge-offs		101			451			254			3,883
(Credit) loss provisions charged to operations		(91	)		249			246			661
Allowance for loan losses, end of period	$	13,339		$	14,007		$	13,339		$	14,007

Net charge-offs to average loans during the period (annualized)		0.04	%		0.22	%		0.05	%		0.83	%¹
Allowance as a percent of gross loans		1.31	%		1.45	%

¹	Net charge-offs for the six month period ended June 30, 2006 includes $3.3 million related to one 1st State Bank loan relationship that was fully reserved by 1st State Bank as of December 31, 2005.

The Company’s determination of the allowance for loan losses is subject to management’s judgment and analysis of many internal and external factors. While management is comfortable with the adequacy of the current allowance for loan losses, it is possible that these factors and management’s evaluation of the adequacy of the allowance for loan losses will change.

The following table presents an analysis of nonperforming assets as of June 30, 2007, June 30, 2006 and December 31, 2006.

	June 30, 2007			June 30, 2006			December 31, 2006
(Dollars in thousands)	(Unaudited)

Nonaccrual loans:
Commercial	$	6,089		$	3,728		$	2,783
Construction		–			193			616
Consumer		67			106			50
Home equity lines		471			418			410
Mortgage		975			1,695			1,043
Total nonaccrual loans		7,602			6,140			4,902
Foreclosed property held		866			879			1,111
Total nonperforming assets	$	8,468		$	7,019		$	6,013

Nonperforming assets to total loans		0.83	%		0.73	%		0.60	%
Nonperforming assets to total assets		0.59	%		0.51	%		0.42	%
Allowance coverage of nonperforming loans		175	%		228	%		272	%

- 22 -

INDEX

At June 30, 2007, nonperforming assets were $8.5 million, an increase of $2.5 million from December 31, 2006. The majority of the Company’s nonperforming loans are secured by real estate, and to a lesser extent the Company relies on the support of guarantors. The Company monitors the value of the underlying collateral and the liquidity of the guarantors on a periodic basis. Based on this review and analysis, the Company does not currently anticipate any material losses associated with the nonperforming loans at June 30, 2007.

Foreclosed property decreased to $866,000 at June 30, 2007 from $1.1 million at December 31, 2006. The decrease was primarily due to the net disposition of certain foreclosed commercial and residential properties. The Company is actively marketing all of its foreclosed property. All foreclosed assets are recorded at the lower of cost or net realizable fair value.

Liquidity and Capital Resources

The Company’s liquidity management involves planning to meet the Company’s anticipated funding needs at a reasonable cost. Liquidity management is guided by policies formulated by the Company’s senior management and the Asset and Liability Committee of the Bank’s Board of Directors. The Company had $54.2 million in its most liquid assets, cash and cash equivalents as of June 30, 2007. The Company’s principal sources of funds are loan repayments, deposits, Federal Home Loan Bank borrowings, capital and, to a lesser extent, investment repayments. Core deposits (total deposits less certificates of deposits in the amount of $100,000 or more), one of the most stable sources of liquidity, together with equity capital, which totaled $1.03 billion and $1.0 billion at June 30, 2007 and December 31, 2006, respectively, funded 71.4% of total assets at June 30, 2007 compared to 70.1% at December 31, 2006. In addition, the Company has the ability to take advantage of various other funding programs available from the Federal Home Loan Bank of Atlanta, as well as access to funding through various brokered deposit programs, federal funds lines and security repurchase agreements. The management of equity is a critical aspect of capital management in any business. The determination of the appropriate amount of equity is affected by a wide number of factors. The primary factor for a regulated financial institution is the amount of capital needed to meet regulatory requirements, although other factors, such as the “risk equity” the business requires and balance sheet leverage, also affect the determination.

On February 27, 2006, the Company announced that its Board of Directors had authorized the Company to acquire in the open market or in any private transaction, from time-to-time and in accordance with applicable laws, rules and regulations, up to 1.0 million shares of the Company’s common stock. Management plans to utilize share repurchases to manage capital levels of the Company. The Company plans to effect the repurchase program through open-market purchases. During the quarter ended June 30, 2007, the Company repurchased 2,304 shares at a weighted average price of $17.04 per share. See Part II – Other Information, Item 2. Unregistered Sales of Equity Securities and Use of Proceeds for more information on the Company’s share repurchases.

To be categorized as well capitalized, the Company and the Bank must maintain minimum amounts and ratios. The Company’s and the Bank’s actual capital amounts and ratios as of June 30, 2007 and the minimum requirements are presented in the following table.

	Actual					Minimum Requirements To Be Well Capitalized
(Dollars in thousands)	Amount		Ratio			Amount		Ratio

Capital Bank Corporation
Total capital (to risk weighted assets)	$	143,255		11.77	%	$	121,702		10.00	%
Tier I capital (to risk weighted assets)		129,632		10.65	%		73,021		6.00	%
Tier 1 capital (to average assets)		129,632		9.08	%		73,395		5.00	%

Capital Bank
Total capital (to risk weighted assets)	$	138,331		11.70	%	$	118,217		10.00	%
Tier I capital (to risk weighted assets)		124,708		10.55	%		70,930		6.00	%
Tier 1 capital (to average assets)		124,708		9.13	%		68,287		5.00	%

The Company’s total capital to risk weighted assets, Tier I capital to risk weighted assets and Tier I capital to average assets on a consolidated basis as of December 31, 2006 were 11.92%, 10.76% and 9.42%, respectively.

Shareholders’ equity was $164.2 million, or $14.17 per share, at June 30, 2007. Management believes this level of shareholders’ equity provides adequate capital to support the Company’s growth and to maintain a well capitalized position.

- 23 -

INDEX

Item 3. Quantitative and Qualitative Disclosures about Market Risk

As described in more detail in our Annual Report on Form 10-K for the year ended December 31, 2006, asset/liability management involves the evaluation, monitoring and management of interest rate risk, liquidity and funding. While the Board of Directors has overall responsibility for the Company’s asset/liability management policies, the Bank’s Asset and Liability Committee monitors loan, investment, and liability portfolios to ensure comprehensive management of interest rate risk and adherence to the Bank’s policies. The Company has not experienced any material change in the risk of its portfolios of interest-earning assets and interest-bearing liabilities from December 31, 2006 to June 30, 2007.

Item 4. Controls and Procedures

The Company maintains disclosure controls and procedures that are designed to ensure that information required to be disclosed in the reports it files or submits under the Securities Exchange Act of 1934 (the “Exchange Act”) is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the SEC, and that such information is accumulated and communicated to the Company’s management, including its Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), as appropriate, to allow timely decisions regarding disclosure. Management necessarily applies its judgment in assessing the costs and benefits of such controls and procedures, which, by their nature, can provide only reasonable assurance regarding management’s control objectives.

As required by paragraph (b) of Rule 13a-15 under the Exchange Act, an evaluation was carried out under the supervision and with the participation of the Company’s management, including the CEO and CFO, of the effectiveness of the Company’s disclosure controls and procedures as of the end of the period covered by this report. Based upon that evaluation, the CEO and CFO concluded that, as of the period covered by the report, the Company’s disclosure controls and procedures are effective in that they provide reasonable assurances that the information the Company is required to disclose in the reports it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods required by the SEC’s rules and forms.

Changes in Internal Control over Financial Reporting

There were no changes in the Company’s internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) of the Exchange Act) that occurred during the period covered by this report that have materially affected or are reasonably likely to materially affect, the Company’s internal control over financial reporting. Management has implemented changes in internal control over financial reporting as a result of remediation of matters identified through its review of internal control over financial reporting as required under Section 404 of the Sarbanes-Oxley Act; however, it does not believe any of the changes implemented were material in nature.

PART II – OTHER INFORMATION

Item 1. Legal Proceedings

There are no material pending legal proceedings to which the Company is a party or to which any of its property is subject. In addition, the Company is not aware of any threatened litigation, unasserted claims or assessments that could have a material adverse effect on the Company’s business, operating results or condition.

Item 1A. Risk Factors

You should consider the following material risk factors carefully before deciding to invest in the Company’s securities. Additional risks and uncertainties not presently known to us, that we may currently deem to be immaterial or that are similar to those faced by other companies in our industry or business in general, such as competitive conditions, may also impact our business operations. If any of the events described below occur, the Company’s business, financial condition, or results of operations could be materially adversely affected. In that event, the trading price of the Company’s common stock may decline, in which case the value of your investment may decline as well.

- 24 -

INDEX

Our results are impacted by the economic conditions of our principal operating regions.

Our operations are concentrated throughout Central and Western North Carolina. As a result of this geographic concentration, our results may correlate to the economic conditions in these areas. Deterioration in economic conditions in any of these market areas, particularly in the industries on which these geographic areas depend, may adversely affect the quality of our loan portfolio and the demand for our products and services, and accordingly, our results of operations.

We are exposed to risks in connection with the loans we make.

A significant source of risk for us arises from the possibility that losses will be sustained because borrowers, guarantors and related parties may fail to perform in accordance with the terms of their loans. We have underwriting and credit monitoring procedures and credit policies, including the establishment and review of the allowance for loan losses, that we believe are appropriate to minimize this risk by assessing the likelihood of nonperformance, tracking loan performance and diversifying our loan portfolio. Such policies and procedures, however, may not prevent unexpected losses that could adversely affect our results of operations.

We compete with larger companies for business.

The banking and financial services business in our market areas continues to be a competitive field and is becoming more competitive as a result of:

	•	changes in regulations;

	•	changes in technology and product delivery systems; and

	•	the accelerating pace of consolidation among financial services providers.

We may not be able to compete effectively in our markets, and our results of operations could be adversely affected by the nature or pace of change in competition. We compete for loans, deposits and customers with various bank and nonbank financial services providers, many of which have substantially greater resources, including higher total assets and capitalization, greater access to capital markets and a broader offering of financial services.

Our trading volume has been low compared with larger banks.

The trading volume in the Company’s common stock on the NASDAQ Global Select Market has been comparable to other similarly-sized banks. Nevertheless, this trading is relatively low when compared with more seasoned companies listed on the NASDAQ Global Select Market or other consolidated reporting systems or stock exchanges. Thus, the market in the Company’s common stock may be limited in scope relative to other companies.

We depend heavily on our key management personnel.

The Company’s success depends in part on its ability to retain key executives and to attract and retain additional qualified management personnel who have experience both in sophisticated banking matters and in operating a small- to mid-size bank. Competition for such personnel is strong in the banking industry, and we may not be successful in attracting or retaining the personnel we require. We expect to effectively compete in this area by offering financial packages that include incentive-based compensation and the opportunity to join in the rewarding work of building a growing bank.

Technological advances impact our business.

The banking industry is undergoing technological changes with frequent introductions of new technology-driven products and services. In addition to improving customer services, the effective use of technology increases efficiency and enables financial institutions to reduce costs. Our future success will depend, in part, on our ability to address the needs of our customers by using technology to provide products and services that will satisfy customer demands for convenience as well as to create additional efficiencies in our operations. Many of our competitors have substantially greater resources than we do to invest in technological improvements. We may not be able to effectively implement new technology-driven products and services or successfully market such products and services to our customers.

- 25 -

INDEX

Government regulations may prevent or impact our ability to pay dividends, engage in acquisitions or operate in other ways.

Current and future legislation and the policies established by federal and state regulatory authorities will affect our operations. We are subject to supervision and periodic examination by the Federal Deposit Insurance Corporation and the

North Carolina State Banking Commission. Banking regulations, designed primarily for the protection of depositors, may limit our growth and the return to you, our investors, by restricting certain of our activities, such as:

	•	the payment of dividends to our shareholders;

	•	possible mergers with, or acquisitions of or by, other institutions;

	•	our desired investments;

	•	loans and interest rates on loans;

	•	interest rates paid on our deposits;

	•	the possible expansion of our branch offices; and/or

	•	our ability to provide securities or trust services.

We also are subject to capitalization guidelines set forth in federal legislation, and could be subject to enforcement actions to the extent that we are found by regulatory examiners to be undercapitalized. We cannot predict what changes, if any, will be made to existing federal and state legislation and regulations or the effect that such changes may have on our future business and earnings prospects. The cost of compliance with regulatory requirements including those imposed by the SEC may adversely affect our ability to operate profitably.

There are potential risks associated with future acquisitions and expansions.

We intend to continue to explore expanding our branch system through selective acquisitions of existing banks or bank branches in the Research Triangle area and other North Carolina markets. We cannot say with any certainty that we will be able to consummate, or if consummated, successfully integrate, future acquisitions, or that we will not incur disruptions or unexpected expenses in integrating such acquisitions. In the ordinary course of business, we evaluate potential acquisitions that would bolster our ability to cater to the small business, individual and residential lending markets in North Carolina. In attempting to make such acquisitions, we anticipate competing with other financial institutions, many of which have greater financial and operational resources. In addition, since the consideration for an acquired bank or branch may involve cash, notes or the issuance of shares of common stock, existing shareholders could experience dilution in the value of their shares of our common stock in connection with such acquisitions. Any given acquisition, if and when consummated, may adversely affect our results of operations or overall financial condition. In addition, we may expand our branch network through de novo branches in existing or new markets. These de novo branches will have expenses in excess of revenues for varying periods after opening, which could decrease our reported earnings.

Compliance with changing regulation of corporate governance and public disclosure may result in additional risks and expenses.

Changing laws, regulations and standards relating to corporate governance and public disclosure, including the Sarbanes-Oxley Act of 2002 and new SEC regulations, are creating uncertainty for companies such as ours. These laws, regulations and standards are subject to varying interpretations in many cases, and as a result, their application in practice may evolve over time as new guidance is provided by regulatory and governing bodies, which could result in continuing uncertainty regarding compliance matters and higher costs necessitated by ongoing revisions to disclosure and governance practices. We are committed to maintaining high standards of corporate governance and public disclosure. As a result, our efforts to comply with evolving laws, regulations and standards have resulted in, and are likely to continue to result in, increased expenses and a diversion of management time and attention. In particular, our efforts to comply with Section 404 of the Sarbanes-Oxley Act of 2002 and the related regulations regarding management’s required assessment of our internal control over financial reporting and our external auditors’ audit of that assessment has required the commitment of significant financial and managerial resources.

- 26 -

INDEX

We expect these efforts to require the continued commitment of significant resources. Further, the members of our Board of Directors, members of the Audit or Compensation/Human Resources Committees, our chief executive officer, our chief financial officer and certain other of our executive officers could face an increased risk of personal liability in connection with the performance of their duties. As a result, our ability to attract and retain executive officers and qualified Board and committee members could be more difficult. In addition, it may become more difficult and more expensive to obtain director and officer liability insurance.

We are subject to environmental liability risk associated with lending activities.

A significant portion of our loan portfolio is secured by real property. During the ordinary course of business, we may foreclose on and take title to properties securing certain loans. In doing so, there is a risk that hazardous or toxic substances could be found on these properties. If hazardous or toxic substances are found, we may be liable for remediation costs, as well as for personal injury and property damage. Environmental laws may require us to incur substantial expenses and may materially reduce the affected property’s value or limit our ability to use or sell the affected property. In addition, future laws or more stringent interpretations or enforcement policies with respect to existing laws may increase our exposure to environmental liability. Although we have policies and procedures to perform an environmental review before initiating any foreclosure action on nonresidential real property, these reviews may not be sufficient to detect all potential environmental hazards. The remediation costs and any other financial liabilities associated with an environmental hazard could have a material adverse effect on our financial condition and results of operations.

Our controls and procedures may fail or be circumvented.

Management regularly reviews and updates our internal controls, disclosure controls and procedures, and corporate governance policies and procedures. Any system of controls, however well designed and operated, is based in part on certain assumptions and can provide only reasonable, not absolute, assurances that the objectives of the system are met. Any failure or circumvention of our controls and procedures or failure to comply with regulations related to controls and procedures could have a material adverse effect on our business, results of operations and financial condition.

The holders of our subordinated debentures have rights that are senior to those of our shareholders.

We have issued $30.9 million of subordinated debentures in connection with three trust preferred securities issuances by our subsidiaries, Trust I, II and III. We conditionally guarantee payments of the principal and interest on the trust preferred securities. Our subordinated debentures are senior to our shares of common stock. As a result, we must make payments on the subordinated debentures (and the related trust preferred securities) before any dividends can be paid on our common stock and, in the event of bankruptcy, dissolution or liquidation, the holders of the debentures must be satisfied before any distributions can be made to the holders of common stock.

Our information systems may experience an interruption or breach in security.

We rely heavily on communications and information systems to conduct our business. Any failure, interruption or breach in security of these systems could result in failures or disruptions in our customer relationship management, general ledger, deposit, loan and other systems. While we have policies and procedures designed to prevent or limit the effect of the failure, interruption or security breach of our information systems, there can be no assurance that we can prevent any such failures, interruptions or security breaches or, if they do occur, that they will be adequately addressed. The occurrence of any failures, interruptions or security breaches of our information systems could damage our reputation, result in a loss of customer business, subject us to additional regulatory scrutiny, or expose us to civil litigation and possible financial liability, any of which could have a material adverse effect on our financial condition and results of operations.

An investment in our common stock is not an insured deposit.

Our common stock is not a bank deposit and, therefore, is not insured against loss by the FDIC, any other deposit insurance fund or by any other public or private entity. Investment in our common stock is inherently risky for the reasons described in this “Risk Factors” section and elsewhere in this report and is subject to the same market forces that affect the price of common stock in any company. As a result, if you acquire our common stock, you may lose some or all of your investment.

- 27 -

INDEX

Consumers may decide not to use banks to complete their financial transactions.

Technology and other changes are allowing parties to complete financial transactions that historically have involved banks through alternative methods. For example, consumers can now maintain funds that would have historically been held as bank deposits in brokerage accounts or mutual funds. Consumers can also complete transactions such as paying bills and/or transferring funds directly without the assistance of banks. The process of eliminating banks as intermediaries could result in the loss of fee income, as well as the loss of customer deposits and the related income generated from those deposits. The loss of these revenue streams and the lower cost deposits as a source of funds could have a material adverse effect on our financial condition and results of operations.

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

The following table lists all repurchases (both open market and private transactions) during the three months ended June 30, 2007 of any of the Company’s securities registered under Section 12 of the Exchange Act, by or on behalf of the Company, or any affiliated purchaser of the Company.

Issuer Purchases of Equity Securities

Month	Total Number of Shares Purchased		Average Price Paid per Share		Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs ¹		Maximum Number of Shares that May Yet Be Purchased under the Plans or Programs

April 2007		304	$	16.96		304		568,043
May 2007		2,000	$	17.05		2,000		566,043
June 2007		–	$	–		–		566,043

On February 27, 2006, the Company announced that its Board of Directors authorized a program to repurchase (in the open market or in any private transaction), up to 1.0 million shares of the Company’s outstanding common stock. The repurchase program is for a period of up to two years and supersedes the share repurchase program authorized by the Company’s Board of Directors on December 22, 2004, which authorized the repurchase of up to 100,000 shares. The Company did not acquire any shares under this former repurchase program. As of June 30, 2007, there were an aggregate of 566,043 shares remaining authorized for future repurchases.

Item 3. Defaults upon Senior Securities

None

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

On May 24, 2007, the Company held its annual shareholders’ meeting to consider and vote on three issues: (i) election of six nominees to serve as Class I directors with terms continuing until the Annual Meeting of Shareholders in 2010; (ii) ratification of the appointment of Grant Thornton LLP as the Company’s independent registered public accounting firm for the fiscal year ending December 31, 2007; and (iii) approval of the reservation of 125,000 additional shares of Capital Bank Corporation common stock for issuance under the Deferred Compensation Plan. Each item considered was approved by the Company’s shareholders. Of the 11,444,449 shares eligible to vote, 10,357,440 shares were voted as shown on the following table.

- 28 -

INDEX

	For		Against/Withheld		Abstain

Class I Directors:
Charles F. Atkins		8,642,871		1,714,569		–
Oscar A. Keller, Jr.		8,635,784		1,721,656		–
James G. McClure, Jr.		8,643,781		1,713,659		–
James D. Moser, Jr.		8,640,271		1,717,169		–
Don W. Perry		8,642,868		1,714,572		–
B. Grant Yarber		8,388,552		1,968,888		–

Ratification of Auditors		10,225,074		109,773		22,593

Approval of Shares		5,089,795		2,315,528		48,138

The term of office of James A. Barnwell, Jr., John F. Grimes, III, Robert L. Jones, Richard H. Shirley, J. Rex Thomas and Samuel J. Wornom, III continue after the annual shareholders’ meeting until 2008. In addition, the term of office of Leopold I. Cohen, O. A. Keller, III, Ernest A. Koury, Jr., George R. Perkins, III and Carl H. Ricker, Jr. continue after the annual shareholders’ meeting until 2009.

Item 5. Other Information

None

Item 6. Exhibits

Exhibit No.		Description

Exhibit 4.1		In accordance with Item 601(b)(4)(iii)(A) of Regulation S-K, certain instruments respecting long term debt of the registrant have been omitted but will be furnished to the Commission upon request.

Exhibit 31.1		Certification of B. Grant Yarber pursuant to Rule 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

Exhibit 31.2		Certification of A. Christine Baker pursuant to Rule 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

Exhibit 32.1		Certification of B. Grant Yarber pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 [This exhibit is being furnished pursuant to Section 906 of the Sarbanes- Oxley Act of 2002 and shall not, except to the extent required by that act, be deemed to be incorporated by reference into any document or filed herewith for purposes of liability under the Securities Exchange Act of 1934, as amended, or the Securities Act of 1933, as amended, as the case may be.]

Exhibit 32.2		Certification of A. Christine Baker pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 [This exhibit is being furnished pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 and shall not, except to the extent required by that act, be deemed to be incorporated by reference into any document or filed herewith for purposes of liability under the Securities Exchange Act of 1934, as amended, or the Securities Act of 1933, as amended, as the case may be.]

- 29 -

INDEX

Signatures

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, in Raleigh, North Carolina, on the 8th day of August 2007.

	CAPITAL BANK CORPORATION


	By: /s/ A. Christine Baker
	A. Christine Baker
	Chief Financial Officer
	(Authorized Officer and Principal Financial Officer)

- 30 -

INDEX

EXHIBIT INDEX

Exhibit No.		Description

Exhibit 4.1		In accordance with Item 601(b)(4)(iii)(A) of Regulation S-K, certain instruments respecting long term debt of the registrant have been omitted but will be furnished to the Commission upon request.

Exhibit 31.1		Certification of B. Grant Yarber pursuant to Rule 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

Exhibit 31.2		Certification of A. Christine Baker pursuant to Rule 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

Exhibit 32.1		Certification of B. Grant Yarber pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 [This exhibit is being furnished pursuant to Section 906 of the Sarbanes- Oxley Act of 2002 and shall not, except to the extent required by that act, be deemed to be incorporated by reference into any document or filed herewith for purposes of liability under the Securities Exchange Act of 1934, as amended, or the Securities Act of 1933, as amended, as the case may be.]

Exhibit 32.2		Certification of A. Christine Baker pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 [This exhibit is being furnished pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 and shall not, except to the extent required by that act, be deemed to be incorporated by reference into any document or filed herewith for purposes of liability under the Securities Exchange Act of 1934, as amended, or the Securities Act of 1933, as amended, as the case may be.]

- 31 -

INDEX

North Carolina		000-30062		56-2101930
(State or other jurisdiction of incorporation)		(Commission File Number)		(IRS Employer Identification No.)

	June 30, 2007			December 31, 2006
(Dollars in thousands except share data)	(Unaudited)

ASSETS
Cash and due from banks:
Interest earning	$	3,794		$	12,348
Noninterest earning		32,294			33,504
Federal funds sold and short term investments		18,108			8,480
Investment securities – available for sale, at fair value		231,352			228,214
Investment securities – held to maturity, at amortized cost		10,314			10,833
Loans – net of unearned income and deferred fees		1,022,147			1,008,052
Allowance for loan losses		(13,339	)		(13,347	)
Net loans		1,008,808			994,705
Premises and equipment, net		24,137			23,125
Bank-owned life insurance		21,075			20,662
Deposit premium and goodwill, net		63,943			64,543
Other assets		26,415			25,970
Total assets	$	1,440,240		$	1,422,384

LIABILITIES
Deposits:
Demand, noninterest bearing	$	123,628		$	120,945
Savings and interest-bearing demand deposits		416,898			366,243
Time deposits		532,453			568,021
Total deposits		1,072,979			1,055,209
Repurchase agreements and federal funds purchased		34,243			34,238
Borrowings		125,914			125,924
Subordinated debentures		30,930			30,930
Other liabilities		13,772			14,402
Total liabilities		1,277,838			1,260,703

SHAREHOLDERS’ EQUITY
Common stock, no par value; 20,000,000 authorized; 11,459,530 and 11,393,990 issued and outstanding as of June 30, 2007 and December 31, 2006, respectively		140,381			139,484
Retained earnings		26,981			23,754
Accumulated other comprehensive loss		(4,960	)		(1,557	)
Total shareholders’ equity		162,402			161,681
Total liabilities and shareholders’ equity	$	1,440,240		$	1,422,384

	Three Months Ended June 30,					Six Months Ended June 30,
(Dollars in thousands except share and per share data)	2007			2006		2007		2006

Interest income:
Loans and loan fees	$	20,519		$	18,646	$	40,402	$	35,664
Investment securities		2,858			2,155		5,665		4,265
Federal funds and other interest income		291			308		776		850
Total interest income		23,668			21,109		46,843		40,779
Interest expense:
Deposits		9,918			7,328		19,924		13,438
Borrowings and repurchase agreements		2,496			2,173		4,942		4,343
Total interest expense		12,414			9,501		24,866		17,781
Net interest income		11,254			11,608		21,977		22,998
(Credit) provision for loan losses		(91	)		249		246		661
Net interest income after (credit) provision for loan losses		11,345			11,359		21,731		22,337
Noninterest income:
Service charges and other fees		998			1,061		1,926		2,026
Mortgage fees and revenues		580			654		1,121		1,018
Other noninterest income		729			897		1,450		1,583
Total noninterest income		2,307			2,612		4,497		4,627
Noninterest expense:
Salaries and employee benefits		5,314			4,851		10,408		9,393
Occupancy		973			938		1,971		1,716
Furniture and equipment		647			562		1,262		1,054
Director fees		229			283		497		659
Data processing		326			111		622		600
Advertising		250			324		499		579
Amortization of deposit premiums		300			343		600		686
Professional fees		378			354		587		566
Other expenses		1,371			1,575		2,578		2,902
Total noninterest expense		9,788			9,341		19,024		18,155
Net income before tax expense		3,864			4,630		7,204		8,809
Income tax expense		1,188			1,579		2,144		2,995
Net income	$	2,676		$	3,051	$	5,060	$	5,814

Earnings per share – basic	$	0.23		$	0.26	$	0.44	$	0.50
Earnings per share – diluted	$	0.23		$	0.26	$	0.44	$	0.50

Weighted average shares:
Basic		11,503,441			11,639,014		11,498,125		11,628,015
Fully diluted		11,574,110			11,726,584		11,573,632		11,715,510

	Shares of Common Stock			Common Stock			Other Comprehensive Income			Retained Earnings			Total
(Dollars in thousands except share data)

Balance at January 1, 2006		6,852,156		$	70,985		$	(1,672	)	$	14,179		$	83,492
Repurchase of outstanding common stock		(217,782	)		(3,496	)		–			–			(3,496	)
Issuance of common stock for acquisition of 1st State Bancorp, Inc.		4,882,630			74,499			–			–			74,499
Issuance of common stock for options exercised		35,490			380			–			–			380
Noncash compensation		–			58			–			–			58
Net income		–			–			–			5,814			5,814
Other comprehensive loss		–			–			(1,589	)		–			(1,589	)
Comprehensive income														4,225
Dividends ($0.12 per share)		–			–			–			(1,388	)		(1,388	)
Balance at June 30, 2006		11,552,494		$	143,426		$	(3,261	)	$	16,245		$	157,770


Balance at January 1, 2007		11,393,990		$	139,484		$	(1,557	)	$	23,754		$	161,681
Repurchase of outstanding common stock		(2,386	)		(41	)		–			–			(41	)
Issuance of common stock for options exercised		35,597			441			–			–			441
Noncash compensation		32,329			497			–			–			497
Net income		–			–			–			5,060			5,060
Other comprehensive loss		–			–			(3,403	)		–			(3,403	)
Comprehensive income														1,657
Dividends ($0.16 per share)		–			–			–			(1,833	)		(1,833	)
Balance at June 30, 2007		11,459,530		$	140,381		$	(4,960	)	$	26,981		$	162,402

	June 30, 2007			June 30, 2006
(Dollars in thousands)

Cash flows from operating activities:
Net income	$	5,060		$	5,814
Adjustments to reconcile net income to net cash used in operating activities:
Amortization of deposit premium		600			686
Depreciation		1,222			1,019
Loss (gain) on disposal of premises, equipment and real estate owned		18			(138	)
Change in held-for-sale loans, net		(3,868	)		(3,958	)
Amortization of premiums on securities, net		50			73
Deferred income tax (benefit) expense		(163	)		3,258
Issuance of stock for compensation		497			58
Provision for loan losses		246			661
Changes in assets and liabilities:
Accrued interest receivable and other assets		1,064			3,101
Accrued interest payable and other liabilities		(863	)		550
Net cash provided by operating activities		3,863			11,124

Cash flows from investing activities:
Loan originations, net of principal repayments		(11,126	)		(58,670	)
Additions to premises and equipment		(2,323	)		(3,124	)
Net sales of Federal Home Loan Bank stock		931			767
Purchase of securities available for sale		(24,020	)		(30,597	)
Proceeds from calls/maturities of securities available for sale		15,388			6,318
Proceeds from sales of securities available for sale		–			102,396
Proceeds from calls/maturities of securities held to maturity		516			397
Net cash paid in merger transaction		–			(37,541	)
Proceeds from sales of premises, equipment and real estate owned		71			1,229
Net cash used in investing activities		(20,563	)		(18,825	)

Cash flows from financing activities:
Net increase in deposits		17,770			55,433
Net increase in repurchase agreements		5			13,490
Net decrease in borrowings		(10	)		(19,519	)
Repayment of short term debt		–			(30,000	)
Distribution of cash held in escrow		–			33,185
Dividends paid		(1,601	)		(1,106	)
Issuance of common stock for options and other plans		441			380
Repurchase of common stock		(41	)		(3,496	)
Net cash provided by financing activities		16,564			47,971

Net change in cash and cash equivalents		(136	)		40,270
Cash and cash equivalents at beginning of period		54,332			43,904
Cash and cash equivalents at end of period	$	54,196		$	84,174
(continued on next page)

PART I – FINANCIAL INFORMATION		Page No.

Item 1.	Financial Statements
	Condensed Consolidated Balance Sheets as of June 30, 2007 (Unaudited) and December 31, 2006	3
	Condensed Consolidated Statements of Operations for the Three and Six Months Ended June 30, 2007 and 2006 (Unaudited)	4
	Condensed Consolidated Statements of Changes in Shareholders’ Equity for the Six Months Ended June 30, 2007 and 2006 (Unaudited)	5
	Condensed Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2007 and 2006 (Unaudited)	6
	Notes to Condensed Consolidated Financial Statements (Unaudited)	8

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	12

Item 3.	Quantitative and Qualitative Disclosures about Market Risk	24

Item 4.	Controls and Procedures	24

PART II – OTHER INFORMATION

Item 1.	Legal Proceedings	24

Item 1A.	Risk Factors	24

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	28

Item 3.	Defaults upon Senior Securities	28

Item 4.	Submission of Matters to a Vote of Security Holders	28

Item 5.	Other Information	29

Item 6.	Exhibits	29

Signatures