10-Q

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q
[ X ] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended: June 30, 2005
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from __________ to __________
PEOPLES BANCORP OF NORTH CAROLINA, INC.
(Exact name of registrant as specified in its charter)
North Carolina
(State or other jurisdiction of incorporation or organization)
000-27205	56-2132396
(Commission File No.)	(IRS Employer Identification No.)
518 West C Street, Newton, North Carolina	28658
(Address of principal executive offices)	(Zip Code)
(828) 464-5620
(Registrant’s telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
		Yes	X	No
Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2 of the Exchange Act).
		Yes		No	X
Indicate the number of shares outstanding of each of the registrant's classes of common stock, as of the latest practicable date. 3,453,312 shares of common stock, outstanding at August 11, 2005.

INDEX

PART I.	FINANCIAL INFORMATION	PAGE(S)
Item 1.	Financial Statements
	Consolidated Balance Sheets at June 30, 2005 (Unaudited) and December 31,
	2004	3
	Consolidated Statements of Earnings for the three months ended June 30, 2005
	and 2004 (Unaudited), and for the six months ended June 30, 2005 and 2004
	(Unaudited)	4
	Consolidated Statements of Comprehensive Income for the three months ended
	June 30, 2005 and 2004 (Unaudited), and for the six months ended June 30,
	2005 and 2004 (Unaudited)	5
	Consolidated Statements of Cash Flows for the six months ended June 30, 2005
	and 2004 (Unaudited)	6-7
	Notes to Consolidated Financial Statements (Unaudited)	8-12
Item 2.	Management's Discussion and Analysis of Financial Condition
	and Results of Operations	13-20
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	21
Item 4.	Controls and Procedures	22
PART II.	OTHER INFORMATION
Item 1.	Legal Proceedings	23
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	23
Item 3.	Defaults upon Senior Securities	23
Item 4.	Submission of Matters to a Vote of Security Holders	23
Item 5.	Other Information	24
Item 6.	Exhibits	24-25
Signatures		26
Certifications		27-29

Statements made in this Form 10-Q, other than those concerning historical information, should be considered forward-looking statements pursuant to the safe harbor provisions of the Securities Exchange Act of 1934 and the Private Securities Litigation Act of 1995. These forward-looking statements involve risks and uncertainties and are based on the beliefs and assumptions of management and on the information available to management at the time that this Form 10-Q was prepared. These statements can be identified by the use of words like “expect,”“anticipate,”“estimate,” and “believe,” variations of these words and other similar expressions. Readers should not place undue reliance on forward-looking statements as a number of important factors could cause actual results to differ materially from those in the forward-looking statements. Factors that could cause actual results to differ materially include, but are not limited to, (1) competition in the markets served by Peoples Bank, (2) changes in the interest rate environment, (3) general national, regional or local economic conditions may be less favorable than expected, resulting in, among other things, a deterioration in credit quality and the possible impairment of collectibility of loans, (4) legislative or regulatory changes, including changes in accounting standards, (5) significant changes in the federal and state legal and regulatory environments and tax laws, (6) the impact of changes in monetary and fiscal policies, laws, rules and regulations and (7) other risks and factors identified in the Company’s other filings with the Securities and Exchange Commission, including but not limited to those described in Peoples Bancorp of North Carolina, Inc.’s annual report on Form 10-K for the year ended December 31, 2004.

2

PART I.            FINANCIAL INFORMATION

Item 1.Financial Statements

PEOPLES BANCORP OF NORTH CAROLINA, INC. AND SUBSIDIARIES
Consolidated Balance Sheets
	June 30,			December 31,
Assets	2005			2004
	(Unaudited)
Cash and due from banks	$	20,211,985			15,067,871
Federal funds sold		2,767,000			1,723,000
Cash and cash equivalents		22,978,985			16,790,871
Investment securities available for sale		105,768,532			105,598,106
Other investments		6,494,249			5,396,959
Total securities		112,262,781			110,995,065
Mortgage loans held for sale		3,356,750			3,783,175
Loans		551,104,351			535,467,733
Less allowance for loan losses		(8,021,456	)		(8,048,627	)
Net loans		543,082,895			527,419,106
Premises and equipment, net		13,008,791			12,742,730
Cash surrender value of life insurance		6,202,973			6,034,188
Accrued interest receivable and other assets		8,665,824			8,582,937
Total assets	$	709,558,999			686,348,072
Liabilities and Shareholders' Equity
Deposits:
Non-interest bearing demand	$	94,679,521			78,024,194
NOW, MMDA & savings		184,084,578			193,917,507
Time, $100,000 or more		151,069,343			154,300,926
Other time		139,014,564			130,279,446
Total deposits		568,848,006			556,522,073
Demand notes payable to U.S. Treasury		801,899			1,184,392
FHLB borrowings		69,000,000			59,000,000
Junior subordinated debentures		14,433,000			14,433,000
Accrued interest payable and other liabilities		3,832,783			4,270,755
Total liabilities		656,915,688			635,410,220
Shareholders' equity:
Preferred stock, no par value; authorized
5,000,000 shares; no shares issued
and outstanding		-			-
Common stock, no par value; authorized
20,000,000 shares; issued and
outstanding 3,453,312 shares in 2005
and 3,448,341 shares in 2004		41,378,990			35,040,390
Retained earnings		11,933,784			16,018,206
Accumulated other comprehensive income		(669,463	)		(120,744	)
Total shareholders' equity		52,643,311			50,937,852
Total liabilities and shareholders' equity	$	709,558,999			686,348,072
See accompanying notes to consolidated financial statements.

3

PEOPLES BANCORP OF NORTH CAROLINA, INC. AND SUBSIDIARIES
Consolidated Statements of Earnings
	Three months ended				Six months ended
	June 30,				June 30,
	2005		2004		2005		2004
	(Unaudited)		(Unaudited)		(Unaudited)		(Unaudited)
Interest income:
Interest and fees on loans	$	9,220,188		7,913,382		17,682,125		15,980,196
Interest on federal funds sold		1,425		6,787		2,905		9,427
Interest on investment securities:
U.S. Government agencies		854,201		668,074		1,702,557		1,282,084
States and political subdivisions		180,632		163,149		362,495		312,854
Other		91,924		95,395		178,957		196,987
Total interest income		10,348,370		8,846,787		19,929,039		17,781,548
Interest expense:
NOW, MMDA & savings deposits		641,962		411,448		1,275,282		776,105
Time deposits		2,101,247		1,783,441		3,890,924		3,674,643
FHLB borrowings		710,008		643,017		1,421,784		1,288,824
Junior subordinated debentures		225,516		162,371		432,990		324,743
Other		7,045		1,487		11,111		3,159
Total interest expense		3,685,778		3,001,764		7,032,091		6,067,474
Net interest income		6,662,592		5,845,023		12,896,948		11,714,074
Provision for loans losses		723,000		868,000		1,413,000		1,727,000
Net interest income after provision for loan losses		5,939,592		4,977,023		11,483,948		9,987,074
Other income:
Service charges		947,309		881,111		1,752,569		1,684,355
Other service charges and fees		270,865		148,299		515,492		327,030
Mortgage banking income		101,640		84,481		204,756		156,781
Insurance and brokerage commissions		102,761		97,964		212,520		256,203
Miscellaneous		419,181		318,851		794,487		606,392
Total other income		1,841,756		1,530,706		3,479,824		3,030,761
Other expense:
Salaries and employee benefits		2,971,765		2,766,467		6,034,266		5,547,068
Occupancy		988,560		893,757		1,957,626		1,778,836
Other		1,340,364		1,213,243		2,567,644		2,267,053
Total other expenses		5,300,689		4,873,467		10,559,536		9,592,957
Earnings before income taxes		2,480,659		1,634,262		4,404,236		3,424,878
Income taxes		872,600		547,000		1,519,400		1,159,700
Net earnings	$	1,608,059		1,087,262		2,884,836		2,265,178
Basic earnings per share	$	0.47		0.31		0.84		0.66
Diluted earnings per share	$	0.46		0.31		0.82		0.65
Cash dividends declared per share	$	0.10		0.09		0.20		0.18
See accompanying notes to consolidated financial statements.

4

PEOPLES BANCORP OF NORTH CAROLINA, INC. AND SUBSIDIARIES
Consolidated Statements of Comprehensive Income
	Three months ended					Six months ended
	June 30,					June 30,
	2005		2004			2005			2004
	(Unaudited)		(Unaudited)			(Unaudited)			(Unaudited)
Net earnings	$	1,608,059		1,087,262			2,884,836			2,265,178
Other comprehensive income (loss):
Unrealized holding gains (losses) on securities
available for sale		696,306		(3,634,998	)		(906,427	)		(2,372,248	)
Unrealized holding gains (losses) on derivative
financial instruments qualifying as cash flow
hedges		243,826		(1,081,000	)		(75,174	)		(715,000	)
Reclassification adjustment for losses (gains) on
derivative financial instruments qualifying as
cash flow hedges included in net earnings		82,798		(246,313	)		82,798			(551,370	)
Total other comprehensive income (loss),
before income taxes		1,022,930		(4,962,311	)		(898,803	)		(3,638,618	)
Income tax expense (benefit) related to other
comprehensive income:
Unrealized holding gains (losses) on securities
available for sale		271,211		(1,415,832	)		(353,053	)		(923,991	)
Unrealized holding gains (losses) on derivative
financial instruments qualifying as cash flow
hedges		94,970		(421,049	)		(29,281	)		(278,492	)
Reclassification adjustment for losses (gains) on
derivative financial instruments qualifying as
cash flow hedges included in net earnings		32,250		(95,939	)		32,250			(214,759	)
Total income tax expense (benefit) related to
other comprehensive income		398,431		(1,932,820	)		(350,084	)		(1,417,242	)
Total other comprehensive income (loss),
net of tax		624,499		(3,029,491	)		(548,719	)		(2,221,376	)
Total comprehensive income (loss)	$	2,232,558		(1,942,229	)		2,336,117			43,802
See accompanying notes to consolidated financial statements.

5

PEOPLES BANCORP OF NORTH CAROLINA, INC. AND SUBSIDIARIES
Consolidated Statements of Cash Flows
Six months ended June 30, 2005 and 2004
	2005			2004
		(Unaudited)			(Unaudited)
Cash flows from operating activities:	$	2,884,836			2,265,178
Net earnings
Adjustments to reconcile net earnings to
net cash provided by operating activities:
Depreciation, amortization and accretion		836,359			794,433
Provision for loan losses		1,413,000			1,727,000
Recognition of gain on sale of derivative instruments		82,798			(551,370	)
Amortization of deferred gain on sale of premises		(10,447	)		(10,448	)
Gain on sale of premises and equipment		(1,088	)		-
Loss (gain) on sale of repossessed assets		(2,859	)		27,376
Change in:
Mortgage loans held for sale		426,425			(2,342,425	)
Cash surrender value of life insurance		(168,785	)		(891,870	)
Other assets		1,010,727			(1,089,494	)
Other liabilities		(437,971	)		945,777
Net cash provided by operating activities		6,032,995			874,157
Cash flows from investing activities:
Purchases of investment securities available for sale		(6,655,522	)		(23,563,918	)
Proceeds from calls and maturities of investment securities
available for sale		5,503,368			8,734,571
Purchases of other investments		(4,395,790	)		(1,582,500	)
Proceeds from sale of other investments		3,298,500			1,177,500
Net change in loans		(17,111,546	)		2,880,017
Purchases of premises and equipment		(987,910	)		(778,317	)
Proceeds from sale of premises and equipment		1,750			1,179,833
Proceeds from sale of repossessed assets		59,487			-
Payment from sale of derivative financial instruments		(870,000	)		-
Net cash used by investing activities		(21,157,663	)		(11,952,814	)
Cash flows from financing activities:
Net change in deposits		12,325,933			1,226,019
Net change in demand notes payable to U.S. Treasury		(382,493	)		772,142
Proceeds from FHLB borrowings		129,500,000			59,050,000
Repayments of FHLB borrowings		(119,500,000	)		(49,550,000	)
Proceeds from exercise of options		64,514			179,764
Cash paid in lieu of fractional shares		(4,700	)		-
Cash dividends paid		(690,472	)		(628,923	)
Net cash provided by financing activities		21,312,782			11,049,002
Net change in cash and cash equivalent		6,188,114			(29,655	)
Cash and cash equivalents at beginning of period		16,790,871			20,782,786
Cash and cash equivalents at end of period	$	22,978,985			20,753,131

6

PEOPLES BANCORP OF NORTH CAROLINA, INC. AND SUBSIDIARIES
Consolidated Statements of Cash Flows, continued
Six months ended June 30, 2005 and 2004
(Continued)
	2005			2004
	(Unaudited)			(Unaudited)
Supplemental disclosures of cash flow information:
Cash paid during the year for:
Interest	$	6,951,184			5,764,638
Income taxes	$	814,000			692,966
Noncash investing and financing activities:
Change in unrealized gain (loss) on investment securities
available for sale, net	$	(553,373	)		(1,448,257	)
Change in unrealized gain (loss) on derivative financial
instruments, net	$	4,654			(773,119	)
Transfer of loans to other real estate and repossessions	$	34,757			693,715
Financed sale of other real estate	$	-			340,000
Transfer of retained earnings to common stock for
issuance of stock dividend	$	6,274,087			-
See accompanying notes to consolidated financial statements.

7

PEOPLES BANCORP OF NORTH CAROLINA, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(1)           Summary of Significant Accounting Policies

The consolidated financial statements include the financial statements of Peoples Bancorp of North Carolina, Inc. and its wholly owned subsidiary, Peoples Bank (the “Bank”), along with the Bank’s wholly owned subsidiaries, Peoples Investment Services, Inc. and Real Estate Advisory Services, Inc. (collectively called the “Company”). All significant intercompany balances and transactions have been eliminated in consolidation.

The consolidated financial statements in this report are unaudited. In the opinion of management, all adjustments (none of which were other than normal accruals) necessary for a fair presentation of the financial position and results of operations for the periods presented have been included. Management of the Company has made a number of estimates and assumptions relating to reporting of assets and liabilities and the disclosure of contingent assets and liabilities to prepare these consolidated financial statements in conformity with generally accepted accounting principles. Actual results could differ from those estimates.

The Company’s accounting policies are fundamental to understanding management’s discussion and analysis of results of operations and financial condition. Many of the Company’s accounting policies require significant judgment regarding valuation of assets and liabilities and/or significant interpretation of the specific accounting guidance. A description of the Company’s significant accounting policies can be found in Note 1 of the notes to consolidated financial statements in the Company’s 2005 Annual Report to Shareholders which is Appendix A to the Proxy Statement for the May 5, 2005 Annual Meeting of Shareholders.

(2)           Allowance for Loan Losses

The following is an analysis of the allowance for loan losses for the six months ended June 30, 2005 and 2004:

		2005	2004
Balance, beginning of period	$	8,048,627	9,722,267
Provision for loan losses		1,413,000	1,727,000
Less:
Charge-offs		(1,681,002)	(2,418,702)
Recoveries		240,831	122,523
Net charge-offs		(1,440,171)	(2,296,179)
Balance, end of period	$	8,021,456	9,153,088

(3)           Net Earnings Per Share

Net earnings per common share is based on the weighted average number of common shares outstanding during the period while the effects of potential common shares outstanding during the period are included in diluted earnings per share. The average market price during the year is used to compute equivalent shares.

The reconciliation of the amounts used in the computation of both “basic earnings per share” and “diluted earnings per share” for the three and six months ended June 30, 2005 is as follows:

For the three months ended June 30, 2005
		Net Earnings	Common Shares		Per Share Amount
Basic earnings per share	$	1,608,059	3,452,621	$	0.47
Effect of dilutive securities:
Stock options		-	48,312
Diluted earnings per share	$	1,608,059	3,500,933	$	0.46

8

For the six months ended June 30, 2005
		Net Earnings	Common Shares		Per Share Amount
Basic earnings per share	$	2,884,836	3,451,454	$	0.84
Effect of dilutive securities:
Stock options		-	50,803
Diluted earnings per share	$	2,884,836	3,502,257	$	0.82

The reconciliation of the amounts used in the computation of both “basic earnings per share” and “diluted earnings per share” for the three and six months ended June 30, 2004 is as follows:

For the three months ended June 30, 2004
		Net Earnings	Common Shares		Per Share Amount
Basic earnings per share	$	1,087,262	3,460,689	$	0.31
Effect of dilutive securities:
Stock options		-	43,393
Diluted earnings per share	$	1,087,262	3,504,082	$	0.31

For the six months ended June 30, 2004
		Net Earnings	Common Shares		Per Share Amount
Basic earnings per share	$	2,265,178	3,457,695	$	0.66
Effect of dilutive securities:
Stock options		-	45,250
Diluted earnings per share	$	2,265,178	3,502,945	$	0.65

(4)           Derivative Financial Instruments and Hedging Activities

In the normal course of business, the Company enters into derivative contracts to manage interest rate risk by modifying the characteristics of the related balance sheet instruments in order to reduce the adverse effect of changes in interest rates. All derivative financial instruments are recorded at fair value in the financial statements.

On the date a derivative contract is entered into, the Company designates the derivative as a fair value hedge, a cash flow hedge, or a trading instrument. Changes in the fair value of instruments used as fair value hedges are accounted for in the earnings of the period simultaneous with accounting for the fair value change of the item being hedged. Changes in the fair value of the effective portion of cash flow hedges are accounted for in other comprehensive income rather than earnings. Changes in fair value of instruments that are not intended as a hedge are accounted for in the earnings of the period of the change.

If a derivative instrument designated as a fair value hedge is terminated or the hedge designation removed, the difference between a hedged item’s then carrying amount and its face amount is recognized into income over the original hedge period. Likewise, if a derivative instrument designated as a cash flow hedge in terminated or the hedge designation removed, related amounts accumulated in other accumulated comprehensive income are reclassified into earnings over the original hedge period during which the hedged item affects income.

9

The Company formally documents all hedging relationships, including an assessment that the derivative instruments are expected to be highly effective in offsetting the changes in fair values or cash flows of the hedged items.

The Company settled two previously outstanding interest rate swap agreements during the quarter ended June 30, 2005. The first swap with a notional amount of $25.0 million and scheduled to mature in April 2006 was sold for a loss of $318,000. The second swap with a notional amount of $30.0 million and scheduled to mature in September 2006 was sold for a loss of $552,000. The losses realized upon settlement are being recognized over the original term of the agreements and during the six-month period ended June 30, 2005, losses of approximately $83,000 were recognized.

(5)           Commitments and Contingencies

The Company is party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit, standby letters of credit and financial guarantees. Those instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized in the balance sheet. The contract amounts of those instruments reflect the extent of involvement the Company has in particular classes of financial instruments. At June 30, 2005, the contractual amounts of the Company’s commitments to extend credit and standby letters of credit were $122.7 million and $3.1 million, respectively.

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates and because they may expire without being drawn upon, the total commitment amount of $122.7 million does not necessarily represent future cash requirements. Standby letters of credit and financial guarantees written are conditional commitments issued by the Company to guarantee the performance of a customer to a third party.

The Company has an overall interest rate-risk management strategy that incorporates the use of derivative instruments to minimize significant unplanned fluctuations in earnings that are caused by interest rate volatility. By using derivative instruments, the Company is exposed to credit and market risk. If the counterparty fails to perform, credit risk is equal to the extent of the fair-value gain in the derivative. The Company attempts to minimize the credit risk in derivative instruments by entering into transactions with counterparties that are reviewed periodically by the Company and are believed to be of high quality.

(6)           Stock-Based Compensation

The Company has an Omnibus Stock Ownership and Long Term Incentive Plan (the “Plan”) whereby certain stock-based rights, such as stock options, restricted stock, performance units, stock appreciation rights, or book value shares, may be granted to eligible directors and employees. A total of 354,046 shares were reserved for possible issuance under this Plan. All rights must be granted or awarded within ten years from the effective date.

Under the Plan, the Company granted incentive stock options to certain eligible employees in order that they may purchase Company stock at a price equal to the fair market value on the date of the grant. The options granted in 1999 vest over a five-year period. Options granted subsequent to 1999 vest over a three-year period. All options expire after ten years. A summary of the activity for the three and six months ended June 30, 2005 and 2004 is presented below:

	Three months ended					Three months ended
	June 30, 2005					June 30, 2004
	Shares			Weighted Average Option Price Per Share		Shares			Weighted Average Option Price Per Share
Outstanding, beginning of period		198,142		$	13.39		208,754		$	13.31
Granted during the period		-			-		2,200			17.01
Forfeited during the period		-			-		-			-
Exercised during the period		(1,906	)		12.08		(6,411	)		13.07
Outstanding, end of period		196,236		$	13.40		204,543		$	13.12
Number of shares exercisable		169,108		$	13.40		141,881		$	13.16

10

	Six months ended					Six months ended
	June 30, 2005					June 30, 2004
	Shares			Weighted  Average Option  Price Per Share		Shares			Weighted Average Option  Price Per Share
Outstanding, beginning of period		202,401		$	13.68		216,713		$	13.76
Granted during the period		-			-		2,200			17.01
Forfeited during the period		(1,194	)		12.82		-			-
Exercised during the period		(4,971	)		12.98		(14,370	)		12.51
Outstanding, end of period		196,236		$	13.40		204,543		$	13.35
Number of shares exercisable		169,108		$	13.40		141,881		$	13.16

The Plan is accounted for under Accounting Principles Board Opinion No. 25 and related interpretations. No compensation expense has been recognized related to the grant of the incentive stock options. Had compensation cost been determined based upon the fair value of the options at the grant dates, the Company’s net earnings and net earnings per share would have been reduced to the proforma amounts listed below. The Company did not grant any options during the three months ended June 30, 2005.

			Three months ended		Three months ended
			June 30, 2005		June 30, 2004
Net earnings	As reported	$	1,608,059	$	1,087,262
	Effect of grants, net of tax		(21,126)		(56,096)
	Effect of forfeitures, net of tax		-		-
	Proforma	$	1,586,933	$	1,031,166
Basic earnings per share	As reported	$	0.47	$	0.31
	Proforma	$	0.46	$	0.30
Diluted earnings per share	As reported	$	0.46	$	0.31
	Proforma	$	0.45	$	0.29
			Six months ended		Six months ended
			June 30, 2005		June 30, 2004
Net earnings	As reported	$	2,884,836	$	2,265,178
	Effect of grants, net of tax		(45,458)		(112,192)
	Effect of forfeitures, net of tax		3,207		-
	Proforma	$	2,842,585	$	2,152,986
Basic earnings per share	As reported	$	0.84	$	0.66
	Proforma	$	0.82	$	0.62
Diluted earnings per share	As reported	$	0.82	$	0.65
	Proforma	$	0.81	$	0.61

(7)           Stock Dividend

On February 17, 2005, the Board of Directors of the Company authorized a 10% stock dividend and a $0.10 per share cash dividend. As a result of the stock dividend, each shareholder received one new share of stock for every ten shares of stock they held as of the record date. Shareholders received a cash payment in lieu of any fractional shares resulting from the stock dividend. The cash dividend was paid based on the number of shares held by shareholders as adjusted by the stock dividend. The stock and cash dividends were paid on March 16, 2005 to shareholders of record on March 3, 2005. All previously reported per share amounts have been restated to reflect this stock dividend.

11

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

Introduction

Management's discussion and analysis of earnings and related data are presented to assist in understanding the consolidated financial condition and results of operations of Peoples Bancorp of North Carolina, Inc. Peoples Bancorp is the parent company of Peoples Bank (the “Bank”) and a registered bank holding company operating under the supervision of the Federal Reserve Board. The Bank is a North Carolina-chartered bank, with offices in Catawba, Lincoln, Alexander and Mecklenburg Counties, operating under the banking laws of North Carolina and the rules and regulations of the Federal Deposit Insurance Corporation (the “FDIC”).

Overview

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

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

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

The Federal Reserve has increased the Federal Funds Rate a total of 2.25% since June 2004 with the rate set at 3.25% as of June 30, 2005, including the last change made on June 30, 2005. These increases had a positive impact on second quarter earnings and should continue to have a positive impact on the Bank’s net interest income in the future periods. The positive impact from the increase in the Federal Funds Rate has been partially offset by the decrease in earnings realized on interest rate swaps utilized by the Company to covert some variable rate loans to fixed rate. These swaps were put in place during the time that the Federal Funds Rate approached 1.00% and helped to offset the decline in income experienced in 2003 and 2004 because of the reductions in the Federal Funds Rate that the Federal Reserve implemented from January 2001 to June 2003.

Summary of Significant Accounting Policies

The consolidated financial statements include the financial statements of Peoples Bancorp of North Carolina, Inc. and its wholly owned subsidiary, Peoples Bank, along with its wholly owned subsidiaries, Peoples Investment Services, Inc. and Real Estate Advisory Services, Inc. (collectively called the “Company”). All significant intercompany balances and transactions have been eliminated in consolidation.

The Company’s accounting policies are fundamental to understanding management’s discussion and analysis of results of operations and financial condition. Many of the Company’s accounting policies require significant judgment regarding valuation of assets and liabilities and/or significant interpretation of specific accounting guidance. The following is a summary of some of the more subjective and complex accounting policies of the Company. A more complete description of the Company’s significant accounting policies can be found in Note 1 of the Notes to Consolidated Financial

12

Statements in the Company’s 2005 Annual Report to Shareholders which is Appendix A to the Proxy Statement for the May 5, 2005 Annual Meeting of Shareholders. The following is a summary of the more subjective and complex accounting policies of the Company.

Many of the Company’s assets and liabilities are recorded using various techniques that require significant judgment as to recoverability. The collectability of loans is reflected through the Company’s estimate of the allowance for loan losses. The Company performs periodic and systematic detailed reviews of its lending portfolio to assess overall collectability. In addition, certain assets and liabilities are reflected at their estimated fair value in the consolidated financial statements. Such amounts are based on either quoted market prices or estimated values derived from dealer quotes used by the Company, market comparisons or internally generated modeling techniques. The Company’s internal models generally involve present value of cash flow techniques. The various techniques are discussed in greater detail elsewhere in management’s discussion and analysis and the notes to the consolidated financial statements.

There are other complex accounting standards that require the Company to employ significant judgment in interpreting and applying certain of the principles prescribed by those standards. These judgments include, but are not limited to, the determination of whether a financial instrument or other contract meets the definition of a derivative in accordance with Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities” (SFAS 133). For a more complete discussion of policies, see the notes to the consolidated financial statements.

In January 2003, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 46, “Consolidation of Variable Interest Entities - An Interpretation of Accounting Research Bulletin No. 51” (“FIN 46”). In December 2003, the FASB issued a revised version of FIN 46 to resolve certain questions and confusion related to the application of the original FIN 46. The Company adopted FIN 46 (Revised) as of December 31, 2003, and as a result, the Company’s wholly owned subsidiary, PEBK Capital Trust I, is no longer included in these consolidated financial statements. The consolidated financial statements have been restated for all periods presented to reflect this change in accounting, and the adoption of FIN 46 (Revised) had no impact on the Company’s reported results of operations or shareholders’ equity.

In November 2003, the Emerging Issues Task Force (“EITF”) of the Financial Accounting Standards Board (“FASB”) reached a consensus on EITF Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.” EITF 03-1 provides guidance on determining other-than-temporary impairments and its application to marketable equity securities and debt securities accounted for under SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities.” In September 2004, the FASB issued FASB Staff Position (“FSP”) EITF Issue 03-1-1, which delayed the effective date for the measurement and recognition guidance contained in the EITF 03-1 pending finalization of the draft FSP EITF Issue 03-1-a, “Implementation Guidance for the Application of Paragraph 16 of EITF 03-1.” The disclosure requirements of EITF 03-1 remain in effect. The Company adopted the disclosure requirements of EITF 03-1 as of December 31, 2003. The adoption of the recognition and measurement provisions of EITF 03-1 are not expected to have a material impact on the Company’s results of operations, financial position or cash flows. On June 29, 2005, the FASB Staff recommended to the FAS Board to nullify paragraphs 10-18 of EITF 03-1. FASB is scheduled to issue a final FSP in the third quarter of 2005.

In December 2004, the FASB revised SFAS No. 123 (“SFAS No. 123 (R)”). SFAS No. 123 (R), “Share-Based Payment”, requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements based on their fair values. Pro forma disclosure is no longer an alternative to financial statement recognition. SFAS No. 123 (R) is effective for periods beginning after December 31, 2005. The Company is still evaluating the transition provisions allowed by SFAS No. 123 (R) and expects to adopt in the first quarter of 2006. The financial statement impact is not expected to be materially different from that shown in the existing pro forma disclosure required under the original SFAS No. 123.

Management of the Company has made a number of estimates and assumptions relating to reporting of assets and liabilities and the disclosure of contingent assets and liabilities to prepare these consolidated financial statements in conformity with generally accepted accounting principles. Actual results could differ from those estimates.

Results of Operations

Summary. Net earnings for the second quarter of 2005 were $1.6 million, or $0.47 basic net earnings per share and $0.46 diluted net earnings per share as compared to $1.1 million, or $0.31 basic and diluted net earnings per share for the same period one-year ago. The increase in net earnings is primarily attributable to an increase in net interest income, an increase in non-interest income and a decrease in the provision for loan losses, which was partially offset by an increase in non-interest expense.

13

The annualized return on average assets was 0.93% for the three months ended June 30, 2005 compared to 0.64% for the same period in 2004, and annualized return on average shareholders' equity was 12.27% for the three months ended June 30, 2005 compared to 8.78% for the same period in 2004.

Net earnings for the six months ended June 30, 2005 were $2.9 million, or $0.84 basic net earnings per share and $0.82 diluted net earnings per share. The increase in net earnings for the six-month period ended June 30, 2005 is primarily attributable to an increase in net interest income, an increase in non-interest income and a decrease in the provision for loan losses, which were partially offset by an increase in non-interest expense.

The annualized return on average assets was 0.84% for the six months ended June 30, 2005 compared to 0.67% for the same period in 2004, and annualized return on average shareholders’ equity was 10.96% for the six months ended June 30, 2005 compared to 9.03% for the same period in 2004.

Net Interest Income. Net interest income, the major component of the Company's net income, was $6.7 million for the three months ended June 30, 2005, an increase of 14% over the $5.8 million earned in the same period in 2004. The increase in net interest income for the second quarter of 2005 was primarily attributable to an increase in interest income offsetting an increase in interest expense.

Interest income increased $1.5 million or 17% for the three months ended June 30, 2005 compared with the same period in 2004. The increase was due to an increase in the average yield received on loans resulting from Federal Reserve interest rate increases combined with an increase in the average outstanding balance of investment securities available for sale. During the quarter ended June 30, 2005 average investment securities available for sale increased $16.3 million to $105.4 million from $89.1 million for the three months ended June 30, 2004.

Interest expense increased $684,000 or 23% for the three months ended June 30, 2005 compared with the same period in 2004. The increase in interest expense was due to an increase in the cost of funds to 2.66% for the three months ended June 30, 2005 from 2.18% for the same period in 2004, combined with an increase in volume of interest-bearing liabilities. The increase in the cost of funds is primarily attributable to increases in the average rate paid on interest-bearing checking and savings accounts and certificates of deposit. The average rate paid on interest-bearing checking and savings accounts was 1.37% for the three months ended June 30, 2005 as compared to 0.96% for the same period of 2004. The average rate paid on certificates of deposits was 2.92% for the three months ended June 30, 2005 from 2.33% for the same period one year ago.

Net interest income for the six-month period ended June 30, 2005 was $12.9 million, an increase of 10% over net interest income of $11.7 million for the six months ended June 30, 2004. The increase in net interest income for the six months ended June 30, 2005 was primarily attributable to an increase in interest income offsetting an increase in interest expense.

Interest income increased $2.1 million or 12% to $19.9 million for the six months ended June 30, 2005 compared to $17.8 million for the same period in 2004. The increase was primarily due to an increase in the average yield received on loans resulting from Federal Reserve interest rate increases combined with an increase in the average outstanding balance of investment securities available for sale. Average investment securities available for sale increased 24% to $104.9 million in the six months ended June 30, 2005 compared to the same period in 2004. All other interest-earning assets including federal funds sold decreased to an average of $7.0 million in the six months ended June 30, 2005 from $8.3 million in the same period in 2004. The tax equivalent yield on average earning assets increased to 6.23% for the six months ended June 30, 2005 from 5.62% for the six months ended June 30, 2004.

Interest expense increased 16% to $7.0 million for the six months ended June 30, 2005 compared to $6.1 million for the corresponding period in 2004. The increase in interest expense was due to an increase in the cost of funds to 2.56% for the six months ended June 30, 2005 from 2.20% for the same period in 2004. The increase in the cost of funds is primarily attributable to increases in the average rate paid on interest-bearing checking and savings accounts and certificates of deposit. The average rate paid on interest-bearing checking and savings accounts was 1.35% for the six months ended June 30, 2005 as compared to 0.94% for the same period in 2004. The average rate paid on certificates of deposits was 2.77% for the six months ended June 30, 2005 from 2.36% for the same period one year ago.

Provision for Loan Losses. For the three months ended June 30, 2005, a contribution of $723,000 was made to the provision for loan losses compared to $868,000 for the same period one year ago. This decrease is due to a $10.3 million reduction in classified loans as of June 30, 2005 when compared to June 30, 2004.

For the six months ended June 30, 2005 a contribution of $1.4 million was made to the provision for loan losses compared to a $1.7 million contribution to the provision for loan losses for the six months ended June 30, 2004. The

14

decrease in the provision for loan losses reflects a reduction in classified loans.

Non-Interest Income. Total non-interest income was $1.8 million in the second quarter of 2005, a 20% increase over the $1.5 million for the same period in 2004. This increase is primarily due to an increase in fee income, mortgage banking income and other miscellaneous income. Service charges were $947,000 and $881,000 for the three months ended June 30, 2005 and 2004, respectively. This increase is primarily due to an increase of $73,000 in NSF fee income. Other service charges and fees increased 83% to $271,000 for the three-month period ended June 30, 2005 when compared to the same period one year ago. This increase is primarily attributable to an increase of $70,000 in check cashing fee income and an increase of $39,000 in miscellaneous fee income. Mortgage banking income increased $17,000 or 20% during the three months ended June 30, 2005 as compared to the corresponding period in 2004. Miscellaneous income was $419,000 for the three months ended June 30, 2005, a 31% increase from $319,000 for the same period in 2004. This increase in miscellaneous income was partially attributable to an increase of $41,000 in debit card fee income primarily associated with increased card usage due to an increased number of demand accounts and a $28,000 increase in income from the Bank’s Real Estate Advisory Services, Inc. subsidiary.

Total non-interest income was $3.5 million for the six months ended June 30, 2005, a 15% increase over the $3.0 million for the same period in 2004. This increase is primarily due to an increase in fee income, mortgage banking income and other miscellaneous income. Service charges were $1.8 million for the six months ended June 30, 2005, a 4% increase over the same period in 2004. This increase is primarily due to an increase of $98,000 in NSF fee income. Other service charges and fees increased 58% to $515,000 for the six months ended June 30, 2005 when compared to the same period one year ago. This increase is primarily attributable to an increase of $108,000 in check cashing fee income and an increase of $65,000 in miscellaneous fee income. Mortgage banking income increased 31% to $48,000 for the six months ended June 30, 2005 when compared to the same period in 2004. Miscellaneous income increased 31% to $794,000 for the six months ended June 30, 2005. This increase in miscellaneous income was partially attributable to an increase of $94,000 in debit card fee income primarily associated with increased card usage due to an increased number of demand accounts.

Non-Interest Expense. Total non-interest expense increased 9% to $5.3 million for the second quarter of 2005 as compared to $4.9 million for the corresponding period in 2004. Salary and employee benefits totaled $3.0 million for the three months ended June 30, 2005, an increase of 7% from the same period in 2004. The increase in salary and employee benefits is due to normal salary increases and increased employee incentive expense. Occupancy expense increased 11% for the quarter ended June 30, 2005 due to an increase in furniture and equipment expense and lease expense. The increase in furniture and equipment expense and lease expense in 2005 was due to software purchases relating to front-end Deposit Platform and loan pricing model for the Bank and overhead expenses, including lease agreements, associated with the opening of the Bank’s Banco de la Gente branches. Other non-interest expense increased 10% to $1.3 million for the three months ended June 30, 2005 as compared to the same period in 2004. The increase in other non-interest expense was primarily due to an increase in advertising expense of $40,000 and an increase in telephone expense of $22,000.

Total non-interest expense was $10.6 million for the six months ended June 30, 2005, an increase of 10% over the same period in 2004. Salary and employee benefits totaled $6.0 million for the six months ended June 30, 2005, an increase of 9% over the same period in 2004. The increase in salary and employee benefits is primarily due to normal salary increases and increased incentive expense. Occupancy expense increased 10% for the six months ended June 30, 2005 primarily due to an increase in furniture and equipment expense and lease expense. Other non-interest expense increased 13% to $2.6 million for the six months ended June 30, 2005 as compared to the same period in 2004. The increase in other non-interest expense included an increase in advertising expense of $118,000 and an increase in telephone expense of $34,000.

Income Taxes. The Company reported income taxes of $873,000 and $547,000 for the second quarters of 2005 and 2004, respectively. This represented effective tax rates of 35% and 33% for the respective periods.

The Company reported income taxes of $1.5 million and $1.2 million for the six months ended June 30, 2005 and 2004, respectively. This represented effective tax rates of 34% the respective periods.

Analysis of Financial Condition

Investment Securities. Available-for-sale securities amounted to $105.8 million at June 30, 2005 compared to $105.6 million at December 31, 2004. Average investment securities available for sale for the six months ended June 30, 2005 amounted to $104.9 million compared to $93.8 million for the year ended December 31, 2004.

Loans. At June 30, 2005, loans amounted to $551.1 million compared to $535.5 million at December 31, 2004, an increase of $15.6 million. Average loans represented 83% of total earning assets for the six months ended June 30, 2005 as compared to 84% for the year ended December 31, 2004. Mortgage loans held for sale were $3.4 million and $3.8 million at June 30, 2005 and December 31, 2004, respectively.

15

Allowance for Loan Losses. The allowance for loan losses reflects management's assessment and estimate of the risks associated with extending credit and its evaluation of the quality of the loan portfolio. The Bank periodically analyzes the loan portfolio in an effort to review asset quality and to establish an allowance for loan losses that management believes will be adequate in light of anticipated risks and loan losses. In assessing the adequacy of the allowance, size, quality and risk of loans in the portfolio are reviewed. Other factors considered are:

·   the Bank’s loan loss experience;

·   the amount of past due and non-performing loans;

·   specific known risks;

·   the status and amount of other past due and non-performing assets;

·   underlying estimated values of collateral securing loans;

·   current and anticipated economic conditions; and

·   other factors which management believes affect the allowance for potential credit losses.

An analysis of the credit quality of the loan portfolio and the adequacy of the allowance for loan losses is prepared by the Bank’s credit administration personnel and presented to the Bank’s Board of Directors on a regular basis. The allowance is the total of specific reserves allocated to significant individual loans plus a general reserve. After individual loans with specific allocations have been deducted, the general reserve is calculated by applying general reserve percentages to the nine risk grades within the portfolio. Loans are categorized as one of nine risk grades based on management’s assessment of the overall credit quality of the loan, including payment history, financial position of the borrower, underlying collateral and internal credit review. The general reserve percentages are determined by management based on its evaluation of losses inherent in the various risk grades of loans. The allowance for loan losses is established through charges to expense in the form of a provision for loan losses. Loan losses and recoveries are charged and credited directly to the allowance.

The following table presents the percentage of loans assigned to each risk grade along with the general reserve percentage applied to loans in each risk grade at June 30, 2005 and December 31, 2004.

LOAN RISK GRADE ANALYSIS:	Percentage of Loans		General Reserve
	By Risk Grade*		Percentage
	06/30/2005	12/31/2004	06/30/2005	12/31/2004
Risk 1 (Excellent Quality)	15.10%	13.44%	0.15%	0.15%
Risk 2 (High Quality)	20.58%	23.03%	0.50%	0.50%
Risk 3 (Good Quality)	55.79%	53.89%	1.00%	1.00%
Risk 4 (Management Attention)	5.05%	5.67%	2.50%	2.50%
Risk 5 (Watch)	0.67%	0.95%	7.00%	7.00%
Risk 6 (Substandard)	0.87%	0.61%	12.00%	12.00%
Risk 7 (Low Substandard)	0.68%	1.46%	25.00%	25.00%
Risk 8 (Doubtful)	0.00%	0.00%	50.00%	50.00%
Risk 9 (Loss)	0.00%	0.00%	100.00%	100.00%
*Excludes non-accrual loans

At June 30, 2005 there was one relationship exceeding $1.0 million (which totaled $1.1 million) in the Watch risk grade, two relationships exceeding $1.0 million each (which totaled $2.6 million) in the Substandard risk grade and one relationship exceeding $1.0 million (which totaled $3.2 million) in the Low Substandard risk grade. Balances of individual relationships exceeding $1.0 million in these risk grades ranged from $1.1 million to $3.2 million. These customers continue to meet payment requirements and these relationships would not become non-performing assets unless they are unable to meet those requirements.

An allowance for loan losses is also established, as necessary, for individual loans considered to be impaired in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 114. A loan is considered impaired when, based on current information and events, it is probable that all amounts due according to the contractual terms of the loan will not be collected. Impaired loans are measured based on the present value of expected future cash flows, discounted at the loan’s effective interest rate, or at the loan’s observable market price, or the fair value of collateral if the loan is collateral dependent. At June 30, 2005 and December 31, 2004, the recorded investment in loans that were considered to be impaired under SFAS No. 114 was approximately $7.1 million and $5.3 million, respectively, with related allowance for loan losses of approximately $1.7 million and $787,000, respectively.

The allowance for loan losses totaled $8.0 million at June 30, 2005 and December 31, 2004, which represented

16

1.46% of total loans outstanding at June 30, 2005 and 1.50% of total loans outstanding as of December 31, 2004. While non-performing loans increased at June 30, 2005 compared to December 31, 2004, total classified loans, including non-performing loans, decreased by $2.1 million.

The Bank’s allowance for loan losses is also subject to regulatory examinations and determinations as to adequacy, which may take into account such factors as the methodology used to calculate the allowance for loan losses and the size of the allowance for loan losses compared to a group of peer banks identified by the regulators. During their routine examinations of banks, the FDIC and the North Carolina Commissioner of Banks may require the Company to recognize additions to the allowance based on their judgments about information available to them at the time of their examination.

While it is the Bank's policy to charge off in the current period loans for which a loss is considered probable, there are additional risks of future losses which cannot be quantified precisely or attributed to particular loans or classes of loans. Because these risks include the state of the economy, management’s judgment as to the adequacy of the allowance is necessarily approximate and imprecise. After review of all relevant matters affecting loan collectability, management believes that the allowance for loan losses is appropriate.

The Company grants loans and extensions of credit primarily within the Catawba Valley region of North Carolina, which encompasses Catawba, Alexander, Iredell and Lincoln counties and also in Mecklenburg County. Although the Bank has a diversified loan portfolio, a substantial portion of the loan portfolio is collateralized by real estate, which is dependent upon the real estate market. Non-real estate loans also can be affected by local economic conditions. At June 30, 2005, approximately 6% of the Company’s portfolio was not secured by any type of collateral. Unsecured loans generally involve higher credit risk than secured loans and, in the event of customer default, the Company has a higher exposure to potential loan losses.

Non-performing Assets. Non-performing assets totaled $7.7 million at June 30, 2005 or 1.09% of total assets, compared to $6.0 million at December 31, 2004, or 0.88% of total assets. Non-accrual loans were $6.8 million at June 30, 2005, an increase of $1.7 million from non-accruals of $5.1 million at December 31, 2004. As a percentage of total loans outstanding, non-accrual loans were 1.24% at June 30, 2005 compared to 0.95% at December 31, 2004. The Bank had loans ninety days past due and still accruing at June 30, 2005 of $209,000 as compared to $245,000 at December 31, 2004. Other real estate owned totaled $660,000 as of June 30, 2005 as compared to $682,000 at December 31, 2004. The Bank had no repossessed assets as of June 30, 2005 and December 31, 2004. The increase in non-accrual loans was primarily due to the movement to non-accrual of one relationship totaling $2.7 million that is a furniture manufacturer.

Total non-performing loans, which include non-accrual loans and loans ninety days past due and still accruing, were $7.1 million and $5.3 million at June 30, 2005 and December 31, 2004, respectively. This increase is the result of the movement to non-accrual of one relationship as previously mentioned. The ratio of non-performing loans to total loans was 1.28% at June 30, 2005, as compared to 1.00% at December 31, 2004.

Deposits. Total deposits at June 30, 2005 were $568.8 million, an increase of $12.3 million over deposits of $556.5 million at December 31, 2004. Core deposits, which include non-interest bearing demand deposits, NOW, MMDA, savings and certificates of deposits of denominations less than $100,000, increased $15.6 million to $417.8 million at June 30, 2005 as compared to $402.2 million at December 31, 2004 primarily due to an increase of $16.7 in non-interest bearing demand deposits. Certificates of deposit in amounts greater than $100,000 or more totaled $151.1 million at June 30, 2005 as compared to $154.3 million at December 31, 2004. At June 30, 2005, brokered deposits amounted to $48.8 million as compared to $39.4 million at December 31, 2004. Brokered deposits outstanding as of June 30, 2005 had a weighted average rate of 3.09% with a weighted average original term of 21 months.

Borrowed Funds. Borrowings from theFederal Home Loan Bank of Atlanta (“FHLB”) totaled $69.0 million at June 30, 2005 compared to $59.0 million at December 31, 2004. The average balance of FHLB borrowings for the six months ended June 30, 2005 was $64.5 million compared to $58.7 million for the year ended December 31, 2004. At June 30, 2005, FHLB borrowings with maturities exceeding one year amounted to $59.5 million. The FHLB has the option to convert $62.0 million of the total advances to a floating rate and, if converted, the Bank may repay advances without payment of a prepayment fee. The Company had no federal funds purchased as of June 30, 2005 or December 31, 2004.

Junior Subordinated Debentures (related to Trust Preferred Securities). In December 2001 the Company formed a wholly owned Delaware statutory trust, PEBK Capital Trust I (“PEBK Trust”), which issued $14.0 million of guaranteed preferred beneficial interests in the Company’s junior subordinated deferrable interest debentures that qualify as Tier 1 capital under Federal Reserve Board guidelines. All of the common securities of PEBK Trust are owned by the Company. The proceeds from the issuance of the common securities and the trust preferred securities were used by PEBK Trust to purchase $14.4 million of junior subordinated debentures of the Company, which pay a floating rate equal to prime plus 50 basis points. The proceeds received by the Company from the sale of the junior subordinated debentures were used for

17

general purposes, primarily to provide capital to the Bank. The debentures represent the sole asset of PEBK Trust. PEBK Trust is not included in the consolidated financial statements at June 30, 2005 or December 31, 2004.

The trust preferred securities accrue and pay quarterly distributions based on the liquidation value of $50,000 per capital security at a floating rate of prime plus 50 basis points. The Company has guaranteed distributions and other payments due on the trust preferred securities to the extent PEBK Trust has funds with which to make the distributions and other payments. The net combined effect of all the documents entered into in connection with the trust preferred securities is that the Company is liable to make the distributions and other payments required on the trust preferred securities.

The trust preferred securities are mandatorily redeemable upon maturity of the debentures on December 31, 2031, or upon earlier redemption as provided in the indenture. The Company has the right to redeem the debentures purchased by PEBK Trust, in whole or in part, on or after December 31, 2006. As specified in the indenture, if the debentures are redeemed prior to maturity, the redemption price will be the principal amount and any accrued but unpaid interest.

Asset Liability and Interest Rate Risk Management. The objective of the Company’s Asset Liability and Interest Rate Risk strategies is to identify and manage the sensitivity of net interest income to changing interest rates and to minimize the interest rate risk between interest-earning assets and interest-bearing liabilities at various maturities. This is to be done in conjunction with the need to maintain adequate liquidity and the overall goal of maximizing net interest income.

The Company manages its exposure to fluctuations in interest rates through policies established by the Asset/Liability Committee (“ALCO”) of the Bank. The ALCO meets monthly and has the responsibility for approving asset/liability management policies, formulating and implementing strategies to improve balance sheet positioning and/or earnings and reviewing the interest rate sensitivity of the Company. ALCO tries to minimize interest rate risk between interest-earning assets and interest-bearing liabilities by attempting to minimize wide fluctuations in net interest income due to interest rate movements. The ability to control these fluctuations has a direct impact on the profitability of the Company. Management monitors this activity on a regular basis through analysis of its portfolios to determine the difference between rate sensitive assets and rate sensitive liabilities.

The Company’s rate sensitive assets are those earning interest at variable rates and those with contractual maturities within one year. Rate sensitive assets therefore include both loans and available-for-sale securities. Rate sensitive liabilities include interest-bearing checking accounts, money market deposit accounts, savings accounts, time deposits and borrowed funds. The Company’s balance sheet is asset-sensitive, meaning that in a given period there will be more assets than liabilities subject to immediate repricing as interest rates change in the market. Because most of the Company’s loans are tied to the prime rate, they reprice more rapidly than rate sensitive interest-bearing deposits. During periods of rising rates, this results in increased net interest income. The opposite occurs during periods of declining rates. Average rate sensitive assets for the six months ended June 30, 2005 totaled $653.7 million, exceeding average rate sensitive liabilities of $553.6 million by $100.1 million.

During the second quarter of 2005, the Company settled two previously outstanding interest rate swap agreements. The first swap, with a notional amount of $25.0 million and scheduled to mature in April 2006 was sold for a loss of $318,000. The second swap with a notional amount of $30.0 million and scheduled to mature in September 2006 was sold for a loss of $552,000. The losses realized upon settlement are being recognized over the original term of the agreements and during the three-month period ended June 30, 2005, losses of approximately $83,000 were realized.

The Bank also utilizes interest rate floors on certain variable rate loans to protect against further downward movements in the prime rate. At June 30, 2005, the Bank had $105.1 million in loans with interest rate floors; however, none of the floors were in effect pursuant to the terms of the promissory notes on these loans.

Liquidity. The objectives of the Company’s liquidity policy are to provide for the availability of adequate funds to meet the needs of loan demand, deposit withdrawals, maturing liabilities and to satisfy regulatory requirements. Both deposit and loan customer cash needs can fluctuate significantly depending upon business cycles, economic conditions and yields and returns available from alternative investment opportunities. In addition, the Company’s liquidity is affected by off-balance sheet commitments to lend in the form of unfunded commitments to extend credit and standby letters of credit. As of June 30, 2005 such unfunded commitments to extend credit were $122.7 million, while commitments in the form of standby letters of credit totaled $3.1 million.

The Company uses several sources to meet its liquidity requirements. The primary source is core deposits, which includes demand deposits, savings accounts and certificates of deposits of denominations less than $100,000. The Company considers these to be a stable portion of the Company’s liability mix and the result of on-going consumer and commercial banking relationships. As of June 30, 2005, the Company’s core deposits totaled $417.8 million, or 73% of total deposits.

18

The other sources of funding for the Company are through large denomination certificates of deposit, including brokered deposits, federal funds purchased and FHLB advances. The Bank is also able to borrow from the Federal Reserve System on a short-term basis.

At June 30, 2005, the Bank had a significant amount of deposits in amounts greater than $100,000, including brokered deposits of $48.8 million, which mature over the next two years. The balance and cost of these deposits are more susceptible to changes in the interest rate environment than other deposits.

The Bank had a line of credit with the FHLB equal to 20% of the Bank’s total assets, with an outstanding balance of $69.0 million at June 30, 2005. The remaining availability at FHLB was $39.3 million at June 30, 2005. The Bank also had the ability to borrow up to $26.5 million for the purchase of overnight federal funds from three correspondent financial institutions as of June 30, 2005.

The liquidity ratio for the Bank, which is defined as net cash, interest bearing deposits with banks, federal funds sold, certain investment securities and certain FHLB advances available under the line of credit, as a percentage of net deposits (adjusted for deposit runoff projections) and short-term liabilities was 35.09% at June 30, 2005 and 34.82% at December 31, 2004. The minimum required liquidity ratio as defined in the Bank’s Asset/Liability and Interest Rate Risk Management Policy is 20%.

Contractual Obligations and Off-Balance Sheet Arrangements. The Company’s contractual obligations and other commitments as of June 30, 2005 and December 31, 2004 are summarized in the table below. The Company’s contractual obligations include the repayment of principal and interest related to FHLB advances and junior subordinated debentures, as well as certain payments under current lease agreements. Other commitments include commitments to extend credit. Because not all of these commitments to extend credit will be drawn upon, the actual cash requirements are likely to be significantly less than the amounts reported for other commitments below.

CONTRACTUAL OBLIGATIONS AND OTHER COMMITMENTS:
		June 30, 2005	December 31, 2004
Contractual Cash Obligations
Long-term borrowings	$	59,500,000	57,000,000
Junior subordinated debentures		14,433,000	14,433,000
Operating lease obligations		8,492,877	8,280,080
Total	$	82,425,877	79,713,080
Other Commitments
Commitments to extend credit	$	122,684,004	123,093,680
Standby letters of credit and financial guarantees written		3,137,965	3,278,326
Total	$	125,821,969	126,372,006

The Company enters into derivative contracts to manage various financial risks. A derivative is a financial instrument that derives its cash flows, and therefore its value, by reference to an underlying instrument, index or referenced interest rate. Derivative contracts are carried at fair value on the consolidated balance sheet with the fair value representing the net present value of expected future cash receipts or payments based on market interest rates as of the balance sheet date. Derivative contracts are written in amounts referred to as notional amounts, which only provide the basis for calculating payments between counterparties and are not a measure of financial risk. Further discussions of derivative instruments are included above in the section entitled “Asset Liability and Interest Rate Risk Management”.

Capital Resources. Shareholders’ equity at June 30, 2005 was $52.6 million compared to $50.9 million at December 31, 2004. At June 30, 2005 and December 31, 2004, unrealized losses, net of taxes, amounted to $669,000 and $121,000, respectively. The increase in unrealized losses at June 30, 2005 is primarily attributable to a decrease in the market value of available for sale securities and derivative instruments. Management expects that accumulated comprehensive income (loss) will continue to fluctuate due to changes in the market value of available for sale investments securities and derivative instruments caused by changes in market interest rates. Annualized return on average equity for the six months ended June 30, 2005 was 10.96% compared to 9.47% for the year ended December 31, 2004. Total cash dividends paid during the six months ended June 30, 2005 amounted to $690,000 as compared to total cash dividends of $629,000 paid for the first six months of 2004.

During second quarter 2005, the Company declared and distributed a 10% stock dividend to its shareholders. All previously reported per share amounts have been restated to reflect the stock dividend.

19

In 2004, the Company repurchased $291,000, or 15,100 shares of its common stock as part of the stock repurchase plan implemented in November 2004, which expires in November 2005.

Under the regulatory capital guidelines, financial institutions are currently required to maintain a total risk-based capital ratio of 8.0% or greater, with a Tier 1 risk-based capital ratio of 4.0% or greater. Tier 1 capital is generally defined as shareholders' equity and Trust Preferred Securities less all intangible assets and goodwill. The Company’s Tier I capital ratio was 11.05% and 10.97% at June 30, 2005 and December 31, 2004, respectively. Total risk-based capital is defined as Tier 1 capital plus supplementary capital. Supplementary capital, or Tier 2 capital, consists of the Company's allowance for loan losses, not exceeding 1.25% of the Company's risk-weighted assets. Total risk-based capital ratio is therefore defined as the ratio of total capital (Tier 1 capital and Tier 2 capital) to risk-weighted assets. The Company’s total risk-based capital ratio was 12.30% and 12.22% at June 30, 2005 and December 31, 2004, respectively. In addition to the Tier I and total risk-based capital requirements, financial institutions are also required to maintain a leverage ratio of Tier 1 capital to total average assets of 4.0% or greater. The Company’s Tier I leverage capital ratio was 9.72% and 9.50% at June 30, 2005 and December 31, 2004, respectively.

The Bank’s Tier 1 risk-based capital ratio was 10.42% and 10.35% at June 30, 2005 and December 31, 2004, respectively. The total risk-based capital ratio for the Bank was 11.67% and 11.60% at June 30, 2005 and December 31, 2004, respectively. The Bank’s Tier 1 leverage capital ratio was 9.15% and 8.95% at June 30, 2005 and December 31, 2004, respectively.

A bank is considered to be "well capitalized" if it has a total risk-based capital ratio of 10.0 % or greater, a Tier I risk-based capital ratio of 6.0% or greater, and has a leverage ratio of 5.0% or greater. Based upon these guidelines, the Bank was considered to be "well capitalized" at June 30, 2005 and December 31, 2004.

The capital treatment of trust preferred securities has been reviewed recently by the Federal Reserve Bank. The Federal Reserve Bank’s proposal for capital treatment of trust preferred securities, released May 4, 2004, would continue to permit the inclusion of trust preferred securities in Tier 1 capital of bank holding companies. Further discussions of FIN 46 are included under “Recent Accounting Pronouncements” in Note 1 of the Notes to Consolidated Financial Statements in the Company’s 2005 Annual Report.

20

Item 3.                    Quantitative and Qualitative Disclosures About Market Risk

There have been no material changes in the quantitative and qualitative disclosures about market risks as of June 30, 2005 from that presented in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2004.

21

Item 4. Controls and Procedures

The Company’s management, with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the Company’s disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of the end of the period covered by this report. Based on such evaluation, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of such period, the Company’s disclosure controls and procedures are effective in recording, processing, summarizing and reporting, on a timely basis, information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act.

There have not been any changes in the Company’s internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the fiscal quarter to which this report relates that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

22

PART II.               OTHER INFORMATION

Item 1.Legal Proceedings

In the opinion of management, the Company is not involved in any pending legal proceedings other than routine, non-material proceedings occurring in the ordinary course of business.

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

(c)   ISSUER PURCHASES OF EQUITY SECURITIES
				Maximum
			Total Number of	Number of Shares
			Shares Purchased	that May Yet Be
	Total Number		as Part of Publicly	Purchased Under
	of Shares	Average Price	Announced Plans	the Plans or
Period	Purchased	Paid per Share	or Programs	Programs
April 1 - 30, 2005	-	-	-	-
May 1 - 31, 2005	817	$  17.75	-	-
June 1 - 30, 2005	-	-	-	-
Total	817	$ 17.75	-	-

Item 3.                    Defaults Upon Senior Securities

                                Not applicable

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

(a)   Annual Shareholders’ Meeting - May 5, 2005

(b)   Directors elected at the meeting are as follows: Charles F. Murray, Douglas S. Howard and Billy L. Price, Jr., M.D.

Continuing directors include: Robert C. Abernethy, James S. Abernethy, Larry E. Robinson, William Gregory Terry, John W. Lineberger, Jr., Gary E. Matthews, Dan Ray Timmerman, Sr. and Benjamin I. Zachary.

(c)   At the May 5, 2005 Annual Shareholders Meeting the following items were submitted to a vote of shareholders:

	Vote For	Withhold Authority
Charles F. Murray	2,727,977	31,729
Douglas S. Howard	2,695,375	48,030
Billy L. Price, Jr., M.D.	2,694,090	48,673

Ratification of appointment of Independent Registered Public Accountants - Porter Keadle Moore, LLP

Votes For - 2,720,022, Votes Against - 6,194, Votes Abstained - 34,781

(d)   Not applicable

23

Item 5.Other Information

                                 Not applicable

Item 6.	Exhibits
	Exhibit (3)(i)	Articles of Incorporation of Peoples Bancorp of North Carolina, Inc., incorporated
		by reference to Exhibit (3)(i) to the Form 8-A filed with the Securities and
		Exchange Commission on September 2, 1999
	Exhibit (3)(ii)	Amended and Restated Bylaws of Peoples Bancorp of North Carolina, Inc.,
		incorporated by reference to Exhibit (3)(ii) to the Form 10-K filed with the
		Securities and Exchange Commission on March 26, 2004
	Exhibit (4)	Specimen Stock Certificate, incorporated by reference to Exhibit (4) to the Form 8-
		A filed with the Securities and Exchange Commission on September 2, 1999
	Exhibit (10)(a)	Employment Agreement between Peoples Bank and Tony W. Wolfe incorporated
		by reference to Exhibit (10)(a) to the Form 10-K filed with the Securities and
		Exchange Commission on March 30, 2000
	Exhibit (10)(b)	Employment Agreement between Peoples Bank and Joseph F. Beaman, Jr.
		incorporated by reference to Exhibit (10)(b) to the Form 10-K filed with the
		Securities and Exchange Commission on March 30, 2000
	Exhibit (10)(c)	Employment Agreement between Peoples Bank and William D. Cable
		incorporated by reference to Exhibit (10)(d) to the Form 10-K filed with the
		Securities and Exchange Commission on March 30, 2000
	Exhibit (10)(d)	Employment Agreement between Peoples Bank and Lance A. Sellers incorporated
		by reference to Exhibit (10)(e) to the Form 10-K filed with the Securities and
		Exchange Commission on March 30, 2000
	Exhibit (10)(e)	Peoples Bancorp of North Carolina, Inc. Omnibus Stock Ownership and Long
		Term Incentive Plan incorporated by reference to Exhibit (10)(f) to the Form 10-K
		filed with the Securities and Exchange Commission on March 30, 2000
	Exhibit (10)(f)	Employment Agreement between Peoples Bank and A. Joseph Lampron
		incorporated by reference to Exhibit (10)(g) to the Form 10-K filed with the
		Securities and Exchange Commission on March 28, 2002
	Exhibit (10)(g)	Peoples Bank Directors' and Officers' Deferral Plan, incorporated by reference to
		Exhibit (10)(h) to the Form 10-K filed with the Securities and Exchange
		Commission on March 28, 2002
	Exhibit (10)(h)	Rabbi Trust for the Peoples Bank Directors' and Officers' Deferral Plan,
		incorporated by reference to Exhibit (10)(i) to the Form 10-K filed with the
		Securities and Exchange Commission on March 28, 2002
	Exhibit (10)(i)	Description of Service Recognition Program maintained by Peoples Bank,
		incorporated by reference to Exhibit (10)(i) to the Form 10-K filed with the
		Securities and Exchange Commission on March 27, 2003
	Exhibit (14)	Code of Business Conduct and Ethics of Peoples Bancorp of North Carolina, Inc.,
		incorporated by reference to Exhibit (14) to the Form 10-K filed with the
		Securities and Exchange Commission on March 25, 2005
	Exhibit (31)(a)	Certification of principal executive officer pursuant to section 302 of the Sarbanes-
		Oxley Act of 2002

24

Exhibit (31)(b)	Certification of principal financial officer pursuant to section 302 of the Sarbanes-
	Oxley Act of 2002
Exhibit (32)	Certification Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section
	906 of the Sarbanes-Oxley Act of 2002

25

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.

	Peoples Bancorp of North Carolina, Inc.
August 11, 2005	/s/ Tony W. Wolfe
Date	Tony W. Wolfe
	President and Chief Executive Officer
	(Principal Executive Officer)
August 11, 2005	/s/ A. Joseph Lampron
Date	A. Joseph Lampron
	Executive Vice President and Chief Financial Officer
	(Principal Financial and Principal Accounting Officer)

26

EX-31.(A)

EXHIBIT (31)(a)

CERTIFICATIONS

I, Tony W. Wolfe, certify that:

1.   I have reviewed this quarterly report on Form 10-Q of Peoples Bancorp of North Carolina Inc.;

2.   Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3.   Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4.   The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have:

a)   designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

b)   evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

c)   disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect the registrant’s internal control over financial reporting; and

5.   The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent functions):

a)   all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and

b)   any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting.

August 11, 2005	/s/ Tony W. Wolfe
Date	Tony W. Wolfe
	President and Chief Executive Officer
	(Principal Executive Officer)

27

EX-31.(B)

EXHIBIT (31)(b)

CERTIFICATIONS

I, A. Joseph Lampron, certify that:

1.   I have reviewed this quarterly report on Form 10-Q of Peoples Bancorp of North Carolina Inc.;

2.   Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3.   Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4.   The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have:

a)   designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

b)   evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation ; and

c)   disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect the registrant’s internal control over financial reporting; and

5.   The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent functions):

a)   all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

b)   any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

August 11, 2005	/s/ A. Joseph Lampron
Date	A. Joseph Lampron
	Executive Vice President and Chief Financial Officer
	(Principal Financial and Principal Accounting Officer)

28

EX-32

EXHIBIT (32)

PEOPLES BANCORP OF NORTH CAROLINA, INC.

Certification of Periodic Financial Report

Pursuant to 18 U.S.C. Section 1350

Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, each of the undersigned officers of Peoples Bancorp of North Carolina, Inc. (the “Company”) certifies that the Quarterly Report on Form 10-Q of the Company for the quarter ended June 30, 2005 fully complies with the requirements of Section 13(a) or 15(d), as applicable, of the Securities Exchange Act of 1934 and information contained in that Form 10-Q fairly presents, in all material respects, the financial condition and results of operations of the Company.

Dated: August 11, 2005	/s/ Tony W. Wolfe
	Tony W. Wolfe
	Chief Executive Officer
Dated: August 11, 2005	/s/ A. Joseph Lampron
	A. Joseph Lampron
	Chief Financial Officer

*This certification is made solely for purpose of 18 U.S.C. Section 1350, subject to the knowledge standard contained therein, and not for any other purpose.

29