10-Q

U. S. SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549
FORM 10-Q
(X)	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF SECURITIES EXCHANGE ACT OF 1934
	For the quarterly period ended June 30, 2007
				OR
(  )	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
	For the transition period from __________ to __________
Commission file number  0-26016
PALMETTO BANCSHARES, INC.
(Exact name of registrant as specified in its charter)
South Carolina						74-2235055
(State or other jurisdiction of incorporation or organization)						(IRS Employer Identification No.)
301 Hillcrest Drive, Laurens, South Carolina						29360
(Address of principal executive offices)						(Zip Code)
(864) 984–4551						www.palmettobank.com
(Registrant’s telephone number)						(Registrant’s web site)
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 a large accelerated filer, an accelerated filer, or a non-accelerated filer.  See definition of "accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange Act.
Large accelerated filer [ ]			Accelerated filer [x]		Non-accelerated filer [ ]
Indicate by check mark whether the registrant is a shell company (as defined by Rule 12b-2 of the Exchange Act).  Yes [ ] No [x]
Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date.
		Class			Outstanding at August 6, 2007
		-----------------------------			-------------------------------
		Common stock, $5.00 par value			6,389,660

PALMETTO BANCSHARES, INC. AND SUBSIDIARY
Table of Contents
			Page
PART I -   FINANCIAL INFORMATION
	Item 1.	Financial Statements	3
	Item 2.	Management's Discussion and Analysis of Financial Condition and	23
		Results of Operations
	Item 3.	Quantitative and Qualitative Disclosures about Market Risk	50
	Item 4.	Controls and Procedures	51
PART II -  OTHER INFORMATION
	Item 1.	Legal Proceedings	52
	Item 4.	Submission of Matters to a Vote of Security Holders	52
	Item 6.	Exhibits	52
SIGNATURES			53

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PART 1 - FINANCIAL INFORMATION

ITEM 1. Financial Statements

PALMETTO BANCSHARES, INC. AND SUBSIDIARY
Consolidated Balance Sheets
(dollars in thousands, except common and per share data)
					June 30,	December 31,
					2007	2006
					(unaudited)
ASSETS
Cash and cash equivalents
	Cash and due from banks			$	33,286	43,084
	Federal funds sold				9,972	3,582
		Total cash and cash equivalents			43,258	46,666
Federal Home Loan Bank ("FHLB") stock, at cost					2,527	2,599
Investment securities available for sale, at fair market value					104,708	116,567
Mortgage loans held for sale					1,293	1,675
Loans					986,529	945,913
	Less: allowance for loan losses				(8,515)	(8,527)
		Loans, net			978,014	937,386
Premises and equipment, net					24,952	24,494
Goodwill					3,691	3,691
Other intangible assets					102	126
Accrued interest receivable					6,201	6,421
Other					15,123	13,511
			Total assets	$	1,179,869	1,153,136
LIABILITIES AND SHAREHOLDERS' EQUITY
Liabilities
Deposits
	Noninterest-bearing			$	137,182	133,623
	Interest-bearing				864,643	859,958
		Total deposits			1,001,825	993,581
Retail repurchase agreements					12,145	14,427
Commercial paper (Master notes)					27,737	20,988
Other short-term borrowings					24,500	6,000
Long-term borrowings					-	10,000
Accrued interest payable					1,523	1,584
Other					6,748	6,180
		Total liabilities			1,074,478	1,052,760
Commitments and contingencies (Note 14)
Shareholders' Equity
Common stock - par value $5.00 per share; authorized 10,000,000
	shares; issued and outstanding 6,389,660 and 6,367,450
	at June 30, 2007 and December 31, 2006, respectively				31,948	31,837
Capital surplus					1,391	1,102
Retained earnings					73,531	68,132
Accumulated other comprehensive loss, net of tax					(1,479)	(695)
		Total shareholders' equity			105,391	100,376
			Total liabilities and shareholders' equity	$	1,179,869	1,153,136
See Notes to Consolidated Interim Financial Statements.

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PALMETTO BANCSHARES, INC. AND SUBSIDIARY
Consolidated Statements of Income
(dollars in thousands, except common and per share data)
						For the three month periods ended June 30,
						2007	2006
						(unaudited)
Interest income
	Interest and fees on loans				$	19,301	17,115
	Interest on investment securities available for sale:
		Government-sponsored enterprises (taxable)				381	509
		State and municipal (nontaxable)				452	496
		Mortgage-backed securities (taxable)				297	210
	Interest on federal funds sold					227	393
	Dividends on FHLB stock					38	46
			Total interest income			20,696	18,769
Interest expense
	Interest on deposits					7,437	6,029
	Interest on retail repurchase agreements					130	177
	Interest on commercial paper					289	206
	Interest on other short-term borrowings					54	16
	Interest on long-term borrowings					78	173
			Total interest expense			7,988	6,601
				Net interest income		12,708	12,168
Provision for loan losses						433	525
				Net interest income after provision for loan losses		12,275	11,643
Noninterest income
	Service charges on deposit accounts					1,991	2,042
	Fees for trust and brokerage services					826	847
	Mortgage-banking income					171	275
	Investment securities gains					-	1
	Other					877	811
			Total noninterest income			3,865	3,976
Noninterest expense
	Salaries and other personnel					6,057	5,709
	Occupancy					379	371
	Furniture and equipment					422	438
	Premises and equipment leases and rentals					335	331
	Premises and equipment depreciation					480	519
	Marketing					219	332
	Amortization of core deposit intangibles					12	12
	Other					1,967	2,373
			Total noninterest expense			9,871	10,085
				Net income before provision for income taxes		6,269	5,534
Provision for income taxes						2,204	1,803
				Net income	$	4,065	3,731
Common and Per Share Data
	Net income - basic				$	0.64	0.59
	Net income - diluted					0.63	0.58
	Cash dividends					0.19	0.18
	Book value					16.49	14.73
	Weighted average common shares outstanding - basic					6,385,483	6,354,888
	Weighted average common shares outstanding - diluted					6,499,649	6,429,759
See Notes to Consolidated Interim Financial Statements.

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PALMETTO BANCSHARES, INC. AND SUBSIDIARY
Consolidated Statements of Income
(dollars in thousands, except common and per share data)
						For the six month periods ended June 30,
						2007	2006
						(unaudited)
Interest income
	Interest and fees on loans				$	38,067	33,568
	Interest on investment securities available for sale:
		Government-sponsored enterprises (taxable)				816	1,039
		State and municipal (nontaxable)				876	993
		Mortgage-backed securities (taxable)				609	432
	Interest on federal funds sold					451	586
	Dividends on FHLB stock					75	99
			Total interest income			40,894	36,717
Interest expense
	Interest on deposits					14,664	11,263
	Interest on retail repurchase agreements					276	351
	Interest on commercial paper					527	344
	Interest on other short-term borrowings					83	114
	Interest on long-term borrowings					173	382
			Total interest expense			15,723	12,454
				Net interest income		25,171	24,263
Provision for loan losses						800	1,050
				Net interest income after provision for loan losses		24,371	23,213
Noninterest income
	Service charges on deposit accounts					3,899	4,028
	Fees for trust and brokerage services					1,522	1,628
	Mortgage-banking income					519	497
	Investment securities gains					-	3
	Other					1,757	1,723
			Total noninterest income			7,697	7,879
Noninterest expense
	Salaries and other personnel					12,194	11,484
	Occupancy					749	754
	Furniture and equipment					903	935
	Premises and equipment leases and rentals					625	646
	Premises and equipment depreciation					986	1,022
	Marketing					487	738
	Amortization of core deposit intangibles					24	24
	Other					4,045	4,548
			Total noninterest expense			20,013	20,151
				Net income before provision for income taxes		12,055	10,941
Provision for income taxes						4,229	3,560
				Net income	$	7,826	7,381
Common and Per Share Data
	Net income - basic				$	1.23	1.17
	Net income - diluted					1.21	1.15
	Cash dividends					0.38	0.36
	Book value					16.49	14.73
	Weighted average common shares outstanding - basic					6,382,019	6,349,099
	Weighted average common shares outstanding - diluted					6,480,454	6,423,970
See Notes to Consolidated Interim Financial Statements.

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PALMETTO BANCSHARES, INC. AND SUBSIDIARY
Consolidated Statements of Changes in Shareholders' Equity and Comprehensive Income
(dollars in thousands, except common and per share data)
(unaudited)
									Accumulated
	Shares of								other
	common		Common		Capital		Retained		comprehensive
	stock		stock		surplus		earnings		(loss), net		Total
Balance at December 31, 2005	6,331,335	$	31,656	$	659	$	57,532	$	(906)	$	88,941
Net income							7,381				7,381
Other comprehensive income, net of tax:
Unrealized holding gains arising during period, net
of tax effect of $511									(816)
Plus: reclassification adjustment included
in net income, net of tax effect of $1									(2)
Net unrealized gains on securities											(818)
Comprehensive income											6,563
Cash dividend declared and paid ($0.36 per share)							(2,287)				(2,287)
Compensation expense related to stock options					55						55
Exercise of stock options	25,300		127		227						354
Balance at June 30, 2006	6,356,635	$	31,783	$	941	$	62,626	$	(1,724)	$	93,626
Balance at December 31, 2006	6,367,450	$	31,837	$	1,102	$	68,132	$	(695)	$	100,376
Net income							7,826				7,826
Other comprehensive income, net of tax:
Unrealized holding gains arising during period, net
of tax effect of $491									(784)
Plus: reclassification adjustment included
in net income, net of tax effect of $0									-
Net unrealized gains on securities											(784)
Comprehensive income											7,042
Cash dividend declared and paid ($0.38 per share)							(2,427)				(2,427)
Compensation expense related to stock options					66						66
Exercise of stock options	22,210		111		223						334
Balance at June 30, 2007	6,389,660	$	31,948	$	1,391	$	73,531	$	(1,479)	$	105,391
See Notes to Consolidated Interim Financial Statements.

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PALMETTO BANCSHARES, INC. AND SUBSIDIARY
Consolidated Statements of Cash Flows
(in thousands)
					For the six month periods ended June 30,
						2007	2006
					(unaudited)
Cash flows from operating activities
	Net income				$	7,826	7,381
	Adjustments to reconcile net income to net cash
		provided by operating activities
			Depreciation, amortization, and accretion, net			1,109	1,007
			Investment securities gains			-	(3)
			Provision for loan losses			800	1,050
			Origination of mortgage loans held for sale			(27,466)	(26,763)
			Proceeds from sale of mortgage loans held for sale			28,183	28,627
			Gain on sale of mortgage loans			(335)	(290)
			Compensation expense related to stock options granted			66	55
			Loss on disposition of other real estate owned			465	1,309
			Recovery from write down of mortgage-servicing rights			(1)	(133)
			Increase of other assets, net			(980)	(2,144)
			Increase (decrease) of other liabilities, net			998	(531)
				Net cash provided by operating activities		10,665	9,565
Cash flows from investing activities
	Purchase of investment securities available for sale					(22,332)	(10,566)
	Maturities, redemption, calls, and principal repayment of investment securities available for sale					32,817	15,697
	Proceeds from sales of investment securities available for sale					-	4,129
	Redemption of FHLB stock					72	1,345
	Purchase of FHLB stock					-	(158)
	Origination of loans, net					(42,010)	(23,621)
	Proceeds on sale of other real estate owned					(294)	(1,121)
	Purchases of premises and equipment					(1,444)	(2,079)
				Net cash used in investing activities		(33,191)	(16,374)
Cash flows from financing activities
	Deposits, net					8,244	62,894
	(Decrease) increase of retail repurchase agreements, net					(2,282)	1,233
	Increase in commercial paper, net					6,749	4,189
	Increase (decrease) of other short-term borrowings, net					18,500	(17,900)
	Decrease of long-term borrowings, net					(10,000)	(13,000)
	Other common stock activity					334	354
	Cash dividends paid on common stock					(2,427)	(2,287)
				Net cash provided by financing activities		19,118	35,483
Net increase (decrease) of cash and cash equivalents						(3,408)	28,674
Cash and cash equivalents, beginning of the period						46,666	37,976
Cash and cash equivalents, end of the period					$	43,258	66,650
Supplemental Cash Flow Data
	Cash paid during the period for
		Interest expense			$	15,784	12,245
		Income taxes				3,618	3,924
	Significant noncash investing and financing activities
		(Decrease) increase of unrealized loss on investment securities available for sale			$	(1,275)	(1,328)
		Loans transferred to other real estate owned, at fair market value				582	83
See Notes to Consolidated Interim Financial Statements.

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PALMETTO BANCSHARES, INC. AND SUBSIDIARY

Notes To Consolidated Interim Financial Statements (Unaudited)

1.       Summary of Significant Accounting Policies

The significant accounting policies followed by the Company for interim financial reporting are consistent with the accounting policies followed for annual financial reporting.  The unaudited Consolidated Interim Financial Statements and footnotes are presented in accordance with the instructions for the Quarterly Report on Form 10-Q.  The information contained in the footnotes included in the Company’s latest Annual Report on Form 10-K should be referred to in connection with the reading of these unaudited Consolidated Interim Financial Statements. 

Principles of Consolidation

The accompanying Consolidated Financial Statements include the accounts of Palmetto Bancshares, Inc. (the “Company”), which includes its wholly owned subsidiary, The Palmetto Bank (the “Bank”), and the Bank's wholly owned subsidiary, Palmetto Capital, Inc. ("Palmetto Capital").  In management’s opinion, all significant intercompany accounts and transactions have been eliminated in consolidation, and all adjustments necessary for a fair presentation of the financial condition and results of operations for periods presented have been included. Any such adjustments are of a normal and recurring nature.  Assets held by the Company or its subsidiary in a fiduciary or agency capacity for customers are not included in the Company’s Consolidated Financial Statements as such items do not represent assets of the Company or its subsidiary.

Use of Estimates

The accounting and reporting policies of the Company conform to accounting principles generally accepted in the United States of America and to general practices within the banking industry. In preparing its Consolidated Financial Statements, the Company’s management makes estimates and assumptions that impact the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities as of the date of the Consolidated Financial Statements for the periods presented. Actual results could differ from these estimates and assumptions. As such, the results of operations for the three and six month periods ended June 30, 2007 are not necessarily indicative of the results of operations that may be expected in future periods.

Reclassifications

Certain amounts previously presented in the Company’s Consolidated Financial Statements for prior periods have been reclassified to conform to current classifications.  All such reclassifications had no impact on prior period net income or retained earnings as previously reported.

During the second half of 2006, the Company made the following reclassifications in the Consolidated Statements of Income:

• Certain accounts related to service charges on deposit accounts in the Other Noninterest Income and Other Noninterest Expense line items were reclassified to the Service Charges on Deposit Accounts line item.

• Certain accounts in the Occupancy line item and the Furniture and Equipment line item were reclassified to the Premises and Equipment Leases and Rentals line item and the Premises and Equipment Depreciation line item.

• Certain accounts in the Other Noninterest Expense line item were reclassified to the Amortization of Core Deposit Intangibles line item.

• Certain accounts in the Marketing line item were deemed to, more often than not, include expenses applicable to general branch operations instead of expenses for creating, communicating, and delivering value to customers and for managing customer relationships, so the Company began classifying this account in the Other Noninterest Expense line item.

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The following table summarizes the Company’s Consolidated Statements of Income for the three and six month periods ended June 30, 2006 as reported prior to these reclassifications (in thousands).

			For the three		For the six
			month period ended		month period ended
			6/30/2006		6/30/2006
Noninterest income
	Service charges on deposit accounts		$	2,047	4,105
	Fees for trust and brokerage services			847	1,628
	Mortgage-banking income			275	497
	Investment securities gains			1	3
	Other			910	1,829
		Total noninterest income		4,080	8,062
Noninterest expense
	Salaries and other personnel			5,709	11,484
	Net occupancy			699	1,391
	Furniture and equipment			960	1,966
	Marketing and advertising			340	796
	Postage and supplies			347	736
	Telephone			182	395
	Professional services			259	480
	Other			1,693	3,086
		Total noninterest expense		10,189	20,334
		Net noninterest expense	$	6,109	12,272

Intangible Assets

Intangible assets, included in Other Assets on the Consolidated Balance Sheets, include goodwill and other identifiable assets, such as customer lists, resulting from acquisitions.  Goodwill, in this context, is the excess of the purchase price in an acquisition transaction over the fair market value of the net assets acquired. Customer list intangibles are amortized on a hybrid double-declining, straight-line basis over such asset’s estimated useful life.  In accordance with SFAS No. 142, “Goodwill and Other Intangible Assets,” goodwill is not amortized but is tested annually for impairment or at any time an event occurs, or circumstances change, that may trigger a decline in the value of the reporting unit. Such impairment testing calculations include estimates. Furthermore, the determination of which intangible assets have finite lives is subjective as is the determination of the amortization period for such intangible assets. The Company tests for goodwill impairment by determining the fair market value for each reporting unit and comparing the fair market value to the carrying amount of the applicable reporting unit. If the carrying amount exceeds fair market value, the potential for impairment exists, and a second step of impairment testing is performed. In the second step, the fair market value of the reporting unit’s goodwill is determined by allocating the reporting unit’s fair market value to all of its assets (recognized and unrecognized) and liabilities as if the reporting unit had been acquired in a business combination at the date of the impairment test. If the implied fair market value of reporting unit goodwill is less than its carrying amount, goodwill is impaired and is written-down to its fair market value. The loss recognized is limited to the carrying amount of goodwill.  Once an impairment loss is recognized, future increases in fair market value will not result in the reversal of previously recognized losses. The Company performs its annual impairment testing as of June 30 by applying the above process to its reportable operating segment of banking. The Company’s impairment testing as of June 30, 2007 indicated that no impairment charge was required as of that date.

See Note 7 for further discussion regarding the Company’s intangible assets.

Recently Issued Accounting Pronouncements

• In September 2006, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 157, “Fair Value Measurements.”  SFAS No. 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. This standard does not require any new fair value measurements but rather eliminates inconsistencies found in various prior pronouncements. SFAS No. 157 is effective for the Company on January 1, 2008. The Company does not believe the adoption of SFAS No. 157 will have a material impact on its financial position, results of operations and cash flows. 

9

• In September 2006, the FASB issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans,” which amends SFAS No. 87 and SFAS No. 106 to require recognition of the overfunded or underfunded status of pension and other postretirement benefit plans on the balance sheet. Under SFAS No. 158, gains and losses, prior service costs and credits, and any remaining transition amounts under SFAS No. 87 and SFAS No. 106 that have not yet been recognized through net periodic benefit cost will be recognized in accumulated other comprehensive income, net of tax effects, until they are amortized as a component of net periodic cost. The measurement date — the date at which the benefit obligation and plan assets are measured — is required to be the company’s fiscal year end. The recognition and disclosure provisions of SFAS No. 158 differ for an employer that is an issuer of publicly traded equity securities (as defined by the Standard) and an employer that is not. As the Company does not meet the definition of an issuer of publicly traded equity securities (as defined by the Standard) for purposes of this Standard, the Company is not required to recognize the funded status of a defined benefit postretirement plan and to provide the required disclosures until the end of the fiscal year ending after June 15, 2007 with the exception of the provisions for the measurement date which are effective for fiscal years ending after December 15, 2008. The Company is currently evaluating the impact that the adoption of SFAS No. 158 will have on its financial position, results of operations, and cash flows. 

• In September 2006, the FASB ratified the consensuses reached by the FASB’s Emerging Issues Task Force (“EITF”) relating to EITF No. 06-4 “Accounting for the Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements.”  EITF No. 06-4 addresses employer accounting for endorsement split-dollar life insurance arrangements that provide a benefit to an employee that extends to postretirement periods.  In such instances, a liability should be recognized for future benefits in accordance with SFAS No. 106, “Employers' Accounting for Postretirement Benefits Other Than Pensions,” or Accounting Principles Board (“APB”) Opinion No. 12, “Omnibus Opinion—1967.”  EITF No. 06-4 is effective for fiscal years beginning after December 15, 2007. Entities should recognize the effects of applying this Issue through either a change in accounting principle through a cumulative-effect adjustment to retained earnings or to other components of equity or net assets in the statement of financial position as of the beginning of the year of adoption or a change in accounting principle through retrospective application to all prior periods.  Although, the Company does not believe the adoption of EITF No. 06-4 will have a material impact on the Company’s financial position, results of operations, or cash flows, management is currently analyzing the impact of adoption.

• In September 2006, the FASB ratified the consensus reached related to EITF 06-5, “Accounting for Purchases of Life Insurance—Determining the Amount That Could Be Realized in Accordance with FASB Technical Bulletin No. 85-4, Accounting for Purchases of Life Insurance.”  EITF No. 06-5 states that a policyholder should consider any additional amounts included in the contractual terms of the insurance policy other than the cash surrender value in determining the amount that could be realized under the insurance contract.  EITF No. 06-5 also states that a policyholder should determine the amount that could be realized under the life insurance contract assuming the surrender of an individual-life by individual-life policy (or certificate by certificate in a group policy). EITF No. 06-5 is effective for fiscal years beginning after December 15, 2007.  Although, the Company does not believe the adoption of EITF No. 06-5 will have a material impact on the Company’s financial position, results of operations, or cash flows, management is currently analyzing the impact of adoption.

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• In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities − Including an amendment of SFAS No. 115.”  This statement permits, but does not require, entities to measure many financial instruments at fair value.  The objective of the statement is to provide entities with an opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions.  Entities electing this option will apply it when the entity first recognizes an eligible instrument and will report unrealized gains and losses on such instruments in current earnings.  This statement applies to all entities, specifies certain election dates, can be applied on an instrument−by−instrument basis with some exceptions, is irrevocable and applies only to entire instruments.  One exception is demand deposit liabilities, which are explicitly excluded as qualifying for fair value.  With respect to SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities,”available for sale and held to maturity securities at the effective date are eligible for the fair value option at that date.  If the fair value option is elected for those securities at the effective date, cumulative unrealized gains and losses at that date shall be included in the cumulative effect adjustment and, thereafter, such securities will be accounted for as trading securities.  SFAS No. 159 is effective for the Company on January 1, 2008.  Earlier adoption is permitted in 2007 if the Company also elects to apply the provisions of SFAS No. 157.  The Company did not early adopt SFAS No. 159 and believes that it is unlikely that it will expand its use of fair value accounting upon the January 1, 2008 effective date.

Other accounting standards may have been issued or proposed by the FASB or other standards-setting bodies that are not applicable to the Company’s business.

Recently Adopted Accounting Pronouncements

Accounting standards issued by the FASB or other standards-setting bodies may have been adopted that were not applicable to the Company’s business and, therefore, did not have a material impact on the Company’s financial position, results of operations or cash flows.

2.       Cash and Cash Equivalents

The following table summarizes the composition of cash and cash equivalents at the dates indicated (in thousands).

		June 30,		December 31,
		2007		2006
Cash working funds		$	7,903	9,190
Noninterest-earning demand deposits
in other banks			16,707	23,511
In-transit funds			8,676	10,383
Interest-earning federal funds sold			9,972	3,582
	Total cash and cash equivalents	$	43,258	46,666

The average outstanding federal funds sold for the three month periods ended June 30, 2007 and 2006 were $19.1 million and $29.9 million, respectively.  The average outstanding federal funds sold for the six month periods ended June 30, 2007 and 2006 were $18.3 million and $24.4 million, respectively.  The maximum amount of federal funds sold at any month-end during the three and six month periods ended June 30, 2007 was $12.1 million and $35.1 million, respectively.  The maximum amount of federal funds sold at any month-end during both the three and six month periods ended June 30, 2006 was $45.5 million. 

The Company is required to maintain average reserve balances computed by applying prescribed percentages to its various types of deposits.  At June 30, 2007, the Federal Reserve required that the Company maintain $9.0 million in reserve balances.  Due to the Company’s levels of vault cash, no reserves were required to be maintained with Bank of America, however, $1.0 million was required to be maintained with the Federal Reserve Bank of Richmond.

3.       Investment Securities Available for Sale

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

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				June 30, 2007
				Gross	Gross	Fair
		Amortized		unrealized	unrealized	market
		cost		gains	losses	value
Government-sponsored enterprises		$	29,672	-	(93)	29,579
State and municipal			53,343	9	(1,728)	51,624
Mortgage-backed			24,099	-	(594)	23,505
	Total investment securities
	available for sale	$	107,114	9	(2,415)	104,708
				December 31, 2006
				Gross	Gross	Fair
		Amortized		unrealized	unrealized	market
		cost		gains	losses	value
Government-sponsored enterprises		$	42,554	-	(171)	42,383
State and municipal			48,780	56	(822)	48,014
Mortgage-backed			26,362	72	(264)	26,170
	Total investment securities
	available for sale	$	117,696	128	(1,257)	116,567

The following table summarizes the gross unrealized losses, fair market value, and the number of securities in each category of investment securities available for sale, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at June 30, 2007 and December 31, 2006 (dollars in thousands).

		June 30, 2007
		Less than 12 months					12 months or longer			Total
			Fair		Gross			Fair	Gross		Fair	Gross
			market		unrealized			market	unrealized		market	unrealized
		#	value		losses		#	value	losses	#	value	losses
Government-sponsored enterprises		7	$	18,177	$	35	6	11,402	58	13	29,579	93
State and municipal		26		9,474		255	98	37,802	1,473	124	47,276	1,728
Mortgage-backed		5		8,786		199	25	13,584	395	30	22,370	594
	Total investment securities
	available for sale	38	$	36,437	$	489	129	62,788	1,926	167	99,225	2,415

							December 31, 2006
		Less than 12 months					12 months or longer			Total
			Fair		Gross			Fair	Gross		Fair	Gross
			market		unrealized			market	unrealized		market	unrealized
		#	value		losses		#	value	losses	#	value	losses
Government-sponsored enterprises		3	$	2,980	$	3	10	39,402	168	13	42,382	171
State and municipal		10		4,898		52	91	34,437	770	101	39,335	822
Mortgage-backed		-		-		-	30	16,327	264	30	16,327	264
	Total investment securities
	available for sale	13	$	7,878	$	55	131	90,166	1,202	144	98,044	1,257

Management believes that the above summarized unrealized losses are due to interest rate changes, rather than credit quality, on investments that the Company classifies to indicate that sale is a possibility but also for which the Company has the ability to hold until maturity.  If liquidity is needed, the Company does not automatically chose an impaired or the most impaired security to sell to provide needed liquidity, but rather considers many factors including, but not limited to, asset – liability management. Since the Company has the ability and intent to hold these investments until a market price recovery or maturity, management does not consider these investments to be other-than-temporarily impaired.

The following table summarizes the percentage of the applicable investment segments of the investment securities available for sale by Moody’s credit ratings at June 30, 2007.

		State and		Mortgage-
		municipal		backed
A3		2	%	-
Aa1		4		-
Aaa		78		100
Not rated		16		-
	Total	100	%	100

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Of the state and municipal investment securities not rated by Moody’s at June 30, 2007, 97% was rated Aaa by Standard and Poor’s while 3% was rated Aa+.

The following tables summarize the gross realized gains and losses of investment securities available for sale at the dates indicated (in thousands).

		For the three month			For the six month
		periods ended June 30,			periods ended June 30,
		2007		2006	2007	2006
Realized gains		$	-	1	-	25
Realized losses			-	-	-	(22)
	Net unrealized gains (losses)	$	-	1	-	3

Public funds are bank deposits of state and local municipalities and typically require that the Bank pledge investment grade securities to the accounts to ensure repayment.  Approximately 75% of the investment securities portfolio was pledged to secure public deposits as of June 30, 2007 as compared with 62% at December 31, 2006 and 94% at June 30, 2006.  Approximately 42.6% of investment securities portfolio secured public deposits as of June 30, 2007 as compared with 38% at December 31, 2006 and 74% at June 30, 2006. 

Concentrations of Credit Risk. The Company’s investment portfolio consists principally of securities issued by government-sponsored enterprises, and securities issued by states and municipalities within the United States. The Company places its deposits and correspondent accounts with, and sells its federal funds to, high quality institutions.  Management believes credit risk associated with correspondent accounts is not significant.

4.       Loans

The following table summarizes loans, by loan purpose, excluding those mortgage loans held for sale, by classification at the dates indicated (dollars in thousands).

		June 30, 2007				December 31, 2006
		Total		% of Total		Total	% of Total
Commercial business		$	120,916	12.4	%	112,264	12.0
Commercial real estate			618,084	63.1		593,377	63.2
Installment			23,280	2.4		22,139	2.4
Installment real estate			68,633	7.0		66,161	7.0
Indirect			43,098	4.4		43,634	4.6
Credit line			1,926	0.2		1,982	0.2
Prime access			52,272	5.3		53,883	5.7
Residential mortgage			42,920	4.4		35,252	3.7
Bankcards			11,461	1.2		11,813	1.3
Business manager			316	-		370	-
Other			1,623	0.2		1,793	0.2
	Loans, unadjusted gross		984,529	100.6		942,668	100.3
Loans in process			1,279	0.1		2,587	0.3
Deferred loans fees and costs			721	0.1		658	0.1
	Loans, adjusted gross		986,529	100.8		945,913	100.7
Mortgage loans held for sale			1,293	0.1		1,675	0.2
	Total loans, gross		987,822	100.9		947,588	100.9
Allowance for loan losses			(8,515)	(0.9)		(8,527)	(0.9)
	Total loans, net	$	979,307	100.0	%	939,061	100.0

Loans included in the table are net of participations sold, and mortgage loans sold and serviced for others.  Mortgage loans serviced for the benefit of others amounted to $330.2 million, $325.1 million, and $312.8 million at June 30, 2007, December 31, 2006, and June 30, 2006, respectively. See Note 6 for further discussion regarding the Company’s mortgage-servicing rights portfolio. Net gains on the sale of mortgage loans included in Mortgage Banking Income in the Company’s Consolidated Statements of Income totaled $157 thousand and $132 thousand for the three month periods ended June 30, 2007 and 2006, respectively. Net gains on the sale of mortgage loans totaled $335 thousand and $290 thousand for the six month periods ended June 30, 2007 and 2006, respectively.

The following table summarizes nonaccrual loans and loans past due 90 days and still accruing interest at the dates indicated (in thousands).

	June 30,		December 31,	June 30,
	2007		2006	2006
Nonaccrual loans	$	12,436	6,999	6,551
Loans past due 90 days and still accruing (1)		290	260	122
	$	12,726	7,259	6,673
(1) Substantially all of these loans are bankcard loans

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The following table summarizes the activity impacting the allowance for loan losses (“Allowance”) for the periods indicated (in thousands).

		For the three month periods			For the six month periods
		ended June 30,			ended June 30,
		2007		2006	2007		2006
Allowance, beginning of period		$	8,460	8,727		8,527	8,431
Provision for loan losses			433	525		800	1,050
Loans charged-off			(460)	(433)		(990)	(712)
Loan recoveries			82	60		178	110
	Net loans charged-off		(378)	(373)		(812)	(602)
Allowance, end of period		$	8,515	8,879		8,515	8,879

Troubled debt restructurings entered into by the Company during the three month periods ended June 30, 2007 were reviewed by the Company to ensure loan classifications were in accordance with applicable regulations.  Any specific allocations identified during the review based on probable losses have been included in the Company’s Allowance for the applicable period.

The Company makes contractual commitments to extend credit that are legally binding agreements to lend money to customers at predetermined interest rates for a specific period of time.  The Company also provides standby letters of credit.  See Note 14 for further discussion regarding the Company’s commitments.

At June 30, 2007, of its approximately $102.0 million qualifying loans available to serve as collateral against borrowings and letters of credit from the FHLB, the Company pledged as collateral $78.5 million.

5.       Premises and Equipment, Net

The following table summarizes the Company’s premises and equipment balances at the dates indicated (in thousands).

		June 30,		December 31,
		2007		2006
Land		$	6,703	6,305
Buildings			17,611	17,124
Leasehold improvements			2,857	2,847
Furniture and equipment			18,167	17,762
Software			3,238	3,194
Bank automobiles			886	859
	Premises and equipment, gross		49,462	48,091
Accumulated depreciation and amortization			(24,510)	(23,597)
	Premises and equipment, net	$	24,952	24,494

At June 30, 2007, the Company had thirty-two full-service banking offices in the Upstate region of South Carolina in the following counties: Laurens County (4), Greenville County (10), Spartanburg County (6), Greenwood County (5), Anderson County (3), Cherokee County (2), Pickens County (1), and Oconee County (1) in addition to two Palmetto Capital offices independent of banking office locations, 39 automatic teller machine (“ATM”) locations (including nine in nonbanking office locations), and five limited service banking offices located in retirement centers in the Upstate.   One principal banking office is located in each of the following counties: Laurens, Greenville, Spartanburg, Greenwood, and Anderson.  

During the first six months of 2007, the Bank completed its purchase of real estate on which it plans to construct and relocate its existing Pendleton banking office in Anderson County. Additionally, during the first six months of 2007, the Bank completed the renovation of its Montague banking office in Greenwood County, completed the upfit of, and relocated to, its temporary downtown Greenville banking office to be used during the construction of the Company’s new corporate headquarters, and added a new nonbanking office ATM location at Batesville Plaza Shopping Center in Greenville County. 

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The table set forth below summarizes the activity impacting accumulated depreciation for the periods indicated (in thousands). Depreciation balances were impacted during the period by the activity discussed herein.

			For the three month periods			For the six month periods
			ended June 30,			ended June 30,
			2007		2006	2007		2006
Accumulated depreciation, beginning of period			$	24,030	22,262		23,597	21,759
Depreciation
	Buildings			108	118		220	233
	Leasehold improvements			33	46		73	82
	Furniture and equipment			237	248		483	496
	Software			55	68		116	135
	Bank automobiles			47	39		94	76
		Total depreciation		480	519		986	1,022
Disposals				-	(71)		(73)	(71)
Accumulated depreciation, end of period			$	24,510	22,710		24,510	22,710

6.       Mortgage-Servicing Rights

The Company sells a portion of its originated fixed-rate and adjustable-rate mortgage loans servicing retained. All of the Company’s loan sales have been without recourse. Mortgage loans serviced for the benefit of others amounted to $330.2 million, $325.1 million, and $312.8 million at June 30, 2007, December 31, 2006, and June 30, 2006, respectively. Mortgage loans serviced for the benefit of others are held by the Company or its subsidiary in a fiduciary or agency capacity for customers and, as such, are not included in the Company’s Consolidated Financial Statements as such items do not represent assets of the Company or its subsidiary.

The following table summarizes the changes in the Company’s mortgage-servicing rights portfolio for the periods indicated (dollars in thousands).

			For the three month periods				For the six month periods
			ended June 30,				ended June 30,
			2007			2006	2007	2006
Mortgage-servicing rights portfolio, net of valuation
	allowance, beginning of period		$	2,785		2,628	2,648	2,626
		Capitalized mortgage-servicing rights		207		149	410	319
		Mortgage-servicing rights portfolio amortization		(270)		(123)	(337)	(405)
		Change in mortgage-servicing rights portfolio valuation allowance		-		19	1	133
Mortgage-servicing rights portfolio, net of valuation
	allowance, end of period		$	2,722		2,673	2,722	2,673
Mortgage-servicing rights portfolio amortization as a percentage of the
		mortgage-servicing rights portfolio, beginning of period, and
		capitalized mortgage-servicing rights during the period		36.2	%	17.8	22.2	27.7

Mortgage-servicing rights amortization and valuation allowances are included in Mortgage-Banking Income on the Consolidated Statements of Income.

The aggregate fair market value of the Company’s mortgage-servicing rights portfolio at June 30, 2007, December 31, 2006, and June 30, 2006 was $4.1 million, $3.6 million, and $3.6 million , respectively.

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The following table summarizes the activity impacting the valuation allowance for impairment of the mortgage-servicing rights portfolio for the periods indicated (in thousands).

		For the three month periods			For the six month periods
		ended June 30,			ended June 30,
		2007		2006	2007	2006
Valuation allowance, beginning of period		$	3	34	4	148
	Aggregate additions charged and reductions credited to operations		-	(19)	(1)	(133)
Valuation allowance, end of period		$	3	15	3	15

See Consolidated Statements of Cash Flows for a further discussion of the activity impacting the Company’s mortgage-servicing rights portfolio.

7.      Intangible Assets

The following table summarizes intangible assets, which are included in Other Assets on the Consolidated Balance Sheets, net of accumulated amortization, at the dates indicated (in thousands).

		June 30,		December 31,
		2007		2006
Goodwill		$	3,691	3,691
Customer list intangibles			102	126
	Total intagible assets	$	3,793	3,817

The following table summarizes the activity of intangible assets with finite lives, which are comprised of customer list intangibles, and the related amortization, which is included in Other Noninterest Expense in the Consolidated Statements of Income, for the periods indicated (in thousands). 

	For the three month periods			For the six month periods
	ended June 30,			ended June 30,
	2007		2006	2007		2006
Balance, at beginning of period	$	114	163		126	175
Less: amortization		(12)	(12)		(24)	(24)
Balance, at end of period	$	102	151		102	151

The following table summarizes the gross carrying amount and accumulated amortization of intangible assets with finite lives at the dates indicated (in thousands).

	June 30,		December 31,	June 30,
	2007		2006	2006
Customer list intangibles, gross	$	1,779	1,779		1,779
Less: accumulated amortization		(1,677)	(1,653)		(1,628)
Customer list intangibles, net	$	102	126		151

In its Annual Report on Form 10-K for the year ended December 31, 2006, the Company estimated amortization expense related to intangible assets with finite lives of $48 thousand for the year ended December 31, 2007, $45 thousand for the year ended December 31, 2008, and $34 thousand for the year ended December 31, 2009.  Management is aware of no material events or uncertainties that would cause amortization expense related to the Company’s intangible assets with finite lives not to be indicative of future financial condition or results of operations or that would cause future financial condition or results of operations to differ materially from these projections.

The Company’s intangible assets with infinite lives (goodwill) are subject to periodic impairment tests that are performed by the Company as of June 30 annually, or more often, if events or circumstances indicate that there may be impairment. The valuation as of June 30, 2007 indicated that no impairment charge was required as of that date. Management is aware of no material events or uncertainties that have occurred since June 30, 2007 that would indicate that there might be impairment.

8.       Real Estate and Personal Property Acquired in Settlement of Loans

The following table summarizes real estate and personal property acquired in settlement of loans for the periods indicated (in thousands).                         

	June 30,		December 31,	June 30,
	2007		2006	2006
Real estate acquired in settlement of loans	$	717	600	728
Repossessed automobiles acquired in settlement of loans		386	319	357
Total property acquired in settlement of loans	$	1,103	919	1,085

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The following table summarizes the changes in the Company’s real estate acquired in settlement of loans, including the balance at the beginning and end of each period, provision charged to expense, and losses charged to the Allowance related to the Company’s real estate acquired in settlement of loans for the periods indicated (in thousands).

		At and for the three month			At and for the six month
		periods ended June 30,			periods ended June 30,
		2007		2006	2007	2006
Real estate acquired in settlement of loans, beginning of period		$	934	932	600	1,954
	Add: New real estate acquired in settlement of loans		81	31	582	83
	Less: Sales / recoveries of real estate acquired in settlement of loans		(294)	(190)	(294)	(1,121)
	Less: Provision charged to expense		(4)	(45)	(171)	(188)
Real estate acquired in settlement of loans, end of period		$	717	728	717	728

Based on the Company’s regular review of fair market values of real estate acquired in settlement of loans and writedowns taken as a result of those reviews, management believes that the properties within the portfolio were properly valued at June 30, 2007.

9.       Deposits

The following table summarizes the Company’s deposit composition at the dates indicated (in thousands).

		June 30,		December 31,
		2007		2006
Transaction deposit accounts		$	500,398	447,236
Money market deposit accounts			108,903	124,874
Savings deposit accounts			41,590	41,887
Time deposit accounts			350,934	379,584
	Total deposit accounts	$	1,001,825	993,581

At June 30, 2007, $518 thousand of overdrawn transaction deposit accounts had been reclassified as loan balances compared with $606 thousand at December 31, 2006.

The table set forth below summarizes the Company’s interest expense on deposit accounts costs for the periods indicated (in thousands).

		For the three month periods			For the six month periods
		ended June 30,			ended June 30,
		2007		2006	2007	2006
Transaction and money market deposit accounts		$	3,447	2,150	6,627	3,745
Savings deposit accounts			36	38	70	73
Time deposit accounts			3,954	3,841	7,967	7,445
	Total interest expense on deposit accounts	$	7,437	6,029	14,664	11,263

10.    Short-Term Borrowings

Short-term borrowings at June 30, 2007 totaled $64.4 million compared to $41.4 million at December 31, 2006.  Borrowings as a percentage of total liabilities were approximately 6.0% and 4.9% at June 30, 2007 and December 31, 2006, respectively. The following table summarizes the Company’s borrowings composition at the dates indicated (dollars in thousands).

		June 30, 2007				December 31, 2006
		Total		% of Total		Total	% of Total
Retail repurchase agreements		$	12,145	18.9	%	14,427	34.8
Commercial paper			27,737	43.1		20,988	50.7
Other short-term borrowings			24,500	38.0		6,000	14.5
	Total borrowings	$	64,382	100.0	%	41,415	100.0

If needed, funding sources have been arranged through federal funds lines at correspondent banks, the Federal Reserve Discount Window, and the FHLB. 

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At June 30, 2007, the Company had additional funding sources at correspondent banks totaling $50 million that were accessible at the Company’s option of which $15 million had been utilized. Due to the maturity terms of such sources, utilized borrowed funds are considered to be short-term. During April 2007, Nexity Bank extended the Bank a federal funds accommodation in the amount of $10 million for a period beginning on April 25, 2007 and ending April 30, 2008 subject to specified terms and conditions. Advances under this accommodation are advances of federal funds with a maturity of the next Banking Day (the next day other than Saturday or Sunday on which banking business is conducted in South Carolina). This additional federal funds accommodation in the amount of $10 million increased the Company’s accessible funding sources from $40 million to $50 million. 

At June 30, 2007, of its approximately $102.0 million available credit based on qualifying loans to serve as collateral against borrowings and letters of credit from the FHLB, the Company employed $9.5 million in borrowings, all of which was determined to be short-term when employed, and employed $69.0 million in a letter of credit used to secure public deposits as required or permitted by law.  FHLB letters of credit provide an attractive alternative to using traditional collateral for various transactions. Advantages of FHLB letters of credit include enhancing member liquidity (substituting letter of credit for securities as collateralization of public unit deposits) and utilization of residential mortgage loans as collateral for the letters of credit. However, the utilization of FHLB letters of credit reduces the Company’s available credit based on qualifying loans to serve as collateral.  The Company uses the FHLB letter of credit for collateralization of public deposits. At June 30, 2007, the Company had approximately $23.5 million available credit based on qualifying loans to serve as collateral against short-term borrowings, long-term borrowings, and / or letters of credit from the FHLB.

11.    Long-Term Borrowings

Long-term borrowings are those having maturities greater than one year when executed. The Company’s remaining $10.0 million in long-term FHLB borrowings matured on June 14, 2007. These $10.0 million in long-term FHLB borrowings were outstanding at June 30, 2006.

As noted above with regard to short-term borrowings, at June 30, 2007, of its approximately $102.0 million available credit based on qualifying loans to serve as collateral against borrowings and letters of credit from the FHLB, the Company employed $9.5 million in borrowings, all of which was determined to be short-term when employed, and employed $69.0 million in a letter of credit used to secure public deposits as required or permitted by law.  At June 30, 2007, the Company had approximately $23.5 million available credit based on qualifying loans to serve as collateral against short-term borrowings, long-term borrowings, and / or letters of credit from the FHLB.

12.    Employee Benefit Plans

Postretirement Benefits

Cost of Benefit Plan. The following table summarizes the combined net postretirement benefit expense components for the Company’s defined benefit pension plan, which is included in Salaries and Other Personnel Expense on the Consolidated Statements of Income, at and for the periods indicated (in thousands).

		For the three month periods			For the six month periods
		ended June 30,			ended June 30,
		2007		2006	2007		2006
Service cost		$	197	141		390	282
Interest cost			231	165		457	330
Expected return on plan assets			(321)	(229)		(635)	(458)
Amortization of prior service cost			4	3		8	6
Amortization of loss			28	20		55	40
	Postretirement benefit expense, net	$	139	100		275	200

Expected Contributions. Contributions to the Company’s defined benefit pension plan assets totaling $1.1 million are expected during fiscal year 2007. Contributions during the second quarter of 2007 totaled $275 thousand compared with $308 thousand during the second quarter of 2006. Contributions during the first six months of 2007 totaled $549 thousand compared with $617 thousand during the same period of 2006.

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Stock Option Plans

Determining Fair Value. The following table summarizes the stock-based awards granted by the Company, the fair market value of each award granted as estimated on the date of grant using the Black-Scholes option-pricing model, and the weighted average assumptions used for such grants for the grant dates indicated.

	Stock-based awards granted during the
	six month period ended June 30,
	2007		2006
Grant Date	1/16/2007		6/20/2006	1/17/2006
Stock option awards granted	800		5,000	10,000
Option price	$            30.40		27.30	27.30
Fair market value of stock option awards	$              6.24		4.79	3.39
Expected dividend yields	2.5	%	2.7	2.7
Expected volatility	13	%	5	5
Risk-free interest rate	5	%	5	4
Expected term (years)	10		10	10
Vesting period (years)	5		5	5

Stock Option Compensation Expense. The compensation cost that was charged against pretax net income during the second quarter of 2007 related stock options was $33 thousand compared with $30 thousand during the second quarter of 2006.  Expense during the first six months of 2007 totaled $66 thousand compared with $55 thousand during the same period of 2006.

At June 30, 2007, based on options outstanding at that time, the total compensation cost related to nonvested stock option awards granted under the Company’s stock option plans but not yet recognized was $255 thousand. Stock option compensation expense is recognized on a straight-line basis over the vesting period of the option. The Company expects to recognize this cost over a remaining period of 4.5 years.

Stock Option Activity. The following table summarizes stock option activity for the Palmetto Bancshares, Inc. 1997 Stock Compensation Plan for the periods indicated.

			Weighted-
			average
		Stock options	exercise
		outstanding	price
Outstanding at December 31, 2005		252,785	$	16.63
	Granted	15,000		27.30
	Forfeited	-		-
	Exercised	(25,300)		14.00
Outstanding at June 30, 2006		242,485	$	17.57
Outstanding at December 31, 2006		251,670	$	18.67
	Granted	800		30.40
	Forfeited	-		-
	Exercised	(22,210)		15.06
Outstanding at June 30, 2007		230,260	$	19.06

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Cash received from stock option exercises under the Company’s stock option plan for the six month periods ended June 30, 2007 and 2006 was $334 thousand and $354 thousand, respectively.

401(k) Retirement Plan

During the three month periods ended June 30, 2007 and 2006, the Company made matching contributions to employee 401(k) retirement plans totaling $71 thousand, and $65 thousand, respectively. During the six month periods ended June 30, 2007 and 2006, the Company made matching contributions to employee 401(k) retirement plans totaling $149 thousand, and $134 thousand, respectively.

13.    Net Income per Common Share

The following table summarizes the Company’s reconciliation of the numerators and denominators of the basic and diluted net income per common share computations for the periods indicated.

		For the three month periods			For the six month periods
		ended June 30,			ended June 30,
		2007		2006	2007	2006
Weighted average common shares outstanding - basic		6,385,483		6,354,888	6,382,019	6,349,099
	Dilutive impact resulting from potential common share issuances	114,166		74,871	98,435	74,871
Weighted average common shares outstanding - diluted		6,499,649		6,429,759	6,480,454	6,423,970
Per Share Data
	Net income - basic	$	0.64	0.59	1.23	1.17
	Net income - diluted		0.63	0.58	1.21	1.15

At June 30, 2007, all outstanding options were included in the calculation of diluted net income per common share because the exercise price of all options was lower than the average market price as determined by an independent valuation of common shares.

The Company paid cash dividends of $0.19 and $0.18 per share for the three month periods ended June 30, 2007 and 2006, respectively and cash dividends of $0.38 and $0.36 per share for the six month periods ended June 30, 2007 and 2006, respectively. 

14.    Commitments and Contingencies

Legal Proceedings

The Company is currently subject to various legal proceedings and claims that have arisen in the ordinary course of its business. In the opinion of management, based on consultation with external legal counsel, any reasonably foreseeable outcome of such current litigation would not materially impact the Company's financial condition or results of operations.

Lease Agreements

During the second quarter of 2007, the Company signed a build-to-suit lease agreement with regard to the relocation of its corporate headquarters to Greenville, South Carolina.  Under the terms of this agreement, the Company’s new headquarters will be constructed on the site of the Company’s current downtown Greenville banking office that is leased from the same lessor. The lease provides for an initial term of fifteen years and five options to extend the term after the initial term expiration date, of five years each.  In conjunction with the demolition of the current downtown Greenville banking office, the Company anticipates an immaterial write off in leasehold improvements during the third quarter of 2007.  The Company anticipates construction completion during the third quarter of 2008. The Company is currently analyzing the accounting treatment of this lease agreement. The Company filed a Current Report on Form 8-K on June 26, 2007 to announce its entry into this material definitive agreement.

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During the second quarter of 2007, the Company executed a ground lease contract on which to put in service a nonretail office ATM location at Woodmont Village Shopping Center on Highway 25 in Moonville, South Carolina.  The Company plans to have this location in service by January 2008. 

Lending Commitments

The Company’s contractual commitments to extend credit increased slightly from $265.8 million at December 31, 2006 to $266.6 million at June 30, 2007.

The following table summarizes the Company’s contractual commitments to extend credit, by collateral type, at June 30, 2007 (in thousands).

Commercial and industrial		$	25,964
Real estate			177,034
Credit line			7,663
Bankcards			43,508
Others			12,406
	Total contractual commitments to extend credit	$	266,575

Guarantees

At June 30, 2007, the Company recorded no liability for the current carrying amount of the obligation to perform as a guarantor, and no contingent liability was considered necessary as such amounts were not considered material.  The maximum potential amount of undiscounted future payments related to standby letters of credit at June 30, 2007 was $9.2 million compared with $8.3 million at December 31, 2006.  Past experience indicates that these standby letters of credit will expire unused. However, through its various sources of liquidity, the Company believes that it has the necessary resources available to meet these obligations should the need arise.  Additionally, the Company does not believe that the current fair market value of such guarantees was material at June 30, 2007.

Other Off-Balance Sheet Arrangements

At June 30, 2007, the Company engaged in no transactions, agreements, or other contractual arrangements to which an entity unconsolidated with the Company is a party, under which the Company has:

• Any obligation under a guarantee contract;

• A retained or contingent interest in assets transferred to an unconsolidated entity or similar arrangement that serves as credit, liquidity or market risk support to such entity for such assets;

• Any obligation under a contract that would be accounted for as a derivative instrument considering exceptions; or

• Any obligation arising out of a variable interest in an unconsolidated entity that is held by, and material to, the Company, where such entity provides financing, liquidity, market risk or credit risk support to, or engages in leasing, hedging or research and development services with, the Company.

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Other

During the second quarter of 2007, in conjunction with the audit of the Company’s benefit plans, a discrepancy was discovered with regard to a definition in the benefit plan’s legal plan document and the definition as consistently applied by the Company in practice. Management is currently exploring options for resolution of the discrepancy and is analyzing any potential participant and / or financial statement impact.   At the time of this filing, the impact of this discrepancy could not be reasonably estimated.

15.    Derivative Financial Instruments and Hedging Activities

At June 30, 2007, the Company’s derivative instruments consisted of forward sales commitments relating to the Company’s commitments to originate certain residential loans held for sale.

Outstanding commitments on mortgage loans not yet closed (primarily single-family loan commitments) amounted to approximately $1.6 million at June 30, 2007 compared to approximately $3.8 million at December 31, 2006.  The fair market value of derivative assets related to commitments to originate such residential loans held for sale was not significant at June 30, 2007.  The fair market value of derivative assets related to forward sales commitments did not significantly differ from the carrying amount at June 30, 2007. The decrease in forward sales commitments during the first six months was the result of the Company’s decision to retain more residential loans in its in-house portfolio during the period.

16.    Regulatory Capital Requirements

At June 30, 2007, the most recent notification from federal banking agencies categorized the Company and the Bank as well capitalized under United States federal banking regulations. To be categorized as well capitalized, minimum total risk-based capital, Tier 1 capital, and Tier 1 leverage ratios must be maintained as set forth in the following table (dollars in thousands). Since June 30, 2007, there have been no events or conditions that management believes would change these categories.

							To be well capitalized
							under prompt
					For capital adequacy		corrective action
		Actual			purposes		provisions
		amount		ratio	amount	ratio	amount	ratio
At June 30, 2007
Total capital to risk-weighted assets
	Company	$	111,320	10.43%	85,404	8.00	n/a	n/a
	Bank		113,353	10.60	85,576	8.00	106,970	10.00
Tier 1 capital to risk-weighted assets
	Company		102,805	9.63	42,702	4.00	n/a	n/a
	Bank		104,838	9.80	42,788	4.00	64,182	6.00
Tier 1 capital to average assets
	Company		102,805	8.85	46,490	4.00	n/a	n/a
	Bank		104,838	9.02	46,511	4.00	58,139	5.00
At June 30, 2006
Total capital to risk-weighted assets
	Company	$	100,119	10.34%	77,457	8.00	n/a	n/a
	Bank		98,902	10.21	77,457	8.00	96,821	10.00
Tier 1 capital to risk-weighted assets
	Company		91,240	9.42	38,728	4.00	n/a	n/a
	Bank		90,023	9.30	38,728	4.00	58,093	6.00
Tier 1 capital to average assets
	Company		91,240	8.22	44,416	4.00	n/a	n/a
	Bank		90,023	8.10	44,429	4.00	55,537	5.00

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

Discussions of certain matters contained in this Quarterly Report on Form 10-Q may constitute forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities and Exchange Act of 1934, as amended (the Exchange Act), and as such, may involve risks and uncertainties. These forward-looking statements relate to, among other things, expectations of the business environment in which the Company operates, projections of future performance, perceived opportunities in the market, and statements regarding the Company’s mission and vision. The Company cautions readers that a number of factors could cause actual results, performance, and achievements to differ materially from the results, performance, and achievements expressed or implied in such forward-looking statements. For a discussion of some of the factors that might cause such a difference, see Part 1, Item 1A in the Company’s Annual Report on Form 10-K for the year ended December 31, 2006 and Part II, Item IA in this Quarterly Report on Form 10-Q for the quarter ended June 30, 2007. The Company does not undertake and specifically disclaims any obligation to update such forward-looking statements to reflect occurrences or unanticipated events or circumstances after the date of such statements except as required by law.

The following discussion and analysis is presented to assist the reader with understanding the financial condition and results of operations of the Company.  The information presented in the following discussion of financial condition and results of operations of the Company results from the activities of its subsidiary, the Bank, which comprises the majority of the consolidated net income, revenues, and assets of the Company.  This discussion should be read in conjunction with the Consolidated Financial Statements and related notes and other financial data appearing in this report as well as in the Company’s Annual Report on Form 10-K for the year ended December 31, 2006.  Results of operations for the three and six month periods ended June 30, 2007 are not necessarily indicative of results that may be attained for any other period.  Percentage calculations contained herein have been calculated based on rounded results presented herein.

Overview

Who is Palmetto Bancshares, Inc?

Palmetto Bancshares, Inc. is a regional financial services holding company headquartered in Laurens, South Carolina and organized in 1982 under the laws of South Carolina. Through its wholly owned subsidiary, The Palmetto Bank (the "Bank"), Palmetto Bancshares, Inc. engages in the general banking business through 32 retail banking offices in the Upstate, South Carolina markets of Laurens, Greenville, Spartanburg, Greenwood, Anderson, Cherokee, Abbeville, Pickens, and Oconee counties (the “Upstate”).  The Company’s primary market area is located within the Upstate. In addition to retail offices, at June 30, 2007, the Company had 39 automatic teller machine (“ATM”) locations (including nine at nonretail office locations) and five-limited service offices located in retirement centers in the Upstate. The Bank was organized and chartered under South Carolina law in 1906. The Bank has one active subsidiary, Palmetto Capital, Inc. (“Palmetto Capital”), that provides investment products. Throughout this report, the "Company" shall refer to Palmetto Bancshares, Inc. and its subsidiary, the Bank, which includes Palmetto Capital, Inc.

Mission and Strategic Vision

The Company’s mission as an independent Upstate financial institution is to achieve superior long-term shareholder value, exercise exemplary corporate citizenship, and create an environment which promotes and rewards employee development and the consistent delivery of quality service to our customers. 

From a strategic vision perspective, the Company strives to be widely recognized as Upstate South Carolina’s premier independent community banking organization.  Through a variety of delivery channels, the Company provides a full range of high-quality financial products and services throughout its extended trade area.  The Company and its personnel strive to provide a level of consistently superior personal service setting the Company apart from other bank and nonbank competitors. 

Financial Highlights

The following tables summarize the Company’s financial highlights at and for the dates indicated (dollars in thousands).

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(dollars in thousands, except common and per share data)
		At and for the three month							At and for the six month
		periods ended June 30,				Variance				periods ended June 30,		Variance
		2007			2006	$		%		2007	2006		$	%
		(unaudited)								(unaudited)
RESULTS OF OPERATIONS
Interest income		$	20,696		18,769		1,927	10.3	%	40,894	36,717		4,177	11.4
Interest expense			7,988		6,601		1,387	21.0		15,723	12,454		3,269	26.2
	Net interest income		12,708		12,168		540	4.4		25,171	24,263		908	3.7
Provision for loan losses			433		525		(92)	(17.5)		800	1,050		(250)	(23.8)
	Net interest income after provision for loan losses		12,275		11,643		632	5.4		24,371	23,213		1,158	5.0
Noninterest income			3,865		3,976		(111)	(2.8)		7,697	7,879		(182)	(2.3)
Noninterest expense			9,871		10,085		(214)	(2.1)		20,013	20,151		(138)	(0.7)
	Income before provision for income taxes		6,269		5,534		735	13.3		12,055	10,941		1,114	10.2
Provision for income taxes			2,204		1,803		401	22.2		4,229	3,560		669	18.8
	Net income	$	4,065		3,731		334	9.0	%	7,826	7,381		445	6.0
COMMON SHARE DATA
Net income:
	Basic	$	0.64		0.59		0.05	8.5	%	1.23	1.17		0.06	5.1
	Diluted		0.63		0.58		0.05	8.6		1.21	1.15		0.06	5.2
Cash dividends			0.19		0.18		0.01	5.6		0.38	0.36		0.02	5.6
Book value			16.49		14.73		1.76	11.9		16.49	14.73		1.76	11.9
Outstanding shares			6,389,660		6,356,635		33,025	0.5		6,389,660	6,356,635		33,025	0.5
Weighted average outstanding - basic			6,385,483		6,354,888		30,595	0.5		6,382,019	6,349,099		32,920	0.5
Weighted average outstanding - diluted			6,499,649		6,429,759		33,229	0.5		6,480,454	6,423,970		35,554	0.6
Dividend payout ratio			29.87	%	30.67		(0.80)	(2.6)		31.01	30.99		0.02	0.1
PERIOD-END BALANCES
Assets		$	1,179,869		1,116,073		63,796	5.7	%	1,179,869	1,116,073		63,796	5.7
Investment securities available for sale, at fair market value			104,708		115,440		(10,732)	(9.3)		104,708	115,440		(10,732)	(9.3)
Loans (1)			987,822		892,364		95,458	10.7		987,822	892,364		95,458	10.7
Deposits and borrowings			1,066,207		1,016,342		49,865	4.9		1,066,207	1,016,342		49,865	4.9
Shareholders' equity			105,391		93,626		11,765	12.6		105,391	93,626		11,765	12.6
AVERAGE BALANCES
Assets		$	1,166,247		1,114,489		51,758	4.6	%	1,161,523	1,100,971		60,552	5.5
Interest-earning assets			1,098,323		1,034,089		64,234	6.2		1,091,709	1,025,236		66,473	6.5
Investment securities available for sale, at fair market value			107,759		121,053		(13,294)	(11.0)		110,585	123,472		(12,887)	(10.4)
Loans (1)			968,985		880,061		89,838	10.3		960,302	874,118		86,895	10.0
Deposits and borrowings			917,615		880,344		37,271	4.2		916,459	869,382		47,077	5.4
Shareholders' equity			105,223		93,625		11,598	12.4		103,680	92,439		11,241	12.2
SIGNIFICANT OPERATING RATIOS BASED ON EARNINGS
Return on average assets			1.40	%	1.34		0.06	4.5	%	1.36	1.35		0.01	0.7
Return on average shareholders' equity			15.50		15.98		(0.48)	(3.0)		15.22	16.10		(0.88)	(5.5)
Net interest margin			4.64		4.72		(0.08)	(1.7)		4.65	4.77		(0.12)	(2.5)
(1) Calculated using loans including mortgage loans held for sale, net of unearned, excluding the allowance for loan losses

Results of Operations. Unlike many companies that manufacture goods or provide services, virtually all of the assets and liabilities of the Company are monetary in nature and, as a result, the Company’s operations are impacted by interest rate fluctuations.  The Company actively manages the gap between its interest-sensitive assets and liabilities. 

The actions of the Federal Reserve influence the growth of loans, investments, and deposits and impact the interest rates charged on loans and paid on deposits. The Federal Reserve’s policies have had a significant impact on the operating results of the Bank and are expected to continue to do so in the future.

Since the second quarter of 2004, the federal funds rate has increased from 1.0% to 5.25% in a series of seventeen moves. Moreover, since January 2006, the federal funds rate has increased 100 basis points from 4.25% to 5.25% in a series of four moves the last two of which occurred during the second quarter of 2006.  These actions of the Federal Reserve Open Market Committee impacted net interest income during the three month period ended June 30, 2007 over the same periods of 2006. 

Net interest income for the second quarter of 2007 was $12.7 million, an increase of 4.4% compared to the second quarter of 2006. During the three month period ended June 30, 2007 compared with the same period of 2006, the Company experienced increases in both average yield on interest-earning assets and average cost of interest-bearing liabilities. The average yield on interest-earning assets increased 28 basis points to 7.56% during the second quarter of 2007 from 7.28% during the same period of 2006. The average cost of interest-bearing liabilities increased 48 basis points to 3.49% from 3.01% when comparing the same periods. Average interest-earning assets increased $64.2 million during the quarter ended June 30, 2007 over the same quarter of 2006, primarily within the loan portfolio, while interest-bearing liabilities increased $37.3 million over the same period.

The following analysis summarizes the dollar amount of changes in interest income and interest expense attributable to changes in volume and the amount attributable to changes in rate when comparing the three month period ended June 30, 2007 to the three month period ended June 30, 2006 (in thousands). 

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		Volume		Rate		Total
Total interest-earning assets		$	1,479		448		1,927
Total interest-bearing liabilities			276		1,111		1,387
	Net interest income	$	1,203		(663)		540

Noninterest expenses as a percentage of total revenue has decreased from 44.3% in the second quarter of 2006 to 40.2% in the second quarter of 2007.

Period-End Balances.  At June 30, 2007, the investment security portfolio represented 8.9% of total assets, a decline from 10.1% at December 31, 2006. The decline in the total investment securities portfolio from December 31, 2006 to June 30, 2007 resulted primarily from short-term taxable securities issued by government-sponsored enterprises not being reinvested but instead being used to fund loan growth and repay borrowings during the six month period ended June 30, 2007. Approximately 75% of the investment securities portfolio was pledged to secure public deposits as of June 30, 2007 as compared with 62% at December 31, 2006 and 94% at June 30, 2006.  Approximately 42.6% of investment securities portfolio secured public deposits as of June 30, 2007 as compared with 38% at December 31, 2006 and 74% at June 30, 2006.  Of the Company’s $104.7 million available for sale investment securities balance at June 30, 2007, $25.9 million was unpledged and, therefore, available as a liquidity source. The fluctuation in pledged securities between these periods was the result of a diversification of assets pledged to secure public deposits, securities sold under agreements to repurchase, and for other purposes as required or permitted by law. 

Loans represent the most significant component of the Company’s interest-earning assets with average loans accounting for 88.2% of average interest-earning assets during the three month periods ended June 30, 2007. Total loans, including mortgage loans held for sale, increased $40.2 million, during the first six months of 2006.  During this period, increases were experienced in the commercial business, commercial real estate, and residential mortgage loan portfolios when analyzing the loan portfolio by loan purpose.  During this period, mortgage loans held for sale decreased $382 thousand to $1.3 million at June 30, 2007. During 2006, the Company introduced business credit scoring and began placing an emphasis on small commercial loans.  Management believes that these changes continued to result in increases in commercial business loans as a percentage of the total portfolio during the first six months of 2007. Management anticipates that aggressive commercial real estate building in recent years may indicate an upcoming period of oversupply.  In order to avoid an excess supply of commercial limited-service properties, the Company has tightened underwriting standards with regard to such loans resulting in little change in commercial real estate loans as a percentage of the total portfolio. The Company experienced an increase in residential mortgage loans and a decrease in mortgage loans held for sale during the first six months of 2007 as a result of the Company’s decision to retain more residential loans in its in-house portfolio during the period.

The Allowance totaled $8.5 million, at both December 31, 2006 and June 30, 2007, respectively representing 0.90% and 0.86% of loans, calculated using loans excluding mortgage loans held for sale and the allowance for loan losses, net of unearned income. Management believes that the declining trend of the Allowance as a percentage of ending loans results from several factors including, but not limited to, management’s conservative philosophy regarding its lending mix which impacts risk grades assigned at loan origination, the ongoing management of asset quality, and growth within the portfolio being primarily loans secured by real estate which generally involve less risk that other types of lending, all of which impact Allowance allocations.

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The Company experienced an increase of $8.2 million in traditional deposit accounts during the first six months of 2007 as a result of an increase in transaction deposit accounts totaling $53.2 million offset by declines in money market, savings, and time deposit accounts.  The increase in transaction deposit accounts resulted from the Company’s continued ability to attract deposits through pricing adjustments, expansion of its geographic market area, level of quality customer service, and through the Company’s reputation in the communities served. Additionally, the Company has made efforts to enhance its deposit mix by working to attract lower cost deposit accounts.  The Company believes that the growth in traditional deposit continues to be enhanced by the introduction, continuation, and enhancement of product programs and promotions.  During the first six months of 2007, approximately $8 million of the public funds deposited within a Company money market deposit account was transferred from the Bank, and, money market funds of the Bank’s trust department declined approximately $3 million, which together comprised the majority of the decline in the Company’s money market deposit accounts over the periods noted.  Time deposit accounts decreased by $28.7 million, or 7.5% during the first six months of 2007. Prior promotional certificate of deposit accounts offered by the Company matured during the first six months of 2007.  During this time, the Company offered a specifically targeted time deposit program in an effort to retain maturing funds.   Management believes that the Company’s time deposit accounts declined during the first six months of 2007 as a result of returns currently available from alternative investments. 

Although the Bank has historically directly competed for deposits with commercial banks and other financial institutions, in recent years, money market, stock, and fixed income mutual funds have attracted an increasing share of household savings.  Consequently, the Company considers these funds to be competitors of the Bank. Competition among various financial institutions is based on interest rates offered on deposit accounts, service charges, the quality of service rendered, and the convenience of banking offices. The Bank feels that it sets itself apart from its competitors by providing superior personal service through a variety of delivery channels and a full range of high quality financial products and services. 

In addition to traditional deposit funding, the Company utilized borrowings to support interest-earning asset growth during the first six months of 2006, which increased $13.0 million during the period.

During the first six months of 2007, shareholders’ equity was increased through the retention of net income, stock option activity, and compensation expense related to stock options granted.  These increases were offset by an increase in cash dividends and in accumulated other comprehensive loss over the six month period. 

Other Highlights

• In conjunction with the Company’s 100^th anniversary celebration on September 21, 2006, the Company announced its plan to relocate its corporate headquarters to downtown Greenville in 2008. Tentative plans project construction of the new leased facility to begin in 2007 with a projected completion date in 2008.  On May 2, 2007, The Bank entered into a Commercial Lease (Build-to-Suit) (the "Lease Agreement") with Charles E. Howard and Doris H. Howard ("Lessor").  Pursuant to the Lease Agreement, the Lessor will complete site work, construct an approximately 42,000 square foot building, and lease the combined parcels and building to the Company to be used as the Company’s new corporate headquarters. During construction of the new corporate headquarters, branch operations will be temporarily housed and conducted within the existing building and parking facilities owned by the Bank and located at 105 North Church Street. In conjunction with the demolition of the current downtown Greenville banking office, the Company anticipates an immaterial write off in leasehold improvements during the third quarter of 2007.  The Company is currently analyzing the accounting treatment of this lease agreement. The Company filed a Current Report on Form 8-K on June 26, 2007 to announce its entry into this material definitive agreement.

• During the second quarter of 2007, the Company executed a ground lease contract for a nonretail office ATM location at Woodmont Village Shopping Center on Highway 25 in Moonville, South Carolina.  The Company plans to have this location in service by January 2008. 

• As reported in the Company’s Annual Report on Form 10-K for the Year Ended Dec ember 31, 2006, during February 2007, the Bank purchased real estate in Anderson County on which to construct and relocate its existing Pendleton banking office.  Ground was broken on this site in July 2007. 

• During the second quarter of 2007, the Company contracted to purchase property at the intersection of West Wade Hampton Boulevard and Middleton Way in Greenville County on which to construct and relocate its existing Greer banking office.  The Company expects to close on this property during the third quarter of 2007.

• During April 2007, Nexity Bank extended to the Bank a federal funds accommodation in the amount of $10 million for a period beginning on April 25, 2007 and ending April 30, 2008 subject to specified terms and conditions. Advances under this Accommodation are advances of federal funds with a maturity of the next Banking Day (the next day other than Saturday or Sunday on which banking business is conducted in South Carolina). This additional federal funds accommodation in the amount of $10 million increased the Company’s accessible funding sources from $40 million to $50 million. 

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• At June 30, 2007, of its approximately $102.0 million available credit based on qualifying loans to serve as collateral against borrowings and letters of credit from the FHLB, the Company employed $9.5 million in borrowings, all of which was determined to be short-term when employed, and employed $69.0 million in a letter of credit used to secure public deposits as required or permitted by law.  At June 30, 2007, the Company had approximately $23.5 million available credit based on qualifying loans to serve as collateral against short-term borrowings, long-term borrowings, and / or letters of credit from the FHLB.

• The Company’s remaining $10.0 million in long-term FHLB borrowings matured on June 14, 2007.

• At June 30, 2007 and 2006, Palmetto Bancshares and the Bank were each categorized as well capitalized under the regulatory framework for prompt corrective regulatory action.

Critical Accounting Policies

The Company’s accounting and financial reporting policies are in conformity with generally accepted accounting principles (“GAAP”).  The preparation of financial statements in conformity with such principles requires management to make estimates and assumptions that impact the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities during the reporting period, and the reported amounts of revenue and expense during the reporting period.  The Company’s significant accounting policies are discussed in Item 8, Note 1 to the Consolidated Financial Statements of the Annual Report on Form 10-K for the year ended December 31, 2006.  Of these significant accounting policies, the Company has determined that its most critical accounting estimates include the accounting for its allowance for loan losses, pension plan, mortgage-servicing rights portfolio, past acquisitions, and income taxes to be its most critical accounting policies due to the valuation techniques used and the sensitivity of these financial statement amounts to the methods, assumptions, and estimates underlying these balances.  Accounting for these critical areas requires a significant degree of judgment that could be subject to revision as newer information becomes available. In order to determine the Company’s critical accounting policies, management considers if the accounting estimate requires assumptions about matters that were highly uncertain at the time the accounting estimate was made and if different estimates that reasonably could have been used in the current period or changes in the accounting estimate that are reasonably likely to occur from period to period would have a material impact on the presentation of financial condition, changes in financial condition, or results of operations. In conjunction with the filing of the Company’s Annual Report on Form 10-K for the year ended December 31, 2006, management and the Company’s independent registered public accounting firm discussed the development and selection of the critical accounting estimates discussed herein with the Audit Committee of the Company’s Board of Directors.

Other Information

Impact of Inflation

The Consolidated Financial Statements and related financial data presented herein have been prepared in accordance with generally accepted accounting principles.  These principles require the measurement of financial condition and results of operations in terms of historical dollars without considering changes in relative purchasing power over time due to inflation. 

Securities and Exchange Commission

The public may read and copy any materials filed in hard copy by the Company with the Securities and Exchange Commission (the “SEC”) at the SEC’s Public Reference Room at 450 Fifth Street, N.W., Washington, D.C.  20549.  The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330.  The Company files reports electronically with the SEC.  The SEC maintains an Internet site that contains reports, proxy and information statements, and other information regarding issuers that file reports electronically.  This site may be accessed at www.sec.gov.  Filings filed by the Company electronically with the SEC may be accessed through this website.

The Company currently makes reports filed with the Securities and Exchange Commission available, free of charge, through its website (www.palmettobank.com) through a link to the SEC’s website as noted above.  The Company is currently exploring options to make such reports available through its website without having to navigate from its main website.  Such reports may also be requested through sending written correspondence directed to 301 Hillcrest Drive, Laurens, South Carolina 29360 Attention: Senior Vice President, Finance and Accounting.

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Financial Condition

The following information is intended to supplement any information relating to the Consolidated Balance Sheets contained within Part I, Item 1 of this Quarterly Report on Form 10-Q.   

Overview

PALMETTO BANCSHARES, INC. AND SUBSIDIARY
Consolidated Balance Sheets
(dollars in thousands, except common and per share data)
				June 30,		December 31,	Variance
				2007		2006	$	%
ASSETS
Cash and cash equivalents
	Cash and due from banks			$	33,286	43,084	(9,798)	(22.7)	%
	Federal funds sold				9,972	3,582	6,390	178.4
		Total cash and cash equivalents			43,258	46,666	(3,408)	(7.3)
Federal Home Loan Bank ("FHLB") stock, at cost					2,527	2,599	(72)	(2.8)
Investment securities available for sale, at fair market value					104,708	116,567	(11,859)	(10.2)
Mortgage loans held for sale					1,293	1,675	(382)	(22.8)
Loans					986,529	945,913	40,616	4.3
	Less: allowance for loan losses				(8,515)	(8,527)	12	(0.1)
		Loans, net			978,014	937,386	40,628	4.3
Premises and equipment, net					24,952	24,494	458	1.9
Goodwill					3,691	3,691	-	-
Other intangible assets					102	127	(25)	(19.7)
Accrued interest receivable					6,201	6,421	(220)	(3.4)
Other					15,123	13,510	1,613	11.9
			Total assets	$	1,179,869	1,153,136	26,733	2.3	%
LIABILITIES AND SHAREHOLDERS' EQUITY
Liabilities
Deposits
	Noninterest-bearing			$	137,182	133,623	3,559	2.7	%
	Interest-bearing				864,643	859,958	4,685	0.5
		Total deposits			1,001,825	993,581	8,244	0.8
Retail repurchase agreements					12,145	14,427	(2,282)	(15.8)
Commercial paper (Master notes)					27,737	20,988	6,749	32.2
Other short-term borrowings					24,500	6,000	18,500	308.3
Long-term borrowings					-	10,000	(10,000)	(100.0)
Accrued interest payable					1,523	1,584	(61)	(3.9)
Other					6,748	6,180	568	9.2
		Total liabilities			1,074,478	1,052,760	21,718	2.1
Shareholders' Equity
Common stock					31,948	31,837	111	0.3
Capital surplus					1,391	1,102	289	26.2
Retained earnings					73,531	68,132	5,399	7.9
Accumulated other comprehensive loss, net of tax					(1,479)	(695)	(784)	112.8
		Total shareholders' equity			105,391	100,376	5,015	5.0
			Total liabilities and shareholders' equity	$	1,179,869	1,153,136	26,733	2.3	%

Investment Securities Available for Sale

The following table summarizes the composition of the Company’s investment securities available for sale portfolio at the dates indicated (dollars in thousands).

		June 30, 2007			December 31, 2006
		Total		% of Total	Total	% of Total
Government-sponsored enterprises		$	29,579	28.3%	42,383	36.4
State and municipal			51,624	49.3	48,014	41.2
Mortgage-backed			23,505	22.4	26,170	22.4
	Total investment securities
	available for sale	$	104,708	100.0%	116,567	100.0

At June 30, 2007, the investment security portfolio represented 8.9% of total assets, a decline from 10.1% at December 31, 2006. The decline in the total investment securities portfolio from December 31, 2006 to June 30, 2007 resulted primarily from short-term taxable securities issued by government-sponsored enterprises (“GSEs”) not being reinvested but instead being used to fund loan growth and repay borrowings during the six month period ended June 30, 2007.

See Part I, Item 1. Financial Statements, Consolidated Statements of Cash Flows contained herein for further discussion regarding how purchases of and proceeds from the sale, maturities, and / or calls of investment securities as well as principal paydowns of mortgage-backed securities impacted the investment securities available for sale portfolio during the six month period ended June 30, 2007.

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

		June 30, 2007			December 31, 2006
				Fair		Fair
		Amortized		market	Amortized	market
		cost		value	cost	value
Government-sponsored enterprises		$	29,672	29,579	42,554	42,383
State and municipal			53,343	51,624	48,780	48,014
Mortgage-backed			24,099	23,505	26,362	26,170
	Total investment securities
	available for sale	$	107,114	104,708	117,696	116,567

Public funds are bank deposits of state and local municipalities and typically require that the Bank pledge investment grade securities to the accounts to ensure repayment.  Approximately 75% of the investment securities portfolio was pledged to secure public deposits as of June 30, 2007 as compared with 62% at December 31, 2006 and 94% at June 30, 2006.  Approximately 42.6% of investment securities portfolio secured public deposits as of June 30, 2007 as compared with 38% at December 31, 2006 and 74% at June 30, 2006.  The fluctuation in pledged securities between these periods was the result of a diversification of assets pledged to secure public deposits, securities sold under agreements to repurchase, and for other purposes as required or permitted by law as further discussed in Part I, Item 1. Financial Statements, Note 10 and Note 11 contained herein with regard to the Company’s borrowings from the FHLB.

See Part I, Item 1. Financial Statements, Note 3 contained herein for further discussion regarding the Company’s investment securities portfolio.

Concentrations of Credit Risk. The following table summarizes the amortized cost and fair market value of the securities of issuers that, in the aggregate, exceed ten percent of shareholders’ equity at June 30, 2007 (dollars in thousands).

		Amortized				Fair market
		Cost		% of GSEs		value	% of GSEs
Government-sponsored enterprises
	FHLB	$	25,704	86.7	%	25,632	86.6
	FHLMC		2,982	10.0		2,975	10.1
	FNMA		986	3.3		972	3.3
		$	29,672	100.0	%	29,579	100.0
		Amortized				Fair market
		Cost		% of MBSs		value	% of MBSs
Mortgage-backed
	FHLMC	$	7,555	31.3	%	7,350	31.3
	FNMA		16,544	68.7		16,155	68.7
		$	24,099	100.0	%	23,505	100.0
				% of
				portfolio			% of
		Amortized		amortized		Fair market	portfolio fair
		Cost		cost		value	market value
Total GSEs and MBSs
	FHLB	$	25,704	24.0	%	25,632	24.5
	FHLMC		10,537	9.8		10,325	9.9
	FNMA		17,530	16.4		17,127	16.4
		$	53,771	50.2	%	53,084	50.8

The Company places its deposits and correspondent accounts with, and sells its federal funds to, high quality institutions.  Management believes credit risk associated with correspondent accounts is not significant.

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Loans

General.  Loans represent the most significant component of the Company’s interest-earning assets with average loans accounting for 88.2% and 85.1% of average interest-earning assets during the three month periods ended June 30, 2007 and June 30, 2006, respectively and 88.0% and 85.3% of average interest-earning assets during the six month periods ended June 30, 2007 and June 30, 2006, respectively. The following table summarizes the Company’s loan portfolio, by collateral type, at the dates indicated (dollars in thousands).

		June 30, 2007				December 31, 2006
		Total		% of Total		Total	% of Total
Commercial and industrial		$	73,943	7.4	%	126,742	13.4
Real estate - 1 - 4 family			211,190	21.4		171,828	18.1
Real estate - construction			39,695	4.0		19,959	2.1
Real estate - other			574,516	58.2		540,869	57.1
	Total loans secured by real estate		825,401	83.6		732,656	77.3
General consumer			70,814	7.2		70,502	7.4
Credit line			5,055	0.5		4,868	0.5
Bankcards			11,461	1.2		11,813	1.3
Others			1,148	0.1		1,007	0.1
	Total loans, gross	$	987,822	100.0	%	947,588	100.0

During the first six months of 2007, management performed tasks in order to comply with commercial real estate regulatory reporting requirements. Specifically, in order to adequately monitor segments of the loan portfolio, the Company reviewed its stratifications within the loan portfolio using parameters including, but not limited to, loan type, loan purpose, geographic distribution, and collateral, if applicable, as management believes that this stratification assists in the identification of factors that either heighten or reduce the inherent risk. As a result of this process, management deemed it necessary to adjust various stratification identifiers of such loans resulting in fluctuations within loan outstanding balances when reviewed by such stratification identifiers. These reclassifications may impact the comparability of 2006 and 2007 balances.  Management is currently exploring ways in which to improve the comparability of these numbers in the future.

The following table summarizes loans by loan purpose at the dates indicated (dollars in thousands).

		June 30, 2007				December 31, 2006
		Total		% of Total		Total	% of Total
Commercial business		$	120,916	12.4	%	112,264	12.0
Commercial real estate			618,084	63.1		593,377	63.2
Installment			23,280	2.4		22,139	2.4
Installment real estate			68,633	7.0		66,161	7.0
Indirect			43,098	4.4		43,634	4.6
Credit line			1,926	0.2		1,982	0.2
Prime access			52,272	5.3		53,883	5.7
Residential mortgage			42,920	4.4		35,252	3.7
Bankcards			11,461	1.2		11,813	1.3
Business manager			316	-		370	-
Other			1,623	0.2		1,793	0.2
	Loans, unadjusted gross		984,529	100.6		942,668	100.3
Loans in process			1,279	0.1		2,587	0.3
Deferred loans fees and costs			721	0.1		658	0.1
	Loans, adjusted gross		986,529	100.8		945,913	100.7
Mortgage loans held for sale			1,293	0.1		1,675	0.2
	Total loans, gross		987,822	100.9		947,588	100.9
Allowance for loan losses			(8,515)	(0.9)		(8,527)	(0.9)
	Total loans, net	$	979,307	100.0	%	939,061	100.0

During 2006, the Company introduced business credit scoring and began placing an emphasis on small commercial loans.  Management believes that these changes continue to result in increases in commercial business loans as a percentage of the total portfolio. 

Management believes that the aggressive commercial real estate building in recent years may indicate an upcoming period of oversupply.  In order to avoid an excess supply of commercial limited-service properties, the Company has tightened underwriting standards with regard to such loans resulting in little change in commercial real estate loans as a percentage of the total portfolio.

The increase in residential mortgage loans and the decrease in mortgage loans held for sale during the first six months was the result of the Company’s decision to retain more residential loans in its in-house portfolio during the period.

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See Part I, Item 1. Financial Statements, Note 4 contained herein for further discussion regarding the Company’s loan portfolio.

Credit Quality.  The following table summarizes trends in problem assets and other asset quality indicators at the dates indicated (dollars in thousands). The composition of nonaccrual loans is based on loan collateral type.

		June 30,			December 31,
		2007			2006
Real estate		$	12,041		6,271
Commercial and industrial		329			549
Consumer		66			179
	Total nonaccrual loans		12,436		6,999
Real estate acquired in settlement of loans			717		600
Repossessed automobiles			386		319
	Total nonperforming assets	$	13,539		7,918
Loans past due 90 days and still accruing (1)		$	290		260
Ending loans (2)		$	986,529		945,913
Nonaccrual loans as a percentage of loans (2)			1.26	%	0.74
Nonperforming assets as a percentage of
	total assets		1.15	%	0.69
Allowance for loan losses to nonaccrual
	loans		0.68	x	1.22
(1)	Substantially all of these loans are bankcard loans
(2)	Calculated using loans excluding mortgage loans held for sale, net of unearned, excluding the Allowance

Total nonaccrual loans increased $5.4 million from December 31, 2006 to June 30, 2007 primarily due to an increase in nonaccrual loans secured by real estate.  Management believes that the increase in nonaccrual loans at June 30, 2007 over December 31, 2006 does not indicate a deterioration of asset quality as the increase can be attributed, for the most part, to isolated loan circumstances. During the first quarter of 2007, two loans, both of which were secured by other real estate, were placed in nonaccrual status.  At June 30, 2007, the principal balance of these loans totaled $5.3 million.  During July 2007, foreclosure proceedings were completed with regard to the real estate collateral securing both loans.  Both properties were placed into the Bank’s real estate in settlement of loans portfolio in July at fair market value.  Management expects that the sale of the collateral securing these loans will fully cover the Company’s investment. Excluding the impact of these loans, virtually all other nonaccrual comparisons remained relatively unchanged from December 31, 2006 to June 30, 2007.  In its consideration of collectibility of nonaccrual loans, management takes into consideration, among other factors, that 96.8% of nonaccrual loans at June 30, 2007 were secured by real estate. In the event of foreclosure, any losses would be offset by funds received through the liquidation of the underlying real estate collateral. 

Also included within nonaccrual loans at both December 31, 2006 and June 30, 2007 was a loan secured by other real estate placed in nonaccrual during the fourth quarter of 2005.  In accordance with the Bank’s Lending Policy, the loan was downgraded to “substandard” at that time.  At both December 31, 2006 and June 30, 2007, the principal balance of this loan totaled $3.9 million.  $878 thousand of the loan balance was specifically reserved at both December 31, 2006.  At the time of this filing, the borrower has filed for protection under the bankruptcy code placing a stay on the Bank's foreclosure order.

Troubled debt restructurings entered into by the Company during the three month period ended June 30, 2007 were reviewed by the Company to ensure loan classifications were in accordance with applicable regulations.  Any specific allocations identified during the review based on probable losses have been included in the Company’s Allowance for the applicable period.

As of June 30, 2007, management was aware of no other potential problem loans that were not already categorized as nonaccrual, past due, or restructured, or that had borrower credit problems causing management to have serious doubt as to the ability of the borrower to comply with the present loan repayment terms. 

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The Company regularly reviews its loan portfolio and management determines whether any loans require classification in accordance with applicable regulations.  The Company’s believes that loans are appropriately classified.

The following table summarizes the composition of the Company’s classified assets by collateral type at the dates indicated (in thousands).

		June 30, 2007
		Special
		mention		Substandard	Doubtful	Loss	Total
Commercial and industrial		$	286	963	776	-	2,025
Real estate			923	18,358	809	-	20,090
General consumer			16	270	32	-	318
Credit line			6	34	1	-	41
	Total classified loans	$	1,231	19,625	1,618	-	22,474
	Total classified loans, unadjusted, as a percentage of total loans (1)						2.3%
	Total classified loans, adjusted, as a percentage of total loans (1)						1.7%
		December 31, 2006
		Special
		mention		Substandard	Doubtful	Loss	Total
Commercial and industrial		$	301	1,098	839	-	2,238
Real estate			1,063	12,398	942	-	14,403
General consumer			2	321	36	-	359
Credit line			6	47	1	-	54
	Total classified loans	$	1,372	13,864	1,818	-	17,054
	Total classified loans, unadjusted, as a percentage of total loans (1)						1.8%
(1)	Calculated using loans excluding mortgage loans held for sale, net of unearned, excluding the Allowance.

Overall, classified assets increased $5.4 million from December 31, 2006 to June 30, 2007.  From a portfolio perspective, the increase was experienced primarily in classified assets secured by real estate.  From a classification perspective, the increase was experienced primarily in substandard assets discussed previously in conjunction with the increase in nonaccrual loans over the same periods. Management believes that the increase in classified assets, from both the portfolio and classification perspectives, at June 30, 2007 over December 31, 2006 can be attributed, for the most part, to two loans, secured by other real estate, which were placed in nonaccrual status during the first quarter of 2007. In accordance with the Company’s Lending Policy, the loans were downgraded to “substandard.” At June 30, 2007, the principal balance of these loans totaled $5.3 million.  During July 2007, foreclosure proceedings were completed with regard to the real estate collateral securing both loans.  Both properties were placed into the Bank’s real estate in settlement of loans portfolio in July at fair market value.  Management expects that the sale of the collateral securing these loans will fully cover the Company’s investment. Excluding the impact of these loans, virtually all other comparisons, whether from a portfolio or classification perspective, remained relatively unchanged from December 31, 2006 to June 30, 2007. 

As noted above in conjunction with the discussion of nonaccrual loans, also included within nonaccrual loans at both December 31, 2006 and June 30, 2007 was a loan secured by other real estate placed in nonaccrual during the fourth quarter of 2005.  In accordance with the Bank’s Lending Policy, the loan was downgraded to “substandard” at that time.  At both December 31, 2006 and June 30, 2007, the principal balance of this loan totaled $3.9 million.  $878 thousand of the loan balance was specifically reserved at both December 31, 2006.

The following table summarizes the changes in the Company’s real estate acquired in settlement of loans, including the balance at the beginning and end of each period, provision charged to expense, and losses charged to the Allowance related to the Company’s real estate acquired in settlement of loans for the periods indicated (in thousands).

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		At and for the three month			At and for the six month
		periods ended June 30,			periods ended June 30,
		2007		2006	2007	2006
Real estate acquired in settlement of loans, beginning of period		$	934	932	600	1,954
	Add: New real estate acquired in settlement of loans		81	31	582	83
	Less: Sales / recoveries of real estate acquired in settlement of loans		(294)	(190)	(294)	(1,121)
	Less: Provision charged to expense		(4)	(45)	(171)	(188)
Real estate acquired in settlement of loans, end of period		$	717	728	717	728

When Federal Reserve Chairman Ben Bernanke testified before the House Financial Services Committee on July 18, 2007, he noted that rising delinquencies and foreclosures are creating personal, economic and social distress for many homeowners and communities. Consistent with these trends, the Company’s new real estate acquired in settlement of loans totaled $582 thousand during the first six months of 2007 compared with $83 thousand during the same period of 2006.  Although during the six month period June 30, 2006, $1.1 million in sales and recoveries from the portfolio were experienced, the portfolio balance at that time from which sales were derived (beginning balance plus additions to the portfolio) were considerably higher than those on which sales were derived for the six month period ended June 30, 2007.  Management believes that real estate acquired in settlement of loans is effectively managed by the Company considering the increasing industry trends with regard to foreclosure evidenced by the relatively unchanged balance in the portfolio when comparing June 30, 2006 to June 30, 2007. 

Management believes that there will always remain a core level of delinquent loans and real estate and personal property acquired in settlement of loans from normal lending operations.

Concentrations of Credit Risk. Financial instruments, which potentially subject the Company to concentrations of credit risk, consist principally of loans, investment securities, federal funds sold and due from bank balances.

The Company makes loans to individuals and small to medium-sized businesses for various personal and commercial purposes primarily in Upstate, South Carolina.  The Company’s loan portfolio is not concentrated in loans to any single borrower or a relatively small number of borrowers.  Additionally, management is not aware of any concentrations of loans to classes of borrowers or industries that would be similarly impacted by economic conditions.  Management has identified, and the following table summarizes at the dates indicated, concentrations of types of lending that it monitors (dollars in thousands).

		June 30, 2007
		Outstanding		As a percentage		As a percentage of
		balance		of total equity		total loans
Loans secured by:
	Commercial and industrial nonmortgage instruments	$	73,943	70	%	7	%
	Residential mortgage instruments		211,190	200		21
	Nonresidential mortgage instruments		574,516	545		58
		December 31, 2006
		Outstanding		As a percentage		As a percentage of
		balance		of total equity		total loans
Loans secured by:
	Commercial and industrial nonmortgage instruments	$	126,742	126	%	13	%
	Residential mortgage instruments		171,828	171		18
	Nonresidential mortgage instruments		540,869	539		57

As previously discussed, the fluctuations in outstanding balances during the first six months of 2007 were a result of the Company’s review of stratifications within the loan portfolio and the resulting adjustments made to various stratification identifiers. These reclassifications may impact the comparability of 2006 and 2007 balances.  Management is currently exploring ways in which to improve the comparability of these numbers in the future.

Management realizes that there are inherent risks in all loan portfolios and that there is always risk associated with a lack of diversification.  However, management believes that risks associated with the concentration of loans secured by nonresidential mortgage instruments are mitigated through the analysis and underwriting of the credit requests, the retention of adequate collateral, and the oversight of development or construction processes, where applicable.  The collateral associated with such loans ranges from income producing commercial properties to new residential or commercial development projects. Sources of repayment are analyzed to determine the degree of risk related to each loan during the underwriting process.  Additionally, although included in one reporting category, loans secured by nonresidential mortgage instruments are comprised of many types of loans to many types of borrowers located in many geographical areas. 

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In addition to monitoring potential concentrations of loans to particular borrowers or groups of borrowers, industries, geographic regions, and loan types, management monitors whether or not the Company has exposure to credit risk from other lending practices such as loans that subject borrowers to substantial payment increases (e.g. principal deferral periods, loans with initial interest-only periods, etc.) and loans with high loan-to-value ratios.  Management has determined that, at June 30, 2007, the Company has no concentrations in such loans, as the Company does not typically engage in such lending practices. 

Additionally, there are industry practices that could subject the Company to increased credit risk should economic conditions change over the course of a loan’s life.  For example, the Company makes adjustable-rate loans and fixed-rate principal-amortizing loans with maturities prior to the loan being fully paid (i.e. balloon-term loans).  These loans are underwritten and monitored to manage the associated risks.  Therefore, management believes that these particular practices do not subject the Company to unusual credit risk.

Allowance for Loan Losses

The Allowance totaled $8.5 million, at both December 31, 2006 and June 30, 2007, respectively representing 0.90% and 0.86% of loans, calculated using loans excluding mortgage loans held for sale and the allowance for loan losses, net of unearned income.

The following table indicates management’s breakdown of the allowance for loan losses by loan category and the percentage of loans in each category to gross loans at the dates indicated (dollars in thousands). Management believes that the Allowance can be allocated by category only on an approximate basis.  The allocation of the Allowance to each category is not necessarily indicative of future losses and does not restrict the use of the Allowance to absorb losses in other categories.

		June 30,				December 31,
		2007				2006
				% of			% of
				loans			loans
		Total		to total		Total	to total
		allowance		loans		allowance	loans
Commercial and industrial		$	845	7.4	%	1,167	13.4
Real estate - 1 - 4 family			1,287	21.4		1,344	18.1
Real estate - construction			39	4.0		20	2.1
Real estate - other			3,943	58.2		2,745	57.1
General consumer			1,075	7.2		1,860	7.4
Credit line			156	0.5		162	0.5
Bankcards			346	1.2		382	1.3
Others			824	0.1		847	0.1
	Total	$	8,515	100.0	%	8,527	100.0

The increase in the allocation of the Allowance to the portfolio secured by other real estate was due, in large part, to two loans placed in nonaccrual status during the first three months of 2007 as discussed in Loans, both of which were secured by other real estate.  As such, the loans were downgraded to substandard in accordance with the Company’s Lending Policy.  Although it was determined that these loans did not require specific allocations, general reserves were allocated to these loans.  At June 30, 2007, the principal balance of these loans totaled $5.3 million.  The decrease in allocation of the Allowance to the loan portfolio secured by general consumer collateral was due primarily to a decrease in the historical loss percentage with regard to this category.

See Loans contained herein for discussion regarding the composition of the loan portfolio as well as the fluctuations within the portfolio from December 31, 2006 to June 30, 2007.

The following table summarizes activity within the Allowance at the dates and for the periods indicated (dollars in thousands). Losses and recoveries are charged or credited to the Allowance at the time realized.

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			At and for the three month				At and for the six month
			periods ended June 30				periods ended June 30
			2007			2006	2007	2006
Allowance balance, beginning of period			$	8,460		8,727	8,527	8,431
Provision for loan losses				433		525	800	1,050
Loans charged-off
	Commercial and industrial			32		98	138	214
	Real estate - 1 - 4 family			125		21	212	40
	Real estate - construction			-		-	-	-
	Real estate - other			51		100	158	100
	Consumer			252		214	482	358
		Total loans charged-off		460		433	990	712
Recoveries
	Commercial and industrial			3		7	21	29
	Real estate - 1 - 4 family			30		13	33	13
	Real estate - construction			-		-	-	-
	Real estate - other			2		1	3	3
	Consumer			47		39	121	65
		Total recoveries		82		60	178	110
		Net loans charged-off		378		373	812	602
Allowance balance, end of period			$	8,515		8,879	8,515	8,879
Average loans (1)			$	966,064		876,226	957,630	870,735
Ending loans (1)				986,529		889,117	986,529	889,117
Net loans charged-offs to average loans (1)				0.16	%	0.17	0.17	0.14
Allowance for loan losses to ending loans (1)				0.86		1.00	0.86	1.00
(1)	Calculated using loans excluding mortgage loans held for sale, net of unearned income, excluding allowance for loan losses.

See Earnings Review, For the Three Months Ended June 30, 2007, Provision for Loan Losses and Earnings Review, For the Six Months Ended June 30, 2007, Provision for Loan Losses contained herein for discussion regarding the decrease in the provision for loan losses during the three and six month periods ended June 30, 2007 over the same periods of 2006.

Total net loans charged-off remained relatively unchanged when comparing the second quarter of 2006 with the same quarter of 2007. Net loans charged-off during the six month period ended June 30, 2007 were up $210 thousand from the same period of 2006 due to increased net loans charged-off during the first quarter of 2007 when compared with the same period of 2006.  In conjunction with the Quarterly Report on Form 10-Q for the Quarter Ended March 31, 2007, management reported that net loans charged-off during the first quarter of 2006 were not believed to necessarily be indicative of historical or future credit trends.  For the quarters ended March 31, 2006, June 30, 2006, September 30, 2006, December 31, 2006, and March 31, 2007, net loans charged-offs as a percentage of average loans were 0.11%, 0.17%, 0.19%, 0.21%, and 0.19%, respectively.

Management believes that the declining trend of the Allowance as a percentage of ending loans results from several factors including, but not limited to, management’s conservative philosophy regarding its lending mix which impacts risk grades assigned at loan origination, the ongoing management of asset quality, and growth within the portfolio being primarily loans secured by real estate which generally involve less risk that other types of lending, all of which impact Allowance allocations.

Based on the current economic environment and other factors that impact the assessment of the Company’s Allowance as discussed above, management believes that the Allowance at June 30, 2007 was maintained at a level adequate to provide for estimated probable losses in the loan portfolio.  However, assessing the adequacy of the Allowance is a process that requires considerable judgment. Management's judgments are based on numerous assumptions about current events believed to be reasonable but which may or may not be valid. Thus, there can be no assurance that loan losses in future periods will not exceed the current Allowance or that future increases in the Allowance will not be required. No assurance can be given that management's ongoing evaluation of the loan portfolio, in light of changing economic conditions and other relevant circumstances, will not require future additions to the Allowance, thus adversely impacting the results of operations of the Company.

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Deposits

The following table summarizes the Company’s deposit composition at the dates indicated (dollars in thousands).

		June 30,				December 31,
		2007				2006
		Total		% of Total		Total	% of Total
Noninterest-bearing transaction deposit accounts		$	136,898	13.7	%	133,623	13.4
Interest-bearing transaction deposit accounts			363,500	36.3		313,613	31.6
	Transaction deposit accounts		500,398	50.0		447,236	45.0
Money market deposit accounts			108,903	10.9		124,874	12.6
Savings deposit accounts			41,590	4.1		41,887	4.2
Time deposit accounts			350,934	35.0		379,584	38.2
	Total traditional deposit accounts	$	1,001,825	100.0	%	993,581	100.0

The increase in transaction deposit accounts during the first six months of 2007 was primarily a result of the Company’s continued ability to attract deposits through pricing adjustments, expansion of its geographic market area, level of quality customer service, and through the Company’s reputation in the communities served. Additionally, the Company has made efforts to enhance its deposit mix by working to attract lower cost deposit accounts.  The Company believes that the growth in transaction deposit accounts continues to be enhanced by the introduction, continuation, and enhancement of product programs and promotions. 

During 2006, the Company reported $14 million of growth within money market deposit accounts related to temporary public funds from one entity and an increase in money market funds of the Company’s trust department of approximately $6 million. During the first six months of 2007, approximately $8 million of the public funds were transferred from the Bank, and, in addition, money market funds of the Bank’s trust department declined approximately $3 million, which together contributed to the decline in money market deposit accounts over the periods noted.

Time deposit accounts decreased by $28.7 million, or 7.5% during the first six months of 2007. Prior promotional certificate of deposit accounts offered by the Company matured during the first six months of 2007.  During this time, the Company offered a specifically targeted time deposit program in an effort to retain maturing funds.   Management believes that the Company’s time deposit accounts declined during the first six months of 2007 as a result of returns currently available from alternative investments. 

The table set forth below summarizes the Company’s weighted average deposit costs for the periods indicated.

	For the three month			For the six month
	periods ended June 30,			periods ended June 30,
	2007		2006	2007	2006
Average cost of core deposit accounts	2.76	%	2.05	2.71	1.87
Average cost of time deposit accounts	4.39		3.91	4.35	3.80
Average cost of total traditional deposit accounts	3.44		2.95	3.41	2.82

The table set forth below summarizes the Company’s interest expense on deposit accounts costs for the periods indicated (in thousands).

		For the three month periods			For the six month periods
		ended June 30,			ended June 30,
		2007		2006	2007	2006
Transaction deposit accounts		$	2,532	1,167	4,732	1,973
Money market deposit accounts			915	983	1,895	1,772
Savings deposit accounts			36	38	70	73
Time deposit accounts			3,954	3,841	7,967	7,445
	Total interest expense on deposit accounts	$	7,437	6,029	14,664	11,263

As summarized in Earnings Review for the applicable period, the increase in interest expense on deposit accounts when comparing both the three and six month periods ended June 30, 2007 over the same periods of 2006 was attributable primarily to changes in rate.

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Management does not believe that its dependence on traditional deposit account funding changed materially from December 31, 2006 to June 30, 2007.  At June 30, 2007, traditional deposit accounts as a percentage of liabilities were 93.2% compared with 94.4% at December 31, 2006.

Borrowings

In addition to the funds employed from the decline in the investment security portfolio and the net growth in traditional deposit accounts, borrowings increased $13.0 million during the first six months of 2007 to fund loan growth. Borrowings as a percentage of total liabilities were approximately 6.0% and 4.9% at June 30, 2007 and December 31, 2006, respectively. The following table summarizes the Company’s borrowings composition at the dates indicated (dollars in thousands).

		June 30, 2007				December 31, 2006
		Total		% of Total		Total	% of Total
Retail repurchase agreements		$	12,145	18.9	%	14,427	28.1
Commercial paper			27,737	43.1		20,988	40.8
Other short-term borrowings			24,500	38.0		6,000	11.7
Long-term borrowings			-	-		10,000	19.4
	Total borrowings	$	64,382	100.0	%	51,415	100.0

The following table summarizes short-term borrowing information at and for the periods indicated (dollars in thousands).

		At and for the three month				At and for the six month
		periods ended June 30,				periods ended June 30,
		2007			2006	2007	2006
Retail repurchase agreements
	Amount outstanding at period end	$	12,145		17,961	12,145	17,961
	Average amount outstanding during period		12,442		17,196	13,154	18,204
	Maximum amount outstanding at any period end		12,145		20,071	12,771	23,344
	Rate paid at period end		3.63	%	3.63	3.63	3.63
	Weighted average rate paid during the period		4.19		4.13	4.23	3.89
Commercial paper
	Amount outstanding at period end	$	27,737		22,104	27,737	22,104
	Average amount outstanding during period		26,804		20,401	24,540	18,221
	Maximum amount outstanding at any period end		27,737		22,104	27,737	22,104
	Rate paid at period end		3.81	%	3.81	3.81	3.81
	Weighted average rate paid during the period		4.32		4.05	4.33	3.81
Other short-term borrowings
	Amount outstanding at period end	$	24,500		-	24,500	-
	Average amount outstanding during period		3,570		1,135	2,807	4,857
	Maximum amount outstanding at any period end		24,500		-	24,500	13,900
	Rate paid at period end		5.63	%	-	5.63	-
	Weighted average rate paid during the period		6.07		2.47	5.96	4.73
*	Rates paid are tiered based on level of deposit.  Rate presented represents the average rate for all tiers offered at year-end.

If needed, funding sources have been arranged through federal funds lines at correspondent banks, the Federal Reserve Discount Window, and the FHLB. 

At June 30, 2007, the Company had additional funding sources at correspondent banks totaling $50 million that were accessible at the Company’s option of which $15 million had been utilized. These additional sources included the Bank’s additional federal funds accommodation in the amount of $10 million from Nexity Bank obtained during the second quarter of 2007.

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Federal Reserve advances, commonly referred to as “discount window borrowings,” are secured borrowings from Federal Reserve Banks. These borrowings are generally available to any depository institution that maintains reservable transaction accounts or nonpersonal time deposits and provide back-up funding for commercial banks. Such borrowings provide short-term funds to help eligible institutions meet temporary funding requirements or to cushion a more persistent outflow of funds while the bank makes an orderly adjustment of its balance sheet. All borrowings must be secured to the satisfaction of the local Reserve Bank. Satisfactory collateral generally includes United States government securities, federal agency securities, and, if they are of acceptable quality, mortgage notes on one- to four- family residences, state and local government securities, and the notes of businesses, consumers, and other customers. As such, the acceptable collateral available to secure such borrowings limits the Company’s borrowings through this funding source.  A collateralized borrowing relationship with the Federal Reserve was in place for the Bank to meet emergency funding needs at June 30, 2007, however, no borrowings were outstanding. The Bank has not historically utilized discount window borrowings from the Federal Reserve and has no plans to do so in the near term. The Bank would typically only utilize this funding source to meet emergency funding needs.

At June 30, 2007, of its approximately $102.0 million available credit based on qualifying loans to serve as collateral against borrowings and letters of credit from the FHLB, the Company employed $9.5 million in borrowings, all of which was determined to be short-term when employed, and employed $69.0 million in a letter of credit used to secure public deposits as required or permitted by law.  At June 30, 2007, the Company had approximately $23.5 million available credit based on qualifying loans to serve as collateral against short-term borrowings, long-term borrowings, and / or letters of credit from the FHLB.

Long-term borrowings are those having maturities greater than one year when executed. The Company’s remaining $10.0 million in long-term FHLB borrowings matured on June 14, 2007. The following table summarizes long-term borrowing information, all of which were obtained through the FHLB, at and for the periods indicated (dollars in thousands).

		At and for the three month				At and for the six month
		periods ended June 30,				periods ended June 30,
		2007			2006	2007	2006
Long-term FHLB borrowings
	Amount outstanding at period end	$	-		10,000	-	10,000
	Average amount outstanding during period		8,242		20,571	9,116	21,779
	Maximum amount outstanding at any period end		10,000		23,000	10,000	23,000
	Rate paid at period end		-	%	3.85	-	3.85
	Weighted average rate paid during the period		3.80		3.55	3.83	3.54

Capital Resources

Average shareholders’ equity was $105.2 million for the three month period ended June 30, 2007, or 9.0% of average assets, compared with $93.6 million, or 8.4% of average assets, for the same period of 2006.  For the six month period ended June 30, 2007, average shareholders’ equity was $103.7 million, or 8.9% of average assets, compared with $92.4 million, or 8.4% of average assets, for the same period of 2006. 

Total shareholders’ equity increased from $100.4 million at December 31, 2006 to $105.4 million at June 30, 2007. The Company’s capital ratio of total shareholders’ equity to total assets was 8.9% at June 30, 2007 compared with 8.7% at December 31, 2006. During the first six months of 2007, shareholders’ equity was increased through the retention of net income, stock option activity, and compensation expense related to stock options granted.  These increases were offset by an increase in cash dividends and in accumulated other comprehensive loss over the six month period.  See Part I, Item 1. Financial Statements, Consolidated Statements of Changes in Shareholders’ Equity and Comprehensive Income contained herein for further discussion regarding the changes in stockholders’ equity during the six month period ended June 30, 2007.

Palmetto Bancshares and the Bank are required to meet regulatory capital requirements that currently include several measures of capital.  At June 30, 2007 and 2006, both were each categorized as well capitalized under the regulatory framework for prompt corrective regulatory action.

See Part I, Item 1. Financial Statements, Note 16 contained herein for further discussion regarding the Bank’s and Palmetto Bancshares’ capital regulatory requirements.  At June 30, 2007, there were no conditions or events of which management was aware that would materially change Palmetto Bancshares’ or the Bank’s capitalization status.

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For the second quarter of 2007, the Company’s cash dividend payout ratio was 29.87% compared with a payout ratio of 30.67% during the same period of 2006. Cash dividends per common share during the second quarter of 2007 totaled $0.19, an increase of 5.6% over dividends per common share during the same period of 2006 of $0.18. For the six month periods ended June 30, 2007 and 2006, respectively, the Company’s cash dividend payout ratio was 31.01% and 30.99%.  During the same periods, cash dividends per common share totaled $0.38 and $0.36, an increase of 5.6%. The amount of the dividends declared is dependent upon the Company’s earnings, financial condition, capital position, and such other factors the Board deems relevant.  South Carolina regulations restrict the amount of dividends that the Bank can pay to the holding company and may require prior approval before declaration and payment of any excess dividend.

Liquidity

General

The term liquidity refers to the Company’s ability to timely meet obligations when they come due without incurring unacceptable losses. The Company’s management is charged with ensuring that sufficient funds are available at a reasonable cost to meet potential demands from both funds providers and borrowers. Banks generally hold some liquid assets to supplement liquidity from deposits and other liabilities. These assets can be quickly and easily converted to cash at a reasonable cost. Liquid assets include those that can be pledged or used in a repurchase agreement.

The Company considers its money market assets to be the most liquid of it assets. Money market assets include federal funds sold with an overnight maturity or term maturity within 30 days.  At June 30, 2007, the Company had federal funds sold totaling $10.0 million.

The Company's investment portfolio can provide liquidity through any of three ways including the maturity of a security, the sale of securities for cash, or through the use of securities as collateral in a repurchase agreement or other borrowing. The Company considers an investment security to be saleable if it is not encumbered, i.e., the security cannot be sold under a repurchase agreement or pledged or used as collateral, and it is marketable.

Public funds are bank deposits of state and local municipalities. Although the funds are usually a low-cost, relatively stable source of funding for the Bank, availability depends on the particular government's fiscal policies and cash flow needs. Public funds typically require that the Bank pledge investment grade securities to the accounts to ensure repayment.  Of the Company’s $104.7 million available for sale investment securities balance at June 30, 2007, $25.9 million was unpledged and, therefore, available as a liquidity source.

The following table summarizes the gross unrealized losses, fair market value, and the number of securities in each category of investment securities available for sale, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at June 30, 2007 (dollars in thousands).

		June 30, 2007
		Less than 12 months					12 months or longer			Total
			Fair		Gross			Fair	Gross		Fair	Gross
			market		unrealized			market	unrealized		market	unrealized
		#	value		losses		#	value	losses	#	value	losses
Government-sponsored enterprises		7	$	18,177	$	35	6	11,402	58	13	29,579	93
State and municipal		26		9,474		255	98	37,802	1,473	124	47,276	1,728
Mortgage-backed		5		8,786		199	25	13,584	395	30	22,370	594
	Total investment securities
	available for sale	38	$	36,437	$	489	129	62,788	1,926	167	99,225	2,415

Management believes that the above summarized unrealized losses are due to interest rate changes, rather than credit quality, on investments that the Company classifies to indicate that sale is a possibility but also for which the Company has the ability to hold until maturity.  If liquidity is needed, the Company does not automatically chose an impaired or the most impaired security to sell to provide needed liquidity, but rather considers many factors including, but not limited to, asset – liability management. Since the Company has the ability and intent to hold these investments until a market price recovery or maturity, management does not consider these investments to be other-than-temporarily impaired.

The following table summarizes the percentage of the applicable investment segments of the investment securities available for sale by Moody’s credit ratings at June 30, 2007.

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		State and		Mortgage-
		municipal		backed
A3		2	%	-
Aa1		4		-
Aaa		78		100
Not rated		16		-
	Total	100	%	100

Of the state and municipal investment securities not rated by Moody’s at June 30, 2007, 97% was rated Aaa by Standard and Poor’s while 3% was rated Aa+. 

The Company generally has ready access to borrowed funds and generally finds that such borrowings are an economical way to meet short-term or unanticipated loan demand or deposit withdrawals. Additionally, the Company’s reliance on liability liquidity has increased during the first six months of 2007, as net funds provided through traditional deposit accounts have remained relatively unchanged. Traditional deposit accounts are the Company’s primary funding source.

Management believes that through managing liabilities instead of assets, liabilities can be tailored to fit cash flow needs instead of apportioning asset types and amounts to a given liability base. Additionally, management believes that by locking in term funding liquidity risk can be reduced. By accessing external funding sources, the Company can obtain funds quickly and in large amounts instead of slowly accumulating traditional deposit accounts.

If needed, alternative funding sources have been arranged through federal funds lines at correspondent banks, the Federal Reserve Discount Window, and the FHLB.  Alternative funding is also used when traditional deposit funding is not available. The Company’s alternative funds providers are typically other financial institutions.

The federal funds market is the day-to-day unsecured lending of excess reserve funds between banks. If a bank needs funds to meet either its reserve requirements or other obligations, it can purchase the excess reserves of another bank. The primary federal funds market is overnight, but maturities may extend a few days or weeks. At June 30, 2007, the Company had additional funding sources at correspondent banks totaling $50 million that were accessible at the Company’s option of which $15 million had been utilized. These additional sources included the Bank’s additional federal funds accommodation in the amount of $10 million from Nexity Bank obtained during the second quarter of 2007.

Federal Reserve advances, commonly referred to as “discount window borrowings” are secured borrowings from Federal Reserve Banks. These borrowings are generally available to any depository institution that maintains reservable transaction accounts or nonpersonal time deposits. Such borrowings provide short-term funds to help eligible institutions meet temporary funding requirements or to cushion a more persistent outflow of funds while the bank makes an orderly adjustment of its balance sheet. All borrowings must be secured to the satisfaction of the local Reserve Bank. Satisfactory collateral generally includes United States government securities, federal agency securities, and, if they are of acceptable quality, mortgage notes on one- to four- family residences, state and local government securities, and the notes of businesses, consumers, and other customers. As such, the acceptable collateral available to secure such borrowings limits the Company’s borrowings through this funding source. 

The FHLB generally establishes credit availability for each creditworthy institution. Credit availability is not a formal commitment to extend credit but an indication of the amount of credit the FHLB is willing to extend to a member. The FHLB monitors each member’s credit availability on a periodic basis and may make adjustments to the credit availability as needed. The amount of a member’s credit availability is contingent upon a number of factors, including, but not limited to, continued financial soundness of the member, and adequacy of the amount of qualifying collateral available to secure new and outstanding advances.  Qualifying collateral may include various types of mortgage loans, securities, and deposits.  The member has certain obligations to the FHLB for its pledged collateral. These obligations include periodic reporting on eligible, pledged collateral and adherence to the FHLB’s collateral verification review procedures.

The FHLB has established an overall credit limit for each member. Generally, this credit limit is 40 percent of the member’s total assets. However, a member’s eligibility to borrow in excess of 30 percent of assets is subject to its meeting eligibility criteria.

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The FHLB may provide funding in large amounts to banks primarily through two types of funding to commercial banks: collateralized advances and uncollateralized investments.  At June 30, 2007, the Company had approximately $23.5 million available credit based on qualifying loans to serve as collateral against short-term borrowings, long-term borrowings, and / or letters of credit from the FHLB.

See Part I, Item 1. Financial Statements, Consolidated Statements of Cash Flows contained herein to review factors that impacted liquidity during the periods presented. 

See Borrowings for further discussion regarding the Company’s short-term and long-term borrowings.

Lending Commitments

The Company enters into agreements, in the normal course of business, to extend credit to meet the financial needs of its customers. See Off-Balance Sheet Arrangements below for further discussion regarding the potential impact the Company’s lending commitments could have on liquidity at June 30, 2007.

Other

During the second quarter of 2007, in conjunction with the audit of the Company’s benefit plans, a discrepancy was discovered with regard to a definition in the benefit plan’s legal plan document and the definition as consistently applied by the Company in practice. Management is currently exploring options for resolution of the discrepancy and is analyzing any potential participant and / or financial statement impact.   At the time of this filing, the impact of this discrepancy could not be reasonably estimated.

Off-Balance Sheet Arrangements

In the normal course of business, the Company engages in a variety of financial transactions that, in accordance with generally accepted accounting principles, are not recorded in its financial statements or are recorded in amounts that differ from the notional amounts.  These transactions involve elements of credit, interest rate, and liquidity risk. 

The Company’s off-balance sheet arrangements principally include lending commitments, guarantees, and derivatives.

Lending Commitments

In the normal course of business, the Company makes contractual commitments to extend credit that are legally binding agreements to lend money to customers at predetermined interest rates for a specific period of time. The Company also provides standby letters of credit. The Company’s credit policies and standards are applied when making these types of commitments. These instruments are not recorded until funds are advanced under the commitments. The Company’s contractual commitments to extend credit increased slightly from $265.8 million at December 31, 2006 to $266.6 million at June 30, 2007. The following table summarizes the Company’s contractual commitments to extend credit, by collateral type, at June 30, 2007 (in thousands).

Commercial and industrial		$	25,964
Real estate			177,034
Credit line			7,663
Bankcards			43,508
Others			12,406
	Total contractual commitments to extend credit	$	266,575

Guarantees

At June 30, 2007, the Company recorded no liability for the current carrying amount of the obligation to perform as a guarantor, and no contingent liability was considered necessary as such amounts were not considered material.  The maximum potential amount of undiscounted future payments related to standby letters of credit at June 30, 2007 was $9.2 million compared with $8.3 million at December 31, 2006.  Past experience indicates that these standby letters of credit will expire unused. However, through its various sources of liquidity, the Company believes that it has the necessary resources available to meet these obligations should the need arise.  Additionally, the Company does not believe that the current fair market value of such guarantees was material at June 30, 2007.

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Other Off-Balance Sheet Arrangements

At June 30, 2007, the Company engaged in no transactions, agreements, or other contractual arrangements to which an entity unconsolidated with the Company is a party, under which the Company has:

• Any obligation under a guarantee contract;

• A retained or contingent interest in assets transferred to an unconsolidated entity or similar arrangement that serves as credit, liquidity or market risk support to such entity for such assets;

• Any obligation under a contract that would be accounted for as a derivative instrument considering exceptions; or

• Any obligation arising out of a variable interest in an unconsolidated entity that is held by, and material to, the Company, where such entity provides financing, liquidity, market risk or credit risk support to, or engages in leasing, hedging or research and development services with, the Company.

Derivatives and Hedging Activities

At June 30, 2007, the Company’s derivative instruments consisted of forward sales commitments relating to the Company’s commitments to originate certain residential loans held for sale.

Outstanding commitments on mortgage loans not yet closed (primarily single-family loan commitments) amounted to approximately $1.6 million at June 30, 2007 compared to approximately $3.8 million at December 31, 2006.  The fair market value of derivative assets related to commitments to originate such residential loans held for sale was not significant at June 30, 2007.  The fair market value of derivative assets related to forward sales commitments did not significantly differ from the carrying amount at June 30, 2007. The decrease in forward sales commitments during the first six months was the result of the Company’s decision to retain more residential loans in its in-house portfolio during the period.

Earnings Review
 

For the Three Months Ended June 30, 2007

Overview. The following information is intended to supplement any information relating to the Consolidated Statements of Income contained within Part I, Item 1 of this Quarterly Report on Form 10-Q.   

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			PALMETTO BANCSHARES, INC. AND SUBSIDIARY
Consolidated Statements of Income
			(dollars in thousands, except common and per share data)
				For the three month periods
				ended June 30,			Variance
				2007		2006	$		%
				(unaudited)
Interest income
	Interest and fees on loans			$	19,301	17,115		2,186	12.8
	Interest on investment securities available for sale				1,130	1,215		(85)	(7.0)
	Interest on federal funds sold				227	393		(166)	(42.2)
	Dividends on FHLB stock				38	46		(8)	(17.4)
		Total interest income			20,696	18,769		1,927	10.3
Interest expense
	Interest on deposits				7,437	6,029		1,408	23.4
	Interest on retail repurchase agreements				130	177		(47)	(26.6)
	Interest on commercial paper				289	206		83	40.3
	Interest on other short-term borrowings				54	16		38	237.5
	Interest on long-term borrowings				78	173		(95)	(54.9)
		Total interest expense			7,988	6,601		1,387	21.0
			Net interest income		12,708	12,168		540	4.4
Provision for loan losses					433	525		(92)	(17.5)
			Net interest income after provision for loan losses		12,275	11,643		632	5.4
Noninterest income
	Service charges on deposit accounts				1,991	2,042		(51)	(2.5)
	Fees for trust and brokerage services				826	847		(21)	(2.5)
	Mortgage-banking income				171	275		(104)	(37.8)
	Investment securities gains				-	1		(1)	(100.0)
	Other				877	811		66	8.1
		Total noninterest income			3,865	3,976		(111)	(2.8)
Noninterest expense
	Salaries and other personnel				6,057	5,709		348	6.1
	Occupancy				379	371		8	2.2
	Furniture and equipment				422	438		(16)	(3.7)
	Premises and equipment leases and rentals				335	331		4	1.2
	Premises and equipment depreciation				480	519		(39)	(7.5)
	Marketing				219	332		(113)	(34.0)
	Amortization of core deposit intangibles				12	12		-	-
	Other				1,967	2,373		(406)	(17.1)
		Total noninterest expense			9,871	10,085		(214)	(2.1)
			Net income before provision for income taxes		6,269	5,534		735	13.3
Provision for income taxes					2,204	1,803		401	22.2
			Net income	$	4,065	3,731		334	9.0
Common and Per Share Data
	Net Income - basic			$	0.64	0.59		0.05	8.5
	Net Income - diluted				0.63	0.58		0.05	8.6
	Cash dividends				0.19	0.18		0.01	5.6
	Book value				16.49	14.73		1.76	11.9
	Weighted average common shares outstanding - basic				6,385,483	6,354,888
	Weighted average common shares outstanding - diluted				6,499,649	6,429,759

Net Interest Income. Net interest income is the difference between interest and fees on interest-earning assets, primarily loans and investment securities, and interest paid on interest-bearing deposits and other interest-bearing liabilities.  This measure represents the largest component of earnings for the Company. The net interest margin measures how effectively the Company manages the difference between the yield on interest-earning assets and the rate paid on funds to support those assets. Balances of interest-earning assets and successful management of the net interest margin determine the level of net interest income. Changes in interest rates earned on interest-earning assets and interest rates paid on interest-bearing liabilities, the rate of growth of the asset and liability base, the ratio of interest-earning assets to interest-bearing liabilities, and the management of interest rate sensitivity factor into changes in net interest income.

The following table summarizes the Company’s average balance sheets and net interest income analysis for the periods indicated (dollars in thousands). The Company's yield on interest-earning assets and cost of interest-bearing liabilities shown in the table are derived by dividing interest income and expense by the average balances of interest-earning assets or interest-bearing liabilities. The following table does not include a tax-equivalent adjustment to net interest income adjusting the yield for interest-earning assets earning tax-exempt income to a comparable yield on a taxable basis.

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				For the three month periods ended June 30,
				2007				2006
				Average	Income/	Yield/		Average	Income/	Yield/
				Balance	Expense	Rate		Balance	Expense	Rate
ASSETS
Interest-earnings assets
	Loans, net of unearned (1)			$            968,985	$         19,301	7.99	%	$            880,061	$     17,115	7.80	%
	Investment securities available for sale, nontaxable (2)			50,729	452	3.57		54,751	496	3.63
	Investment securities available for sale, taxable (2)			57,030	678	4.77		66,302	719	4.35
	Federal funds sold			19,054	227	4.78		29,869	393	5.28
	FHLB stock			2,525	38	6.04		3,106	46	5.94
		Total interest-earning assets		1,098,323	20,696	7.56		1,034,089	18,769	7.28
Noninterest-earning assets
	Cash and due from banks			29,073				44,193
	Allowance for loan losses			(8,443)				(8,743)
	Premises and equipment, net			24,982				23,432
	Goodwill			3,688				3,688
	Other intangible assets			109				156
	Accrued interest receivable			5,873				5,049
	Other			12,642				12,625
		Total noninterest-earning assets		67,924				80,400
			Total assets	$         1,166,247				$         1,114,489
LIABILITIES AND SHAREHOLDERS' EQUITY
Liabilities
Interest-bearing liabilities
	Transaction and money market deposit accounts			$            463,322	$           3,447	2.98	%	$            380,615	$       2,150	2.27	%
	Savings deposit accounts			41,950	36	0.34		46,535	38	0.33
	Time deposit accounts			361,285	3,954	4.39		393,891	3,841	3.91
		Total interest-bearing deposits		866,557	7,437	3.44		821,041	6,029	2.95
	Retail repurchase agreements			12,442	130	4.19		17,196	177	4.13
	Commercial paper (Master notes)			26,804	289	4.32		20,401	206	4.05
	Other short-term borrowings			3,570	54	6.07		1,135	7	2.47
	Long-term borrowings			8,242	78	3.80		20,571	182	3.55
		Total interest-bearing liabilities		917,615	7,988	3.49		880,344	6,601	3.01
Noninterest-bearing liabilities
	Noninterest-bearing deposits			134,599				134,161
	Accrued interest payable			2,468				2,212
	Other			6,342				4,147
		Total noninterest-bearing liabilities		143,409				140,520
		Total liabilities		1,061,024				1,020,864
Shareholders' equity				105,223				93,625
		Total liabilities and shareholders' equity		$         1,166,247				$         1,114,489
NET INTEREST INCOME / NET YIELD ON
	INTEREST-EARNING ASSETS				$         12,708	4.64	%		$     12,168	4.72	%
(1)	Calculated including mortgage loans held for sale.  Nonaccrual loans are included in average balances for yield computations.
	The effect of foregone interest income as a result of loans on nonaccrual was not considered in the above analysis.  All loans
	and deposits are domestic.
(2)	The average balances for investment securities include the unrealized gain or loss recorded for available for sale securities.

44

During the three month period ended June 30, 2007 compared with the same period of 2006, the Company experienced increases in both average yield on interest-earning assets and average cost of interest-bearing liabilities. The average yield on interest-earning assets increased 28 basis points to 7.56% during the second quarter of 2007 from 7.28% during the same period of 2006. The average cost of interest-bearing liabilities increased 48 basis points to 3.49% from 3.01% when comparing the same periods. Average interest-earning assets increased $64.2 million during the quarter ended June 30, 2007 over the same quarter of 2006, primarily within the loan portfolio, while interest-bearing liabilities increased $37.3 million over the same period. Rates paid during the three and six month periods ended June 30, 2007 increased from those paid for the three and six month periods ended June 30, 2006. The primary reason for this change is increases in the federal funds rate by the Federal Reserve Open Market Committee.

The following rate / volume analysis summarizes the dollar amount of changes in interest income and interest expense attributable to changes in volume and the amount attributable to changes in rate when comparing the three month period ended June 30, 2007 to the three month period ended June 30, 2006 (in thousands).  The impact of the combination of rate and volume change has been divided equally between the rate change and volume change.

			For the three month period ended June 30,
			2007 compared with the three month period
			ended June 30, 2006
			Volume		Rate	Total
Interest-earnings assets
	Loans, net of unearned		$	1,763	423	2,186
	Investment securities available for sale			(143)	58	(85)
	Federal funds sold			(132)	(34)	(166)
	FHLB stock			(9)	1	(8)
		Total interest-earning assets	$	1,479	448	1,927
Interest-bearing liabilities
	Interest-bearing deposits		$	348	1,060	1,408
	Retail repurchase agreements			(50)	3	(47)
	Commercial paper			68	15	83
	Other short-term borrowings			28	19	47
	Long-term borrowings			(118)	14	(104)
		Total interest-bearing liabilities	$	276	1,111	1,387
		NET INTEREST INCOME	$	1,203	(663)	540

Provision for Loan Losses. The Company’s process for determining an appropriate level for the Allowance is based on a comprehensive, well-documented, and consistently applied analysis of its loan portfolio. As discussed in Financial Condition, Allowance for Loan Losses, all significant factors that affect the collectibility of the portfolio and support the credit losses estimated are considered during this process. Once this monthly process is completed, a provision for loan losses is charged to earnings in order to maintain the Allowance at a level adequate to provide for estimated probable losses in the loan portfolio.

The provision for loan losses was $433 thousand and $535 thousand for the three month periods ended June 30, 2007 and 2006.  The percentage of allowance for loan losses was reduced to 0.86% of gross loans, excluding mortgage loans held for sale, outstanding at June 30, 2007 from 1.00% at June 30, 2006. See Financial Condition, Allowance for Loan Losses and Financial Condition, Loans contained herein for a discussion regarding the Company’s accounting policies related to, factors impacting, and methodology for analyzing the adequacy of the Company’s Allowance and the related provision for loan losses.

Noninterest Income.  Noninterest income during the three month period ended June 30, 2007 decreased $111 thousand, or 2.8%, to $3.9 million from $4.0 million during the three month period ended June 30, 2006 due to decreases in all noninterest income financial statement line items except other noninterest income. 

The Company sells most of the residential mortgage loans it originates in the secondary market with servicing rights retained. Mortgage loans serviced for the benefit of others amounted to $330.2 million, $325.1 million, and $312.8 million at June 30, 2007, December 31, 2006, and June 30, 2006, respectively.

Mortgage-banking income decreased $104 thousand, or 37.8%, during the three month period ended June 30, 2007 over the three month period ended June 30, 2006 primarily as a result of increased amortization, impairment, and recoveries between the periods. The following table summarizes the components of mortgage-banking income for the periods indicated (in thousands).

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Table of Contents

		For the three month
		periods ended June 30,
		2007		2006
Mortgage-servicing fees		$	206	192
Gain on sale of loans			157	132
Mortgage-serciving right amortization, impairment, and recoveries			(234)	(104)
Other mortgage-banking income			42	55
	Total mortgage-banking income	$	171	275

See Part I, Item 1. Financial Statements, Note 6 contained herein for a further discussion regarding the Company’s mortgage-servicing rights portfolio.

Noninterest Expense.  Noninterest expense during the three month period ended June 30, 2007 decreased $214 thousand, or 2.1%, to $9.9 million from $10.1 million during the three month period ended June 30, 2006. This decrease resulted primarily from decreases in marketing and other noninterest expense offset by an increase in salaries and other personnel expense.

Comprising 61.4% of noninterest expense during the three month period ended June 30, 2007 and 56.6% of noninterest expense during the three month period ended June 30, 2006, salaries and other personnel expense increased by $348 thousand to $6.1 million during the three month period ended June 30, 2007 from $5.7 million during the three month period ended June 30, 2006. The majority of the increase in salaries and other personnel expense resulted from annual merit raises for employees and officers and the addition of new officer positions including those positions created in connection with the opening of the new Boiling Springs banking office during 2006. 

Marketing and advertising expense decreased $113 thousand during the three month period ended June 30, 2007 compared with the three month period ended June 30, 2006 primarily due to marketing costs during the second quarter of 2006 in preparation of the Company’s 100-year anniversary celebration.

Other noninterest expense decreased $406 thousand during second quarter of 2007 when compared with the same quarter of 2006.  This decrease was the result of an accumulation of changes in several accounts, none of which were determined to be unusual or infrequent events or transactions or due to any significant economic changes that materially impacted the amount of reported income from continuing operations. 

Provision for Income Taxes. Income tax expense totaled $2.2 million for the three month period ended June 30, 2007 compared with $1.8 million for the three month period ended June 30, 2006.  The Company's effective tax rate was 35.2% during the 2007 period and 32.6% during the 2006 period.   In the Company’s Annual Report on Form 10-K for the year ended December 31, 2006, the Company reported that it anticipated the effective income tax rate applicable to current taxable income to approximate between 34% and 36% for 2007. Since December 31, 2006, there have been no events or conditions that management believes would change this projection.

For the Six Months Ended June 30, 2007

Overview. The following information is intended to supplement any information relating to the Consolidated Statements of Income contained within Part I, Item 1 of this Quarterly Report on Form 10-Q.   

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PALMETTO BANCSHARES, INC. AND SUBSIDIARY
Consolidated Statements of Income
(dollars in thousands, except common and per share data)
				For the six month periods
				ended June 30,			Variance
				2007		2006	$	%
				(unaudited)
Interest income
	Interest and fees on loans			$	38,067	33,568	4,499	13.4
	Interest on investment securities available for sale				2,301	2,464	(163)	(6.6)
	Interest on federal funds sold				451	586	(135)	(23.0)
	Dividends on FHLB stock				75	99	(24)	(24.2)
		Total interest income			40,894	36,717	4,177	11.4
Interest expense
	Interest on deposits				14,664	11,263	3,401	30.2
	Interest on retail repurchase agreements				276	351	(75)	(21.4)
	Interest on commercial paper				527	344	183	53.2
	Interest on other short-term borrowings				83	114	(31)	(27.2)
	Interest on long-term borrowings				173	382	(209)	(54.7)
		Total interest expense			15,723	12,454	3,269	26.2
			Net interest income		25,171	24,263	908	3.7
Provision for loan losses					800	1,050	(250)	(23.8)
			Net interest income after provision for loan losses		24,371	23,213	1,158	5.0
Noninterest income
	Service charges on deposit accounts				3,899	4,028	(129)	(3.2)
	Fees for trust and brokerage services				1,522	1,628	(106)	(6.5)
	Mortgage-banking income				519	497	22	4.4
	Investment securities gains				-	3	(3)	(100.0)
	Other				1,757	1,723	34	2.0
		Total noninterest income			7,697	7,879	(182)	(2.3)
Noninterest expense
	Salaries and other personnel				12,194	11,484	710	6.2
	Occupancy				749	754	(5)	(0.7)
	Furniture and equipment				903	935	(32)	(3.4)
	Premises and equipment leases and rentals				625	646	(21)	(3.3)
	Premises and equipment depreciation				986	1,022	(36)	(3.5)
	Marketing				487	738	(251)	(34.0)
	Amortization of core deposit intangibles				24	24	-	-
	Other				4,045	4,548	(503)	(11.1)
		Total noninterest expense			20,013	20,151	(138)	(0.7)
			Net income before provision for income taxes		12,055	10,941	1,114	10.2
Provision for income taxes					4,229	3,560	669	18.8
			Net income	$	7,826	7,381	445	6.0
Common and Per Share Data
	Net Income - basic			$	1.23	1.17	0.06	5.1
	Net Income - diluted				1.21	1.15	0.06	5.2
	Cash dividends				0.38	0.36	0.02	5.6
	Book value				16.49	14.73	1.76	11.9
	Weighted average common shares outstanding - basic				6,382,019	6,349,099
	Weighted average common shares outstanding - diluted				6,480,454	6,423,970

Net Interest Income.   The following table summarizes the Company’s average balance sheets and net interest income analysis for the periods indicated (dollars in thousands).

47

 

				For the six month periods ended June 30,
				2007				2006
				Average	Income/	Yield/		Average	Income/	Yield/
				Balance	Expense	Rate		Balance	Expense	Rate
ASSETS
Interest-earnings assets
	Loans, net of unearned (1)			$          960,302	$     38,067	7.99	%	$            874,118	$            33,568	7.74	%
	Investment securities available for sale, nontaxable (2)			49,251	876	3.59		54,979	993	3.64
	Investment securities available for sale, taxable (2)			61,334	1,425	4.69		68,493	1,471	4.33
	Federal funds sold			18,262	451	4.98		24,377	586	4.85
	FHLB stock			2,560	75	5.91		3,269	99	6.11
		Total interest-earning assets		1,091,709	40,894	7.55		1,025,236	36,717	7.22
Noninterest-earning assets
	Cash and due from banks			30,332				39,463
	Allowance for loan losses			(8,435)				(8,638)
	Premises and equipment, net			24,925				23,255
	Goodwill			3,688				3,688
	Other intangible assets			115				163
	Accrued interest receivable			5,916				5,078
	Other			13,273				12,726
		Total noninterest-earning assets		69,814				75,735
			Total assets	$       1,161,523				$         1,100,971
LIABILITIES AND SHAREHOLDERS' EQUITY
Liabilities
Interest-bearing liabilities
	Transaction and money market deposit accounts			$          455,404	$       6,627	2.93	%	$            365,361	$              3,745	2.07	%
	Savings deposit accounts			42,066	70	0.34		46,138	73	0.32
	Time deposit accounts			369,372	7,967	4.35		394,822	7,445	3.80
		Total interest-bearing deposits		866,842	14,664	3.41		806,321	11,263	2.82
	Retail repurchase agreements			13,154	276	4.23		18,204	351	3.89
	Commercial paper (Master notes)			24,540	527	4.33		18,221	344	3.81
	Other short-term borrowings			2,807	83	5.96		4,857	114	4.73
	Long-term borrowings			9,116	173	3.83		21,779	382	3.54
		Total interest-bearing liabilities		916,459	15,723	3.46		869,382	12,454	2.89
Noninterest-bearing liabilities
	Noninterest-bearing deposits			132,857				132,898
	Accrued interest payable			2,469				2,097
	Other			6,058				4,155
		Total noninterest-bearing liabilities		141,384				139,150
		Total liabilities		1,057,843				1,008,532
Shareholders' equity				103,680				92,439
		Total liabilities and shareholders' equity		$       1,161,523				$         1,100,971
NET INTEREST INCOME / NET YIELD ON
	INTEREST-EARNING ASSETS				$     25,171	4.65	%		$            24,263	4.77	%
(1)	Calculated including mortgage loans held for sale.  Nonaccrual loans are included in average balances for yield computations.
	The effect of foregone interest income as a result of loans on nonaccrual was not considered in the above analysis.  All loans
	and deposits are domestic.
(2)	The average balances for investment securities include the unrealized gain or loss recorded for available for sale securities.

48

 

During the six month period ended June 30, 2007 compared with the same period of 2006, the Company experienced increases in both average yields on interest-earning assets and average cost of interest-bearing liabilities. The average yield on interest-earning assets increased 33 basis points to 7.55% during the six month period ended June 30, 2007 from 7.22% during the same period of 2006. The average cost of interest-bearing liabilities increased 57 basis points to 3.46% from 2.89% when comparing the same periods. Average interest-earning assets increased $66.5 million during the six month period ended June 30, 2007 over the same period of 2006, primarily within the loan portfolio, while interest-bearing liabilities increased $47.1 million over the same period. Rates paid during the three and six month periods ended June 30, 2007 increased from those paid for the three and six month periods ended June 30, 2006. The primary reason for this change is increases in the federal funds rate by the Federal Reserve Open Market Committee.

The following rate / volume analysis summarizes the dollar amount of changes in interest income and interest expense attributable to changes in volume and the amount attributable to changes in rate when comparing the six month period ended June 30, 2007 to the six month period ended June 30, 2006 (in thousands).  The impact of the combination of rate and volume change has been divided equally between the rate change and volume change.

			For the six month period ended June 30,
			2007 compared with the six month period
			ended June 30, 2006
			Volume		Rate	Total
Interest-earnings assets
	Loans, net of unearned		$	3,390	1,109	4,499
	Investment securities available for sale			(276)	113	(163)
	Federal funds sold			(151)	16	(135)
	FHLB stock			(21)	(3)	(24)
		Total interest-earning assets	$	2,942	1,235	4,177
Interest-bearing liabilities
	Interest-bearing deposits		$	892	2,509	3,401
	Retail repurchase agreements			(110)	35	(75)
	Commercial paper			131	52	183
	Other short-term borrowings			(83)	52	(31)
	Long-term borrowings			(243)	34	(209)
		Total interest-bearing liabilities	$	587	2,682	3,269
		NET INTEREST INCOME	$	2,355	(1,447)	908

Provision for Loan Losses. The provision for loan losses was $800 thousand and $1.1 million for the six-month periods ended June 30, 2007 and 2006.  The percentage of allowance for loan losses was reduced to 0.86% of gross loans, excluding mortgage loans held for sale, outstanding at June 30, 2007 from 1.00% at June 30, 2006. See Financial Condition, Allowance for Loan Losses and Financial Condition, Loans contained herein for a discussion regarding the Company’s accounting policies related to, factors impacting, and methodology for analyzing the adequacy of the Company’s Allowance and the related provision for loan losses.

Noninterest Income. Noninterest income during the six month period ended June 30, 2007 decreased $182 thousand, or 2.3%, to $7.7 million from $7.9 million during the six month period ended June 30, 2006 due to changes in several accounts, none of which constituted material fluctuations.

Noninterest Expense.  Noninterest expense during the six month period ended June 30, 2007 decreased $138 thousand, or 0.7%, to $20.0 million from $20.2 million during the six month period ended June 30, 2006. This decrease resulted primarily from decreases in marketing and other noninterest expense offset by an increase in salaries and other personnel expense.

Comprising 60.9% of noninterest expense during the six month period ended June 30, 2007 and 57.0% of noninterest expense during the six month period ended June 30, 2006, salaries and other personnel expense increased by $710 thousand to $12.2 million during the six month period ended June 30, 2007 from $11.5 million during the six month period ended June 30, 2006. The majority of the increase in salaries and other personnel expense resulted from annual merit raises for employees and officers and the addition of new officer positions including those positions created in connection with the opening of the new Boiling Springs banking office during 2006. 

Marketing and advertising expense decreased $251 thousand during the six month period ended June 30, 2007 compared with the six month period ended June 30, 2006 primarily due to marketing costs during the second quarter of 2006 in preparation of the Company’s 100-year anniversary celebration.

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Other noninterest expense decreased $503 thousand during the six month period ended June 30, 2007 when compared with the same period of 2006. 

During the second quarter of 2006, as a result of a software upgrade, the Company experienced a temporary delay in check processing and electronic check processing.  At December 31, 2006, the Bank had exposure of, and reserved for in Other Noninterest Expense in the Consolidated Statements of Income, approximately $174 thousand related to items uncollected at that date.  At the end of the first quarter of 2007, the Bank believed it had collected virtually all of these items.  As such, this reserve was reversed within other noninterest expense during the first quarter of 2007. Although items have continued to settle since the first quarter of 2007, the Company believes that the items will net to an immaterial amount when settlement is completed.  As such, no reserve was recorded in its financial statements at June 30, 2007. 

The remaining decrease in other noninterest expense was the result of an accumulation of changes in several accounts, none of which were determined to be unusual or infrequent events or transactions or due to any significant economic changes that materially impacted the amount of reported income from continuing operations. 

Provision for Income Taxes. Income tax expense totaled $4.2 million for the six month period ended June 30, 2007 compared with $3.6 million for the six month period ended June 30, 2006.  The Company’s effective tax rate was 35.1% during the 2007 period and 32.5% during the 2006 period.   In the Company’s Annual Report on Form 10-K for the year ended December 31, 2006, the Company reported that it anticipated the effective income tax rate applicable to current taxable income to approximate between 34% and 36% for 2007. Since December 31, 2006, there have been no events or conditions that management believes would change this projection.

Accounting and Reporting Matters

See Part I, Item 1. Financial Statements, Note 1 contained herein for further discussion regarding recently adopted and recently issued accounting pronouncements and their expected impact on the Company.

Item 3.  Quantitative and Qualitative Disclosures about Market Risk

The Company has risk management policies and systems which attempt to monitor and limit exposure to interest rate risk. Specifically, the Company manages its exposure to fluctuations in interest rates through policies established by its Asset / Liability Committee and approved by its Board of Directors. The primary goal of the Asset / Liability Committee is to monitor and limit exposure to interest rate risk through implementation of various strategies. While the Asset / Liability Committee considers these strategies to ultimately position the balance sheet to minimize fluctuations in income associated with interest rate risk, it also monitors the Company’s liquidity and capital positions to ensure that its strategies result in adequate capital positions. The Company’s primary source of capital has been the retention of net income. In order to ensure adequate levels of capital, an ongoing assessment is conducted of projected sources and uses of capital in conjunction with projected increases in assets and the level of risk. Management believes it has adequate capital to meet its needs without entering capital markets.

Market risk sensitive instruments are generally defined as derivatives and other financial instruments. At June 30, 2007, the Company had not used any derivatives to alter its interest rate risk profile. The Company’s financial instruments include loans, federal funds sold, FHLB stock, investment securities, deposits, and borrowings. At June 30, 2007, the Company’s interest-sensitive assets totaled approximately $1.1 billion while interest-sensitive liabilities totaled approximately $929.0 million. At December 31, 2006, the Company’s interest-sensitive assets totaled approximately $1.1 billion while interest-sensitive liabilities totaled approximately $911.4 million.

The yield on interest-sensitive assets and the cost of interest-sensitive liabilities for the three month period ended June 30, 2007 was 7.58% and 3.49%, respectively, compared to 7.28% and 3.01%, respectively, for the same period of 2006. The yield on interest-sensitive assets and the cost of interest-sensitive liabilities for the six month period ended June 30, 2007 was 7.57% and 3.46%, respectively, compared to 7.22% and 2.89%, respectively, for the same period of 2006. The increase in the yield on interest-sensitive assets and the cost of interest-sensitive liabilities during both the three and six month periods ended June 30, 2007 over the same periods of 2006 resulted primarily from  increases in the federal funds rate by the Federal Reserve Open Market Committee.

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Table of Contents

The Company evaluated the results of its net interest income simulation prepared as of June 30, 2007 for interest rate risk management purposes. Overall, the model results indicate that the Company’s interest rate risk sensitivity is within limits set by the Company’s guidelines and the Company’s balance sheet is liability sensitive. A liability sensitive balance sheet suggests that in falling interest rate environment, net interest margin would increase and during an increasing interest rate environment, net interest margin would decrease.

Net Interest Income Simulation

The following table summarizes forecasted net interest income and net interest margin as of June 30, 2007 using a base market rate and the estimated change to the base scenario given upward and downward movement in interest rates of 100 basis points and 200 basis points (dollars in thousands).

							Net
							interest
							margin
	Adjusted		Percentage		Net		change
	net interest		change from		interest		(in basis
Interest rate scenario	income		base		margin		points)
Up 200 basis points	$	49,930	(4.27)	%	4.52	%	(0.20)
Up 100 basis points		52,111	(0.08)		4.72		-
BASE CASE		52,155	-		4.72		-
Down 100 basis points		56,086	7.54		5.08		0.36
Down 200 basis points		57,860	10.94		5.24		0.52

The simulation results as of June 30, 2007 indicate the Company’s interest rate risk position was liability sensitive as the simulated impact of a downward movement in interest rates of 100 basis points would result in a 7.54% increase in net interest income over the subsequent 12 month period while an upward movement in interest rates of 100 basis points would result in a 0.08% decrease in net interest income over the next 12 months. The simulation results indicate that a 100 basis point downward shift in interest rates would result in a 36 basis point increase in net interest margin, assuming all other variables remained unchanged. Conversely, a 100 basis point increase in interest rates would cause no change in net interest margin. The projected negative impact on the Company’s net interest income for the twelve month period does not exceed the 20% threshold prescribed by the Asset – Liability Committee’s policy. 

Item 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

An evaluation of the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) promulgated under the Securities Exchange Act of 1934) was carried out under the supervision and with the participation of the Company’s Chief Executive Officer, the President and Chief Operating Officer (Principal Financial Officer) and several other members of the Company’s senior management as of June 30, 2007, the last day of the period covered by this Quarterly Report. The Company’s Chief Executive Officer and the President and Chief Operating Officer (Principal Financial Officer) concluded that the Company’s disclosure controls and procedures were effective as of June 30, 2007 in ensuring that the information required to be disclosed by the Company in the reports it files or submits under the Securities Exchange Act of 1934 is (i) accumulated and communicated to the Company’s management (including the Chief Executive Officer and the President and Chief Operating Officer (Principal Financial Officer)) in a timely manner, and is (ii) recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms.

During the second quarter of 2007, the Company did not make any changes in its internal controls over financial reporting that has materially affected or is reasonably likely to materially affect those controls.

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PART II – OTHER INFORMATION

Any item which is inapplicable or to which the answer is negative has been omitted and no reference thereto has been made in this report.

Item 1. Legal Proceedings

See Part I, Item 1. Financial Statements, Note 14 contained herein for a discussion of the information required by this item.

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

The Company's Annual Meeting of Shareholders was held on April 17, 2007.  4,591,962 shares were voted of the 6,379,805 shares of $5 par value common stock entitled to vote at the Annual Shareholders' Meeting. 

Proposal #1 - Election of Directors.  The Board of Directors is divided into three classes. At each Annual Meeting of Shareholders, the Company's shareholders elect the members of one of the three classes to three-year terms. At this Annual Meeting, four directors were nominated for reelection for terms expiring at the 2010 Annual Meeting of Shareholders and three Directors were nominated for terms expiring at each of the 2008, 2009, and 2010 Annual Meeting of Shareholders. The nominees included Jane S. Sosebee who was appointed to a Board term expiring at the 2008 Meeting by action of the Board of Directors in September 2006, L. Stewart Spinks who was appointed to a Board term expiring at the 2009 Meeting by action of the Board of Directors in June 2006 to fill the vacancy created by the death of William S. Moore, II during the first quarter of 2005, and Albert V. Smith who was appointed to a Board term expiring at the 2010 Meeting by action of the Board of Directors in September 2006. 

	Annual Meeting of Shareholders at Which Term Expires	Number of Votes For	Number of Votes Withheld
Jane S. Sosebee	2008	4,591,662	300
L. Stewart Spinks	2009	4,591,062	900
Albert V. Smith	2010	4,443,799	148,163
Michael D. Glenn	2010	4,590,428	1,534
Ann B. Smith	2010	4,591,662	300
W. Fred Davis, Jr.	2010	4,577,637	14,325
David P. George, Jr.	2010	4,586,278	5,684

The following directors' term of office continued after the meeting: John T. Gramling, II, John D. Hopkins, Jr., L. Leon Patterson, Sam B. Phillips, Jr., E. Keith Snead, III, Paul W. Stringer, and J. David Wasson, Jr.

Item 6.  Exhibits

10.1         Lease Agreement dated as of May 2, 2007, by and between The Palmetto Bank and Charles E. Howard and Doris H. Howard (incorporated by reference from Exhibit 10.1 of Palmetto Bancshares Inc.’s Current Report on Form 8-K filed on June 26, 2007) (File no. 000-26016).

31.1         L. Leon Patterson's Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

31.2         Paul W. Stringer's Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

32            Certifications Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

Exhibits 31.1, 31.2, and 32 have been filed with the Securities and Exchange Commission in conjunction with this Quarterly Report on Form 10-Q. Copies of these exhibits are available upon written request to Lauren S. Greer, The Palmetto Bank, Post Office Box 49, Laurens, South Carolina 29360.

52

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.

PALMETTO BANCSHARES, INC.

/s/      L. Leon Patterson                          

 L. Leon Patterson

 Chairman and Chief Executive Officer

/s/      Paul W. Stringer                                         

 Paul W. Stringer

 President and Chief Operating Officer

 (Principal Financial Officer)

Dated:   August 9, 2007

53

EX-31.1

Exhibit 31.1

CERTIFICATION

I, L. Leon Patterson, certify that: 

1.	I have reviewed this quarterly report on Form 10-Q of Palmetto Bancshares, 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 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(s) 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)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) 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.	Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;
		c.	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
		d.	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(s) 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 the 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.

/s/      L. Leon Patterson                          

L. Leon Patterson

Chairman and Chief Executive Officer

Dated: August 9, 2007

EX-31.2

Exhibit 31.2

CERTIFICATION

I, Paul W. Stringer, certify that: 

1.	I have reviewed this quarterly report on Form 10-Q of Palmetto Bancshares, 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 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(s) 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)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) 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.	Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;
		c.	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
		d.	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(s) 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 the 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.

/s/      Paul W. Stringer                          

Paul W. Stringer

President and Chief Operating Officer

(Principal Financial Officer)

Dated: August 9, 2007

EX-32

Exhibit 32

CERTIFICATION OF PRINCIPAL EXECUTIVE OFFICER AND PRINCIPAL FINANCIAL OFFICER OF PALMETTO BANCSHARES, INC. PURSUANT TO 18 U.S.C. SECTION 1350

The undersigned, as the chief executive officer and principal financial officer of Palmetto Bancshares, Inc., certify that the Quarterly Report on Form 10-Q for the period ended June 30, 2007, which accompanies this certification, fully complies with the requirements of Section 13(a) or 15(d), as applicable, of the Securities Exchange Act of 1934, and that the information contained in the periodic report fairly presents, in all material respects, the financial condition and results of operations of Palmetto Bancshares, Inc. at the dates and for the periods indicated.  The foregoing certification is made pursuant to § 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. § 1350) and no purchaser or seller of securities or any other person shall be entitled to rely upon the foregoing certification for any purpose.  The undersigned expressly disclaims any obligation to update the foregoing certification except as required by law.

/s/      L. Leon Patterson                          

 L. Leon Patterson

 Chairman and Chief Executive Officer

/s/      Paul W. Stringer                                              

 Paul W. Stringer

 President and Chief Operating Officer

Principal Financial Officer

Dated:   August 9, 2007