Citizens South Banking 10-Q 2007 Q3 Quarterly report

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

þ Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the quarterly period ended September 30, 2007

OR

o Transitional report pursuant to Section 13 or 15 (d) of the Securities Exchange Act of 1934

For the transition period from ______ to ______

Commission File Number 0-23971

Citizens South Banking Corporation

(Exact name of registrant as specified in its charter)

Delaware	54-2069979
(State or other jurisdiction of	(I.R.S. Employer Identification Number)
incorporation or organization)
519 South New Hope Road, Gastonia, NC	28054
(Address of principal executive offices)	(Zip Code)

(704) 868-5200

(Registrant's telephone number, including area code)

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ  No o

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. (Check one):

Large accelerated filer o Accelerated filer þ  Non-accelerated filer o

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act.)

Yes oNo þ

Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date.

Common stock, $0.01 par value

7,724,432 shares outstanding as of November 6, 2007

Citizens South Banking Corporation

Index

		Page
PART I. — Financial Information
Item 1.	Condensed Consolidated Financial Statements:
Condensed Consolidated Statements of Financial Condition September 30, 2007 and December 31, 2006		1
Condensed Consolidated Statements of Operations for the Three and Nine Months Ended September 30, 2007 and 2006		2
Condensed Consolidated Statements of Comprehensive Income for the Nine Months Ended September 30, 2007 and 2006...		3
Condensed Consolidated Statements of Changes in Stockholders’ Equity for the Nine Months Ended September 30, 2007 and 2006		4
Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2007 and 2006		5
Notes to Condensed Consolidated Financial Statements		6
Item 2.	Management's Discussion and Analysis of Financial Condition and Results of Operations	9
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	19
Item 4.	Controls and Procedures	19
PART II — Other Information		20
Item 1.	Legal Proceedings	20
Item 1A.	Risk Factors	20
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	20
Item 3.	Defaults Upon Senior Securities	20
Item 4.	Submission of Matters to a Vote of Security Holders	20
Item 5.	Other Information	21
Item 6.	Exhibits	21
Signatures		21

PART I.FINANCIAL INFORMATION

ITEM 1.  Condensed Consolidated Financial Statements

Citizens South Banking Corporation

Condensed Consolidated Statements of Financial Condition

(dollars in thousands, except per share data)

	September 30,			December 31,
	2007			2006
	(unaudited)
Assets:
Cash and cash equivalents:
Cash and due from banks	$	10,633		$	17,581
Interest-earning bank balances		960			8,433
Fed funds sold		67			207
Total cash and cash equivalents		11,660			26,221
Investment securities available-for-sale, at fair value		61,537			65,326
Mortgage-backed and related securities available-for-sale, at fair value		66,284			60,691
Loans:
Loans receivable, net of unearned income		548,026			515,402
Allowance for loan losses		(6,292	)		(5,764	)
Net loans		541,734			509,638
Other real estate owned		636			139
Premises and equipment, net		18,122			18,287
Accrued interest receivable		3,712			3,236
Federal Home Loan Bank stock		3,786			3,581
Intangible assets		31,183			31,666
Cash value of bank-owned life insurance policies		15,926			15,527
Other assets		6,407			9,058
Total assets	$	760,987		$	743,370
Liabilities and Stockholders’ Equity:
Deposits:
Demand deposit accounts	$	93,159		$	90,540
Money market deposit accounts		124,304			117,632
Savings accounts		12,901			16,027
Time deposits		341,750			338,603
Total deposits		572,114			562,802
Borrowed money		95,983			85,964
Deferred compensation		5,300			5,723
Other liabilities		3,212			2,920
Total liabilities		676,609			657,409
Stockholders’ Equity:
Preferred stock, 10,000,000 shares authorized, none issued		-			-
Common stock, $0.01 par value, 20,000,000 shares authorized;
Issued: 9,062,727 shares;
Outstanding: 7,769,732 shares in 2007 and 8,111,659 shares in 2006		91			91
Additional paid-in-capital		67,560			67439
Unallocated common stock held by Employee Stock Ownership Plan		(1,293	)		(1,430	)
Retained earnings		35,315			33,031
Accumulated other comprehensive loss, net of deferred income taxes		(996	)		(991	)
Treasury stock of 1,292,995 shares at September 30, 2007, and
951,068 shares at December 31, 2006, at cost		(16,299	)		(12,179	)
Total stockholders’ equity		84,378			85,961
Total liabilities and stockholders’ equity	$	760,987		$	743,370

See notes to condensed consolidated financial statements.

1

Citizens South Banking Corporation

Condensed ConsolidatedStatements of Operations (unaudited)

(in thousands, except per share data)

	Three Months				Nine Months
	Ended September 30,				Ended September 30,
	2007		2006		2007		2006
Interest Income:
Loans	$	10,377	$	9,804	$	30,331	$	27,501
Investment securities		710		467		2,070		1,458
Interest-bearing deposits		73		210		342		487
Mortgage-backed and related securities		783		644		2,150		2,027
Total interest income		11,943		11,125		34,893		31,473
Interest Expense:
Deposits		5,741		4,858		16,672		12,802
Borrowed funds		1,099		1,065		2,999		3,156
Total interest expense		6,840		5,923		19,671		15,958
Net interest income		5,103		5,202		15,222		15,515
Provision for loan losses		300		300		960		865
Net interest income after provision for loan losses		4,803		4,902		14,262		14,650
Noninterest Income:
Fee income on deposit accounts		680		742		2,026		2,157
Mortgage banking income		239		213		749		406
Income on lending activities		116		146		358		458
Dividends on FHLB stock		53		58		149		169
Increase in cash value of bank-owned life insurance		191		166		578		580
Fair value adjustment on deferred compensation assets		52		101		110		143
Life insurance proceeds, net		-		-		112		-
Net gain (loss) on sale of assets		-		8		336		(40	)
Other noninterest income		203		209		633		553
Total noninterest income		1,534		1,643		5,051		4,426
Noninterest Expense:
Compensation and benefits		2,461		2,281		7,167		6,861
Fair value adjustment on deferred comp. obligations		52		101		110		143
Occupancy and equipment expense		661		610		2,001		1,990
Professional services		127		116		403		420
Amortization of intangible assets		156		186		483		558
Impairment of securities		-		-		162		-
Merger and integration expenses		-		-		-		57
Other noninterest expense		1,097		1,094		3,130		3,186
Total noninterest expense		4,554		4,388		13,456		13,215
Income before income taxes		1,783		2,157		5,857		5,861
Provision for income taxes		434		719		1,519		1,889
Net income	$	1,349	$	1,438	$	4,338	$	3,972
Net income per common share:
Basic	$	0.18	$	0.18	$	0.56	$	0.49
Diluted	$	0.18	$	0.18	$	0.55	$	0.49
Weighted average common shares outstanding:
Basic		7,627,620		8,019,286		7,748,605		8,042,271
Diluted		7,691,722		8,095,750		7,817,438		8,119,781

See notes to condensed consolidated financial statements.

2

Citizens South Banking Corporation

Condensed ConsolidatedStatements of Comprehensive Income (unaudited)

(dollars in thousands)

	Nine Months
	Ended September 30,
	2007			2006
Net income	$	4,338		$	3,972
Items of other comprehensive (gains) losses:
Items of other comprehensive (gains) losses, before tax
Unrealized holding (gains) losses arising during period		(88	)		458
Reclassification adjustment for securities losses included in net income		79			(93	)
Other comprehensive (gain) loss, before tax		(9	)		365
Change in deferred income taxes related to change in unrealized gains or losses
on securities available for sale		4			(131	)
Items of other comprehensive (gains) losses, net of tax		(5	)		234
Comprehensive income	$	4,333		$	4,206

See notes to condensed consolidated financial statements.

3

Citizens South Banking Corporation

Condensed ConsolidatedStatements of Changes in Stockholders’ Equity (unaudited)

(dollars in thousands)

	Nine Months
	Ended September 30,
	2007			2006
Common stock, $0.01 par value:
At beginning of period	$	91		$	91
Issuance of common stock		-			-
At end of period		91			91
Additional paid-in-capital:
At beginning of period		67,439			67,049
Grant of additional shares from RRP		(128	)		-
Vesting of shares for RRP		226			210
Stock-based compensation expense		23			18
At end of period		67,560			67,277
Unallocated common stock held by ESOP:
At beginning of period		(1,430	)		(1,613	)
Allocation from shares purchased with loan from ESOP		137			137
At end of period		(1,293	)		(1,476	)
Retained earnings, substantially restricted:
At beginning of period		33,031			30,311
Net income		4,338			3,972
Exercise of options		(199	)		(324	)
Dividends paid		(1,855	)		(1,803	)
At end of period		35,315			32,156
Accumulated unrealized loss on securities available for sale, net of tax:
At beginning of period		(991	)		(1,567	)
Other comprehensive income, net of tax		(5	)		234
At end of period		(996	)		(1,333	)
Treasury stock:
At beginning of period		(12,179	)		(10,013	)
Grant of additional shares from RRP		128			-
Exercise of options		283			459
Purchase of common stock for treasury		(4,531	)		(1,385	)
At end of period		(16,299	)		(10,939	)

See notes to condensed consolidated financial statements.

4

Citizens South Banking Corporation

Condensed ConsolidatedStatements of Cash Flows (unaudited)

(dollars in thousands)

	Nine Months
	Ended September 30,
	2007			2006
Cash flows from operating activities:
Net income	$	4,338		$	3,972
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for loan losses		960			865
Depreciation		886			1,014
Impairment on investment securities		162			-
Net gain on sale of investment securities		(1	)		(93	)
Net loss on sale of mortgage-backed securities		80			-
Net gain on sale of loans		(5	)		-
Net loss on sale of other real estate owned		9			103
Net (gain) loss on sale of premises and equipment		(419	)		30
Deferred loan origination fees		(69	)		(45	)
Allocation of shares to the ESOP		137			137
Stock-based compensation expense		23			18
Vesting of shares for the Recognition and Retention Plan		226			210
Increase in accrued interest receivable		(476	)		(615	)
Amortization of intangible assets		483			558
(Increase) decrease in other assets		1,567			(222	)
Increase (decrease) in other liabilities		(358	)		576
Net cash provided by operating activities		7,543			6,508
Cash flows from investing activities:
Net increase in loans		(33,184	)		(45,240	)
Proceeds from the sale of investment securities		3,000			98
Proceeds from the sale of mortgage-backed securities		3,364			-
Proceeds from the sale of loans		202			-
Proceeds from the sale of other real estate owned		233			1,012
Proceeds from the sale premise and equipment		801			28
Maturities and prepayments of investment securities		9,987			5,977
Maturities and prepayments of mortgage-backed securities		9,608			11,698
Purchases of investments		(9,805	)		(242	)
Purchases of mortgage-backed securities		(18,208	)		-
(Purchases) sale of FHLB stock		(205	)		435
Capital expenditures for premises and equipment		(1,153	)		(232	)
Net cash used in investment activities		(35,360	)		(26,466	)
Cash flows from financing activities:
Net increase in deposits		9,312			31,455
Exercise of options		84			135
Dividends paid		(1,855	)		(1,803	)
Purchase of common stock for treasury		(4,531	)		(1,385	)
Net increase (decrease) in borrowed money		10,018			(8,996	)
Increase in advances from borrowers for insurance and taxes		228			261
Net cash provided by financing activities		13,256			19,667
Net decrease in cash and cash equivalents		(14,561	)		(291	)
Cash and cash equivalents at beginning of period		26,221			26,653
Cash and cash equivalents at end of period	$	11,660		$	26,362

See notes to condensed consolidated financial statements.

5

CITIZENS SOUTH BANKING CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Note 1 - Basis of Presentation

The condensed consolidated financial statements of Citizens South Banking Corporation (the “Company”) are unaudited and reflect all adjustments of a normal recurring nature which are, in the opinion of management, necessary for a fair presentation of the interim period financial statements as of and for the three- and nine-month periods ended September 30, 2007 and 2006. Amounts as of December 31, 2006 included in the condensed consolidated financial statements and related notes were derived from the audited consolidated financial statements. Results for the three- and nine-month periods ended September 30, 2007, are not necessarily indicative of the results that may be expected for future periods, including the year ending December 31, 2007.

The unaudited condensed consolidated financial statements of the Company have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission, including Rule 10-01 of Regulation S-X. Accordingly, certain information normally included in financial statements prepared in conformity with accounting principles generally accepted in the United States of America have been condensed or omitted. These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto in the Company’s Annual Report on Form 10-K for the year ended December 31, 2006 (the “Annual Report”).

The condensed consolidated financial statements include the accounts of Citizens South Banking Corporation and the Company’s wholly owned subsidiary, Citizens South Bank (the “Bank”).

Note 2 - Earnings per Share

Basic earnings per share is calculated by dividing net income by the weighted average number of common shares outstanding. Diluted earnings per share is calculated by dividing net income by the sum of the weighted average number of common shares outstanding and potential common stock. Potential common stock consists of additional common stock that would have been outstanding as a result of the exercise of dilutive stock options. In determining the number of shares of potential common stock, the treasury stock method was applied. This method assumes that the number of shares issuable upon exercise of the stock options is reduced by the number of common shares assumed purchased at market prices with the proceeds from the assumed exercise of the common stock options plus any tax benefits received as a result of the assumed exercise. The following is a summary of the diluted earnings per share calculation for the three and nine months ended September 30, 2007 and 2006:  

	Three Months Ended				Nine Months Ended
	September 30,				September 30,
	2007		2006		2007		2006
	(dollars in thousands, except per share amounts)
Net income	$	1,349	$	1,438	$	4,338	$	3,972
Weighted average shares outstanding		7,627,620		8,019,286		7,748,605		8,042,271
Dilutive effect of stock options		64,102		76,464		68,833		77,510
Weighted average diluted shares outstanding ...		7,691,722		8,095,750		7,817,438		8,119,781
Diluted earnings per share	$	0.18	$	0.18	$	0.55	$	0.49

For the periods ended September 30, 2007 and 2006, there were 571,751 and 553,482 shares, respectively, attributed to stock options that were excluded from the calculation of diluted earnings per share because their inclusion would have been anti-dilutive because the average market price of the stock was below the strike price on these options.

6

Note 3 - Commitments to Extend Credit

Commitments to extend credit are agreements to lend as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since commitments may expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. These commitments represent no more than normal lending risk that the Bank commits to its borrowers and management believes that these commitments can be funded through normal operations. Commitments to extend credit that include both fixed and variable rates are as follows:

	September 30, 2007		December 31, 2006
Loan commitments:
Residential mortgage loans	$	9,541,000	$	6,193,000
Non-residential mortgage loans		14,874,000		34,842,000
Commercial loans		170,000		1,535,000
Consumer loans		4,602,000		3,857,000
Total loan commitments	$	29,187,000	$	46,427,000
Unused lines of credit:
Commercial	$	39,903,000	$	43,424,000
Consumer		69,103,000		61,912,000
Total unused lines of credit	$	109,006,000	$	105,336,000
Undisbursed construction loan proceeds	$	3,663,000	$	8,472,000

Note 4 - Dividend Declaration

On October 22, 2007, the Board of Directors of the Company approved and declared a regular cash dividend of eight cents ($0.08) per share of common stock to stockholders of record as of November 1, 2007, payable on November 15, 2007.

Note 5 - Stock Repurchase Program

On January 22, 2007, the Board of Directors of the Company authorized the repurchase of up to 400,000 shares, or approximately 5% of the Company’s then outstanding shares of common stock. These repurchases may be carried out through open market purchases, block trades, and negotiated private transactions. The stock may be repurchased on an ongoing basis and will be subject to the availability of stock, general market conditions, the trading price of the stock, alternative uses for capital, and the Company’s financial performance. Under this plan the Company had repurchased a total of 343,448 shares at an average price of $12.90 per share and had 56,552 shares remaining to be repurchased at September 30, 2007. The Company will consider repurchasing additional shares of common stock of the Company at prices management considers to be attractive and in the best interests of both the Company and its stockholders. Any repurchased shares will be held as treasury stock and will be available for general corporate purposes.

Note 6 - Subsequent Events

On October 22, 2007, the Board of Directors authorized the repurchase of up to 200,000 shares, or approximately 2.5% of the Company’s then outstanding shares of stock upon completion of the current stock repurchase program described in Note 5 above. These repurchases may be carried out through open market purchases, block trades, and negotiated private transactions. The stock may be repurchased on an ongoing basis and will be subject to the availability of stock, general market conditions, the trading price of the stock, alternative uses for capital, and the Company’s financial performance. The Company will consider repurchasing additional shares of common stock of the Company at prices management considers to be attractive and in the best interests of both the Company and its stockholders. Any repurchased shares will be held as treasury stock and will be available for general corporate purposes.

7

Note 6 - Recent Accounting Pronouncements

The following is a summary of recent authoritative pronouncements that could impact the accounting, reporting, and/or disclosure of financial information by the Company.

In September 2006, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 157, “Fair Value Measurements” (“SFAS No. 157”), which enhances existing guidance for measuring assets and liabilities using fair value and requires additional disclosure about the use of fair value for measurement. This Statement does not require any new fair value measurements. SFAS No. 157 is effective for the Company January 1, 2008. The Company is currently evaluating the impact of the adoption of SFAS No. 157 on its financial position and results of operations, including the valuation methods and support for the assumptions that underlie the valuation.

In February 2007, FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS No. 159”), which permits entities to choose and measure many financial instruments and certain other items at fair value. The objective of this Statement is to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. This Statement is effective for fiscal years beginning after November 15, 2007, with early adoption permitted under certain circumstances. The Company has chosen not to early adopt the provisions of SFAS No. 159, so this Statement will be effective for the Company on January 1, 2008. The Company has evaluated this statement and does not believe it will have a material effect on the Company’s consolidated financial statements.

In September 2006, the Emerging Issues Task Force issued EITF Issue 06-4, “Accounting for Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements” (“EITF Issue 06-4”). EITF Issue 06-4 requires that for endorsement split-dollar insurance arrangements that provide a benefit to an employee that extends to postretirement periods, an employer should recognize a liability for future benefits in accordance with SFAS No. 106 or APB No. 12 based on the substantive agreement of the employee. If the employee has effectively agreed to maintain a life insurance policy during postretirement periods, the costs of the life insurance policy during the postretirement periods should be accrued in accordance with either SFAS No. 106 or APB No. 12. If the employer has agreed to provide a death benefit, the employer should recognize a liability for the future death benefit in accordance with either SFAS No. 106 or APB No. 12. EITF Issue 06-4 is effective for fiscal years beginning after December 15, 2007. The Company is currently evaluating the impact of EITF Issue 06-4 on its financial position and results of operations.

In June 2007, the FASB ratified the consensus reached by the EITF on Issue No. 06-11, “Accounting for Income Tax Benefits of Dividends on Share-Based Payment Awards” to provide guidance on how an entity should recognize the income tax benefit received on dividends that are paid to employees holding certain types of shares or options and are charged to retained earnings under Statement 123(R). This issue will be applied for the Company beginning January 1, 2008. The Company is currently evaluating the impact of EITF Issue 06-11 on its financial position and results of operations.

8

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

Forward Looking Statements

This report contains certain forward-looking statements that represent the Company's expectations or beliefs concerning future events. Such forward-looking statements are based on our current beliefs and expectations and are inherently subject to significant business, economic, and competitive uncertainties and contingencies, many of which are beyond our control. These forward-looking statements are based on assumptions with respect to future business strategies and decisions that are subject to change based on changes in the economic and competitive environment in which we operate. Forward-looking statements speak only as of the date they are made and the Company is under no duty to update these forward-looking statements or to reflect the occurrence of unanticipated events. A number of factors could cause actual conditions, events, or results to differ significantly from those described in the forward-looking statements. Factors that could cause such a difference include, but are not limited to, the timing and amount of revenues that may be recognized by the Company, changes in local or national economic trends, increased competition among depository and financial institutions, continuation of current revenue and expense trends (including trends affecting chargeoffs and provisions for loan losses), changes in interest rates, changes in the shape of the yield curve, and adverse legal, regulatory or accounting changes. Because of the risks and uncertainties inherent in forward-looking statements, readers are cautioned not to place undue reliance on these statements. Readers should carefully review the risk factors described in other documents the Company files from time to time with the SEC, including annual reports on Form 10-K, quarterly reports on Form 10-Q, and current reports on Form 8-K.

9

Overview

Management’s Discussion and Analysis is provided to assist in understanding and evaluating the Company’s results of operations and financial condition. The following discussion is designed to provide a general overview of the Company’s performance for the three-month and nine-month periods ended September 30, 2007 and September 30, 2006. Readers seeking a more in-depth analysis should read the detailed discussions below, as well as the condensed consolidated financial statements and related notes. Financial highlights are presented in the table below. 

	Three months ended September 30, 2007			Three months ended September 30, 2006			% Change			Nine months ended September 30, 2007			Nine months ended September 30, 2006			% Change
Earnings:
Net interest income	$	5,103		$	5,202			1.90	%	$	15,222		$	15,515			(1.89)	%
Provision for loan losses		(300	)		(300	)		0.00			(960	)		(865	)		10.98
Noninterest income		1,534			1,643			(6.63	)		5,051			4,426			14.12
Noninterest expense		(4,554	)		(4,388	)		3.78			(13,456	)		(13,215	)		1.82
Income tax expense		(434	)		(719	)		(39.64	)		(1,519	)		(1,889	)		(19.59	)
Net Income	$	1,349		$	1,438			(6.19	)	$	4,338		$	3,972			9.21
Per Share Data:
Avg. common shares outstanding, basic		7,627,620			8,019,286			(4.88)	%		7,748,605			8,042,271			(3.65)	%
Basic net income	$	0.18		$	0.18			0.00		$	0.56		$	0.49			14.29
Avg. common shares outstanding, diluted		7,691,722			8,095,750			(4.99)	%		7,817,438			8,119,781			(3.72)	%
Diluted net income	$	0.18		$	0.18			0.00		$	0.55		$	0.49			12.24
Cash dividends paid	$	0.08		$	0.075			6.67	%	$	0.235		$	0.22			6.67	%
Period-end book value		10.86			10.46			3.82			10.86			10.46			3.82
Financial Ratios (annualized):
Return on average stockholders’ equity		6.37	%		6.70	%		(4.93)	%		6.83	%		6.26	%		9.11	%
Return on average assets		0.70			0.79			(5.34	)		0.78			0.75			0.68
Efficiency ratio		68.61			64.11			(11.39	)		66.37			66.27			4.00
Net interest margin		3.13			3.31			(5.44	)		3.20			3.39			(2.53	)
Average equity to average assets		11.06			11.81			(6.35	)		11.37			11.92			0.15
Asset Quality Data:
Allowance for loan losses	$	6,292		$	5,560			13.17	%	$	6,292		$	5,560			13.17	%
Nonperforming loans		2,528			1,925			31.32			2,528			1,925			31.32
Nonperforming assets		3,164			2,070			52.85			3,164			2,070			52.85
Net charge-offs		135			154			(12.34	)		432			409			5.32
Allowance for loan losses to total loans		1.15	%		1.07	%		7.48			1.15	%		1.07	%		7.48
Nonperforming loans to total loans		0.46			0.37			24.32			0.46			0.37			24.32
Nonperforming assets to total assets		0.42			0.29			44.83			0.42			0.29			44.83
Average Balances:
Total assets	$	759,132		$	721,204			5.26	%	$	746,974		$	711,344			5.01	%
Loans, net of unearned income		532,902			503,491			5.84			519,132			487,860			6.41
Interest-earning assets		668,671			628,548			6.38			653,662			616,516			6.03
Deposits		579,141			540,201			7.21			573,374			528,988			8.39
Interest-bearing liabilities		625,128			588,402			6.24			612,301			582,538			5.11
Stockholders’ equity		83,984			85,178			(1.40	)		83,984			84,813			(0.98	)
At Period End:
Total assets	$	760,987		$	725,908			4.83	%	$	760,987		$	725,908			4.83	%
Loans, net of unearned income		548,026			512,652			6.90			548,026			512,652			6.90
Interest-earning assets		676,874			639,054			5.92			676,874			639,054			5.92
Deposits		572,114			548,999			4.21			572,114			548,999			4.21
Interest-bearing liabilities		628,084			593,183			5.88			628,084			593,183			5.88
Stockholders’ equity		84,378			85,776			(1.63	)		84,378			85,776			(1.63	)

10

Critical Accounting Policies

The accounting and reporting policies of the Company and its subsidiaries are based on accounting principles generally accepted in the United States and conform to general practices in the banking industry. We consider a critical accounting policy to be one that is both very important to the portrayal of the Company’s financial condition and results of operations and requires a difficult, subjective or complex judgment by management. What makes these judgments difficult, subjective and/or complex is the need to make estimates about the effects of matters that are inherently uncertain. Changes in underlying factors, assumptions or estimates could have a material impact on our future financial condition and results of operations. Based on the size of the item or significance of the estimate, our critical accounting and reporting policies include our accounting for investment securities and the allowance for loan losses.

Allowance for Loan Losses. The allowance for loan losses is calculated with the objective of maintaining an allowance sufficient to absorb estimated probable loan losses. Management’s determination of the adequacy of the allowance is based on quarterly evaluations of the loan portfolio and other relevant factors. However, this evaluation is inherently subjective, as it requires an estimate of the loss for each type of loan and for each impaired loan, an estimate of the amounts and timing of expected future cash flows, and an estimate of the value of the collateral.

Management has established a systematic method for periodically evaluating the credit quality of the loan portfolio in order to establish an allowance for loan losses. The methodology is set forth in a formal policy and includes a review of all loans in the portfolio on which full collectibility may or may not be reasonably assured. The loan review considers among other matters, the estimated fair value of the collateral, economic conditions, historical loan loss experience, our knowledge of inherent losses in the portfolio that are probable and reasonably estimable and other factors that warrant recognition in providing an appropriate loan loss allowance. Specific allowances are established for certain individual loans that management considers impaired under SFAS No. 114, Accounting by Creditors for Impairment of a Loan. The remainder of the portfolio is segmented into groups of loans with similar risk characteristics for evaluation and analysis. In originating loans, we recognize that losses will be experienced and that the risk of loss will vary with, among other things, the type of loan being made, the creditworthiness of the borrower, the term of the loan, general economic conditions, and in the case of a secured loan, the quality of the collateral. We increase our allowance for loan losses by charging provisions for loan losses against our current period income. Management’s periodic evaluation of the adequacy of the allowance is consistently applied and is based on our past loan loss experience, particular risks inherent in the different kinds of lending that we engage in, adverse situations that may affect the borrower’s ability to repay, the estimated value of any underlying collateral, current economic conditions, and other relevant internal and external factors that affect loan collectibility. Management believes this is a critical accounting policy because this evaluation involves a high degree of complexity and requires us to make subjective judgments that often require assumptions or estimates about various matters.

Other-Than-Temporary Impairment of Securities. Management periodically reviews all investment securities with significant declines in fair value for potential other-than-temporary impairment pursuant to the guidance provided by SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities. In November 2006, FASB issued Staff Position (“FSP”) FAS 115-1 and FAS 124-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.” The FSP addressed the determination as to when an investment is considered impaired, whether the impairment is other-than-temporary, and the measurement of an impairment loss. It also included accounting considerations subsequent to the recognition of an other-than-temporary impairment and requires certain disclosures about unrealized losses that have not been recognized as other-than-temporary impairments. The guidance in this FSP amended SFAS No. 115 Accounting for Certain Investments in Debt and Equity Securities, No. 124, Accounting for Certain Investments Held by Not-for-Profit Organizations, and APB Opinion 18, The Equity Method of Accounting for Investments in Common Stock.

Effective June 30, 2007, management evaluated the Company’s investment portfolio and determined that a $162,000 “other-than-temporary” impairment existed on a $305,000 equity investment in a closely held company. The impairment was considered to be “other-than-temporary” due to the company’s continuing operating losses and deteriorating book value. The Company’s remaining equity interest in the company amounts to $143,000. Effective September 30, 2007 and 2006, management evaluated the Company’s investment portfolio and determined that all unrealized losses were the direct result of temporary changes in interest rates and that such losses may be recovered in the foreseeable future. As a result, management did not consider any unrealized losses as “other-than-temporary” at September 30, 2007 and 2006.

11

Comparison of Financial Condition

Assets. Total assets of the Company increased by $17.6 million, or 2.4%, from $743.4 million at December 31, 2006, to $761.0 million at September 30, 2007. This increase was primarily due to a $32.6 million increase in loans and a $5.6 million increase in mortgage-backed securities. This increase was partly offset by a $14.6 million decrease in cash and cash equivalents and a $3.8 million decrease in investment securities.

Loans receivable increased by $32.6 million, or 6.3%, to $548.0 million at September 30, 2007. The growth in loans was primarily comprised of a $22.4 million, or 8.8%, increase in commercial real estate loans to $276.7 million. Also during the nine-month period, construction loans increased by $7.6 million, or 9.9% to $83.8 million, consumer loans increased by $2.1 million, or 3.0%, to $72.2 million and commercial business loans increased by $849,000, or 2.6%, to $32.8 million. These increases in loans were partly offset by a $4.1 million, or 5.0%, decrease in residential mortgage loans to $78.9 million. Loan production has been strong during 2007, totaling $66.9 million during the first quarter, $86.4 million during the second quarter and $81.3 million during the third quarter. As a result of increased production, loans outstanding increased by $3.5 million in the first quarter, $16.9 million in the second quarter and $12.2 million in the third quarter. In order to increase loan growth for the remainder of 2007 and 2008, the Company has added several experienced lenders and an additional credit officer. The local economy remains vibrant compared to most of the country; however, housing starts and demand for commercial real estate have slowed during the year as evidenced by the $17.2 million decrease in loan commitments outstanding at December 31, 2006, compared to September 30, 2007. A more significant slowdown in the local economy would have a negative impact on the Company’s ability to increase the current level of loan growth.

Management will seek to continue to grow the loan portfolio in a safe and sound manner with an emphasis on adjustable-rate loans and shorter-term fixed rate loans. As of September 30, 2007, $262.9 million, or 48.4%, of the Company’s loan portfolio, was scheduled to reprice in one month. This sensitivity to falling interest rates was a factor in the Company’s margin compression during the third quarter of 2007 as the prime interest rate decreased by 50 basis points during the quarter. Decreasing short-term interest rates will cause short-term margin compression, as these adjustable-rate loans will reprice at lower interest rates at a faster pace than the Company’s funding costs. However, as time deposits reprice over time, the Company’s cost of funds will decrease and the Company’s net interest margin should begin to expand.

Cash and cash equivalents decreased by $14.6 million, or 55.5%, from $26.2 million at December 31, 2006, to $11.7 million at September 30, 2007. This decrease was primarily attributable to loan growth of $32.6 million outpacing growth in deposits and borrowed money of $19.3 million. Management expects that the level of cash and cash equivalents will remain stable through the end of 2007. Proceeds needed to fund future loan growth and repurchase Company stock will be generated from expected growth in deposits, maturing investment and mortgage-backed securities and / or additional borrowings.

During the nine-month period ended September 30, 2007, mortgage-backed securities (“MBS”) increased $5.6 million, or 9.2%, to $66.3 million and investment securities decreased by $3.8 million, or 5.8%, to $61.5 million. The increase in MBS was due to the purchase of $18.2 million of MBS during the period, the effects of which were partly offset by the sale of $3.4 million in MBS and by $9.6 million of normal principal amortization. The decrease in investment securities was primarily due to the normal maturities of $10.0 million and the sale of $3.0 million during the period, the effects of which were partly offset by the purchase of $9.8 million in investment securities. Management expects the investment and mortgage-backed securities portfolios to decrease as a percentage of total assets as the cash flows generated from these investments are used to fund loan growth, repay borrowings and repurchase common stock. This restructuring of the balance sheet from lower-yielding cash and cash equivalents, investments, and MBS to higher-yielding loans is expected to be a positive factor in improving the Company’s net interest margin.

12

Other real estate owned, which consists of ten one-to-four family residential dwellings acquired by the Bank through foreclosure, increased by $497,000 to $636,000 at September 30, 2007. All foreclosed properties are written down to their estimated fair value at acquisition and are located in the Bank’s primary lending area. Management will continue to aggressively market foreclosed properties for a timely disposition.

Allowance for loan losses and nonperforming assets. The Company has established a systematic methodology for determining the adequacy of the allowance for loan losses. This methodology is set forth in a formal policy and considers all loans in the portfolio. Specific allowances are established for certain individual loans that management considers impaired. The remainder of the portfolio is segmented into groups of loans with similar risk characteristics for evaluation and analysis. Management’s periodic evaluation of the allowance is consistently applied and based on inherent losses in the portfolio, past loan loss experience, risks inherent in the different types of loans, the estimated value of any underlying collateral, current economic conditions, the borrower’s financial position, and other relevant internal and external factors that may affect loan collectibility. The allowance for loan losses is increased by charging provisions for loan losses against income. As of September 30, 2007, the allowance for loan losses was $6.3 million, or 1.15% of total loans. Management believes that this amount meets the requirement for losses on loans that management considers to be impaired, for known losses, and for incurred losses inherent in the remaining loan portfolio. Although management believes that it uses the best information available to make such determinations, future adjustments to the allowance for loan losses may be necessary and results of operations could be significantly adversely affected if circumstances differ substantially from the assumptions used in making the determinations. The following table presents an analysis of changes in the allowance for loan losses for the periods and information with respect to nonperforming assets at the dates indicated.

	At and For the Three						At and For the Nine
	Months Ended September 30,						Months Ended September 30,
	2007			2006			2007			2006
	(dollars in thousands)						(dollars in thousands)
Allowance for loan losses:
Beginning of period	$	6,128		$	5,414		$	5,764		$	5,104
Add:
Provision for loan losses		300			300			960			865
Recoveries		66			7			86			10
Less:
Charge-offs		202			161			518			419
End of period	$	6,292		$	5,560		$	6,292		$	5,560
Nonaccrual loans	$	2,528		$	1,925		$	2,528		$	1,925
Real estate owned		636			145			636			145
Nonperforming assets	$	3,164		$	2,070		$	3,164		$	2,070
Allowance for loan losses as a percentage of total loans		1.15	%		1.07	%		1.15	%		1.07	%
Nonperforming loans to total loans		0.46	%		0.37	%		0.46	%		0.37	%
Nonperforming assets to total assets		0.42	%		0.29	%		0.42	%		0.29	%

Premises and equipment decreased by $165,000, or 0.9%, to $18.1 million at September 30, 2007. During the first quarter of 2007, the Company opened a loan production office in Waxhaw, North Carolina. The loan production office is located in leased office space and is staffed by a local mortgage originator. This represents the Company’s third loan production office. Management also plans to open a full service office in Rock Hill, South Carolina by first quarter of 2008 in a leased facility. This will replace the current loan production office in Rock Hill that was opened in February 2006. During 2007, the Company also purchased a lot in Indian Trail, North Carolina for future branch expansion. These capital expenditures were partly offset by the sale of the vacant operations center of the former Citizens Bank in Salisbury, North Carolina for $414,000 and the sale of a right of way parcel from the Mooresville, North Carolina property for $387,000, as well as normal depreciation of buildings and equipment.

13

Liabilities. Total liabilities increased by $19.2 million, or 2.9%, from $657.4 million at December 31, 2006, to $676.6 million at September 30, 2007. This increase was primarily due to a $9.3 million increase in total deposits and a $10.0 million increase in borrowed money.

While total deposits increased by $9.3 million, or 1.7%, to $572.1 million at September 30, 2007, core deposits (which exclude time deposits) increased by $6.2 million, or 2.7%, to $230.4 million at September 30, 2007. During the nine-month period ended September 30, 2007, demand deposit accounts (checking accounts) increased by $2.6 million, or 2.9%, to $93.2 million and money market deposit accounts increased by $6.7 million, or 5.7%, to $124.3 million. The increase in these core deposits was primarily due to a continued emphasis on increasing the Company’s number of retail and business checking account customers. This increase was partially offset by a $3.1 million, or 19.5%, decrease in savings accounts to $12.9 million at September 30, 2007. The decrease in savings accounts was largely due to customers moving these lower-yielding deposit accounts to higher-yielding accounts such as time deposits or money market deposit accounts. Management has always focused on increasing deposits by building customer relationships and typically avoids growing deposits by offering the highest rates in the market. However, if loan growth significantly outpaces deposit growth in the future, management may be more aggressive in attracting more retail deposits, which may increase the Company’s cost of funds. In addition, management may use brokered deposits to fund future loan growth if additional liquidity is needed. During the nine-month period ended September 30, 2007, time deposits increased by $3.1 million, or 0.9%, to $341.7 million. Brokered deposits totaled only $3.5 million, or 0.6% of total deposits at September 30, 2007.

Borrowed money increased by $10.0 million, or 11.7%, to $96.0 million at September 30, 2007. This increase was primarily due to additional Federal Home Loan Bank advances that were obtained primarily for the purpose of funding loan growth. Additional borrowed money may be used in the future to fund additional loan growth, repurchase stock, or purchase investment or mortgage-backed securities. However, maturing advances will generally be repaid if there is a sufficient level of cash and cash equivalents

Stockholders’ Equity. Total stockholders’ equity decreased by $1.6 million, or 1.8%, from $86.0 million at December 31, 2006, to $84.4 million at September 30, 2007. The decrease in stockholders’ equity was primarily due to the repurchase of 351,438 shares of common stock for $4.5 million, at an average cost of $12.89 per share. On January 22, 2007, the Board of Directors authorized the repurchase of up to 400,000 shares, or approximately 5%, of the then outstanding shares of common stock. As of September 30, 2007, the Company had repurchased a total of 343,448 shares under the current program at an average price of $12.90 per share and had 56,552 shares remaining to be repurchased. The Company will consider repurchasing additional shares of common stock at prices that management considers to be attractive and in the best interests of both the Company and its stockholders. Any repurchased shares will be held as treasury stock and will be available for general corporate purposes. In addition, the Company paid cash dividends totaling $1.9 million during the period, representing $0.235 per share. Also during the nine-month period, the unrealized losses on available-for-sale securities increased by $5,000. These unrealized losses were primarily due to an increase in market interest rates during the period. These decreases in stockholders’ equity were partly offset by $4.3 million in net income during the nine-month period ended September 30, 2007.

Comparison of Results of Operations for the Three Months Ended September 30, 2007 and 2006

General. Net income for the three months ended September 30, 2007, amounted to $1.3 million, or $0.18 per diluted share, as compared to $1.4 million, or $0.18 per diluted share, for the three months ended September 30, 2006. This represented a 6.2% decrease in net income and no change in diluted earnings per share for the comparable periods.

Net interest income. During the comparable quarters, interest income increased by $817,000, or 7.4%, to $11.9 million for the third quarter of 2007, primarily as a result of organic loan growth and higher interest rates. Average interest-earning assets increased by $40.1 million, or 6.4%, to $668.7 million for the three months ended September 30, 2007. The increase in average interest-earning assets was primarily the result of a $29.4 million, or 5.8%, increase in average outstanding loans to $532.9 million. The Company’s average yield on earning assets increased by 15 basis points to 7.18% for the quarter ended September 30, 2007. Interest expense increased by $917,000, or 15.5%, for the comparable quarters to $6.8 million for the third quarter of 2007. This increase in interest expense was largely due to increased deposits and higher interest rates. The Company experienced a $36.7 million, or 6.2%, increase in the average balance of interest-bearing liabilities to $625.1 million for the three months ended September 30, 2007. Average interest-bearing liabilities increased primarily as a result of a $37.3 million, or 7.4%, increase in average interest-bearing deposits, the effects of which were partly offset by a $649,000, or 0.8%, decrease in average borrowed money. In addition, the average cost of funds increased by 35 basis points to 4.34% for the quarter ended September 30, 2007.

14

Net interest income decreased by $100,000, or 1.9%, to $5.1 million for the three months ended September 30, 2007. In addition, the tax-equivalent net interest margin decreased by 18 basis points to 3.13% for the quarter ended September 30, 2007, compared to 3.31% for the quarter ended September 30, 2006. This decrease in the net interest margin was primarily the result of funding costs rising at a faster rate than yields on earnings assets, resulting from the continued flat / inverted yield curve and the effects of a 50 basis point decrease in the prime lending rate during the third quarter 2007. On a linked-quarter basis, the Company’s tax-equivalent net interest margin decreased nine basis points from 3.22% for the second quarter of 2007 to 3.13% for the third quarter of 2007. While the Company maintains a relatively neutral interest rate risk position on a cumulative one-year basis, the Federal Reserve Board’s action to lower short-term interest rates by 50 basis points in the third quarter of 2007 will have a more pronounced negative impact in the first three months following the decrease in short-term interest rates. The short-term negative effects of a decrease in interest rates are expected to be mostly offset by time deposits that mature over the next twelve months and reprice at a lower cost to the Company.

Provision for loan losses. The provision for loan losses amounted to $300,000 for both the three months ended September 30, 2007, and the three months ended September 30, 2006. While the provision for loan losses was flat during the comparable periods, the allowance for loan losses was $6.3 million, or 1.15% of total loans as of September 30, 2007, compared to $5.6 million, or 1.07% of total loans as of September 30, 2006. The Company continues to emphasize commercial real estate loans and its ratio of nonperforming loans to total loans was 0.46% on September 30, 2007, compared to 0.37% on September 30, 2006. A substantial portion of the Company’s nonperforming loans at September 30, 2007, was secured by real estate located in the Company’s normal lending market.

Noninterest income. Noninterest income decreased by $109,000, or 6.6%, to $1.5 million for the three months ended September 30, 2007, as compared to $1.6 million for the three months ended September 30, 2006. This decrease was largely attributable to a $62,000, or 8.4%, decrease in fee income on deposit accounts, a $30,000, or 20.7%, decrease in fee income on lending activities and a $49,000 decrease in the fair value adjustment on deferred compensation assets. The decrease in fee income on deposit accounts follows a continuing trend of lower fees generated from checks returned for non-sufficient funds (“NSFs”). Management expects that this declining trend will continue for the remainder of 2007. Fees generated by lending activities decreased for the second straight quarter due in part to fewer loan originations of construction and acquisition and development loans which generally generate larger loan fees. Management expects that fee income from lending activities will improve in the short-term, due in part to the additional commercial lenders that were hired during the second quarter of 2007. The $49,000 decrease in the fair value adjustment on deferred compensation assets was directly offset by a corresponding decrease in noninterest expense, resulting in no net impact to the Company.

These decreases in noninterest income were partly offset by a $26,000, or 12.2%, increase in mortgage banking income and a $24,000, or 14.7%, increase in cash value of bank-owned life insurance. During the 12 months ended September 30, 2007, the Company increased its number of commission-based mortgage loan originators resulting in an increase in mortgage-banking revenues. Continued expansion of the mortgage banking area is expected in 2008. In December 2006, the Company exchanged a large portion of its bank-owned life insurance contracts to obtain a more favorable crediting rate. As a result, the cash value of these policies increased by $24,000 during the comparable periods.

15

The Company did not recognize any significant net gains from the sale of assets during the quarter ended September 30, 2007. During the quarter ended September 30, 2006, the Company realized a net gain of $8,000 from the sale of $103,000 in residential real estate owned and from the sale of $98,000 in equity securities.

Noninterest expense. Noninterest expense increased by $166,000, or 3.8%, to $4.6 million for the quarter ended September 30, 2007, compared to $4.4 million for the quarter ended September 30, 2006. The primary reason was a $181,000, or 7.9%, increase in compensation and benefits, a $51,000, or 8.4%, increase in occupancy and equipment expense and an $11,000, or 9.3%, increase in professional services. Management hired several experienced lenders and an experienced credit officer during 2007 which contributed to the increase in compensation and benefits. However, we expect that the additional loan growth associated with these new positions will cover the additional compensation expense beginning in 2008. The Company opened its third loan production office in 2007 and plans to open its fifteenth full-service office in Rock Hill, South Carolina, during the first quarter 2008. As a result, office occupancy and equipment expense is expected to continue to increase in 2008. The $11,000 increase in professional services was primarily associated with miscellaneous services provided to management in various areas of operations.

These increases in noninterest expense were partly offset by a $49,000 decrease in the fair value adjustment on deferred compensation and a $30,000 decrease in the amortization expense of intangible assets. The decrease in the fair value adjustment on deferred compensation during the comparable quarters was directly offset by a corresponding decrease to noninterest income, resulting in no net impact to the Company. The amortization of intangible assets is expected to continue to decrease as the amount of the core deposit intangible decreases.

Income taxes. Income taxes amounted to $434,000, or 24.4% of taxable income, for the quarter ended September 30, 2007, as compared to $719,000, or 33.4% of taxable income, for the quarter ended September 30, 2006. The decrease in the effective tax rate during the comparable periods was primarily due to a $356,000 increase in nontaxable income from the third quarter 2006 to the third quarter 2007. This income was primarily generated from interest earned on bank-qualified municipal securities and loans. The Company invests in tax-advantaged sources of income to reduce its overall tax burden. However, as the Company continues to increase the amount of income derived from interest income on loans and fee income on loans and deposits, the effective tax rate is expected to increase.

Comparison of Results of Operations for the Nine Months Ended September 30, 2007 and 2006

General. Net income for the nine months ended September 30, 2007 amounted to $4.3 million, or $0.55 per diluted share, as compared to $4.0 million, or $0.49 per diluted share, for the nine months ended September 30, 2006. This represented a 9.2% increase in net income and a 12.2% increase in diluted earnings per share for the comparable periods.

Net interest income. Interest income increased by $3.4 million, or 10.9%, to $34.9 million for the nine-month period ending September 30, 2007, primarily as a result of organic loan growth and higher interest rates. Average interest-earning assets increased by $37.1 million, or 6.0%, to $653.7 million for the nine months ended September 30, 2007. The increase in average interest-earning assets was primarily the result of a $31.3 million, or 6.4%, increase in average outstanding loans to $519.1 million. The Company’s average yield on earning assets increased by 40 basis points to 7.22% for the nine months ended September 30, 2007. Interest expense increased by $3.7 million, or 23.3%, for the comparable nine-month periods. This increase in interest expense was largely due to increased deposits and higher interest rates. The Company experienced a $29.8 million, or 5.1%, increase in the average balance of interest-bearing liabilities to $612.3 million for the nine months ended September 30, 2007. Average interest-bearing liabilities increased primarily as a result of a $39.6 million, or 8.0%, increase in average interest-bearing deposits, the effects of which were partly offset by a $9.9 million, or 11.2%, decrease in average borrowed money during the period. Also, the average cost of funds increased by 63 basis points to 4.29% for the nine months ended September 30, 2007.

Net interest income decreased by $294,000, or 1.9%, to $15.2 million for the nine months ended September 30, 2007. In addition, the net interest margin decreased by 19 basis points to 3.20% for the nine months ended September 30, 2007, compared to 3.39% for the nine months ended September 30, 2006. This decrease in the net interest margin was primarily the result of rising funding costs resulting from the continued flat / inverted yield curve coupled with the effects of a 50 basis point decrease in the prime lending rate during the third quarter 2007.

16

Provision for loan losses. The provision for loan losses amounted to $960,000 for the nine months ended September 30, 2007, compared to $865,000 for the nine months ended September 30, 2006. The increase in the provision for loan losses was primarily attributable to the continued growth in the commercial real estate portfolio. The allowance for loan losses was $6.3 million, or 1.15% of total loans, as of September 30, 2007, compared to $5.6 million, or 1.07% of total loans, as of September 30, 2006.

Noninterest income. Noninterest income increased by $625,000, or 14.1%, to $5.1 million for the nine months ended September 30, 2007, as compared to $4.4 million for the nine months ended September 30, 2006. This increase was largely attributable to the $343,000, or 84.6%, increase in mortgage banking income and an $80,000, or 14.5%, increase in other noninterest income. During the 12 months ended September 30, 2007, the Company increased its number of commission-based mortgage loan originators located throughout the Company’s normal lending area, resulting in a material increase in mortgage-banking revenues. Continued expansion of the mortgage banking area is expected in 2008. However, continued weakness in the housing market could have a negative impact on the Company’s ability to grow or maintain the level of mortgage-banking revenues. Other noninterest income increased, in part, due to increased commissions on the sale of financial products, higher merchant fee income, and increased early withdrawal fees on time deposits.

The Company also experienced a $336,000 net gain on the sale of assets during the first nine months of 2007 and $112,000 of net income generated from life insurance proceeds payable to the Company. The net gain on the sale of assets included the sale of the vacant operations center of the former Citizens Bank in Salisbury, North Carolina for $414,000 and the sale of a right of way parcel from the Mooresville, North Carolina property for $387,000. These sales resulted in a net gain of $419,000. Additional net gains of $6,000 were incurred from the sale of $3.0 million in investment securities and $202,000 from the sale of loans. Offsetting a portion of these gains were net losses of $80,000 from the sale of $3.4 million in mortgage-backed securities and $9,000 from the sale of various parcels of foreclosed properties. The $112,000 of net life insurance proceeds was the result of the untimely death of one of the Bank’s officers after a courageous fight with cancer. During the nine months ended September 30, 2006, the Company recognized a net loss of $40,000 from the sale of various parcels of residential properties acquired through foreclosure totaling $1.0 million, the sale of $98,000 in investment securities and the sale of miscellaneous fixed assets totaling $28,000.

These increases in noninterest income were partly offset by a $130,000, or 6.1%, reduction in fee income on deposit accounts, a $100,000, or 21.8%, decrease in fee income on lending activities, a $19,000, or 11.4% decrease in dividends on FHLB stock, and a $34,000 decrease in the fair value adjustment on deferred compensation assets. The decrease in fee income on deposit accounts follows a continuing trend of lower fees generated from checks returned for non-sufficient funds. Management expects that this declining trend will continue for the remainder of 2007. Fee income generated by lending activities decreased during the comparable periods due, in part, to a reduction of commercial construction loan originations which generally generate larger loan fees. Management expects that fee income from lending activities will improve, due in part to the additional commercial lenders that were hired during the second quarter of 2007. The $19,000 decrease in dividends on FHLB stock was due to having fewer shares of FHLB stock. The Company’s shares of FHLB stock were partly based on the outstanding amount of FHLB borrowing, which had a lower average outstanding balance from September 30, 2006 to September 30, 2007. The decrease in the fair value adjustment on deferred compensation assets was directly offset by a corresponding increase in noninterest expense, resulting in no net impact to the Company.

Noninterest expense. Noninterest expense increased by $241,000, or 1.8%, to $13.5 million for the nine months ended September 30, 2007, compared to $13.2 million for the nine months ended September 30, 2006. The primary reason was a $307,000, or 4.5% increase in compensation and benefits and a$12,000, or 0.6%, increase in occupancy and equipment expense. Management hired several experienced lenders and one experienced credit officer during 2007 which contributed to the increase in compensation and benefits. However, we expect that the additional loan growth associated with these new positions will cover the additional compensation expense beginning in 2008. The Company opened its third loan production office in 2007 and plans to open its fifteenth full-service office in Rock Hill, South Carolina, during the first quarter 2008. As a result, office occupancy and equipment expense is expected to continue to increase in 2008.

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Effective June 30, 2007, management evaluated the Company’s investment portfolio and determined that a $162,000 “other-than-temporary” impairment existed on a $305,000 equity investment in a closely held company. The impairment was considered to be “other-than-temporary” due to the company’s continuing operating losses and deteriorating book value. The Company’s remaining equity interest in the company amounted to $143,000 at September 30, 2007. Management will continue to evaluate the value of the Company’s remaining investment and make any necessary adjustments as conditions dictate. Management determined that there were no unrealized losses that were considered “other-than-temporary” at September 30, 2007, or September 30, 2006.

These increases in noninterest expense were partly offset by a $75,000, or 13.4%, decrease in the amortization of intangible assets, a $17,000, or 4.1%, decrease in professional services, a $34,000 decrease in the fair value adjustment on deferred compensation expense, and a $57,000, or 1.8%, decrease in other noninterest expenses. The amortization of intangible assets will continue to decrease as the amount of the core deposit intangible is amortized on an accelerated basis. Professional expense decreased due to higher than normal expenses experienced during the first quarter of 2006 related to the integration of the Trinity Bank back-office functions. The decrease in the fair value adjustment on deferred compensation assets is directly offset by a corresponding increase in noninterest expense, resulting in no net impact to the Company. Other noninterest expense decreased primarily due to fewer expenses and charge-offs related to checking account overdrafts. Management expects that this declining trend will continue for the remainder of 2007 as the number of overdrafts continues to decrease. Also, as a result of the Trinity Bank acquisition in October 2005, the Company experienced merger-related expenses of $57,000 during the first quarter of 2006. These were one-time expenses and as such, no such expenses were incurred during 2007.

Income taxes. Income taxes amounted to $1.5 million, or 25.9% of taxable income, for the nine months ended September 30, 2007, as compared to $1.9 million, or 32.2% of taxable income, for the nine months ended September 30, 2006. The decrease in income tax expense during the nine months period ending September 30, 2007, was primarily due to a $790,000 increase in nontaxable income generated primarily from bank-qualified municipal securities and loans and $171,000 of non-taxable life insurance proceeds payable to the Company. The Company invests in tax-advantaged sources of income to reduce its overall tax burden. As the Company continues to increase the amount of income derived from interest income on loans and fee income on loans and deposits, the effective tax rate is expected to increase.

Liquidity, Market Risk, and Capital Resources

The objectives of the Company’s liquidity management policy include providing adequate funds to meet the cash needs of both borrowers and depositors, to provide for the on-going operations of the Company, and to capitalize on opportunities for expansion. Liquidity management addresses the Company’s ability to meet deposit withdrawals on demand or at contractual maturity, to repay borrowings as they mature, and to fund new loans and investments as opportunities arise. The primary sources of internally generated funds are principal and interest payments on loans receivable, increases in local deposits, cash flows generated from operations, and cash flows generated by investments. If the Company requires funds beyond its internal funding capabilities, it may rely upon external sources of funds such as brokered deposits, repurchase agreements, and advances. The Company has $97.4 million available to draw from its line of credit with the Federal Home Loan Bank of Atlanta (“FHLB”). The FHLB functions as a central reserve bank providing credit for member financial institutions. As a member of the FHLB, we are required to own capital stock in the FHLB and we are authorized to apply for advances on the security of such stock and certain of our mortgage loans and other assets (principally securities that are obligations of, or guaranteed by, U.S. Government Agencies) provided certain creditworthiness standards have been met. Advances are made pursuant to several different credit programs. Each credit program has its own interest rate and range of maturities. Depending on the program, limitations on the amount of advances are based on the financial condition of the member institution and the adequacy of collateral pledged to secure the credit. The Company also has $13.6 million available from a $20.0 million unsecured federal funds accommodation with The Bankers Bank (“TBB”). TBB is the Company’s primary correspondent bank. The federal funds accommodation is for a term of 12 months and is used for the purpose of providing daily liquidity as needed by the Company. Outstanding advances made under this accommodation are generally repaid on a daily basis at a rate determined by TBB based on their marginal cost of funds. Advances are limited to not more than 14 days in any calendar month. Interest on any advances made over the established line or beyond the 14-day limit will be at a higher rate. The Company may also solicit brokered deposits for providing funds for asset growth. As of September 30, 2007, the Company had outstanding brokered deposits of $3.5 million, or 0.6% of total deposits. The Company believes that it has sufficient sources of liquidity to fund the cash needs of both borrowers and depositors, to provide for the ongoing operations of the Company, and to capitalize on opportunities for expansion.

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In the normal course of business, various commitments are outstanding that are not reflected in the consolidated financial statements. Commitments to extend credit and undisbursed advances on customer lines of credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. The funding of these commitments and previously approved undisbursed lines of credit could affect the Company's liquidity position. At September 30, 2007, the Company had loan commitments of $29.2 million, unused lines of credit of $109.0 million, and undisbursed construction loan proceeds of $3.7 million. The Company believes that it has adequate resources to fund loan commitments and lines of credit as they arise. The Company does not have any special purpose entities or other similar forms of off-balance-sheet financing.

The Company’s most significant form of market risk is interest rate risk, as the Company’s assets and liabilities are sensitive to changes in interest rates. The Company’s Asset / Liability Committee is responsible for monitoring its level of interest rate risk and ensuring compliance with Board-adopted limits. There were no changes in the Company’s asset or liability composition that could result in a material change in the Company’s analysis of interest rate sensitivity as discussed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2006.

The Bank is subject to various regulatory capital requirements administered by the banking regulatory agencies. As of September 30, 2007, the Bank’s capital exceeded all applicable regulatory requirements. The Bank's Tier I capital was $65.2 million, or 8.9% of adjusted total assets. The minimum Tier I capital ratio is 4.00%. Failure to meet minimum capital requirements can result in certain mandatory and possibly discretionary actions by the regulators that, if undertaken, could have a direct material effect on the Bank’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank’s assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The Bank’s capital amounts and classifications are subject to qualitative judgments by the regulators about components, risk-weightings, and other factors.

ITEM 3. Quantitative and Qualitative Disclosures About Market Risk

The information required by this item is included above in Item 2, Management’s Discussion and Analysis of Financial Condition and Results of Operations, under the caption “Liquidity, Market Risk, and Capital Resources.”

ITEM 4. Controls and Procedures

Under the supervision and with the participation of the Company’s management, including the Company’s Principal Executive Officer and Principal Financial Officer, the Company has evaluated the effectiveness of the design and operation of its disclosure controls and procedures (as defined in Rule 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period covered by this report. Based upon that evaluation, the Principal Executive Officer and Principal Financial Officer concluded that, as of the end of the period covered by this report, the Company’s disclosure controls and procedures were effective to ensure that information required to be disclosed in the reports that the Company files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms and in timely alerting them to material information relating to the Company (or its consolidated subsidiaries) required to be filed in its periodic SEC filings.

There has been no change in the Company’s internal control over financial reporting identified in connection with the quarterly evaluation that occurred during the Company’s last fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

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PART II. OTHER INFORMATION

Item 1.Legal Proceedings

There are various claims and lawsuits in which the Bank is periodically involved incidental to the Company's business. In the opinion of management, no material loss is expected from any of such pending claims or lawsuits.

Item 1A. Risk Factors

There were no material changes in the risk factors that were identified in the Form 10-K for the year ended December 31, 2006.

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

During the three-month period ended September 30, 2007, the Company repurchased 116,725 shares of common stock for $1.5 million, at an average cost of $12.73 per share, as detailed in the following table:

Period	Total Number of Shares Purchased		Average Price Paid per Share		Total Number of Shares Purchased as Part of Publicly Announced Plan		Maximum Number of Shares that May Yet be Purchased Under the Publicly Announced Plan
July		80,525	$	12.77		307,248		92,752
August		22,000	$	12.61		329,248		70,752
September		14,200	$	12.66		343,448		56,552
Total		116,725	$	12.73		343,448		56,552

On January 22, 2007, the Board of Directors of the Company authorized the repurchase of up to 400,000 shares, or approximately 5%, of the Company’s then-outstanding shares of common stock. These repurchases may be carried out through open market purchases, block trades, and negotiated private transactions. The stock may be repurchased on an ongoing basis and will be subject to the availability of stock, general market conditions, the trading price of the stock, alternative uses for capital, and the Company’s financial performance. As of September 30, 2007, the Company had repurchased a total of 343,448 shares at an average price of $12.90 per share and had 56,552 shares remaining to be repurchased under this plan. Management will consider repurchasing additional shares of common stock of the Company at prices management considers to be attractive and in the best interests of both the Company and its stockholders. Any repurchased shares will be held as treasury stock and will be available for general corporate purposes.

Item 3. Defaults Upon Senior Securities

Not applicable.

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

There were no meetings of stockholders during the quarter ended September 30, 2007.

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Item 5.Other Information

Not applicable.

Item 6. Exhibits

31.1 Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2 Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1 Written statement of Chief Executive Officer furnished pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

32.2 Written statement of Chief Financial Officer furnished pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed by the undersigned thereunto duly authorized.

	Citizens South Banking Corporation
Date: November 8, 2007	By:	/s/ Kim S. Price
		Kim S. Price
		President and Chief Executive Officer

Date: November 8, 2007	By:	/s/ Gary F. Hoskins
		Gary F. Hoskins
		Executive Vice President, Chief Financial Officer and Treasurer

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