Newbridge Bancorp (NBBC) 10-Q 2005 Q3 Quarterly report

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 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 endedSeptember 30, 2005

OR

o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                    to                    

Commission file number000-11448

LSB BANCSHARES, INC.

(Exact Name of Registrant as Specified in Its Charter)

North Carolina	56-1348147
(State or Other Jurisdiction of Incorporation or Organization)	(I.R.S. Employer Identification No.)

LSB BANCSHARES, INC.
ONE LSB PLAZA
LEXINGTON, NORTH CAROLINA 27292
(Address of Principal Executive Offices)
(Zip Code)

(336) 248-6500
(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 Yesþ Noo

     Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yesþ Noo

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

     LSB Bancshares, Inc. had 8,524,646 shares of common stock outstanding as of October 31, 2005.

LSB BANCSHARES, INC.
AND SUBSIDIARIES

FORM 10-Q
TABLE OF CONTENTS

		Page
	PART I
	Financial Information
Item 1	Financial Statements		3
	Consolidated Balance Sheets September 30, 2005 and December 31, 2004		3
	Consolidated Statements of Income Nine Months and Three Months Ended September 30, 2005 and 2004		4
	Consolidated Statements of Changes in Shareholders’ Equity Nine Months Ended September 30, 2005 and 2004		5
	Consolidated Statements of Cash Flows Nine Months Ended September 30, 2005 and 2004		6
	Notes to Consolidated Financial Statements Nine Months Ended September 30, 2005 and 2004		8
Item 2	Management’s Discussion and Analysis of Financial Condition and Results of Operations		14
Item 3	Quantitative and Qualitative Disclosures About Market Risk		25
Item 4	Controls and Procedures		26
	PART II
	Other Information
Item 1	Legal Proceedings		26
Item 2	Unregistered Sales of Equity Securities and Use of Proceeds		26
Item 3	Defaults Upon Senior Securities		26
Item 4	Submission of Matters to a Vote of Security Holders		27
Item 5	Other Information		27
Item 6	Exhibits		27

2

PART I
FINANCIAL INFORMATION

Item 1. Financial Statements.

Consolidated Balance Sheets

	(Unaudited)
	September 30			December 31
(In thousands, except shares)	2005			2004
Assets
Cash and Due from Banks	$	42,069		$	35,407
Interest-Bearing Bank Balances		2,590			2,115
Federal Funds Sold		25,802			14,246
Investment Securities (Note 3):
Held to Maturity, Market Value $28,007 and $29,642, respectively		27,432			28,539
Available for Sale		102,745			100,655
Loans (Note 4)		763,211			712,185
Less, Allowance for Loan Losses (Note 4)		(8,684	)		(7,962	)
Net Loans		754,527			704,223
Premises and Equipment		18,671			17,390
Other Assets		17,989			12,413
Total Assets	$	991,825		$	914,988
Liabilities
Deposits:
Demand	$	127,382		$	88,805
Savings, N.O.W. and Money Market Accounts		411,668			417,584
Certificates of Deposit of less than $100,000		146,384			118,569
Certificates of Deposit of $100,000 or more		132,288			97,317
Total Deposits		817,722			722,275
Securities Sold Under Agreements to Repurchase		1,474			1,536
Borrowings from the Federal Home Loan Bank		75,000			95,000
Other Liabilities		6,156			5,435
Total Liabilities		900,352			824,246
Shareholders’ Equity
Preferred Stock, Par Value $.01 Per Share:
Authorized 10,000,000 Shares; None issued		—			—
Common Stock, Par Value $5 Per Share:
Authorized 50,000,000 Shares; Issued 8,525,846 Shares as of September 30, 2005 and 8,590,184 Shares as of December 31, 2004		42,629			42,951
Paid-In Capital		9,462			10,482
Directors’ Deferred Plan		(1,313	)		(1,197	)
Retained Earnings		41,398			38,592
Accumulated Other Comprehensive Income (loss)		(703	)		(86	)
Total Shareholders’ Equity		91,473			90,742
Total Liabilities and Shareholders’ Equity	$	991,825		$	914,988
Memorandum: Standby Letters of Credit	$	5,522		$	4,980

Notes to consolidated financial statements are an integral part hereof.

3

Consolidated Statements of Income
(Unaudited)

	Three Months Ended				Nine Months Ended
	September 30				September 30
(In thousands, except shares and per share amounts)	2005		2004		2005		2004
Interest Income
Interest and Fees on Loans	$	14,261	$	11,068	$	40,060	$	32,510
Interest on Investment Securities:
Taxable		916		853		2,672		2,444
Tax Exempt		366		370		1,080		1,124
Interest-Bearing Bank Balances		92		41		285		127
Federal Funds Sold		145		71		326		156
Total Interest Income		15,780		12,403		44,423		36,361
Interest Expense
Deposits		3,658		1,783		8,980		5,025
Securities Sold Under Agreements to Repurchase		4		1		9		6
Borrowings from the Federal Home Loan Bank		912		831		2,824		2,461
Total Interest Expense		4,574		2,615		11,813		7,492
Net Interest Income		11,206		9,788		32,610		28,869
Provision for Loan Losses (Note 4)		715		1,104		2,314		2,396
Net Interest Income after Provision for Loan Losses		10,491		8,684		30,296		26,473
Noninterest Income
Service Charges on Deposit Accounts		1,774		1,875		5,027		5,381
Gains on Sales of Mortgages		105		133		383		390
Other Operating Income		1,519		1,532		4,731		5,014
Total Noninterest Income		3,398		3,540		10,141		10,785
Noninterest Expense
Personnel Expense		5,443		5,026		16,129		15,135
Occupancy Expense		454		437		1,374		1,317
Equipment Depreciation and Maintenance		555		615		1,722		1,708
Other Operating Expense		3,635		3,576		10,433		10,066
Total Noninterest Expense		10,087		9,654		29,658		28,226
Income Before Income Taxes		3,802		2,570		10,779		9,032
Income Taxes		1,302		793		3,617		2,866
Net Income	$	2,500	$	1,777	$	7,162	$	6,166
Earnings Per Share:
Basic	$	0.29	$	0.21	$	0.84	$	0.72
Diluted	$	0.29	$	0.21	$	0.83	$	0.72
Weighted Average Shares Outstanding:
Basic		8,534,578		8,579,468		8,558,693		8,573,443
Diluted		8,575,859		8,616,515		8,599,251		8,620,923

Notes to consolidated financial statements are an integral part hereof.

4

Consolidated Statements
Of Changes in Shareholders’ Equity
(Unaudited)

																Accumulated
										Directors’						Other			Total
	Common Stock						Paid-in			Deferred			Retained			Comprehensive			Shareholders’
(In thousands, except shares)	Shares			Amount			Capital			Plan			Earnings			Income (loss)			Equity
Balances at December 31, 2003		8,548,942		$	42,745		$	10,205		$	(1,101	)	$	35,702		$	1,009		$	88,560
Net Income		—			—			—			—			6,166			—			6,166
Change in unrealized gain on securities available for sale, net of deferred income taxes		—			—			—			—			—			(676	)		(676	)
Comprehensive income		—			—			—			—			—			—			5,490
Cash dividends declared on common stock		—			—			—			—			(4,114	)		—			(4,114	)
Common stock issued for stock options exercised		50,326			251			394			—			—			—			645
Common stock acquired		(19,800	)		(99	)		(202	)		(85	)		—			—			(386	)
Balances at September 30, 2004		8,579,468		$	42,897		$	10,397		$	(1,186	)	$	37,754		$	333		$	90,195
Balances at December 31, 2004		8,590,184		$	42,951		$	10,482		$	(1,197	)	$	38,592		$	(86	)	$	90,742
Net Income		—			—			—			—			7,162			—			7,162
Change in unrealized gain on securities available for sale, net of deferred income taxes		—			—			—			—			—			(617	)		(617	)
Comprehensive income		—			—			—			—			—			—			6,545
Cash dividends declared on common stock		—			—			—			—			(4,356	)		—			(4,356	)
Common stock issued for stock options exercised		38,257			191			267			—			—			—			458
Common stock acquired		(102,595	)		(513	)		(1,287	)		(116	)		—			—			(1,916	)
Balances at September 30, 2005		8,525,846		$	42,629		$	9,462		$	(1,313	)	$	41,398		$	(703	)	$	91,473

Notes to consolidated financial statements are an integral part hereof.

5

Consolidated Statements of Cash Flows
(Unaudited)

	Nine Months Ended
	September 30
(In thousands)	2005			2004
Cash Flow from Operating Activities
Net Income	$	7,162		$	6,166
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation		1,530			1,541
Securities premium amortization and discount accretion, net		85			88
Decrease in loans held for sale		2,517			2,794
Deferred income taxes		111			(40	)
Decrease in income taxes payable		(451	)		(146	)
Increase in income earned but not received		(995	)		(188	)
Increase (decrease) in interest accrued but not paid		484			(68	)
Net increase in other assets		(4,304	)		(217	)
Net increase in other liabilities		687			357
Provision for loan losses		2,314			2,395
Gain (loss) on sale of premises and equipment		(3	)		50
Net cash provided by operating activities		9,137			12,732
Cash Flow from Investing Activities
Purchases of securities held to maturity		(4,052	)		(4,180	)
Proceeds from maturities of securities held to maturity		5,154			4,713
Purchases of securities available for sale		(19,964	)		(50,266	)
Proceeds from maturities of securities available for sale		16,790			41,562
Net increase in loans made to customers		(55,135	)		(43,545	)
Purchases of premises and equipment		(2,811	)		(3,976	)
Proceeds from sale of premises and equipment		3			46
Net (increase) decrease in federal funds sold		(11,556	)		5,680
Net cash used for investing activities		(71,571	)		(49,966	)
Cash Flow from Financing Activities
Net increase in demand deposits, N.O.W., money market and savings accounts		32,661			24,842
Net increase in time deposits		62,786			5,090
Net decrease in securities sold under agreement to repurchase		(62	)		(726	)
Proceeds from long-term debt		88,000			99,000
Payments on long-term debt		(108,000	)		(86,000	)
Dividends paid		(4,356	)		(4,114	)
Proceeds from issuance of common stock		458			646
Common stock acquired		(1,916	)		(386	)
Net cash provided by financing activities		69,571			38,352
Increase in cash and cash equivalents		7,137			1,118
Cash and cash equivalents at the beginning of the period		37,522			38,685
Cash and cash equivalents at the end of the period	$	44,659		$	39,803

Notes to consolidated financial statements are an integral part hereof.

6

Consolidated Statements of Cash Flows continued
(Unaudited)

	Nine Months Ended
	September 30
(In thousands)	2005			2004
Supplemental Disclosures of Cash Flow Information
Cash paid during the periods for:
Interest	$	11,328		$	7,560
Income Taxes		3,959			3,170
Supplemental Disclosures of Noncash Transactions
Transfer of loans to other real estate owned	$	4,165		$	1,964
Unrealized gains/(losses) on securities available for sale:
Change in securities available for sale		(1,005	)		(1,100	)
Change in deferred income taxes		388			424
Change in shareholders’ equity		(617	)		(676	)

Notes to consolidated financial statements are an integral part hereof.

7

Notes To Consolidated Financial Statements
As of or for the Periods Ended September 30, 2005 and 2004

Note 1 — Basis of Presentation

The accompanying interim unaudited consolidated financial statements have been prepared in accordance with generally accepted accounting principles in the United States for interim financial information and in accordance with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. They do not include all of the information and footnotes required by generally accepted accounting principles in the United States for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three and nine-month periods ended September 30, 2005 are not necessarily indicative of the results that may be expected for the year ending December 31, 2005.

LSB Bancshares, Inc. (“Bancshares”) is a bank holding company headquartered in Lexington, North Carolina. Bancshares’ principal business is providing banking and other financial services through its banking subsidiary, Lexington State Bank (the “Bank”). The Bank has two wholly owned subsidiaries, Peoples Finance Company of Lexington, Inc. (“Peoples Finance”) and LSB Investment Services, Inc. (“LSBIS”). The Bank offers a complete array of services in commercial banking including accepting deposits, corporate cash management, discount brokerage, IRA plans, mortgage production, secured and unsecured loans and trust functions through twenty-six offices in seventeen communities located in Davidson, Forsyth, Stokes, Guilford, Randolph and Wake counties. Peoples Finance offers secured and unsecured loans to individuals up to a maximum of $10,000 as well as dealer originated loans. LSBIS offers products through UVEST Investment Services, an independent broker-dealer. Investments are neither deposits nor obligations of the Bank, nor are they guaranteed or insured by any depository institution, the Federal Deposit Insurance Corporation, or any other government agency.

The organization and business of Bancshares, accounting policies followed by Bancshares and other relevant information are contained in the notes to the consolidated financial statements in Bancshares’ Annual Report on Form 10-K for the fiscal year ended December 31, 2004, filed with the Securities and Exchange Commission (the “SEC”) on March 11, 2005 (SEC File No. 000-11448)(the “Form 10-K”). This quarterly report should be read in conjunction with such Form 10-K.

Note 2 — Net Income Per Share

Basic and diluted net income per share is computed based on the weighted average number of shares outstanding during each period. Diluted net income per share reflects the potential dilution that could occur if stock options were exercised, resulting in the issuance of common stock that then shares in the net income of Bancshares.

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A reconciliation of the basic average common shares outstanding to the diluted average common shares outstanding is as follows:

	Three Months Ended				Nine Months Ended
	September 30				September 30
	2005		2004		2005		2004
Weighted average number of common shares used in computing basic net income per share		8,534,578		8,579,468		8,558,693		8,573,443
Effect of diluted stock options		41,281		37,047		40,558		47,480
Diluted weighted average common shares outstanding		8,575,859		8,616,515		8,599,251		8,620,923

Note 3 — Investment Securities(In thousands)

	September 30, 2005 — Securities Held to Maturity
	Amortized		Unrealized		Unrealized		Market
	Cost		Gains		Losses		Value
State, county and municipal securities	$	27,432	$	787	$	212	$	28,007

	September 30, 2005 — Securities Available for Sale
	Amortized		Unrealized		Unrealized		Market
	Cost		Gains		Losses		Value
U.S. government agency obligations	$	96,069	$	181	$	1,217	$	95,033
State, county and municipal securities		2,618		—		109		2,509
Equity securities		5,203		—		—		5,203
Total	$	103,890	$	181	$	1,326	$	102,745

	December 31, 2004 — Securities Held to Maturity
	Amortized		Unrealized		Unrealized		Market
	Cost		Gains		Losses		Value
State, county and municipal securities	$	28,539	$	1,121	$	18	$	29,642

	December 31, 2004 — Securities Available for Sale
	Amortized		Unrealized		Unrealized		Market
	Cost		Gains		Losses		Value
U.S. government agency obligations	$	91,685	$	593	$	687	$	91,591
State, county and municipal securities		3,101		36		82		3,055
Equity securities		6,009		—		—		6,009
Total	$	100,795	$	629	$	769	$	100,655

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The following is a schedule of securities in a loss position as of September 30, 2005 (In thousands):

	Less than 1 year				1 Year or More				Total
	Market		Unrealized		Market		Unrealized		Market		Unrealized
	Value		Loss		Value		Loss		Value		Loss
U.S. government agency obligations	$	45,528	$	508	$	27,142	$	709	$	72,670	$	1,217
State, county and municipal securities		5,158		225		2,002		96		7,160		321
Total securities	$	50,686	$	733	$	29,144	$	805	$	79,830	$	1,538

Investment securities with amortized cost of $100,529,000 and $84,470,000, as of September 30, 2005, and December 31, 2004, respectively, were pledged to secure public deposits and for other purposes. The Bank has also obtained two $10,000,000 and a $20,000,000 irrevocable letter of credit, which will expire on May 10, 2006, August 11, 2010, and September 3, 2014, respectively. These letters of credit were issued by the Federal Home Loan Bank of Atlanta (“FHLB”) in favor of the State of North Carolina and are used in lieu of securities to pledge against public deposits.

No investment securities were sold during the nine months ending September 30, 2005.

Note 4 — Loans and Allowance for Loan Loss

A summary of consolidated loans follows (In thousands):

	September 30		December 31
	2005		2004
Commercial, financial, & agricultural	$	293,465	$	281,909
Real estate – construction		31,070		50,125
Real estate – mortgage		360,070		314,822
Installment loans to individuals		76,142		62,987
Lease financing		540		447
Other		1,924		1,895
Total loans, net of unearned income	$	763,211	$	712,185

Nonperforming assets are summarized as follows (In thousands):

	September 30		December 31
	2005		2004
Nonaccural loans	$	492	$	685
Restructured loans		858		582
Loans past due 90 days or more		2,390		1,313
Total nonperforming loans		3,740		2,580
Foreclosed real estate		4,713		1,531
Total nonperforming assets	$	8,453	$	4,111

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Impaired loans and related information are summarized in the following tables (In thousands):

	September 30		December 31
	2005		2004
Loans specifically identified as impaired	$	7,621	$	3,484
Allowance for loan losses associated with impaired loans	$	830	$	939

	Three Months Ended				Nine Months Ended
	September 30				September 30
	2005		2004		2005		2004
Average balances of impaired loans	$	7,357	$	6,163	$	6,141	$	6,571
Interest income recorded for impaired loans	$	134	$	58	$	283	$	215

Bancshares’ policy for impaired loan accounting subjects all loans to impairment recognition except for large groups of smaller balance homogeneous loans such as credit card, residential mortgage and consumer loans. Bancshares generally considers loans 90 days or more past due and all nonaccrual loans to be impaired. Interest income on impaired loans is recognized consistent with Bancshares’ income recognition policy of daily accrual of income until the loan is determined to be uncollectible and placed in a nonaccrual status.

An analysis of the changes in the allowance for loan losses follows (In thousands):

	Nine Months Ended September 30
	2005			2004
Balance, beginning of period	$	7,962		$	7,846
Provision for loan losses		2,314			2,396
Recoveries of amounts previously charged off		385			625
Loans charged off		(1,977	)		(2,861	)
Balance, end of period	$	8,684		$	8,006

At September 30, 2005, loans totaling $16,291,000 were held for sale stated at the lower of cost or market on an individual basis.

Note 5 — Recent Accounting Pronouncements

In March 2004, the FASB issued Emerging Issues Task Force Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” (“EITF Issue No. 03-1”), which provides new guidance for assessing impairment losses on debt and equity investments and includes new disclosure requirements for investments that are deemed to be temporarily impaired. In September 2004, the FASB delayed the accounting provisions of EITF Issue No. 03-1; however, the disclosure requirements remain effective and have been adopted by Bancshares in these financial statements. Bancshares adopted the currently effective provisions of EITF Issue No. 03-1 with no resulting material effect on its financial position or operating results.

In December 2004, the FASB issued Statement of Financial Accounting Standards No. 123R, “Share-Based Payment” (“SFAS 123R”), which is a revision of SFAS 123 and supersedes APB Opinion No. 25. SFAS 123R requires all share-based payments to employees, including grants of employee stock options,

11

to be valued at fair value on the date of grant, and to be expensed over the applicable vesting period. In addition, compensation cost for the unvested portion of previously granted awards that remain outstanding on the effective date of SFAS 123R shall be recognized on or after the effective date, as the related services are rendered, based on the awards’ grant-date fair value as previously calculated for the pro-forma disclosure under SFAS 123. SFAS 123R is effective for all stock-based awards granted on or after January 1, 2006. Bancshares is currently assessing the effect of adopting SFAS 123R on its financial position and operating results.

At the April 13, 2005 FASB Board meeting, the Board authorized the final drafting of certain amendments to Statement on Financial Accounting Standards No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities” (“SFAS 140”) regarding beneficial interests and servicing rights. On August 11, 2005 the Board issued three exposure drafts — “Accounting for Transfers of Financial Assets, Accounting for Servicing of Financial Assets and Accounting for Certain Hybrid Financial Instrument”—as proposed amendments to SFAS No. 140. Management is currently monitoring and evaluating the potential impact of these various amendments, including the proposed one-time irrevocable election to move servicing rights from a LOCOM (lower of cost or fair market value) to a fair value accounting basis, which management intends to adopt.

At the June 29, 2005 FASB Board meeting, the Board agreed to issue FSP FAS 115-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” which will replace the guidance previously set forth in EITF 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments”. This FSP effectively eliminates the accounting guidance provided in EITF 03-1 in favor of existing impairment recognition guidance under SFAS No. 115, SAB No. 59, APB No. 18, and EITF Topic D-44. The FSP is for periods beginning after September 15, 2005, but its adoption is not expected to have a material impact on our consolidated financial statements.

Note 6 — Stock Compensation Plans

Bancshares accounts for its stock-based compensation plans using the accounting prescribed by Accounting Principles Board Opinion Number 25, “Accounting for Stock Issued to Employees.” In October 1995, Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”), was issued and encourages, but does not require, adoption of a fair value method of accounting for employee stock-based compensation plans. In December 2002, the FASB Issued Statement of Financial Accounting Standards No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure-an Amendment of FASB Statement No. 123” (“SFAS 148”). As permitted by SFAS 123 and SFAS 148, Bancshares has elected to disclose the pro forma net income and earnings per share as if the fair value method had been applied in measuring compensation cost.

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Bancshares had stock based compensation plans at September 30, 2005 accounted for under Accounting Principles Board Opinion Number 25, under which no compensation cost has been recognized. Had compensation cost for these plans been determined consistent with SFAS 123 and SFAS 148, Bancshares’ net income and earnings per share would have been reduced to the following pro forma amounts (In thousands, except per share amounts):

	Three Months Ended				Nine Months Ended
	September 30				September 30
	2005		2004		2005		2004
Net income, as reported	$	2,500	$	1,777	$	7,162	$	6,166
Less, total stock-based employee compensation expense determined under the fair value based method for all awards, net of related tax effects		26		71		321		220
Pro forma net income	$	2,474	$	1,706	$	6,841	$	5,946

	Three Months Ended				Nine Months Ended
	September 30				September 30
	2005		2004		2005		2004
Earnings Per Share:
Basic – as reported	$	0.29	$	0.21	$	0.84	$	0.72
Basic – pro forma	$	0.29	$	0.20	$	0.80	$	0.69
Diluted – as reported	$	0.29	$	0.21	$	0.83	$	0.72
Diluted – pro forma	$	0.29	$	0.20	$	0.80	$	0.69

Due to the pending adoption of SFAS No. 123(R), effective April 11, 2005, the Stock Option and Compensation Committee of the Board of Directors of Bancshares (the “Compensation Committee”) voted to immediately vest certain unvested and underwater options held by current employees and executive officers.

The early vesting of these options was made to reduce compensation expense that otherwise would have been recorded in future periods once Bancshares became subject to SFAS 123(R), which is currently scheduled to become effective for Bancshares’ fiscal year beginning January 1, 2006. As a result of this accelerated vesting, Bancshares expects to reduce its future aggregate compensation expense related to the options subject to the vesting by a total of approximately $227,000, based on estimated value calculations using Black-Scholes valuation methodology.

Note 7 — Pension and Post Retirement Medical Benefit Expenses

The components of net periodic benefit cost for pension and retiree medical plans are as follows:

	Pension Benefits						Retiree Medical
	Three Months Ended						Three Months Ended
	September 30						September 30
	2005			2004			2005		2004
Service cost	$	216		$	193		$	15	$	13
Interest cost		202			181			15		14
Expected Return on plan assets		(196	)		(166	)		—		—
Amortization of prior service		16			16			—		—
Amortization of transition obligation		—			—			3		3
Amortization of loss		53			48			4		4
Net periodic benefit cost	$	291		$	272		$	37	$	34

13

	Pension Benefits						Retiree Medical
	Nine Months Ended						Nine Months Ended
	September 30						September 30
	2005			2004			2005		2004
Service cost	$	648		$	579		$	45	$	39
Interest cost		606			543			45		42
Expected Return on plan assets		(588	)		(498	)		—		—
Amortization of prior service		48			48			—		—
Amortization of transition obligation		—			—			9		9
Amortization of loss		159			144			12		12
Net periodic benefit cost	$	873		$	816		$	111	$	102

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

The discussion presented herein is intended to provide an overview of the changes in financial condition and results of operation during the time periods required by Item 303 of Regulation S-K for Bancshares and its wholly-owned subsidiary the Bank. The consolidated financial statements also include the accounts and results of operation of the Bank’s wholly owned subsidiaries, Peoples Finance and LSBIS. This discussion and analysis is intended to complement the unaudited financial statements, footnotes and supplemental financial data in this Form 10-Q, and should be read in conjunction therewith.

This report contains certain forward-looking statements related to anticipated future operating and financial performance, and other similar statements of expectations. These forward-looking statements are often identified by words such as “believes”, “anticipates”, “expects” or other similar words or phrases. These forward-looking statements are based on estimates, beliefs and assumptions made by management and are not guarantees of future performance. Actual results may differ from those expressed or implied as the result of various factors, including: (1) the strength of the United States’ economy generally and the strength of the local economies in which Bancshares conducts operations may be different than expected resulting in, among other things, a deterioration in credit quality or a reduced demand for credit, including the resultant effect on Bancshares’ loan portfolio and allowance for loan losses; (2) the effects of, and changes in, trade, monetary and fiscal policies and laws, including interest rate policies of the Board of Governors of the Federal Reserve System; (3) inflation, interest rate, market and monetary fluctuations; (4) adverse conditions in the stock market, the public debt market and other capital markets (including changes in interest rate conditions) and the impact of such conditions on Bancshares’ capital markets and capital management activities, including, without limitation, Bancshares’ private equity investment activities and brokerage activities; (5) the timely development (or lack thereof) of competitive new products and services by Bancshares and the acceptance of these products and services by new and existing customers; (6) the willingness of customers to accept third party products marketed by Bancshares; (7) the willingness of customers to substitute competitors’ products and services for Bancshares’ products and services and vice versa; (8) the impact of changes in financial services’ laws and regulations (including laws concerning taxes, banking and securities); (9) technological changes; (10) changes in consumer spending and saving habits; (11) the effect of corporate restructurings, acquisitions and/or dispositions, and the failure to achieve the expected revenue growth and/or expense savings from such corporate restructurings, acquisitions and/or dispositions; (12) the growth and profitability of Bancshares’ noninterest or fee income being less than expected; (13) unanticipated regulatory or judicial proceedings; (14) the impact of changes in accounting policies by the SEC or other regulatory agencies; (15) adverse changes in financial performance and/or condition of Bancshares’ borrowers which could impact repayment of such borrowers’ outstanding loans; and (16) Bancshares’ success at managing the

14

risks involved in the foregoing. Bancshares cautions that the foregoing list of important factors is not exclusive. Bancshares does not undertake to update any forward-looking statement, whether written or oral, that may be made from time to time by or on behalf of Bancshares.

Introduction

Bancshares is a bank holding company headquartered in Lexington, North Carolina. Its principal assets are all of the outstanding shares of common stock of its commercial bank subsidiary, Lexington State Bank. Founded in 1949, the Bank operates as a North Carolina chartered commercial bank serving customers through twenty-six offices in seventeen communities located in Davidson, Forsyth, Stokes, Guilford, Randolph, and Wake counties in North Carolina. Bancshares expanded its operations during 2004 through the opening of a mortgage loan production office in the Raleigh-Durham area of North Carolina and with the opening of a full service bank branch located in Jamestown, North Carolina. In the third quarter of 2004, the Bank completed the modernization and consolidation of its branch network in Lexington in order to better serve its customers. This was accomplished through the closing of one office and the consolidation of two other offices into existing branches. Through the Bank and the Bank’s two non-bank subsidiaries, Peoples Finance and LSBIS, Bancshares provides a wide range of financial services to individual and corporate customers.

Bancshares’ results of operations are dependent primarily on the results of operations of the Bank and thus are dependent to a significant extent on net interest income, which is the difference between the income earned on its loan and investment portfolios and its cost of funds, consisting of interest paid on deposits and borrowings. The Bank’s noninterest income has become increasingly important to its performance through fees earned by its non-bank subsidiary LSBIS. Results of operations are also affected by Bancshares’ provision for loan losses, mortgage loan sales activities, service charges and other fee income, and noninterest expense. Bancshares’ noninterest expense principally consists of compensation and employee benefits, office occupancy and equipment expense, data processing, professional fees, and advertising and business promotion expenses. Bancshares’ results of operations are also significantly affected by general economic and competitive conditions, particularly changes in interest rates, government policies and actions of regulatory authorities.

The Bank (and Bancshares as its holding company) faces competition in both the attraction of deposit accounts and in the origination of mortgage, commercial, and consumer loans. Its most direct competition for deposits has historically derived from other commercial banks located in and around the counties in which it maintains banking offices. The Bank also competes for deposits with both regional and super-regional banks, and money market instruments and mutual funds. The Bank competes for loans principally through the interest rates and loan fees it charges and the efficiency and quality of services it provides borrowers. Its competition for loans also comes principally from other commercial banks, including offices of regional and super-regional banks, located in and around the counties in which it maintains banking offices. Competition for deposits and loans is likely to continue to increase as a result of legislative, regulatory and technological changes and the continuing trend of consolidation in the financial services industry. Technological advances, for example, have lowered barriers to market entry, allowed banks to expand their geographic reach by providing services over the Internet and made it possible for non-depository institutions to offer products and services that traditionally have been provided by banks. Recent legislation permits affiliation among banks, securities firms and insurance companies, and further legislation will likely continue to change the competitive environment in which Bancshares does business.

The following discussion and analysis is presented on a consolidated basis and focuses on the major components of Bancshares’ operations and significant changes in its results of operations for the periods

15

presented. For further information, refer to the Consolidated Financial Statements and footnotes thereto included in the Form 10-K.

Critical Accounting Policies

The accounting and reporting policies of the Bank and its subsidiaries comply with generally accepted accounting principles in the United States and conform to standards within the industry. Bancshares believes that its most significant accounting policies deal with:

• The allowance for loan loss, as it requires the most subjective and complex judgments from senior management. Management considers several factors in determining the allowance for loan loss. These include economic conditions, advice of regulators, historical experience and factors affecting particular borrowers. Changes in the assumptions of these policies could result in a significant impact on the Bank’s financial statements. For further information, see the Asset Quality and Allowance for Loan Losses section.

• Pension and post retirement benefit plans to employees. The calculation of obligations and related expenses under these plans requires the use of actuarial valuation methods and assumptions. Actuarial valuations and the determination of future market values of plan assets are subject to management judgment and may differ significantly if different assumptions are used. Please refer to Note 7, “Pension and Post Retirement Medical Benefit Expenses,” in the “Notes to Consolidated Financial Statements” for disclosures related to Bancshares’ benefits plans.

16

Three Months Ended September 30, 2005 Compared to Three Months Ended September 30, 2004

Net Interest Income

The primary source of earnings for Bancshares is net interest income, which represents the dollar amount by which interest generated from earning assets exceeds the cost of funds. Earning assets consist primarily of loans and investment securities and cost of funds is the interest paid on interest-bearing deposits and borrowed funds.

Net interest income for the third quarter of 2005 of $11.206 million increased $1.418 million or 14.5% compared to $9.788 million for the third quarter of 2004. The increase was largely attributable to an improvement in the net interest margin from 4.76% for the quarter ended September 30, 2004 to 4.92% for the quarter ended September 30, 2005, and 8.8% growth in average earning assets for the quarter. In 2005, there have been six increases to the federal funds rate of 0.25% each by the Federal Reserve. The Bank has followed each increase in the federal funds rate with the same increase to its prime rate. Normally, rising interest rates negatively affect the Bank’s margin performance but during this cycle the Bank has been able to control interest costs while benefiting from increased asset yields.

Noninterest Income and Expense

Noninterest income declined $142,000 or 4.0%. The decline in noninterest income for the quarter was primarily the result of a decrease in service charges on deposit accounts from $1.875 million for the third quarter of 2004 to $1.774 million for the third quarter of 2005, a 5.4% decrease.

In the third quarter of 2005, noninterest expense increased $433,000 or 4.5% compared to the same period in 2004 due mainly to an increase in personnel expense. Personnel expense in the third quarter of 2005, consisting of employee salaries and benefits, increased $417,000 or 8.3% from the same period in 2004. The increase in personnel expense is largely attributable to the following areas: (1) an increase in salary expense of $105,000 due to the following; full-time equivalents for both September 30, 2004 and 2005 were 421, however, due to the consolidation of three branches in 2004, there were teller and customer service representative positions eliminated while recent new positions hired have been at a higher compensation level; and annual salary increases for officers were effective in the second quarter ; and (2) an increase in incentive compensation of $255,000 for the quarter; due to the Bank and its subsidiaries, improved overall financial performance and loan and sales performance for 2005 over 2004. Occupancy expense increased $17,000 or 3.9% in the third quarter of 2005 primarily due to increased depreciation related to the Jamestown branch and renovations to two other branches in 2004.

For the changes in other operating expenses, please see the table, Other Operating Income and Expenses, below.

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Other Operating Income and Expenses (In thousands)

	Three Months Ended
	September 30,					Percentage
	2005		2004			Variance
Other operating income:
Bankcard income	$	635		616			3.1	%
Fee income(1)		449		380			18.2
Investment Services commissions(2)		224		336			(33.3	)
Insurance commissions(2)		47		57			(17.5	)
Trust income(3)		136		154			(11.7	)
Other income(4)		28		(11	)		354.5
	$	1,519		1,532			(0.8	)%
Other operating expenses:
Advertising	$	169		157			7.6	%
Automated services(5)		731		597			22.4
Bankcard expense		485		468			3.6
Legal and professional fees(6)		484		594			(18.5	)
Postage(7)		218		150			45.3
Stationery, printing and supplies(8)		186		233			(20.2	)
OREO expense(9)		285		36			691.7
Other expense		1,077		1,341			(19.7	)
	$	3,635	$	3,576			1.6	%

(1)	This increase is primarily due to the large increased use of debit card purchases which results in merchant fees collected by the Bank.
(2)	The decrease is due to a decreased volume of Investment Services and insurance products sold.
(3)	Fees for trust services are collected quarterly for the previous quarter. The fee accrued for the second quarter of 2005 were slightly over the actual income received and assets under management at the end of the third quarter decrease which accounts for the lower income versus the three months ended September 30, 2004.
(4)	The increase is due to a loss on sale of fixed assets that was recognized in the third quarter of 2004 of $50,200.
(5)	This increase is due to Impact ’05 initiatives put in place to improve the Bank’s performance in operations, retail delivery system and technology. These include enhancements to our data processing systems and the renewal and license fee costs associated with these, an upgrade in our communication lines to the branches and contingency planning.
(6)	The decrease is due to SOX related expenses incurred in 2004.
(7)	The increases is due to the Bank contracting the mailing of its new images statements in the third quarter of 2005. There were upfront costs for programming the postage machines and payment of the postage for the upcoming mailing.
(8)	The decrease is due to the outsourcing of the Bank’s supply room starting in the second quarter of 2005.
(9)	The increase is due to the materials and professional fees to remediate the condominiums discussed in “Asset Quality and Allowance for Loan Losses” on page 22 of this report.

Nine Months Ended September 30, 2005 Compared to Nine Months Ended September 30, 2004

Net Interest Income

Net interest income for the first nine months of 2005 of $32.610 million was up $3.741 million or 13.0% compared to $28.869 million for the same period of 2004. The increase was largely attributable to an improvement in the net interest margin from 4.74% for the nine months ended September 30, 2004 to 4.93% for the nine months ended September 30, 2005, and an 8.4% growth in average earning assets. Loan growth in the nine months ended September 30, 2005 was up $51.026 million or 7.2% compared to December 31, 2004, and $61.250 million or 8.7% compared to September 30, 2004. For the period ended September 30, 2005, total deposits were up $95.447 million or 13.2% compared to December 31, 2004, and $85.289 million or 11.6% compared to September 30, 2004.

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The following table provides an analysis of average volumes, yields and rates and net interest income on a tax-equivalent basis for the nine months ended September 30, 2005 and 2004.

Fully taxable equivalent basis¹(Dollars in thousands):

	Nine Months Ended								Nine Months Ended
	September 30, 2005								September 30, 2004
				Interest		Annualized						Interest		Annualized
	Average			Income/		Average			Average			Income/		Average
	Balance			Expense		Yield/Rate			Balance			Expense		Yield/Rate
Earning assets:
Loans and leases receivable2	$	749,715		$	40,060		7.14	%	$	683,490		$	32,510		6.35	%
Taxable securities		92,768			2,672		3.85			87,491			2,444		3.73
Tax exempt securities		31,265			1,523		6.51			31,377			1,630		6.94
Federal Home Loan Bank		5,862			196		4.47			3,831			104		3.59
Interest-bearing bank balances		2,282			89		2.70	3		2,258			23		1.36
Federal funds sold		14,955			326		2.91			19,050			156		1.09
Total earning assets		896,847			44,866		6.69			827,497			36,867		5.95
Non-earning assets:
Cash and due from banks		38,703								36,742
Premises and equipment		17,899								16,410
Other assets		14,724								12,270
Allowance for loan losses		(8,286	)							(8,183	)
Total assets	$	959,887		$	44,866				$	884,736		$	36,867
Interest-bearing liabilities:
Savings and time deposits	$	661,687		$	8,980		1.81	%	$	627,630		$	5,025		1.07	%
Securities sold under agreement to repurchase		1,193			9		1.01			1,268			6		0.63
Borrowing from the Federal Home Loan Bank		90,425			2,824		4.18			74,770			2,461		4.40
Total interest-bearing liabilities		753,305			11,813		2.10			703,668			7,492		1.42
Other liabilities and shareholders’ equity:
Demand deposits		109,136								86,115
Other liabilities		5,796								4,731
Shareholders’ equity		91,650								90,222
Total liabilities and shareholders’ equity	$	959,887			11,813				$	884,736			7,492
Net interest income and net interest margin4				$	33,053		4.93	%				$	29,375		4.74	%
Interest rate spread5							4.59	%							4.53	%

1	Income related to securities exempt from federal income taxes is stated on a fully taxable-equivalent basis, assuming a federal income tax rate of 34%, and is then reduced by the non-deductible portion of interest expense.
2	The average loans and leases receivable balances include non-accruing loans. Loan fees for the nine months ended September 30, 2005 and 2004 of $1,499 and $1,868, respectively, are included in interest income.
3	In calculating the annualized yield for Interest-bearing bank balances for 2005 we excluded $43,000, which was received as interest on overpayments.
4	Net interest margin is computed by dividing net interest income by average earning assets.
5	Earning assets yield minus interest-bearing liability rate.

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Noninterest Income and Expense

Noninterest income, net of a one-time gain in the second quarter of 2004 of $292,000 on the sale of property that had been classified as other real estate owned, declined $473,000 or 4.5%. The decline in noninterest income for the 2005 period was primarily the result of a decrease in service charges on deposit accounts from $5.381 million for the nine months ended September 30, 2004 to $5.027 million for the nine months ended September 30, 2005, a 6.6% decrease.

For the nine months ended September 30, 2005, noninterest expense increased $1.432 or 5.1% compared to the same period in 2004 primarily due to an increase in personnel expense. Personnel expense for the nine months ended September 30, 2005, consisting of employee salaries and benefits, increased $994,000 or 6.6% from the same period in 2004. The increase in personnel expense is largely attributable to an increase in incentive compensation of $514,000 for the nine months ended 2005 over 2004, due to the Bank and its subsidiaries’ improved financial performance and increased loan and sales performance for 2005 over the 2004 activity, an increase in health insurance costs of $120,000, due to unusually low claims activity in the first quarter of 2004 and an increase in salary expense of $222,000 (this increase was explained in the third quarter comparison above).

For the changes in other operating expenses, please see the table, Other Operating Income and Expenses, below.

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Other Operating Income and Expenses (In thousands)

	Nine Months Ended
	September 30,				Percentage
	2005		2004		Variance
Other operating income:
Bankcard income	$	1,888		1,866		1.2	%
Fee income(1)		1,311		1,127		16.3
Investment Services commissions(2)		721		1,029		(29.9	)
Insurance commissions(2)		155		182		(14.8	)
Trust income		480		469		2.3
Other income(3)		176		341		(48.4	)
	$	4,731		5,014		(5.6	)%
Other operating expenses:
Advertising(4)	$	619		681		(9.1	)%
Automated services(5)		2,229		1,804		23.6
Bankcard expense		1,419		1,331		6.6
Legal and professional fees		1,459		1,579		(7.6	)
Postage		583		554		5.2
Stationery, printing and supplies(6)		521		702		(25.8	)
OREO expense(7)		295		122		141.8
Other expense		3,308		3,293		0.5
	$	10,433	$	10,066		3.6	%

(1)	This increase is primarily due to the large increased use of debit card purchases which results in merchant fees collected by the Bank.
(2)	This decrease is due to a decreased volume of Investment Services and insurance products sold.
(3)	The one-time gain on the sale of other real estate of $292,000 during the second quarter of 2004 is included in other income.
(4)	During the second quarter of 2004 there was a large emphasis on marketing branding and product promotions, which accounts for the decrease in the nine months ended September 30, 2005 from the same period in 2004.
(5)	This increase is due to Impact ’05 initiatives put in place to improve the Bank’s performance in operations, retail delivery system and technology. These include enhancements to our data processing systems and the renewal and license fee costs associated with these, an upgrade in our communication lines to the branches and contingency planning.
(6)	The decrease is due to the outsourcing of the Bank’s supply room starting in the second quarter of 2005.
(7)	The increase is due to the materials and professional fees to remediate the condominiums discussed in “Asset Quality and Allowance for Loan Losses” on page 22 of this report.

Asset Quality and Allowance for Loan Losses

At September 30, 2005, the allowance for loan losses was $8.684 million or 1.14% of loans outstanding compared to $7.962 million or 1.12% of loans outstanding at December 31, 2004, and $8.006 million or 1.14% of loans outstanding at September 30, 2004. Net charge-offs for the nine months ended September 30, 2005 were $1.592 million or 0.21% of average loans outstanding compared to net charge-offs of $2.236 million or 0.33% of average loans outstanding as of September 30, 2004. Adequate provisions and allowances for loan loss reserves are based on numerous factors including growth of the loan portfolio, delinquencies, net charge-offs, non-performing loans and collateral values. Additional information regarding the allowance for loan losses is presented in the table, Asset Quality Analysis, below.

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The provision for loan losses charged to operations for the nine months ended September 30, 2005 totaled $2.314 million compared to $2.396 million for the nine months ended September 30, 2004. At September 30, 2005, the allowance for loan losses was 2.32 times nonperforming loans compared to 1.94 at December 31, 2004 and 1.93 times at September 30, 2004. Based on analysis of the current loan portfolio and levels of current problem assets and potential problem loans, management believes the allowance for loan losses to be adequate. Management continues to monitor the asset quality of the loan portfolio. Loans charged-off are recorded based upon the financial condition of the borrower and the likelihood of repayment.

Nonperforming assets, which includes nonaccrual loans, accruing loans more than 90 days past due, other real estate owned and renegotiated debt, totaled $8.453 million at September 30, 2005, as compared to $5.718 million at September 30, 2004. As reported last quarter, substantially all of the increase resulted from a loan to a long-term customer of the Bank, secured by condominiums in a coastal community. Upon default by the customer, during the second quarter, the Bank acquired the condominiums, by means of a deed-in-lieu of foreclosure, and booked this asset in other real estate owned in the amount of $3.0 million. Since acquiring the condominiums, the Bank has learned that some of the condominiums were damaged by water intrusion problems resulting from construction and design defects and storm damage. With the help of appropriate experts, the Bank is aggressively and thoroughly evaluating the extent and cause of the water intrusion problems, the repairs that will be required to keep the problems from recurring, the parties responsible for the problems and possible remedies available to the Bank. The Bank has engaged an experienced company to remediate mold damage in several of its condominium units resulting from water intrusion and the remediation is substantially complete. At this time, it is not possible to determine the extent of additional loss that will be incurred by the Bank.

Loans classified for regulatory purposes as loss, doubtful, substandard or special mention that have not been disclosed herein as nonperforming do not represent or result from trends or uncertainties which management reasonably expects will materially impact future operating results, liquidity, or capital resources. For these loans, management is not aware of any information which causes management to have serious doubts as to the ability of such borrowers to comply with the loan repayment terms. In the opinion of management, all loans where serious doubts exist as to the ability of borrowers to comply with the present repayment terms have been included in the schedule presented below.

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Asset Quality Analysis
(Dollars in thousands)

	September 30			December 31			September 30
	2005			2004			2004
Allowance for Loan Losses:
Beginning Balance	$	7,962		$	7,846		$	7,846
Provision for loan losses		2,314			3,017			2,396
Net (charge-off) recoveries		(1,592	)		(2,901	)		(2,236	)
Ending Balance	$	8,684		$	7,962		$	8,006
Risk Assets:
Nonaccrual loans	$	492		$	685		$	1,825
Foreclosed real estate		4,713			1,531			1,577
Restructured loans		858			582			588
Loans 90 days or more past due and still accruing		2,390			1,313			1,728
Total risk assets	$	8,453		$	4,111		$	5,718
Asset Quality Ratios:
Nonaccrual loans as a percentage of total loans		0.06	%		0.10	%		0.26	%
Nonperforming assets as a percentage of:
Total assets		0.85			0.45			0.63
Loans plus foreclosed property		1.10			0.58			0.81
Net charge-offs as a percentage of average loans		0.28	*		0.42			0.44	*
Allowance for loan losses as a percentage of loans		1.14			1.12			1.14
Ratio of allowance for loan losses to:
Net charge-offs		4.08	*		2.74			2.68	*
Nonaccrual loans		17.65			11.62			4.39

* Denotes Annualized

Accrued income taxes applicable to income for the nine months ended September 30, 2005 were $3.617 million compared to $2.866 million for the nine months ended September 30, 2004. Pretax income for the nine months ended September 30, 2005 of $10.779 million increased $1.747 million compared to $9.032 million for the nine months ended September 30, 2004. The increase in accrued taxes for the nine months ended September 30, 2005 is primarily due to the increased taxable income. During 2003, the Bank purchased an investment tax credit partnership interest for $540,000. The partnership is expected to yield $1.000 million in tax credits over the years 2003 to 2009. Actual credits applied to the nine months ended September 30, 2005 and 2004, were $125,000 and $141,000, respectively. Bancshares accounts for tax credits using the flow-through method, thereby reducing income tax expense in the year in which the credits were received.

Capital Resources and Shareholders’ Equity

In May 2004, the Board of Directors of Bancshares approved an extension of the stock repurchase program, first approved in November of 1998 and extended in August of 1999, for up to an additional 300,000 shares of Bancshares’ common stock. Currently, this repurchase program is scheduled to conclude on May 31, 2006. The Board authorized the repurchase of shares of common stock in the open market or privately negotiated transactions on a time-to-time and ongoing basis, depending upon market

23

conditions and subject to compliance with all applicable securities laws and regulations. The repurchase program assists in the goal of building shareholder value and maintaining appropriate capital levels.

The following table shows a breakdown of the shares that have been repurchased under the repurchase program during the quarter.

Issuer Purchases of Equity Securities

	Total				Total Shares		Maximum Number
	Number of		Average		Purchased Pursuant		of Shares that may
	Shares		Price Paid		to Publicly		yet be Purchased
Month	Purchased		Per Share		Announced Plan		Under the Plan
July 1 – July 31		11,797	$	18.11		555,831		344,169
Aug 1 – Aug 31		7,903	$	17.95		563,734		336,266
Sept 1 – Sept 30		1,442	$	17.56		565,176		334,824
Total		21,142	$	18.02

Regulatory guidelines require minimum levels of capital based on a risk weighting of each asset category and off-balance sheet contingencies. Regulatory agencies divide capital into Tier 1 or core capital and total capital. Tier 1 capital, as defined by regulatory agencies, consists primarily of common shareholders’ equity less goodwill and certain other intangible assets. Total capital consists of Tier 1 capital plus the allowable portion of the allowance for loan losses and certain long-term debt. Additional regulatory capital measures include the Tier 1 leverage ratio. Tier 1 leverage ratio is defined as Tier 1 capital divided by average total assets less goodwill and certain other intangibles and has a regulatory minimum of 3.0%, with most institutions required to maintain a ratio of at least 4.0% to 5.0%, depending primarily upon risk profiles. In addition to the aforementioned risk-based capital requirements, the Bank is subject to a leverage capital requirement, requiring a minimum ratio of Tier 1 Capital (as defined previously) to total adjusted average assets of 3.0% to 5.0%. The Bank’s capital requirements are summarized in the table below (Dollars in thousands):

						��
						Risk-Based Capital
	Leverage Capital					Tier 1 Capital					Total Capital
	Amount		Percent1			Amount		Percent2			Amount		Percent2
Actual	$	91,685		9.32	%	$	91,685		11.27	%	$	100,369		12.34	%
Required		29,498		3.00			32,540		4.00			65,081		8.00
Excess		62,187		6.32			59,145		7.27			35,288		4.34

1	Percentage of total adjusted average assets. The Federal Reserve Board’s minimum leverage ratio requirement is 3.0% to 5.0% depending on the institution’s composite rating as determined by its regulators. The Federal Reserve Board has not advised the Bank of any specific requirement applicable to it.
2	Percentage of risk-weighted assets.

Due to the pending adoption of SFAS No. 123(R), effective April 11, 2005, the Stock Option and Compensation Committee of the Board of Directors of Bancshares (the “Compensation Committee”) voted to immediately vest certain unvested and underwater options held by current employees and executive officers.

The decision to vest these options, which the Compensation Committee and the Executive Committee of the Board of Directors of Bancshares believe was in the best interests of Bancshares and its shareholders, was made to reduce compensation expense that otherwise would have been recorded in future periods once Bancshares became subject to SFAS 123(R), which is currently scheduled to become effective for

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Bancshares’ fiscal year beginning January 1, 2006. As a result of this accelerated vesting, Bancshares expects to reduce its future aggregate compensation expense related to the options subject to the vesting by a total of approximately $227,000, based on estimated value calculations using Black-Scholes valuation methodology.

Commitments

The Bank has recently acquired land in Archdale, NC with intentions of constructing a stand-alone branch in the region to replace the smaller branch already in this community. The Bank plans on funding the construction of this Branch with Bank deposits and FHLB borrowings.

Market Risk Management

Bancshares’ market risk arises primarily from the interest rate risk inherent in its lending and deposit-taking activities. The objectives of market risk management are to ensure long-range profitability performance and minimize risk, adhere to proper liquidity and maintain sound capital. To meet these goals, the Asset/liability Committee of Bancshares (“ALCO”) monitors the exposure to interest rate risk, balance sheet trends, pricing policies and liquidity position. The objectives are to achieve relatively stable net interest margins and assure liquidity through coordinating the volumes, maturities or repricing opportunities of earning assets, deposits and borrowed funds. This is accomplished through strategic pricing of asset and liability accounts. As a result, appropriate maturities and/or repricing opportunities are developed to produce consistent earnings during changing interest rate environments.

Based upon its view of existing and expected market conditions, ALCO adopts balance sheet strategies intended to optimize net interest income to the extent possible while minimizing the risk associated with unanticipated changes in interest rates. Core deposits have historically been the primary funding sources for asset growth. Correspondent relationships have been maintained with several large banks in order to have access to federal funds purchases when needed. The Bank also has available lines of credit maintained with the FHLB, which can be used for funding and/or liquidity needs. This credit is collateralized by a blanket lien on qualifying loans secured by first mortgages on 1-4 family residences as well as qualified multi-family and home equity lines. The Bank has two $10 million and a $20 million irrevocable letter of credit with the FHLB that are used in lieu of securities to pledge against public deposits. The Bank also has retail CD brokerage agreements that provide additional sources of liquidity for funding needs.

To minimize risk of interest rate movements, the asset/liability management process seeks to match maturities and repricing opportunities of interest-sensitive assets and interest-sensitive liabilities. The Bank uses an asset/liability simulation model to produce a gap analysis. The simulation model computes projected runoff of deposits that do not have contractual maturity dates. On September 30, 2005, the one-year cumulative interest sensitivity gap was a positive $133 million for a ratio of interest-sensitive assets to interest-sensitive liabilities of 1.40. Management believes that is an acceptable ratio.

Item 3. Quantitative and Qualitative Disclosures about Market Risk

Market risk reflects the risk of economic loss resulting from adverse changes in market price and interest rates. This risk of loss can be reflected in diminished current market values and/or reduced potential net interest income in future periods.

Bancshares’ market risk arises primarily from the interest rate risk inherent in its lending and deposit-taking activities. The structure of Bancshares’ loan and deposit portfolios is such that a significant decline in interest rates may adversely impact net market values and net interest income. Bancshares does not maintain a trading account nor is it subject to currency exchange risk or commodity price risk.

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Responsibility for monitoring interest rate risk rests with ALCO, which is appointed by Bancshares’ Board of Directors. ALCO meets on a regular basis to review interest rate risk exposure and liquidity positions. Balance sheet management and funding strategies are reviewed to ensure that any potential impact on earnings and liquidity, resulting from a fluctuation in interest rates, is within acceptable standards.

Other than the effects of interest rate increases during the first nine months, management believes there has not been any significant change in the overall analysis of financial instruments considered market risk sensitive, as measured by the factors of contractual maturities, average interest rates and the difference between estimated fair values and book values, since the analysis prepared in the Form 10-K Annual Report for the fiscal year ended December 31, 2004.

Item 4. Controls and Procedures

As of the end of the period covered by this report, Bancshares has evaluated, under the supervision and with the participation of Bancshares’ management, including Bancshares’ Chief Executive Officer and Chief Financial Officer, the effectiveness of Bancshares’ disclosure controls and procedures (as defined in Rule 13a-15(e) promulgated under the Exchange Act). Based upon that evaluation, Bancshares’s Chief Executive Officer and Chief Financial Officer have concluded that Bancshares’s disclosure controls and procedures are effective to ensure that information required to be disclosed by Bancshares in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within time periods specified in the rules and forms of the SEC.

During the quarterly period covered by this report, there has been no change in Bancshares’ internal control over financial reporting (as defined in Rule 13a-15(f) promulgated under the Exchange Act) that has materially affected, or is reasonably likely to materially affect, Bancshares’ internal control over financial reporting.

PART II. OTHER INFORMATION

Item 1. Legal Proceedings

Not applicable.

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

The first paragraph under “Capital Resources and Shareholders’ Equity” in the “Management’s Discussion and Analysis of Financial Condition and Results of Operations” section in Part I, Item 2 above and the table entitled “Issuer Purchases of Equity Securities” immediately after such first paragraph is incorporated herein by reference.

Item 3. Defaults Upon Senior Securities

Not applicable.

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

Not applicable

Item 5. Other Information

Not applicable.

Item 6. Exhibits

Exhibit 31.1	Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (“SOX”)
Exhibit 31.2	Certification Pursuant to Section 302 of SOX
Exhibit 32	Certification Pursuant to Section 906 of SOX

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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.

Date: November 3, 2005		LSB BANCSHARES, INC.
			(Registrant)
		By:	/s/ Monty J. Oliver
		Name: Monty J. Oliver
	Title: Secretary and Chief Financial Officer
	(Authorized Officer and Chief Accounting Officer)

EXHIBIT INDEX

Exhibit No.	Description
31.1	Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (“SOX”).
31.2	Certification Pursuant to Section 302 of SOX.
32	Certification Pursuant to Section 906 of SOX.

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