Newbridge Bancorp (NBBC) 10-Q 2006 Q2 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 endedJune 30, 2006

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 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 filero      Accelerated filerþ      Non-accelerated filero

     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 8,455,506 shares of common stock outstanding as of July 31, 2006.

LSB BANCSHARES, INC.
AND SUBSIDIARIES

FORM 10-Q
TABLE OF CONTENTS

		Page
	PART I
	Financial Information
Item 1	Financial Statements		3
	Consolidated Balance Sheets June 30, 2006 and December 31, 2005		3
	Consolidated Statements of Income Six Months and Three Months Ended June 30, 2006 and 2005		4
	Consolidated Statements of Changes in Shareholders’ Equity Six Months Ended June 30, 2006 and 2005		5
	Consolidated Statements of Cash Flows Six Months Ended June 30, 2006 and 2005		6
	Notes to Consolidated Financial Statements Six Months Ended June 30, 2006 and 2005		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		29
Item 4	Controls and Procedures		29
	PART II
	Other Information
Item 1	Legal Proceedings		30
Item 1A	Risk Factors		30
Item 2	Unregistered Sales of Equity Securities and Use of Proceeds		30
Item 3	Defaults Upon Senior Securities		30
Item 4	Submission of Matters to a Vote of Security Holders		31
Item 5	Other Information		31
Item 6	Exhibits		31

2

PART I
FINANCIAL INFORMATION

Item 1. Financial Statements.

Consolidated Balance Sheets

	(Unaudited)
	June 30			December 31
(In thousands, except shares)	2006			2005
Assets
Cash and Due from Banks	$	38,118		$	45,600
Interest-Bearing Bank Balances		1,220			1,385
Federal Funds Sold		17,118			16,355
Investment Securities (Note 3):
Held to Maturity, Market Value $27,304 and $27,603		27,610			27,427
Available for Sale		116,832			100,732
Loans (Note 4)		756,845			755,398
Less, Allowance for Loan Losses (Note 4)		(8,502	)		(8,440	)
Net Loans		748,343			746,958
Premises and Equipment		19,622			19,358
Other Assets		17,407			17,980
Total Assets	$	986,270		$	975,795
Liabilities
Deposits:
Demand	$	149,653		$	131,515
Savings, N.O.W. and Money Market Accounts		396,558			409,928
Certificates of Deposit of less than $100,000		136,932			140,700
Certificates of Deposit of $100,000 or more		145,568			140,030
Total Deposits		828,711			822,173
Securities Sold Under Agreements to Repurchase		909			1,657
Borrowings from the Federal Home Loan Bank		59,000			53,000
Other Liabilities		6,558			7,136
Total Liabilities		895,178			883,966
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 8,507,355 Shares as of June 30, 2006 and 8,524,033 Shares as of December 31, 2005		42,537			42,620
Paid-In Capital		9,146			9,430
Directors’ Deferred Plan		(1,361	)		(1,334	)
Retained Earnings		42,815			42,424
Accumulated Other Comprehensive Loss		(2,045	)		(1,311	)
Total Shareholders’ Equity		91,092			91,829
Total Liabilities and Shareholders’ Equity	$	986,270		$	975,795
Memorandum: Standby Letters of Credit	$	5,206		$	5,831

     Notes to consolidated financial statements are an integral part hereof.

3

Consolidated Statements of Income
(Unaudited)

	Three Months Ended				Six Months Ended
	June 30				June 30
(In thousands, except shares and per share amounts)	2006		2005		2006		2005
Interest Income
Interest and Fees on Loans	$	15,017	$	13,509	$	29,506	$	25,799
Interest on Investment Securities:
Taxable		1,137		879		2,115		1,756
Tax Exempt		306		368		625		714
Interest-Bearing Bank Balances		83		105		165		193
Federal Funds Sold		223		100		472		181
Total Interest Income		16,766		14,961		32,883		28,643
Interest Expense
Deposits		5,119		2,946		9,668		5,322
Securities Sold Under Agreements to Repurchase		2		1		7		5
Borrowings from the Federal Home Loan Bank		694		963		1,302		1,912
Total Interest Expense		5,815		3,910		10,977		7,239
Net Interest Income		10,951		11,051		21,906		21,404
Provision for Loan Losses (Note 4)		611		1,060		2,018		1,599
Net Interest Income after Provision for Loan Losses		10,340		9,991		19,888		19,805
Noninterest Income
Service Charges on Deposit Accounts		1,843		1,700		3,435		3,253
Gains on Sales of Mortgages		101		146		179		278
Other Operating Income		1,642		1,635		3,171		3,212
Total Noninterest Income		3,586		3,481		6,785		6,743
Noninterest Expense
Personnel Expense		5,545		5,352		11,268		10,686
Occupancy Expense		478		456		957		920
Equipment Depreciation and Maintenance		535		576		1,065		1,167
Other Operating Expense		5,130		3,424		8,680		6,798
Total Noninterest Expense		11,688		9,808		21,970		19,571
Income Before Income Taxes		2,238		3,664		4,703		6,977
Income Taxes		692		1,234		1,416		2,315
Net Income	$	1,546	$	2,430	$	3,287	$	4,662
Earnings Per Share:
Basic	$	0.18	$	0.28	$	0.39	$	0.54
Diluted	$	0.18	$	0.28	$	0.38	$	0.54
Weighted Average Shares Outstanding:
Basic		8,518,434		8,559,262		8,522,718		8,570,943
Diluted		8,549,643		8,593,894		8,560,576		8,610,089

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, 2004		8,590,184		$	42,951		$	10,482		$	(1,197	)	$	38,592		$	(86	)	$	90,742
Net Income														4,662						4,662
Change in unrealized gain on securities available for sale, net of deferred income taxes																	(361	)		(361	)
Comprehensive income																				4,301
Cash dividends declared on common stock														(2,908	)					(2,908	)
Common stock issued for stock options exercised		38,257			191			267												458
Common stock acquired		(80,453	)		(402	)		(999	)		(89	)								(1,490	)
Balances at June 30, 2005		8,547,988		$	42,740		$	9,750		$	(1,286	)	$	40,346		$	(447	)	$	91,103
Balances at December 31, 2005		8,524,033		$	42,620		$	9,430		$	(1,334	)	$	42,424		$	(1,311	)	$	91,829
Net Income														3,287						3,287
Change in unrealized gain on securities available for sale, net of deferred income taxes																	(734	)		(734	)
Comprehensive income																				2,553
Cash dividends declared on common stock														(2,896	)					(2,896	)
Stock-based compensation expense								84												84
Common stock issued for stock options exercised		20,386			102			102												204
Common stock acquired		(37,064	)		(185	)		(470	)		(27	)								(682	)
Balances at June 30, 2006		8,507,355		$	42,537		$	9,146		$	(1,361	)	$	42,815		$	(2,045	)	$	91,092

Notes to consolidated financial statements are an integral part hereof.

5

Consolidated Statements of Cash Flows
(Unaudited)

	Six Months Ended
	June 30
(In thousands)	2006			2005
Cash Flow from Operating Activities
Net Income	$	3,287		$	4,662
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation		953			1,025
Securities premium amortization and discount accretion, net		61			55
(Increase) decrease in loans held for sale		2,017			(6,382	)
Deferred income taxes		76			111
Decrease in income taxes payable		(831	)		(372	)
Increase in income earned but not received		(180	)		(477	)
Increase in interest accrued but not paid		380			370
Net (increase) decrease in other assets		1,137			(4,188	)
Net increase (decrease) in other liabilities		(127	)		640
Provision for loan losses		2,018			1,599
Gain on sale of premises and equipment		—			(3	)
Stock based compensation		84			—
Net cash provided (used) by operating activities		8,875			(2,960	)
Cash Flow from Investing Activities
Purchases of securities held to maturity		(2,450	)		(4,052	)
Proceeds from maturities of securities held to maturity		2,258			3,197
Purchases of securities available for sale		(25,580	)		(13,579	)
Proceeds from maturities of securities available for sale		8,235			11,225
Net increase in loans made to customers		(5,421	)		(49,808	)
Purchases of premises and equipment		(1,217	)		(1,557	)
Proceeds from sale of premises and equipment		—			3
Net increase in federal funds sold		(763	)		(3,144	)
Net cash used for investing activities		(24,938	)		(57,715	)
Cash Flow from Financing Activities
Net increase in demand deposits, N.O.W., money market and savings accounts		4,768			12,657
Net increase in time deposits		1,770			55,255
Net decrease in securities sold under agreement to repurchase		(748	)		(572	)
Proceeds from long-term debt		61,000			48,000
Payments on long-term debt		(55,000	)		(42,000	)
Dividends paid		(2,896	)		(2,908	)
Proceeds from issuance of common stock		204			458
Common stock acquired		(682	)		(1,490	)
Net cash provided by financing activities		8,416			69,400
Increase (decrease) in cash and cash equivalents		(7,647	)		8,725
Cash and cash equivalents at the beginning of the period		46,985			37,522
Cash and cash equivalents at the end of the period	$	39,338		$	46,247

Notes to consolidated financial statements are an integral part hereof.

6

Consolidated Statements of Cash Flows continued
(Unaudited)

	Six Months Ended
	June 30
(In thousands)	2006			2005
Supplemental Disclosures of Cash Flow Information
Cash paid during the periods for:
Interest	$	9,978		$	6,869
Income Taxes		2,210			2,579
Supplemental Disclosures of Noncash Transactions
Transfer of loans to other real estate owned	$	1,124		$	3,425
Unrealized gains/(losses) on securities available for sale:
Change in securities available for sale		(1,194	)		(587	)
Change in deferred income taxes		460			226
Change in shareholders’ equity		(734	)		(361	)

Notes to consolidated financial statements are an integral part hereof.

7

Notes To Consolidated Financial Statements
As of or for the Periods Ended June 30, 2006 and 2005

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 six-month periods ended June 30, 2006 are not necessarily indicative of the results that may be expected for the year ending December 31, 2006.

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, 2005, filed with the Securities and Exchange Commission (the “SEC”) on March 15, 2006 (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 shared 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				Six Months Ended
	June 30				June 30
	2006		2005		2006		2005
Weighted average number of common shares used in computing basic net income per share		8,518,434		8,559,262		8,522,718		8,570,943
Effect of diluted stock options		31,209		34,632		37,858		39,146
Diluted weighted average common shares outstanding		8,549,643		8,593,894		8,560,576		8,610,089

Note 3 — Investment Securities(In thousands)

	June 30, 2006 — Securities Held to Maturity
	Amortized		Unrealized		Unrealized			Market
	Cost		Gains		Losses			Value
State, county and municipal securities	$	27,610	$	328	$	(634	)	$	27,304

	June 30, 2006 — Securities Available for Sale
	Amortized		Unrealized		Unrealized			Market
	Cost		Gains		Losses			Value
U.S. government agency obligations	$	113,018	$	—	$	(3,185	)	$	109,833
State, county and municipal securities		2,536		—		(142	)		2,394
Equity securities		4,605		—		—			4,605
Total	$	120,159	$	—	$	(3,327	)	$	116,832

	December 31, 2005 — Securities Held to Maturity
	Amortized		Unrealized		Unrealized			Market
	Cost		Gains		Losses			Value
State, county and municipal securities	$	27,427	$	505	$	(329	)	$	27,603

	December 31, 2005 — Securities Available for Sale
	Amortized		Unrealized		Unrealized			Market
	Cost		Gains		Losses			Value
U.S. government agency obligations	$	96,040	$	45	$	(2,051	)	$	94,034
State, county and municipal securities		2,612		—		(128	)		2,484
Equity securities		4,214		—		—			4,214
Total	$	102,866	$	45	$	(2,179	)	$	100,732

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The following is a schedule of securities in a loss position as of June 30, 2006 (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	$	52,054	$	(1,070	)	$	56,778	$	(2,115	)	$	108,832	$	(3,185	)
State, county and municipal securities		10,436		(326	)		6,851		(450	)		17,287		(776	)
Total securities	$	62,490	$	(1,396	)	$	63,629	$	(2,565	)	$	126,119	$	(3,961	)

Investment securities with amortized cost of $102,079,000 and $92,705,000, as of June 30, 2006, and December 31, 2005, 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 August 11, 2010, May 11, 2015, 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 six months ending June 30, 2006.

Note 4 — Loans and Allowance for Loan Loss

A summary of consolidated loans follows (In thousands):

	June 30		December 31
	2006		2005
Commercial, financial, & agricultural	$	278,798	$	288,240
Real estate — construction		48,209		38,179
Real estate — mortgage		363,652		354,322
Installment loans to individuals		64,319		72,336
Lease financing		273		403
Other		1,594		1,918
Total loans, net of unearned income	$	756,845	$	755,398

Nonperforming assets are summarized as follows (In thousands):

	June 30		December 31
	2006		2005
Nonaccural loans	$	2,956	$	929
Restructured loans		612		856
Loans past due 90 days or more		1,534		1,911
Total nonperforming loans		5,102		3,696
Foreclosed real estate		3,755		4,391
Total nonperforming assets	$	8,857	$	8,087

10

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

	June 30		December 31
	2006		2005
Loans specifically identified as impaired	$	8,547	$	8,937
Allowance for loan losses associated with impaired loans	$	832	$	1,101

	Three Months Ended				Six Months Ended
	June 30				June 30
	2006		2005		2006		2005
Average balances of impaired loans	$	8,598	$	7,127	$	8,398	$	5,533
Interest income recorded for impaired loans	$	103	$	90	$	269	$	149

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):

	Six Months Ended June 30
	2006			2005
Balance, beginning of period	$	8,440		$	7,962
Provision for loan losses		2,018			1,599
Recoveries of amounts previously charged off		742			247
Loans charged off		(2,698	)		(1,342	)
Balance, end of period	$	8,502		$	8,466

At June 30, 2006, loans totaling $17,173,000 were held for sale stated at the lower of cost or market on an individual basis.

Note 5 — Recent Accounting Pronouncements

In March 2006, the FASB issued Statement of Financial Accounting Standards No. 156, “Accounting for Servicing of Financial Assets” (“SFAS 156”), which is an amendment of FASB Statement No. 140 (“SFAS 140”). SFAS 156 deals with the servicing of financial assets and liabilities. This applies to Bancshares’ sales and servicing of mortgage loans. The statement requires all separately recognized servicing assets and liabilities to be initially measured at fair value, if practicable. This was also required under SFAS 140 and therefore already implemented by Bancshares. The statement now permits an entity to choose either the amortization method or the fair value measurement method for subsequent measurement. Previously, the only subsequent method available was the amortization method which calls for amortizing servicing assets or liabilities in proportion to and over the period of estimated net servicing income or loss and assess servicing assets or liabilities for impairment or increased obligation based on fair value at each reporting date. The fair value measurement method measures servicing assets and liabilities at fair value at each reporting date and reports changes in fair value in earnings in the

11

period in which the changes occur. Since Bancshares is not using any derivative instruments to mitigate risk associated with its mortgage servicing rights they will continue to use the amortization method upon adoption of SFAS 156 on January 1, 2007. Bancshares believes that adopting SFAS 156 will not result in any material effect on its financial position or operating results since Bancshares will still be using the amortization method.

On November 3, 2005, FASB agreed to issue FSP FAS 115-1 / FAS 124-1, “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 December 15, 2005. Its adoption has not had any material impact on Bancshares’ consolidated financial statements.

In December 2004, the FASB issued Statement of Financial Accounting Standards No. 123(R), “Share-Based Payment” (“SFAS 123(R)”), which is a revision of SFAS 123 and supersedes Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (“APB 25”). SFAS 123(R) requires all share-based payments to employees, including grants of employee stock options, 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 123(R) must 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 APB 25. SFAS 123(R) is effective for all stock-based awards granted on or after January 1, 2006 and Bancshares has implemented SFAS 123(R) as of January 1, 2006. See Note 6 for disclosure.

Note 6 — Stock Compensation Plans

Effective January 1, 2006 Bancshares adopted the fair value method of accounting for stock-based compensation arrangements in accordance with SFAS 123(R),using the modified prospective method of transition. Under the provisions of SFAS 123(R), the estimated fair value of share based awards granted under the Comprehensive Benefit Plan, discussed in the 2005 Form 10-K, is recognized as compensation expense over the vesting period. Using the modified prospective method, compensation expense is recognized beginning with the effective date of adoption of SFAS 123(R) for all share based payments (i) granted after the effective date of adoption and (ii) granted prior to the effective date of adoption and that remain unvested on the date of adoption.

Prior to January 1, 2006, Bancshares accounted for stock-based employee compensation plans using the intrinsic value method of accounting in accordance with APB 25, and its related interpretations. Under the provisions of APB 25, no compensation expense was recognized when stock options were granted with exercise prices equal to or greater than market value on the date of grant.

Pursuant to the provisions of SFAS 123(R), Bancshares recorded $59,000, or $0.01 per diluted share and $84,000, or $0.01 per diluted share, of total stock-based compensation expense for the three-month and six-month periods ended June 30, 2006, respectively. The stock-based compensation expense is calculated on a ratable basis over the vesting periods of the related options. This expense had no impact on Bancshares’ reported cash flows. For the three-month and six-month periods ended June 30, 2005, the Company recorded no stock compensation expense pursuant to APB 25. The stock-based compensation expense for the three months and six months ended June 30, 2006 is reported under personnel expense.

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Under the modified prospective method of transition under SFAS 123(R), Bancshares is not required to restate its prior period financial statements to reflect expensing of share-based compensation under SFAS 123(R). Therefore, the results as of June 30, 2006 are not directly comparable to the same period in the prior year.

As required by SFAS 123(R), Bancshares has presented pro forma disclosures of its net income and net income per share for the prior year period assuming the estimated fair value of the options granted prior to January 1, 2006 was amortized to expense over the option-vesting period as illustrated below (In thousands, except per share amounts).

	Three Months		Six Months
	Ended		Ended
	June 30		June 30
	2005		2005
Net income, as reported	$	2,430	$	4,662
Less, total stock-based employee compensation expense determined under the fair value based method for all awards, net of related tax effects		244		325
Pro forma net income	$	2,186	$	4,337
Earnings Per Share:
Basic — as reported	$	0.28	$	0.54
Basic — pro forma	$	0.26	$	0.51
Diluted — as reported	$	0.28	$	0.54
Diluted — pro forma	$	0.25	$	0.50

For purposes of the disclosure in the foregoing table and for purposes of determining estimated fair value under SFAS 123(R), Bancshares has computed the estimated fair values of all share-based compensation using the Black-Scholes option pricing model and has applied the assumptions set forth in the 2005 Form 10-K filed March 15, 2006. There have been no additional options granted during 2006. As of June 30, 2006, there was $237,000 of total unrecognized compensation expense related to stock option arrangements granted under the Comprehensive Benefit Plan. This expense will be fully amortized in December of 2010.

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
	June 30						June 30
	2006			2005			2006		2005
Service cost	$	227		$	210		$	14	$	13
Interest cost		218			199			14		13
Expected Return on plan assets		(218	)		(194	)		—		—
Amortization of prior service		16			17			—		—
Amortization of transition obligation		—			—			3		3
Amortization of loss		62			50			2		2
Net periodic benefit cost	$	305		$	282		$	33	$	31

13

	Pension Benefits						Retiree Medical
	Six Months Ended						Six Months Ended
	June 30						June 30
	2006			2005			2006		2005
Service cost	$	454		$	420		$	29	$	26
Interest cost		436			398			28		26
Expected Return on plan assets		(436	)		(388	)		—		—
Amortization of prior service		32			34			—		—
Amortization of transition obligation		—			—			5		5
Amortization of loss		124			100			4		4
Net periodic benefit cost	$	610		$	564		$	66	$	61

Note 8 – Derivatives

Bancshares began using derivatives in the fourth quarter of 2005. The derivatives are being used in conjunction with the Bank’s sale of Indexed Certificates of Deposits (ICD’s). ICDs pay no periodic interest payments. Rather, under the ICD’s, interest, if any, is paid at maturity and is calculated based on the positive price movements, if any, of the Dow Jones Industrial Average^SM (DJIA) over the entire term of the ICD. The goal is to curtail the interest rate risk of the ICD to the Bank by engaging in “perfectly matched” hedges or option contracts tied to the underlying index with creditworthy hedge providers who will support the inherent performance of the ICD at maturity of the issuances.

This approach will mitigate any exposure to unintended market risk and essentially fix Bancshares’ cost of funds at inception for the term of the ICD without concern over the performance of the DJIA. Bancshares has also considered the risk associated with any default in payment by the hedge providers. This risk is mitigated by all hedge providers having investment grade ratings. If the hedge providers fall below an investment grade rating collateral must be posted. Bancshares will also be using multiple hedge providers to spread the risk and providers are all publicly traded and have been in operation over 60 years.

The following table reflects risk management derivative financial instruments for the six months ended June 30, 2006:

					Average
	Notional		Unrealized		Years
(Dollars in thousands)	Amount		Losses (a)		Maturity
Fair value liability hedges:
Interest rate options	$	92	$	12		4.5

(a) Represents the fair value of derivative financial instruments.

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 operations 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 operations 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 Form 10-Q contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements represent expectations and beliefs of Bancshares including but not limited to Bancshares’ operations, performance, financial condition, growth or

14

strategies. These forward-looking statements are identified by words such as “expects”, “anticipates”, “should”, or other similar statements about future events. For this purpose, any statements contained in this Form 10-Q that are not statements of historical fact may be deemed to be forward-looking statements. These forward-looking statements involve estimates, assumptions by management, risks and uncertainties that could cause actual results to differ materially from current projections depending on a variety of important factors, including without limitation: (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 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; (15) adverse changes in financial performance and/or condition of Bancshares’ borrowers which could impact repayment of such borrowers’ outstanding loans; (16) the occurrence and/or impact of any of the Risk Factors identified in Bancshares’ 2005 Form 10-K; and (17) Bancshares’ success at managing the 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. 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. The benefits of a new Bank training infrastructure were realized during 2005 and are constantly being improved to meet the training needs of our employees. Additionally, the Bank’s Model Branch initiative, which is standardizing the tools and procedures in the branches, should provide branch sales and service employees with even better tools for increased sales, improved customer service and operational efficiencies. In this regard, the installation of a state-of-the-art Enterprise Relationship Management System, which was completed in the first quarter of 2006, and training of all employees just recently completed, is being piloted in four of our branches and will become the primary sales and service platform used by all of Bancshares’ customer service employees. The Bank also recently celebrated the groundbreaking of its new Archdale office which will be a full service branch and will replace the current temporary location. Through the Bank and the Bank’s two non-bank subsidiaries, Peoples Finance and LSBIS, Bancshares provides a wide range of financial services to individuals and corporate customers.

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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 the Bank’s loan and investment portfolios and its cost of funds, consisting of interest paid on deposits and borrowings. 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. 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 presented. For further information, refer to the Consolidated Financial Statements and footnotes thereto included in the 2005 Form 10-K filed with the SEC on March 15, 2006.

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. The preparation of the financial information contained in this Form 10-Q requires Bancshares’ management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. Bancshares’ management evaluates these estimates on an ongoing basis, including those related to allowance for loan loss and pension and post retirement benefit plans to employees. Except with respect to changes in the manner in which Bancshares accounts for share based compensation, as discussed below, there have been no material changes to the critical accounting policies as discussed in greater detail in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” contained in our Form 10-K filed with the SEC on March 15, 2006.

Stock-Based Compensation.On January 1, 2006 Bancshares adopted the fair value method of accounting for stock-based compensation using the modified prospective method of transition as outlined in FAS 123(R). Under FAS 123(R), the estimated fair value of stock-based compensation is recognized as compensation expense. The estimated fair value of stock options is expensed on a straight-line basis over the expected term of the grant. Prior to January 1, 2006, Bancshares accounted for stock-based employee

16

compensation plans using the intrinsic value method of accounting in accordance with APB 25, and its related interpretations. Under the provisions of APB 25, no compensation expense was recognized when stock options were granted with exercise prices equal to or greater than market value on the date of grant.

Under the modified prospective method of transition that Bancshares adopted, compensation expense is recognized beginning with the effective date of adoption for all stock-based payments (i) granted after the effective date of adoption and (ii) granted prior to the effective date of adoption and that remain unvested on the date of adoption. Under the modified prospective method of transition, Bancshares is not required to restate its prior period financial statements to reflect expensing of stock-based compensation under SFAS 123(R). Therefore the three-month results of March 31, 2006, are not directly comparable to the same period in the prior year. Under SFAS 123(R), Bancshares uses the Black Scholes pricing model to estimate the fair value of the stock-based compensation as of the grant date. The Black-Scholes model is highly complex, and dependent upon key data inputs estimated by management. The primary data inputs with the greatest degree of subjective judgment are the estimated lives of the stock-based awards and the estimated volatility of our stock price. The Black-Scholes model is highly sensitive to changes in these two data inputs.

Bancshares has not yet issued any additional options since its adoption of SFAS 123(R). The expense of $59,000 and $84,000 that was recorded during the three-month and six-month periods ended June 30, 2006, respectively, related to the unvested portion of options granted prior to January 1, 2006. See Note 6, Stock Compensation Plans, to the notes to consolidated financial statements for more information about the adoption of SFAS 123(R).

Three Months Ended June 30, 2006 Compared to Three Months Ended June 30, 2005

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 second quarter of 2006 of $10.951 million decreased $100,000 or 1.0% compared to $11.051 million for the second quarter of 2005. The decrease was largely attributable to a decline in the net interest margin from 4.98% for the quarter ended June 30, 2005 to 4.83% for the quarter ended June 30, 2006, partially offset by 1.9% growth in average earning assets for June 30, 2006 compared to June 30, 2005. Deposits continue to steadily grow in 2006. As of June 30, 2006 total deposits were up $38.524 million or 4.9% compared to June 30, 2005.

17

The following table provides an analysis of average volumes, yields and rates and net interest income on a tax-equivalent basis for the quarters ended June 30, 2006 and 2005.

Fully taxable equivalent basis¹(Dollars in thousands):

	Three Months Ended								Three Months Ended
	June 30, 2006								June 30, 2005
				Interest		Annualized						Interest		Annualized
	Average			Income/		Average			Average			Income/		Average
	Balance			Expense		Yield/Rate			Balance			Expense		Yield/Rate
Earning assets:
Loans and leases receivable2	$	755,220		$	15,017		7.98	%	$	757,637		$	13,509		7.15	%
Taxable securities		108,048			1,137		4.22			91,427			879		3.86
Tax exempt securities		31,085			411		5.30			31,199			520		6.69
Federal Home Loan Bank		4,432			62		5.61			6,035			73		4.85
Interest-bearing bank balances3		1,837			21		4.59			1,573			32		2.29
Federal funds sold		18,362			223		4.87			14,084			100		2.85
Total earning assets		918,984			16,871		7.36			901,955			15,113		6.72
Non-earning assets:
Cash and due from banks		37,283								38,023		��
Premises and equipment		19,543								17,819
Other assets		18,561								13,188
Allowance for loan losses		(8,434	)							(7,685	)
Total assets	$	985,937		$	16,871				$	963,300		$	15,113
Interest-bearing liabilities:
Savings and time deposits	$	689,215		$	5,119		2.98	%	$	658,491		$	2,946		1.79	%
Securities sold under agreement to repurchase		805			2		1.00			912			1		0.44
Borrowings from the Federal Home Loan Bank		55,143			694		5.05			93,472			963		4.13
Total interest-bearing liabilities		745,163			5,815		3.13			752,875			3,910		2.08
Other liabilities and shareholders’ equity:
Demand deposits		141,222								112,782
Other liabilities		6,285								6,142
Shareholders’ equity		93,267								91,501
Total liabilities and shareholders’ equity	$	985,937			5,815				$	963,300			3,910
Net interest income and net interest margin4				$	11,056		4.83	%				$	11,203		4.98	%
Interest rate spread5							4.23	%							4.64	%

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 of $336 and $599 for the three months ended June 30, 2006 and 2005, respectively, are included in interest income.
3	In calculating the annualized yield for Interest-bearing bank balances for 2005 there was $22,000 excluded, 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

In the second quarter of 2006, noninterest income increased $105,000 or 3.0% compared with the same period in 2005. The increase in noninterest income was primarily due to growth of $143,000 or 8% in service charges on deposits over the same period in 2005, which more than offset the lower gains on the sale of mortgages.

In the second quarter of 2006, noninterest expense increased $1.880 million or 19.2% compared to the same period in 2005. The primary reason for the large increase was a $1.0 million write-down, from $3.0 million to $2.0 million, of the coastal condominium project in Georgetown, SC that the Bank acquired in the second quarter of 2005 through a deed-in-lieu of foreclosure. This write-down is included in other operating expenses. During the second quarter of 2006, the Bank discovered, for the first time, that a portion of the condominium development assets had not been conveyed to the Bank as the Bank had previously been advised. The Bank is actively pursuing recovery of the losses incurred with this project.

Personnel expense in the second quarter of 2006, consisting of employee salaries and benefits, increased $193,000 or 3.6% from the same period in 2005. The increase in personnel expense is largely attributable to the following areas: (i) an increase in insurance expense of $111,000 due to some unusually high claims activity during the quarter; (ii) an increase in salary expense of $88,000 or 2.1% for the quarter ended June 30, 2006 compared to the same period in 2005. Full-time equivalent employees for Bancshares totaled 420 at June 30, 2006 compared to 421 at June 30, 2005 therefore the increase was primarily due to annual salary review increases; (iii) $59,000 of stock option compensation expense incurred during the second quarter of 2006 due to the adoption of FAS123(R); and (iv) an increase in premiums paid for key-employee life insurance of $38,000 for the quarter ended June 30, 2006 compared to the same period in 2005. These increases were partially offset by a decrease in incentive compensation of $125,000 for the second quarter of 2006.

19

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

Other Operating Income and Expenses (In thousands)

	Three Months Ended
	June 30,					Percentage
	2006			2005		Variance
Other operating income:
Bankcard income	$	655			650		0.7	%
Fee income(1)		542			492		10.2
Investment Services commissions		209			208		0.5
Insurance commissions		54			60		(9.7	)
Trust income(2)		144			168		(14.4	)
Gain (loss) on sale of real estate(3)		(8	)		30		(125.0	)
Other income(4)		46			27		69.6
	$	1,642			1,635		0.5
Other operating expenses:
Advertising(5)	$	312			218		43.2	%
Automated services(6)		927			756		22.7
Bankcard expense		538			501		7.4
Legal and professional fees(7)		727			483		50.5
Postage		144			156		(7.5	)
Stationery, printing and supplies(8)		195			163		19.8
OREO expense(9)		269			1		26770.0
OREO Write-down(10)		1,000			—
Other expense(11)		1,018			1,146		(11.2	)
	$	5,130		$	3,424		49.8

(1)	The increase is primarily due to increased debit card purchases which results in merchant fees collected by the Bank.
(2)	The decrease is due to decreased Trust transactions during 2006 compared to 2005.
(3)	The decrease is due to the loss on the sale of Other Real Estate Owned properties in the second quarter of 2006 compared to gains during the second quarter of 2005.
(4)	The increase in other income is primarily due to an acquisition fee charged by Peoples which was not collected in prior years.
(5)	The increase in advertising for the three months ended June 30, 2006 compared to the same time period in 2005 is primarily due to a large Bank branding campaign that was run during the second quarter of 2006.
(6)	This increase is due to Impact ’05 initiatives put in place to improve the Bank’s performance in operations, retail delivery systems 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.
(7)	The increase during 2006 was primarily due to an increase in professional and consulting expenses of $110,000 largely due to training initiatives; an increase in legal expenses of $49,000; an increase in CPA expenses of $12,000 and employment agent fees of $44,000 paid during the second quarter of 2006 related to the hiring of various lender positions.
(8)	The increase is primarily due to brochures purchased for campaigns and printing of training materials during the second quarter of 2006.
(9)	The increase in 2006 is due to the operating expenses, materials and professional fees to remediate the condominiums discussed in “Asset Quality and Allowance for Loan Losses” on page 25 of this report.
(10)	The OREO write-down of $1.0 million in 2006 relates to the Georgetown, SC property discussed on page 19 under “Noninterest income and expense”.
(11)	The decrease is primarily due to decreases in equity line promotion expenses, security expenses, uncollected loan fees and other miscellaneous expenses during the three months ended June 30, 2006.

20

Six Months Ended June 30, 2006 Compared to Six Months Ended June 30, 2005

Net Interest Income

Net interest income for the first six months of 2006 of $21.906 million was up $502,000 or 2.4% compared to $21.404 million for the same period of 2005. The slight increase was due to the growth in average earnings assets of 3.2% from June 30, 2005 to June 30, 2006 offset by the decrease in the net interest margin from 4.93% for the six months ended June 30, 2005 to 4.87% for the six months ended June 30, 2006. Outstanding loans were relatively flat for the first half of 2006 compared to December 31, 2005, and were down $10.436 million or 1.4% compared to June 30, 2005. Loan demand has been relatively flat, with the exception of residential mortgage lending, due to the on-going economic softness that is affecting the Bank’s customers in many of the markets served. The Bank has begun to aggressively pursue relationships in its growth markets in order to spur more robust loan growth. While these adjustments are not anticipated to have negative impact on net interest income due to anticipated growth in loan volume, it could further reduce the net interest margin.

For the period ended June 30, 2006, total deposits were up $6.538 million or 1.0% compared to December 31, 2005, and $38.524 million or 4.88% compared to June 30, 2005. The increase in Bancshares’ net interest margin, discussed above, is primarily due to the increasing costs of interest-bearing deposits due to intense competition for those deposit dollars. This is shown in the analysis of the average volume, yields and rates table on the following page.

21

The following table provides an analysis of average volumes, yields and rates and net interest income on a tax-equivalent basis for the six months ended June 30, 2006 and 2005.

Fully taxable equivalent basis¹ (Dollars in thousands):

	Six Months Ended								Six Months Ended
	June 30, 2006								June 30, 2005
				Interest		Annualized						Interest		Annualized
	Average			Income/		Average			Average			Income/		Average
	Balance			Expense		Yield/Rate			Balance			Expense		Yield/Rate
Earning assets:
Loans and leases receivable2	$	754,952		$	29,506		7.88	%	$	742,435		$	25,799		7.01	%
Taxable securities		103,465			2,115		4.12			92,111			1,756		3.84
Tax exempt securities		31,395			846		5.43			31,603			1,011		6.45
Federal Home Loan Bank		4,214			130		6.22			5,988			127		4.28
Interest-bearing bank balances3		1,559			35		4.53			1,847			66		2.51
Federal funds sold		20,591			472		4.62			13,834			181		2.64
Total earning assets		916,176			33,104		7.29			887,818			28,940		6.57
Non-earning assets:
Cash and due from banks		36,928								37,149
Premises and equipment		19,421								17,727
Other assets		18,473								13,218
Allowance for loan losses		(8,386	)							(8,170	)
Total assets	$	982,612		$	33,104				$	947,742		$	28,940
Interest-bearing liabilities:
Savings and time deposits	$	695,698		$	9,668		2.80	%	$	652,954		$	5,322		1.64	%
Securities sold under agreement to repurchase		1,143			7		1.23			1,191			5		0.85
Borrowing from the Federal Home Loan Bank		51,591			1,302		5.09			93,431			1,912		4.13
Total interest-bearing liabilities		748,432			10,977		2.96			747,576			7,239		1.95
Other liabilities and shareholders’ equity:
Demand deposits		134,036								102,674
Other liabilities		6,961								6,002
Shareholders’ equity		93,183								91,490
Total liabilities and shareholders’ equity	$	982,612			10,977				$	947,742			7,239
Net interest income and net interest margin4				$	22,127		4.87	%				$	21,701		4.93	%
Interest rate spread5							4.33	%							4.62	%

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 six months ended June 30, 2006 and 2005 of $641 and $1,071, respectively, are included in interest income.
3	In calculating the annualized yield for Interest-bearing bank balances for 2005 there was $43,000 excluded, 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

In the first half of 2006, noninterest income increased $42,000 or 0.6% compared to the same period in 2005. The increase in noninterest income for 2006 was primarily due to growth of $182,000 or 5.6% in service charges on deposits over the same period in 2005, which more than offset the lower gains on the sale of mortgages.

In the first half of 2006, noninterest expense increased $2.399 million or 12.3% compared to the same period in 2005. The year-to-date results for 2006 were affected by the $1.0 million write-down of other real estate owned as described in the quarterly results on page 19 above. Personnel expense in the first half of 2006, consisting of employee salaries and benefits, increased $582,000 or 5.5% from the same period in 2005. The increase in personnel expense is largely attributable to the following: (i) an increase in salaries of $218,000 or 2.7% for the year ended June 30, 2006 compared to the same period in 2005. The increase was primarily due to annual salary review increases; (ii)��an increase in payroll taxes of $50,000 or 7.3% for the six months ended June 30, 2006 compared to the same period in 2005, due to the payout of the management incentive during the first quarter of 2006. There was no management incentive payout during the first quarter of 2005; (iii) an increase in health and life insurance costs of $143,000 or 20.9% for the six months ended June 30, 2006 compared to the same period in 2005; and (iv) $84,000 of stock option compensation incurred during the first quarter of 2006 due to the adoption of FAS 123(R). These increases were partially offset by a decrease in incentive compensation of $125,000 for the six months ended June 30, 2006 compared to the same period in 2005.

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

23

Other Operating Income and Expenses (In thousands)

	Six Months Ended
	June 30,					Percentage
	2006			2005		Variance
Other operating income:
Bankcard income	$	1,251			1,253		(0.2	)%
Fee income(1)		1,008			920		9.5
Investment Services commissions(2)		430			497		(13.4	)
Insurance commissions(3)		90			108		(16.9	)
Trust income(4)		304			344		(11.6	)
Gain (loss) on sale of real estate(5)		(100	)		58		(272.4	)
Other income(6)		188			32		489.1
	$	3,171			3,212		(1.3	)
Other operating expenses:
Advertising(7)	$	609			450		35.2	%
Automated services(8)		1,731			1,498		15.5
Bankcard expense		1,002			934		7.3
Legal and professional fees(9)		1,312			975		34.5
Postage		348			365		(4.8	)
Stationery, printing and supplies(10)		399			335		19.2
OREO expense(11)		403			10		3931.2
OREO Write-down(12)		1,000			—
Other expense(13)		1,878			2,231		(15.8	)
	$	8,680		$	6,798		27.7

(1)	The increase is primarily due to increased debit card purchases which results in merchant fees collected by the Bank.
(2)	The decrease is due to a decreased volume of Investment Services products sold.
(3)	The decrease is due to a decreased volume of Insurance products sold during 2006.
(4)	The decrease is due to decreased Trust transactions during 2006 compared to 2005.
(5)	The decrease is primarily due to the loss on the sale of two Other Real Estate Owned properties in the first quarter of 2006.
(6)	The increase in 2006 is primarily due to a dividend of $48,000 received from low insurance claims experience during 2004, $24,000 in income received from partnership investments and acquisition fees of $65,000 earned during the six months ended June 30, 2006 by Peoples Financial, which fees were not earned in 2005.
(7)	The increase in advertising for the six months ended June 30, 2006 compared to the same time period in 2005 is primarily due to a large deposit and Bank branding campaign that were run during the first six months of 2006 and not during the same time period in 2005.
(8)	This increase is due to Impact ’05 initiatives put in place to improve the Bank’s performance in operations, retail delivery systems 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.
(9)	The increase was primarily due to increased professional expenses of $148,000 largely due to training initiatives; an increase in legal expenses of $49,000; an increase in CPA expenses of $33,000 and employment agent fees of $44,000 paid during the second quarter of 2006 related to the hiring of various lender positions.
(10)	The increase is primarily due to additional supplies purchased during the first six months of 2006 related to brochures purchased for campaigns and printing of training materials.
(11)	The increase in 2006 is due to the operating expenses, materials and professional fees to remediate the condominiums discussed in “Asset Quality and Allowance for Loan Losses” on page 25 of this report.
(12)	The OREO write-down of $1.0 million in 2006 relates to the Georgetown, SC property discussed on page 19 under “Noninterest income and expense”.
(13)	The decrease is primarily due to a decrease of $129,000 in Business Manager expenses related to the 2006 presentation of expensing amounts related to the third party management of these accounts and not grossing up the expenses and interest income as in prior years and decreases in equity line promotion expenses, security expenses, uncollected loan fees and other miscellaneous expenses during the three months ended June 30, 2006.

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Asset Quality and Allowance for Loan Losses

At June 30, 2006, the allowance for loan losses was $8.502 million or 1.12% of loans outstanding compared to $8.440 million or 1.12% of loans outstanding at December 31, 2005, and $8.466 million or 1.10% of loans outstanding at June 30, 2005. Net charge-offs for the six months ended June 30, 2006 were $1.956 million or 0.26% of average loans outstanding compared to net charge-offs of $1.095 million or 0.15% of average loans outstanding as of June 30, 2005. Net charge-offs improved in the second quarter of 2006 compared to the first quarter of 2006 by $501,000. This improvement was due to a large recovery of $371,000 in the second quarter of 2006 and also an indication of market improvement. 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, on the following page.

The provision for loan losses charged to operations for the six months ended June 30, 2006 totaled $2.018 million compared to $1.599 million for the six months ended June 30, 2005. At June 30, 2006, the allowance for loan losses was 1.67 times nonperforming loans compared to 2.28 at December 31, 2005 and 2.48 times at June 30, 2005. 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 closely 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 are defined as nonaccrual loans, restructured loans, other real estate acquired through foreclosed properties and accruing loans ninety days or more past due. The accrual of interest is generally discontinued on all loans that become ninety days past due as to principal or interest unless collection of both principal and interest is assured by way of collateralization, guarantees or other security and the loan is considered to be in the process of collection.

At June 20, 2006 nonperforming assets were $8.857 million compared to $8.087 million at December 31, 2005 and 7.684 million at June 30, 2005. The increase in the nonperforming assets from June 30, 2005 to June 30, 2006 resulted from $2.5 million in loans to a borrower in the furniture industry moved to nonaccrual status as a result of the borrower’s failure to satisfy the terms of a liquidation agreement. A liquidation of the inventory was complete during the second quarter and currently this borrower is in involuntary bankruptcy which has delayed foreclosure proceedings. Following the bankruptcy waiting period the Bank will work with the guarantor through the foreclosure of the property to restructure the debt and reduce credit exposure. While these loans are secured, the extent of losses on the loans, if any, can not be determined as of the current date. The above $2.5 million increase in nonperforming assets was partially offset by (i) a $1.0 million write-down of the residential condominium units in Georgetown, South Carolina during the second quarter of 2006; and (ii) a $500,000 reduction of loans 90 days or more past due and still accruing.

The Bank made loans to a long time customer in connection with a condominium project the customer was developing in Georgetown, South Carolina. The loans were secured by the residential condominium units in the building being developed by the customer. During the second quarter of 2005, the Bank acquired 18 residential condominium units by means of a deed-in-lieu of foreclosure. These 18 units, together with two others owned by third parties, are located on the second and third floors of a three-story building. The ground floor of the building has been developed into retail condominium units by another third party.

At the time of the Bank’s acquisition of the 18 condominium units, the defaulted loans had a $3.4 million principal balance due. After evaluating its potential net realizable value of these condominium units, the

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Bank took an immediate $400,000 charge against earnings and booked the remaining $3.0 million balance in other real estate owned. Subsequently, during the second quarter of 2006, the Bank discovered, for the first time, that a portion of the condominium development assets had not been conveyed to the Bank as the Bank had previously been advised and the Bank took an additional write-down on the asset of $1.0 million, which reduced the carrying value from $3.0 million to $2.0 million. The Bank is actively pursuing recovery of the losses incurred with this project.

The Bank incurred expenses of approximately $700,000 as of December 31, 2005, in connection with its investigation and remediation related to these condominiums. During 2006 the Bank has incurred additional investigation and remediation expenses of $360,000 as of June 30, 2006 ($380,000 as of July 31, 2006). Following the most recent write-down of this property the Bank is continuing to consider remedies to include the sale of the condominium units individually or as a group or the build-out of the 18 condominium units.

Asset Quality Analysis

	June 30			December 31			June 30
(Dollars in thousands)	2006			2005			2005
Reserve for Loan Losses:
Beginning Balance	$	8,440		$	7,962		$	7,962
Provision for loan losses		2,018			3,219			1,599
Net (charge-off) recoveries		(1,956	)		(2,741	)		(1,095	)
Ending Balance	$	8,502		$	8,440		$	8,466
Risk Assets:
Nonaccrual loans	$	2,956		$	929		$	584
Foreclosed real estate		3,755			4,391			4,274
Restructured loans		612			856			789
Loans 90 days or more past due and still accruing		1,534			1,911			2,037
Total risk assets	$	8,857		$	8,087		$	7,684
Asset Quality Ratios:
Nonaccrual loans as a percentage of total loans		0.39	%		0.12	%		0.08	%
Nonperforming assets as a percentage of:
Total assets		0.90			0.83			0.78
Loans plus foreclosed property		1.16			1.06			1.00
Net charge-offs as a percentage of average loans		0.52	*		0.36			0.30	*
Reserve for loan losses as a percentage of loans		1.12			1.12			1.10
Ratio of reserve for loan losses to:
Net charge-offs		2.16	*		3.08			3.83	*
Nonaccrual loans		2.88			9.09			14.50

*Denotes Annualized

Income Taxes

Accrued income taxes applicable to income for the six months ended June 30, 2006 were $1.416 million compared to $2.315 million for the six months ended June 30, 2005. Pretax income for the six months ended June 30, 2006 of $4.703 million decreased $2.274 million compared to $6.977 million for the six months ended June 30, 2005. The decrease in accrued taxes for the six months ended June 30, 2006 is primarily due

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to the decreased 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 six months ended June 30, 2006 and 2005, were $112,000 and $77,000, 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.

Risk Management

It is the design of risk management to ensure long-range profitability performance and minimize risk, adhere to proper liquidity and maintain sound capital. To meet these objectives, the process of asset/liability management monitors the exposure to interest rate risk, balance sheet trends, pricing policies and liquidity position. Reports regarding Credit, Asset/Liability, Market, and Operational Risks are provided to the Bank’s Board of Directors.

Risk management practices include key elements such as independent checks and balances, formal authority limits, policies and procedures, and portfolio management performed by experienced personnel.

Interest Rate Risk Management

The primary purpose of managing interest rate risk is to minimize the volatility to earnings from changes in interest rates and preserve the value of Bancshares’ capital. Interest rate movements and balance sheet composition affect profitability and performance. Management’s responsibility for both liquidity and interest sensitivity reside with a designated Asset/Liability Management Committee (“ALCO”). As a part of its decision-making process, ALCO evaluates market conditions, interest rate trends and the economic environment. 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.

Bancshares also uses simulation analysis to compute net interest income at risk under a variety of market interest rate scenarios to identify interest rate risk exposures. The simulation models used to analyze Bancshares’ net interest income create various at-risk scenarios looking at increases and/or decreases in interest rates from an instantaneous movement. The models are continuously updated to incorporate management action and on-going assumptions. The affect of a 200 basis point instantaneous increase or decrease in interest rates over a one-year period is a key scenario analyzed. Based on the rate sensitivity position on June 30, 2006, net interest income exposure over the next 12 months to an instantaneous increase in interest rates of 200 basis points is estimated to be approximately six percent of base net interest income which is well inside the Bank’s maximum tolerable decline of 15%. These scenarios are used as one estimate of risk, and do not necessarily represent management’s current view of future interest rates or market developments. Actual results will differ from simulated results due to, among other factors, timing, magnitude and frequency of interest rate changes, changes in market conditions, and management’s strategies.

To minimize any potential negative impact 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 interest rate sensitivity gap is defined as the difference between the amount of interest-earning assets maturing or repricing within a specific time period and the amount of interest-bearing liabilities maturing or repricing within the same time period. On June 30, 2006, the one-year cumulative interest sensitivity gap was a negative $20,000 for a ratio of interest-sensitive assets to interest-sensitive liabilities of 0.96. Management believes that is an acceptable ratio.

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Liquidity Risk Management

Liquidity risk is the risk of being unable to fund assets with liabilities of the appropriate duration and interest rate, as well as the risk of not being able to meet unexpected cash needs. The objective of liquidity management is to ensure the continuous availability of funds to meet the demands of depositors, other creditors and borrowers, and the requirements of ongoing operations. The principal sources of funds for Bancshares include cash and cash equivalents, maturing investments and loans, core deposits and the securities available for sale portfolio. Correspondent relationships are also maintained with several large banks in order to have access to federal funds purchases as a secondary source of liquidity. Traditionally, the Bank has been a seller of excess investable funds in the federal funds market and uses these funds as a part of its liquidity management.

The Bank also has available lines of credit maintained with the Federal Home Loan Bank of Atlanta (“FHLB”), which can be used for funding and/or liquidity needs. Borrowings by the Bank under these lines of credit are 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. At June 30, 2006, the Bank had an available line of credit with the FHLB totaling $193.5 million with $99 million outstanding and $59 million funded. While traditionally the FHLB is used for longer-term borrowings, it can be used for short-term liquidity needs. At June 30, 2006, overnight borrowings from the FHLB totaled $28 million. 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.

Net cash provided by operating activities, a primary source of liquidity, was $8.875 million for the six months of 2006 compared to net cash used of $2.960 million for the same period in 2005. The increase in net cash provided by operating activities during the first half of 2006 was primarily attributable to a decrease in loans held for sale during the six months ended June 30, 2006 and a decrease in other assets during that same period. Details of cash flows for the quarters ended June 30, 2006 and 2005 respectively, are provided in the Consolidated Statements of Cash Flows located in Item 1, which begins on page 6.

Credit Risk Management

Loans classified for regulatory purposes as loss, doubtful, substandard or special mention, that have not been disclosed in the schedule “Asset Quality Analysis” on page 26, do not represent or result from trends or uncertainties which management reasonably expects will materially impact future operating results, liquidity, or capital resources, or represent material credits about which management is 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.

Capital Resources and Shareholders’ Equity

During the second quarter of 2006, Bancshares’ Board of Directors approved an extension of its existing stock repurchase program through May 31, 2008. The extension authorizes Bancshares to repurchase a total of 400,000 shares of common stock. Under the stock repurchase program, Bancshares may repurchase its shares of common stock in the open market or privately negotiated transactions on a time-to-time and ongoing basis, depending upon market 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.

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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
April 1 – April 30		7,107	$	17.98		7,107
May 1 – May 31		10,905	$	17.49		10,905		393,931
June 1 – June 30		13,537	$	17.58		13,537		380,394
Total		31,549	$	17.64		31,549

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					TotalCapital
	Amount		Percent1			Amount		Percent2			Amount		Percent2
Actual	$	92,646		9.40	%	$	92,646		11.46	%	$	101,148		12.51	%
Required		29,563		3.00			32,335		4.00			64,669		8.00
Excess		63,083		6.40			60,311		8.46			36,479		4.51

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.

Item 3. Quantitative and Qualitative Disclosures about Market Risk

There were no material changes in market risk for Bancshares in the period covered by this report. See “Risk Management” in Part I, Item 2 “Management Discussion and Analysis of Financial Condition and Results of Operations” beginning on page 27 above for a discussion of market risk for Bancshares.

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

29

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 1A. Risk Factors

There have been no material changes to Bancshares’ Risk Factors as previously disclosed in Bancshares’ Form 10-K filed with the SEC on March 15, 2006. Please see the Risk Factors which begin on page 8 of the above mentioned Form 10-K.

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

See “Capital Resources and Shareholders’ Equity” and “Issuer Purchases of Equity Securities” in Part I, Item 2 “Management’s Discussion and Analysis of Financial Condition and Results of Operations” beginning on pages 24 and 25 above for information about Bancshares’ repurchases of its common stock in the quarter under its publicly announced stock repurchase program.

Item 3. Defaults Upon Senior Securities

Not applicable.

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

Bancshares held its Annual Meeting of Shareholders on April 19, 2006. Proxies were solicited in connection with the Annual Meeting in accordance with Regulation 14 under the Exchange Act pursuant to a Proxy Statement dated March 15, 2006, filed by Bancshares with the SEC on March 15, 2006 (SEC File No. 000-11448) (the “Proxy Statement”).

At the Annual Meeting, the shareholders of Bancshares (i) elected five members to Bancshares’ Board of Directors and (ii) ratified the appointment of Turlington and Company LLP to conduct the independent audit for the year 2006, each as more fully described in the Proxy Statement. Of the 8,529,657 shares of Bancshares’ common stock represented and entitled to vote at the Annual Meeting, the number of shares cast for, against or withheld, and the number of abstentions and broker non-votes, as to each proposal are set forth below:

1. Election of Directors.

	For		Withheld
J. David Branch		6,318,897		61,930
Robert F. Lowe		6,344,189		36,638
Mary E. Rittling		6,323,653		57,174
G. Alfred Webster		6,316,575		64,252
Julius S. Young, Jr.		6,345,359		35,468

2. Ratification of appointment of Turlington and Company LLP, CPAs, to conduct the independent audit for the year 2006:

For	Against		Abstentions
6,335,164		42,132		3,531

In addition to the above individuals who were elected as directors at the Annual Meeting, each of the following individuals were directors of Bancshares’ prior to the Annual Meeting and their term of office as directors continued after the Annual Meeting: Michael S. Albert, Leonard H. Beck, Robert C. Clark, Samuel R. Harris, Walter A. Hill Sr., David A. Smith, Robert B. Smith, Jr., Burr W. Sullivan, John W. Thomas III, and John F. Watts.

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: August 3, 2006		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)

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EXHIBIT INDEX

Exhibit No.
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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