UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                             Washington, D.C. 20549

                                    FORM 10-Q

              [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
                     OF THE SECURITIES EXCHANGE ACT OF 1934

                  For the Quarterly Period Ended June 30, 2005

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

                  For the Transition Period From _____ to ____

                         Commission File Number 0-30062

                            CAPITAL BANK CORPORATION
                            ------------------------
             (Exact name of registrant as specified in its charter)

                    North Carolina                 56-2101930
                    --------------                 ----------
           (State or other jurisdiction of       (IRS Employer
            incorporation or organization)     Identification No.)

                              4901 Glenwood Avenue
                          Raleigh, North Carolina 27612
                        ---------------------------------
               (Address of Principal executive offices) (Zip Code)

       Registrant's telephone number, including area code: (919) 645-6400
                                                          ----------------

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.  X  Yes    No
                                   ---    ---

Indicate  by check mark  whether  the  registrant  is an  accelerated  filer (as
defined in Rule 12b-2 of the Exchange Act).  X Yes     No
                                            ---    ---

As of August 4, 2005 there were 6,722,309 shares outstanding of the registrant's
common stock, no par value.

<PAGE>

                            Capital Bank Corporation
                                    Form 10-Q
                                    CONTENTS


<TABLE>
<CAPTION>
PART I - FINANCIAL INFORMATION                                                        Page No.
<S>                                                                                    <C>
       Item 1. Financial Statements

       Condensed consolidated statements of financial condition at June 30, 2005
            (Unaudited) and December 31, 2004                                                1
       Condensed consolidated statements of income for the three months
            ended June 30, 2005 and 2004 (Unaudited)                                         2
       Condensed consolidated statements of income for the six months
            ended June 30, 2005 and 2004 (Unaudited)                                         3
       Condensed consolidated statements of changes in shareholders' equity for
            the six months ended June 30, 2005 and 2004 (Unaudited)                          4
       Condensed consolidated statements of cash flows for the six months
            ended June 30, 2005 and 2004 (Unaudited)                                     5 - 6
       Notes to condensed consolidated financial statements                             7 - 13

       Item 2. Management's Discussion and Analysis of Financial Condition and
            Results of Operations                                                      13 - 32

       Item 3. Quantitative and Qualitative Disclosures About Market Risk                   32

       Item 4. Controls and Procedures                                                 32 - 33

PART II - OTHER INFORMATION

       Item 1. Legal Proceedings                                                            33

       Item 2. Unregistered Sales of Equity Securities and Use of Proceeds                  33

       Item 3. Defaults Upon Senior Securities                                              33

       Item 4. Submission of Matters to a Vote of Security Holders                     33 - 34

       Item 5. Other Information                                                            34

       Item 6. Exhibits                                                                34 - 35

       Signatures                                                                           36
</TABLE>
<PAGE>

Item 1 Financial Statements
       --------------------


CAPITAL BANK CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
June 30, 2005 and December 31, 2004

<TABLE>
<CAPTION>
                                                                June 30,      December 31,
                                                                  2005            2004
------------------------------------------------------------------------------------------
                                (Dollars in thousands)        (Unaudited)
<S>                                                           <C>             <C>
ASSETS
Cash and due from banks:
     Interest earning                                         $      7,982    $        971
     Noninterest earning                                            24,209          22,036
Federal funds sold and short term investments                       22,038               4
Investment securities - available for sale, at fair value          141,295         140,946
Investment securities - held to maturity, at amortized cost         14,182          13,336
Federal Home Loan Bank stock                                         6,345           6,298
Loans - net of unearned income and deferred fees                   648,765         654,867
Allowance for loan losses                                          (10,075)        (10,721)
                                                              ------------    ------------
         Net loans                                                 638,690         644,146
                                                              ------------    ------------
Premises and equipment, net                                         16,179          15,608
Bank owned life insurance                                           19,280          13,500
Deposit premium and goodwill, net                                   12,958          13,065
Deferred tax assets                                                  6,131           5,985
Accrued interest receivable and other assets                         8,103           6,399
                                                              ------------    ------------
            Total assets                                      $    917,392    $    882,294
                                                              ============    ============

LIABILITIES
Deposits:
     Demand, noninterest bearing                              $     81,778    $     65,673
     Savings and interest bearing demand deposits                  217,627         193,435
     Time deposits                                                 390,592         395,868
                                                              ------------    ------------
         Total deposits                                            689,997         654,976
                                                              ------------    ------------
Repurchase agreements and federal funds purchased                   15,326          16,755
Federal Home Loan Bank advances                                    101,203         102,320
Subordinated debentures                                             20,620          20,620
Accrued interest payable and other liabilities                      10,747           9,885
                                                              ------------    ------------
            Total liabilities                                      837,893         804,556
                                                              ------------    ------------

SHAREHOLDERS' EQUITY
Common stock, no par value; 20,000,000 shares authorized;
     6,625,870 and 6,612,787 issued and outstanding as of
     June 30, 2005 and December 31, 2004, respectively              68,184          68,341
Retained earnings                                                   11,458           9,092
Accumulated other comprehensive income (loss)                         (143)            305
                                                              ------------    ------------
            Total shareholders' equity                              79,499          77,738
                                                              ------------    ------------
            Total liabilities and shareholders' equity        $    917,392    $    882,294
                                                              ============    ============
</TABLE>

See Notes to Condensed Consolidated Financial Statements


                                      -1-
<PAGE>


CAPITAL BANK CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF INCOME
Three Months Ended June 30, 2005 and 2004

<TABLE>
<CAPTION>
                                                                  2005        2004
------------------------------------------------------------------------------------
         (Dollars in thousands, except per share)                   (Unaudited)
<S>                                                             <C>         <C>
Interest income:
      Loans and loan fees                                       $ 10,405    $  8,572
      Investment securities                                        1,727       1,552
      Federal funds and other interest income                        116          39
                                                                --------    --------
          Total interest income                                   12,248      10,163
                                                                --------    --------
Interest expense:
      Deposits                                                     3,676       2,913
      Borrowings and repurchase agreements                         1,412       1,019
                                                                --------    --------
          Total interest expense                                   5,088       3,932
                                                                --------    --------
          Net interest income                                      7,160       6,231
Provision (credit) for loan losses                                  (156)        297
                                                                --------    --------
          Net interest income after provision for loan losses      7,316       5,934
                                                                --------    --------
Noninterest income:
      Service charges and other fees                                 714         768
      Mortgage banking revenues                                      386         365
      Net gain on sale of securities                                   1          --
      Other noninterest income                                       478         411
                                                                --------    --------
          Total noninterest income                                 1,579       1,544
                                                                --------    --------
Noninterest expenses:
      Salaries and employee benefits                               3,479       3,061
      Occupancy                                                      626         582
      Furniture and equipment                                        370         474
      Data processing                                                318         301
      Advertising                                                    163         222
      Amortization of deposit premium                                 53          61
      Other expenses                                               1,480       1,369
                                                                --------    --------
          Total noninterest expenses                               6,489       6,070
                                                                --------    --------
              Income before income tax expense                     2,406       1,408
Income tax expense                                                   803         517
                                                                --------    --------
              Net income                                        $  1,603    $    891
                                                                ========    ========

Earnings per share - basic                                      $   0.24    $   0.13
                                                                ========    ========
Earnings per share - diluted                                    $   0.23    $   0.13
                                                                ========    ========

Weighted average shares
      Basic                                                        6,731       6,709
                                                                ========    ========
      Fully diluted                                                6,871       6,883
                                                                ========    ========
</TABLE>

See Notes to Condensed Consolidated Financial Statements


                                      -2-
<PAGE>

CAPITAL BANK CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF INCOME
Six Months Ended June 30, 2005 and 2004

<TABLE>
<CAPTION>
                                                                  2005        2004
------------------------------------------------------------------------------------
                (Dollars in thousands, except per share)            (Unaudited)
<S>                                                             <C>         <C>
Interest income:
      Loans and loan fees                                       $ 20,147    $ 17,043
      Investment securities                                        3,424       3,270
      Federal funds and other interest income                        133          81
                                                                --------    --------
          Total interest income                                   23,704      20,394
                                                                --------    --------
Interest expense:
      Deposits                                                     6,858       5,775
      Borrowings and repurchase agreements                         2,780       2,119
                                                                --------    --------
          Total interest expense                                   9,638       7,894
                                                                --------    --------
          Net interest income                                     14,066      12,500
Provision (credit) for loan losses                                  (406)        413
                                                                --------    --------
          Net interest income after provision for loan losses     14,472      12,087
                                                                --------    --------
Noninterest income:
      Service charges and other fees                               1,371       1,495
      Mortgage banking revenues                                      658         702
      Net gain on sale of securities                                   7          13
      Other noninterest income                                       883         935
                                                                --------    --------
          Total noninterest income                                 2,919       3,145
                                                                --------    --------
Noninterest expenses:
      Salaries and employee benefits                               6,628       5,903
      Occupancy                                                    1,240       1,154
      Furniture and equipment                                        737         839
      Data processing                                                629         623
      Advertising                                                    379         424
      Amortization of deposit premium                                107         126
      Other expenses                                               2,919       2,638
                                                                --------    --------
          Total noninterest expenses                              12,639      11,707
                                                                --------    --------
              Income before income tax expense                     4,752       3,525
Income tax expense                                                 1,594       1,254
                                                                --------    --------
              Net income                                        $  3,158    $  2,271
                                                                ========    ========

Earnings per share - basic                                      $   0.47    $   0.34
                                                                ========    ========
Earnings per share - diluted                                    $   0.46    $   0.33
                                                                ========    ========

Weighted average shares
      Basic                                                        6,743       6,699
                                                                ========    ========
      Fully diluted                                                6,906       6,885
                                                                ========    ========
</TABLE>

See Notes to Condensed Consolidated Financial Statements


                                      -3-
<PAGE>

Capital Bank Corporation
Consolidated Statements of Changes in Shareholders' Equity
For the Six Months Ended June 30, 2005 and 2004

<TABLE>
<CAPTION>
                                    (Dollars in thousands, except per share)

                                         Shares of                       Other
                                           Common        Common      Comprehensive      Retained
                                           Stock         Stock           Income         Earnings       Total
                                        -----------    ----------    --------------    ----------    ----------
                                        (Unaudited)
<S>                                       <C>          <C>           <C>               <C>           <C>
Balance at January 1, 2004                6,541,495    $   67,381    $          377    $    5,165    $   72,923
Issuance of common stock
     for options exercised                   44,721           444                --            --           444
Net income                                       --            --                --         2,271         2,271
Other comprehensive income                       --            --            (2,365)           --        (2,365)
                                                                                                     ----------
     Comprehensive income                                                                                   (94)
                                                                                                     ----------
Dividends ($0.10 per share)                      --            --                --          (658)         (658)
                                         ----------    ----------    --------------    ----------    ----------
Balance at June 30,  2004                 6,586,216    $   67,825    $       (1,988)   $    6,778    $   72,615
                                         ==========    ==========    ==============    ==========    ==========

Balance at January 1, 2005                6,612,787    $   68,341    $          305    $    9,092    $   77,738
Repurchase of outstanding common stock      (50,000)   $     (892)   $           --    $       --          (892)
Issuance of common stock
     for services                            40,241           380                --            --           380
Issuance of common stock
     for options exercised                   22,842           355                --            --           355
Net income                                       --            --                --         3,158         3,158
Other comprehensive income                       --            --              (448)           --          (448)
                                                                                                     ----------
     Comprehensive income                                                                                 2,710
                                                                                                     ----------
Dividends ($0.12 per share)                      --            --                --          (792)         (792)
                                         ----------    ----------    --------------    ----------    ----------
Balance at June 30,  2005                 6,625,870    $   68,184    $         (143)   $   11,458    $   79,499
                                         ==========    ==========    ==============    ==========    ==========
</TABLE>

See Notes to Condensed Consolidated Financial Statements


                                      -4-
<PAGE>

CAPITAL BANK CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
Six Months Ended June 30, 2005 and 2004

<TABLE>
<CAPTION>
                                                                    2005        2004
--------------------------------------------------------------------------------------
                                  (In thousands)                        (Unaudited)
<S>                                                               <C>         <C>
Cash Flows From Operating Activities
      Net income                                                  $  3,158    $  2,271
      Adjustments to reconcile net income to net cash
         provided by operating activities:
         Amortization of deposit premium                               107         126
         Depreciation                                                  731         744
         Net gains on sale of securities available for sale             (7)        (13)
         Gain on disposal of equipment                                   3          --
         Change in held for sale loans, net                             --        (787)
         Amortization of premiums on securities, net                   147         407
         Deferred income tax expense                                   136         309
         Issuance of stock for compensation                            255          --
         Net proceeds from sale of loans held for sale              (3,914)         --
         Provision (credit) for loan losses                           (406)        413
         Changes in assets and liabilities:
             Accrued interest receivable and other assets           (6,480)        129
             Accrued interest payable and other liabilities            960         472
         Other operating activities, net                                --          69
                                                                  --------    --------
                Net cash used for operating activities              (5,310)      4,140
                                                                  --------    --------
Cash Flows From Investing Activities
      Loan (originations) repayments, net                            8,775     (31,813)
      Additions to premises and equipment                           (1,324)     (2,236)
      Net (purchases) sales of Federal Home Loan Bank stock            (47)        603
      Purchase of securities available for sale                    (15,761)    (27,424)
      Purchase of securities held to maturity                       (1,560)         --
      Proceeds from maturities of securities available for sale     10,146      22,137
      Proceeds from sales of securities available for sale           4,399      16,013
      Proceeds from maturities of securities held to maturity          711          --
      Proceeds from sales of property and equipment                     19         645
      Other investing activities, net                                   --          --
                                                                  --------    --------
                Net cash provided by (used in)
                investing activities                                 5,358     (22,075)
                                                                  --------    --------
Cash Flows From Financing Activities
      Net increase in deposits                                      35,021      42,177
      Net increase (decrease) in repurchase agreements              (1,429)     (2,186)
      Net increase (decrease) in borrowings                             --     (12,135)
      Principal repayments of FHLB borrowings                       (1,117)         --
      Dividends paid                                                  (792)       (658)
      Issuance of common stock for options and other plans             379         444
      Repurchase of common stock                                      (892)         --
                                                                  --------    --------
                Net cash provided by financing activities           31,170      27,642
                                                                  --------    --------
                Net change in cash and cash equivalents             31,218       9,707
      Cash and cash equivalents:
         Beginning of period                                        23,011      25,610
                                                                  --------    --------
         Ending at June 30                                        $ 54,229    $ 35,317
                                                                  ========    ========

                                                                 (continued on next page)
</TABLE>

See Notes to Condensed Consolidated Financial Statements


                                      -5-
<PAGE>


CAPITAL BANK CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)
Six Months Ended June 30, 2005 and 2004

                                                               2005       2004
--------------------------------------------------------------------------------
                                (In thousands)                   (Unaudited)

Supplemental Disclosure of Cash Flow Information
      Transfer from loans to real estate acquired
         through foreclosure                                 $  1,004   $    399
                                                             ========   ========

      Dividends payable                                      $    397   $    328
                                                             ========   ========

      Cash paid for:
         Income taxes                                        $  1,713   $    384
                                                             ========   ========

         Interest                                            $  9,386   $  7,777
                                                             ========   ========

See Notes to Condensed Consolidated Financial Statements


                                      -6-
<PAGE>

Notes to Condensed Consolidated Financial Statements

1. Significant Accounting Policies and Interim Reporting

The accompanying  unaudited condensed  consolidated financial statements include
the accounts of Capital Bank  Corporation  (the  "Company") and its wholly owned
subsidiary,  Capital Bank (the "Bank"). In addition, the Company has interest in
two trusts,  Capital Bank  Statutory  Trust I and II  (hereinafter  collectively
referred to as the  "Trusts").  The Trusts have not been  consolidated  with the
financial  statements of the Company. The interim financial statements have been
prepared in accordance with generally accepted  accounting  principles.  They do
not include all of the information and footnotes  required by generally accepted
accounting  principles for complete financial statements and therefore should be
read in  conjunction  with the audited  financial  statements  and  accompanying
footnotes  in the  Company's  Annual  Report  on Form  10-K for the  year  ended
December 31, 2004, as amended.  In the opinion of  management,  all  adjustments
necessary  for a fair  presentation  of the  financial  position  and results of
operations  for the periods  presented  have been  included and all  significant
intercompany transactions have been eliminated in consolidation.  The results of
operations  for the three month and six month period ended June 30, 2005 are not
necessarily indicative of the results of operations that may be expected for the
year ended December 31, 2005.

The balance  sheet at  December  31, 2004 has been  derived  from the  Company's
audited  consolidated  financial  statements  contained in the Company's  Annual
Report on Form 10-K for the year ended December 31, 2004, as amended.

The  accounting  policies  followed  are as set  forth in Note 1 of the Notes to
Financial  Statements in the  Company's  Annual Report on Form 10-K for the year
ended December 31, 2004, as amended.

2. Comprehensive Income

Comprehensive  income includes net income and all other changes to the Company's
equity,   with  the  exception  of  transactions   with   shareholders   ("other
comprehensive  income").  The Company's  comprehensive  income for the six month
periods ended June 30, 2005 and 2004 are as shown in the Company's  Consolidated
Statements of Changes in Shareholder's  Equity for the six months ended June 30,
2005 and 2004 (unaudited).  The Company's only components of other comprehensive
income relate to unrealized  gains and losses on securities  available for sale,
net of the applicable income tax effect and are as follows:


                                      -7-
<PAGE>


CAPITAL BANK CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE
      INCOME (LOSS)
Three and Six Months Ended June 30, 2005 and 2004

<TABLE>
<CAPTION>
                                                                      2005           2004
---------------------------------------------------------------------------------------------
                                       (In thousands)                      (Unaudited)
<S>                                                                <C>            <C>
Three month period ended June 30, 2005 and 2004:
      Net income                                                   $     1,603    $       891
      Reclassification of gains recognized in net income                    (1)            --
      Unrealized gains (losses) on securities available for sale           998         (5,677)
      Income tax benefit (expense)                                        (384)         2,189
                                                                   -----------    -----------
          Comprehensive income (loss)                              $     2,216    $    (2,597)
                                                                   ===========    ===========

Six month period ended June 30, 2005 and 2004:
      Net income                                                   $     3,158    $     2,271
      Reclassification of gains recognized in net income                    (7)           (13)
      Unrealized gains (losses) on securities available for sale          (723)        (3,825)
      Income tax benefit (expense)                                         282          1,473
                                                                   -----------    -----------
          Comprehensive income (loss)                              $     2,710    $       (94)
                                                                   ===========    ===========
</TABLE>

3. Earnings Per Share

The Company is required  to report  both basic and  diluted  earnings  per share
("EPS").  Basic  EPS  excludes  dilution  and is  computed  by  dividing  income
available to common shareholders by the weighted average number of common shares
outstanding  for the period.  Diluted EPS  assumes the  conversion,  exercise or
issuance of all  potential  common  stock  instruments,  such as stock  options,
unless the effect is to reduce a loss or increase  earnings  per share.  For the
Company,  EPS is adjusted for outstanding stock options using the treasury stock
method  in  order to  compute  diluted  EPS.  The  following  tables  provide  a
computation  and  reconciliation  of basic and diluted EPS for the three and six
month periods ended June 30, 2005 and 2004, respectively:


                                      -8-
<PAGE>

<TABLE>
<CAPTION>
                                                                       2005           2004
                                                                   --------------------------
(Dollars in thousands)                                                    (Unaudited)
<S>                                                                <C>            <C>
Three month periods ended June 30, 2005 and 2004:

      Income available to shareholders - basic and diluted         $     1,603    $       891
                                                                   ===========    ===========
Shares used in the computation of earnings per share:
      Weighted average number of shares outstanding - basic          6,730,979      6,708,742
      Incremental shares from assumed exercise of stock
          options                                                      139,842        174,415
                                                                   -----------    -----------
      Weighted average number of shares outstanding - diluted        6,870,821      6,883,157
                                                                   ===========    ===========

Six month periods ended June 30, 2005 and 2004:

      Income available to shareholders - basic and diluted         $     3,158    $     2,271
                                                                   ===========    ===========
Shares used in the computation of earnings per share:
      Weighted average number of shares outstanding - basic          6,742,712      6,698,844
      Incremental shares from assumed exercise of stock
          options                                                      163,521        186,018
                                                                   -----------    -----------
      Weighted average number of shares outstanding - diluted        6,906,233      6,884,862
                                                                   ===========    ===========
</TABLE>

Options to purchase  approximately  571,633  shares of common stock were used in
the diluted calculation. An aggregate of 75,750 options were not included in the
diluted  calculation  because the option price  exceeded the average fair market
value of the associated shares of common stock.

4. Stock Based Compensation

The Company has a stock  option  plan under  which  options to purchase  Company
common stock may be granted periodically to certain employees. Grants of options
are made by the Board of Directors  or its  Compensation  Committee.  All grants
must be at no less  than  fair  market  value  on the  date  of  grant,  must be
exercised  no later than 10 years from the date of grant,  and may be subject to
certain vesting provisions.

The Company  accounts for stock options under the  provisions of APB Opinion No.
25 ("APB 25"),  Accounting  for Stock Issued to  Employees.  However,  under the
provisions of Statement of Financial Accounting Standards ("SFAS") No. 123 ("FAS
123"),  Accounting  for  Stock-Based  Compensation,  the  Company is required to
disclose the pro forma effects on net income as if it had recorded  compensation
based on the fair value of options granted.  The fair value of each option grant
is estimated on the date of grant using the Black-Scholes  option-pricing  model
with  certain  assumptions.  Option  pricing  models  require  the use of highly
subjective  assumptions,  including  expected stock price  volatility,  which if
changed can materially affect fair value estimates.

Under    SFAS   No.    148   ("FAS    148"),    Accounting    for    Stock-Based
Compensation--Transition and Disclosure,  companies are required to disclose for
each period for which an income statement is


                                      -9-
<PAGE>

presented  an  accounting  policy  footnote  that  includes:  (i) the  method of
accounting  for  stock  options;  (ii)  total  stock  compensation  cost that is
recognized in the income  statement and would have been  recognized  had FAS 123
been adopted for  recognition  purposes as of its effective  date; and (iii) pro
forma net income and earnings per share (where  applicable) that would have been
reported had FAS 123 been adopted for  recognition  purposes as of its effective
date. These  disclosures are required to be made in annual financial  statements
and in quarterly  information provided to shareholders without regard to whether
the entity has adopted FAS 123 for recognition purposes.

The Company  granted  6,000  options to purchase its shares of common stock at a
weighted  average price of $17.49  during the first six months of 2005.  For the
three and six month periods ended June 30, 2005, the following table  summarizes
the net income and stock-based  compensation  expense, as reported,  compared to
pro forma amounts had the fair value method been applied:


                                      -10-
<PAGE>

<TABLE>
<CAPTION>
                                                                       2005           2004
                                                                   --------------------------
                                                                          (Unaudited)
<S>                                                                <C>            <C>
(Dollars in thousands, except per share)
Three month periods ended June 30, 2005 and 2004:

Net income, as reported                                            $     1,603    $       891
Deduct:  Total stock-based employee compensation expense
      determined under fair value based method for all awards,
      net of related tax effects                                           (38)           (39)
                                                                   --------------------------
Pro forma net income                                               $     1,565    $       852
                                                                   ==========================

Earnings per share:
Basic - as reported                                                $      0.24    $      0.13
Basic - pro forma                                                  $      0.24    $      0.13
Diluted - as reported                                              $      0.23    $      0.13
Diluted - pro forma                                                $      0.23    $      0.13

Six month periods ended June 30, 2005 and 2004:

Net income, as reported                                            $     3,158    $     2,271
Deduct:  Total stock-based employee compensation expense
      determined under fair value based method for all awards,
      net of related tax effects                                           (86)           (81)
                                                                   --------------------------
Pro forma net income                                               $     3,072    $     2,190
                                                                   ==========================

Earnings per share:
Basic - as reported                                                $      0.47    $      0.34
Basic - pro forma                                                  $      0.46    $      0.33
Diluted - as reported                                              $      0.46    $      0.33
Diluted - pro forma                                                $      0.45    $      0.32
</TABLE>

The  implementation of SFAS No.123R,  Share Based Payment,  has been delayed and
will not take effect until January 1, 2006.  Additional  details on the expected
impact on the Company as a result of  implementation of SFAS No.123R is included
in footnote 1 to the Notes to Consolidated Financial Statements in the Company's
Annual Report on Form 10-K, as amended.

5. Investment Securities

The  following  table  shows the gross  unrealized  losses and fair value of the
Company's  investments  with  unrealized  losses  that  are  not  deemed  to  be
other-than-temporarily impaired, aggregated by investment category and length of
time that  individual  securities  have  been in a  continuous  unrealized  loss
position, at June 30, 2005:


                                      -11-
<PAGE>

<TABLE>
<CAPTION>
                                                (Unaudited)
(Dollars in thousands)         Less Than 12 Months      12 Months or Greater            Total
                             ----------------------------------------------------------------------------
                                          Unrealized                Unrealized                Unrealized
Description of Security      Fair Value     Losses     Fair Value     Losses     Fair Value     Losses
--------------------------------------------------------------------------------------------------------
<S>                          <C>          <C>          <C>          <C>          <C>          <C>
Available for sale
Direct obligations of U.S.
     government agencies     $   12,624   $       76   $   18,503   $      503   $   31,127   $      579
Municipal bonds                   1,854           13        2,120           67        3,974           80
Federal agency mortgage-
     backed securities           39,733          267       14,937          293       54,670          560
                             ---------------------------------------------------------------------------
                                 54,211          356       35,560          863       89,771        1,219
                             ---------------------------------------------------------------------------
Held to maturity
Direct obligations of U.S.
     government agencies          5,541           44           --           --        5,541           44
Municipal bonds                     294            6           --           --          294            6
Federal agency mortgage-
     backed securities            8,236           61           --           --        8,236           61
                             ---------------------------------------------------------------------------
                                 14,071          111           --           --       14,071          111
                             ---------------------------------------------------------------------------
                             $   68,282   $      467   $   35,560   $      863   $  103,842   $    1,330
                             ===========================================================================
</TABLE>

Government   Agency   Obligations.   The  unrealized  losses  on  the  Company's
investments in direct obligations of U.S. government agencies were the result of
interest rate  increases.  The  contractual  terms of these  investments  do not
permit the issuer to settle the securities at a price  materially  less than the
amortized cost of the investment. Because the Company has the ability and intent
to hold these investments until a recovery of fair value, which may be maturity,
the Company does not consider  these  investments  to be  other-than-temporarily
impaired at June 30, 2005.

Federal  Agency  Mortgage-Backed   Securities.  The  unrealized  losses  on  the
Company's investment in agency mortgage-backed securities issued by FNMA, FHLMC,
and GNMA were caused by interest rate increases.  The Company  purchased most of
these  investments  at either a  discount  or a premium  relative  to their face
amount,  and the  contractual  cash  flows of each is  guaranteed  by the issuer
organization.  Accordingly,  it is  expected  that the  securities  would not be
settled at a price  materially  less than the  amortized  cost of the  Company's
investment.  Because the decline in market value is  attributable  to changes in
interest  rates and not credit  quality  and because the Company has the ability
and intent to hold these investments  until a recovery of fair value,  which may
be  maturity,   the  Company  does  not  consider   these   investments   to  be
other-than-temporarily impaired at June 30, 2005.


                                      -12-
<PAGE>

6. Loans

The  composition of the loan portfolio by loan  classification  at June 30, 2005
and December 31, 2004 is as follows:

                                                        June 30,    December 31,
(Dollars in thousands)                                    2005          2004
                                                        --------    ------------

Commercial                                              $524,635    $    531,834
Consumer                                                  33,503          34,865
Home equity lines                                         61,349          61,925
Residential mortgages                                     29,036          26,020
                                                        --------    ------------
                                                         648,523         654,644
Plus deferred loan costs, net                                242             223
                                                        --------    ------------
                                                        $648,765    $    654,867
                                                        ========    ============

Loans held for sale as of June 30, 2005 and  December 31, 2004 were $7.3 million
and $3.4 million,  respectively,  and were included in the residential  mortgage
category.

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

The  following  discussion  presents  an  overview  of the  unaudited  financial
statements for the three,  and six month period ended June 30, 2005 and 2004 for
Capital Bank  Corporation  (the  "Company")  and it's wholly  owned  subsidiary,
Capital Bank (the "Bank").  This  discussion and analysis is intended to provide
pertinent  information  concerning  financial  position,  results of operations,
liquidity,  and capital  resources for the periods covered and should be read in
conjunction  with the  unaudited  financial  statements  and  related  footnotes
contained in Part I, Item 1 of this report.

Information set forth below contains various  forward-looking  statements within
the  meaning of Section  27A of the  Securities  Act of 1933,  as  amended,  and
Section 21E of the  Securities  Exchange Act of 1934, as amended (the  "Exchange
Act"), which statements  represent the Company's judgment  concerning the future
and are subject to risks and uncertainties that could cause the Company's actual
operating results to differ materially.  Such forward-looking  statements can be
identified by the use of  forward-looking  terminology,  such as "may",  "will",
"expect",  "anticipate",  "estimate",  "believe", or "continue", or the negative
thereof or other  variations  thereof or  comparable  terminology.  The  Company
cautions that such forward-looking statements are further qualified by important
factors  that  could  cause the  Company's  actual  operating  results to differ
materially from those in the forward-looking  statements, as well as the factors
set forth in this discussion and analysis,  and the Company's  periodic  reports
and other filings with the Securities and Exchange Commission (the "SEC").


                                      -13-
<PAGE>

Risk Factors

You should  consider  the  following  material  risk  factors  carefully  before
deciding to invest in Capital Bank Corporation securities.  Additional risks and
uncertainties  not  presently  known  to us,  that we may  currently  deem to be
immaterial or that are similar to those faced by other companies in our industry
or business  in general,  such as  competitive  conditions,  may also impact our
business  operations.  If any of the events described below occur, the Company's
business,  financial  condition,  or results of  operations  could be materially
adversely  affected.  In that event,  the trading price of the Company's  common
stock may  decline,  in which case the value of your  investment  may decline as
well.

Our Results Are Impacted by the Economic  Conditions of Our Principal  Operating
Regions

Our operations are concentrated  throughout  Central and Western North Carolina.
As a result of this geographic  concentration,  our results may correlate to the
economic conditions in these areas.  Deterioration in economic conditions in any
of these market areas,  particularly in the industries on which these geographic
areas  depend,  may adversely  affect the quality of our loan  portfolio and the
demand  for  our  products  and  services,  and  accordingly,   our  results  of
operations.

We Are Exposed to Risks in Connection with the Loans We Make

A significant source of risk for us arises from the possibility that losses will
be  sustained  because  borrowers,  guarantors  and related  parties may fail to
perform in accordance  with the terms of their loans. We have  underwriting  and
credit  monitoring  procedures and credit policies,  including the establishment
and review of the allowance for loan losses,  that we believe are appropriate to
minimize this risk by assessing the likelihood of nonperformance,  tracking loan
performance and diversifying  our loan portfolio.  Such policies and procedures,
however,  may not  prevent  unexpected  losses that could  adversely  affect our
results of operations.

We Compete With Larger Companies for Business

The banking and financial  services business in our market areas continues to be
a competitive  field and is becoming more  competitive as a result of:

      o     Changes in regulations;

      o     Changes in technology and product delivery systems; and

      o     The  accelerating  pace of  consolidation  among financial  services
            providers.

We may not be able to compete  effectively  in our  markets,  and our results of
operations  could be  adversely  affected  by the  nature  or pace of  change in
competition.  We compete for loans, deposits and customers with various bank and
non-bank financial services providers,  many of which have substantially greater
resources  including higher total assets and  capitalization,  greater access to
capital markets and a broader offering of financial services.

Our Trading Volume Has Been Low Compared With Larger Banks

The trading  volume in our common stock on the NASDAQ  National  Market has been
comparable  to  other  similarly-sized  banks.  Nevertheless,  this  trading  is
relatively low when


                                      -14-
<PAGE>

compared with more seasoned  companies  listed on the NASDAQ  National Market or
other consolidated reporting systems or stock exchanges. Thus, the market in our
common stock may be limited in scope relative to other companies.

We Depend Heavily on Our Key Management Personnel

Our  success  depends in part on our  ability to retain  key  executives  and to
attract and retain additional qualified management personnel who have experience
both in sophisticated banking matters and in operating a small to mid-size bank.
Competition for such personnel is strong in the banking  industry and we may not
be successful in attracting or retaining the personnel we require.  We expect to
effectively  compete in this area by offering  financial  packages  that include
incentive-based  compensation  and the opportunity to join in the rewarding work
of building a growing bank.

Technological Advances Impact Our Business

The  banking  industry  is  undergoing   technological   changes  with  frequent
introductions  of new  technology-driven  products and services.  In addition to
improving  customer  services,   the  effective  use  of  technology   increases
efficiency  and  enables  financial  institutions  to reduce  costs.  Our future
success  will  depend,  in part,  on our  ability  to  address  the needs of our
customers by using technology to provide products and services that will satisfy
customer demands for convenience as well as to create additional efficiencies in
our operations.  Many of our competitors have  substantially  greater  resources
than  we do to  invest  in  technological  improvements.  We may  not be able to
effectively   implement   new   technology-driven   products   and  services  or
successfully market such products and services to our customers.

Government  Regulations  May  Prevent  or Impair Our  Ability to Pay  Dividends,
Engage in Acquisitions  or Operate in Other Ways

Current and future  legislation
and the policies  established by federal and state  regulatory  authorities will
affect our operations. We are subject to supervision and periodic examination by
the Federal Deposit  Insurance  Corporation and the North Carolina State Banking
Commission.  Banking  regulations,  designed  primarily  for the  protection  of
depositors,  may limit our  growth  and the  return to you,  our  investors,  by
restricting  certain of our  activities,  such as:

      o     The payment of dividends to our shareholders;

      o     Possible mergers with or acquisitions of or by other institutions;

      o     Our desired investments;

      o     Loans and interest rates on loans;

      o     Interest rates paid on our deposits;

      o     The possible expansion of our branch offices; and/or

      o     Our ability to provide securities or trust services.

We  also  are  subject  to  capitalization   guidelines  set  forth  in  federal
legislation,  and could be subject to enforcement  actions to the extent that we
are found by regulatory examiners to be undercapitalized. We cannot predict what
changes,  if any,  will be made to existing  federal and state  legislation  and
regulations or the effect that such changes may have on our future  business and
earnings  prospects.   The  cost  of  compliance  with  regulatory  requirements
including  those imposed by the SEC may adversely  affect our ability to operate
profitably.


                                      -15-
<PAGE>

There Are Potential Risks Associated With Future Acquisitions and Expansions

We intend to continue to explore  expanding our branch system through  selective
acquisitions  of existing  banks or bank branches in the Research  Triangle area
and other North Carolina markets.  We cannot say with any certainty that we will
be  able  to  consummate,  or if  consummated,  successfully  integrate,  future
acquisitions,  or that we will not incur  disruptions or unexpected  expenses in
integrating such acquisitions.  In the ordinary course of business,  we evaluate
potential  acquisitions  that would  bolster  our  ability to cater to the small
business,  individual and  residential  lending  markets in North  Carolina.  In
attempting  to make  such  acquisitions,  we  anticipate  competing  with  other
financial  institutions,  many of which have greater  financial and  operational
resources.  In addition,  since the consideration for an acquired bank or branch
may involve  cash,  notes or the  issuance of shares of common  stock,  existing
shareholders  could experience  dilution in the value of their shares of the our
common stock in connection with such acquisitions. Any given acquisition, if and
when  consummated,  may  adversely  affect our results of  operations or overall
financial condition.

In  addition,  we may expand  our branch  network  through de novo  branches  in
existing or new markets.  These de novo branches will have expenses in excess of
revenues for varying  periods  after  opening  that could  decrease our reported
earnings.

Compliance  with  Changing   Regulation  of  Corporate   Governance  and  Public
Disclosure May Result in Additional Risks and Expenses

Changing laws,  regulations and standards  relating to corporate  governance and
public  disclosure,  including  the  Sarbanes-Oxley  Act of  2002  and  new  SEC
regulations,  are creating  uncertainty for companies such as ours.  These laws,
regulations and standards are subject to varying  interpretations in many cases,
and as a result,  their  application  in  practice  may evolve  over time as new
guidance is provided by regulatory and governing  bodies,  which could result in
continuing   uncertainty   regarding   compliance   matters  and  higher   costs
necessitated by ongoing revisions to disclosure and governance practices. We are
committed to  maintaining  high  standards of  corporate  governance  and public
disclosure.  As a result, our efforts to comply with evolving laws,  regulations
and  standards  have  resulted  in,  and are  likely to  continue  to result in,
increased  expenses  and a  diversion  of  management  time  and  attention.  In
particular,  our efforts to comply with Section 404 of the Sarbanes-Oxley Act of
2002 and the related regulations  regarding  management's required assessment of
our internal control over financial  reporting and our external  auditors' audit
of that  assessment  has required the  commitment of  significant  financial and
managerial  resources.   We  expect  these  efforts  to  require  the  continued
commitment  of  significant  resources.  Further,  the  members  of our Board of
Directors,  members of the Audit or Compensation committees, our Chief Executive
Officer, our Chief Financial Officer and certain other of our executive officers
could face an  increased  risk of  personal  liability  in  connection  with the
performance  of their  duties.  As a result,  our  ability to attract and retain
executive  officers and  qualified  Board and  committee  members  could be more
difficult.  In  addition,  it may become more  difficult  and more  expensive to
obtain director and officer liability insurance.


                                      -16-
<PAGE>

Our Proposed Transaction with 1st State Bancorp, Inc. is Subject to
Uncertainties.

Our proposed  transaction  with 1st State Bancorp,  Inc. is subject to customary
closing conditions, including regulatory and shareholder approval. If any of the
conditions  to closing are not  satisfied or waived,  the  proposed  transaction
would not be  completed.  In  addition,  the merger  agreement  relating  to the
proposed  transaction  can be terminated  prior to completion of the transaction
under  certain  circumstances,  including  where 1st State  Bancorp  receives an
acquisition  proposal  from a  third  party  that  its  board  believes  is more
favorable to its  shareholders  than the proposed  transaction  (after following
specific  procedures  described in our merger agreement with 1st State Bancorp).
If the merger  agreement is terminated,  the proposed  transaction  would not be
completed, and, in certain circumstances, 1st State Bancorp could be required to
pay us a  termination  fee of $2 million.  If the merger is not  completed,  the
value of our common stock could decline. We are currently targeting to close the
proposed transaction,  assuming the satisfaction or waiver of all conditions, in
the first  quarter of 2006.  The closing of the  proposed  transaction  could be
delayed beyond the first quarter of 2006 due to many factors,  including factors
beyond the control of either party.

Overview

Capital Bank Corporation is a financial holding company  incorporated  under the
laws of the state of North  Carolina on August 10, 1998.  The Company's  primary
function is to serve as the holding  company  for its  wholly-owned  subsidiary,
Capital Bank (the "Bank"). In addition,  the Company has interest in two trusts,
Capital Bank Statutory Trust I and II (hereinafter  collectively  referred to as
the  "Trusts").  The  Trusts  have not  been  consolidated  with  the  financial
statements of the Company. The Bank was incorporated under the laws of the State
of North Carolina on May 30, 1997 and commenced  operations as a state-chartered
banking  corporation  on June 20, 1997.  The Bank is not a member of the Federal
Reserve System and has no subsidiaries.

Capital  Bank is a  community  bank  engaged in the general  commercial  banking
business in Wake,  Chatham,  Granville,  Alamance,  Lee, Buncombe,  Guilford and
Catawba Counties of North Carolina. Wake County has a diversified economic base,
comprised primarily of services,  retail trade, government and manufacturing and
includes the City of Raleigh,  the state capital.  Lee,  Granville,  and Chatham
counties are significant centers for various industries,  including agriculture,
manufacturing,  lumber  and  tobacco.  Alamance  and  Guilford  counties  have a
diversified  economic base,  comprised primarily of manufacturing,  agriculture,
retail and wholesale trade, government,  services and utilities. Catawba County,
which includes  Hickory,  is a regional center for  manufacturing  and wholesale
trade. The economic base of Buncombe County is comprised  primarily of services,
medical,   tourism  and  manufacturing  industries  and  includes  the  city  of
Asheville.

The Bank  offers a full  range of banking  services,  including  the  following:
checking  accounts;  savings  accounts;  NOW  accounts;  money market  accounts;
certificates  of  deposit;  loans  for real  estate,  construction,  businesses,
agriculture,  personal uses, home improvement and automobiles; home equity lines
of credit;  consumer loans;  individual retirement accounts; safe deposit boxes;
bank  money  orders;  internet  banking;   electronic  funds  transfer  services
including wire  transfers;  traveler's  checks;  various  investments;  and free
notary services to all Bank customers.  In addition, the Bank provides automated
teller machine access to its customers for cash withdrawals  through  nationwide
ATM  networks.  At present,  the Bank does not  provide the  services of a trust
department.


                                      -17-
<PAGE>

The Bank offers  non-insured  investment  products  and services by Capital Bank
Financial  Services  through a  partnership  with Capital  Investment  Group,  a
leading  Raleigh,   North  Carolina  based   broker-dealer.   The  Bank  employs
commission-based   financial  advisors  to  offer   full-service   brokerage  to
individual and corporate customers.

The  Trusts  were  formed  for the  sole  purpose  of  issuing  trust  preferred
securities.  The  proceeds  from such  issuances  were  loaned to the Company in
exchange for  subordinated  debentures  (the  "Debentures"),  which are the sole
assets of the  Trusts.  A  portion  of the  proceeds  from the  issuance  of the
Debentures  were used by the  Company to  repurchase  shares of  Company  common
stock.  The Company's  obligation  under the  Debentures  constitutes a full and
unconditional  guarantee  by the  Company of the Trust's  obligations  under the
trust preferred securities.  The Trusts have no operations other than those that
are incidental to the issuance of the trust preferred securities.

The Company has no operations other than those of its subsidiaries.

Executive Summary

As discussed in more detail  below,  the following is a brief summary of certain
of our significant quarterly results:

      o     The  Company  reported  net income for the  second  quarter  2005 of
            $1,603,000  compared  to  $891,000  in the  second  quarter of 2004.
            Earnings per fully diluted share increased to $.23 from $.13 for the
            second quarter 2004

      o     For the six months ended June 30, 2005 and 2004,  respectively,  the
            Company  reported net income of  $3,158,000  and  $2,271,000.  Fully
            diluted  earnings  per share  were $.46 and $.33 for the six  months
            ended June 30, 2005 and 2004, respectively.

      o     For the three months ended June 30, 2005,  the credit  provision for
            loan losses was  $(156,000)  compared to a provision of $297,000 for
            the three months ended June 30, 2004. Net  charge-offs for the three
            months ended June 30, 2005 were $138,000, or 0.09% of average loans,
            compared  to  $101,000,  or 0.06% of  average  loans,  for the three
            months ended June 30,  2004.  For the six months ended June 30, 2005
            and  2004  the  provision   expense  was  $(406,000)  and  $413,000,
            respectively.  The  significant  decline  in the  provision  expense
            during the  periods is largely due to  improved  credit  quality and
            also a modest decline in loan balances.  See "Asset Quality" section
            for further discussion.

      o     Net interest  income  increased  $929,000  from $6.2 million for the
            three month period ended June 30, 2004, to $7.1 million for the same
            period in 2005.  The  Company's net interest  margin  increased by 2
            basis points compared to first quarter of 2005 to 3.55%. For the six
            months  ended  June  30,  2005  and 2004  net  interest  income  was
            $14,066,000   and   $12,500,000,   respectively.   The  increase  is
            attributable  to  increases  in  short-term  interest  rates  as the
            Federal Reserve Open Market Committee's benchmark federal funds rate
            has been  increased 9 times since June 30,  2004  reaching  3.25% at
            June 30, 2005.

      o     Noninterest  income for the three month  period ended June 30, 2005,
            approximated noninterest income for the same period of 2004. For the
            six months ended June 30, 2005 and 2004 noninterest  income declined
            slightly to $2.9 million from $3.1 million,


                                      -18-
<PAGE>

            respectively. The largest single component of the decline was due to
            gains on the sale of  repossessed  property  recorded  in the  first
            quarter 2004.

      o     Noninterest  expense was $6.5  million  for the three  month  period
            ended June 30, 2005  compared to $6.1 million for the same period of
            2004.  Increases  in salaries  and  employee  benefits,  the largest
            noninterest expense category,  were the primary cause of the overall
            noninterest  expense  increase as those costs moved to $3.5  million
            for the three month period ended June 30, 2005 from $3.1 million for
            the same  period  in 2004.  Approximately  50% of the  increase  was
            attributable  to severance  payments  for an executive  officer that
            left the Company in April 2005. The remaining increase was primarily
            due to an  increase  in the  number  of  personnel  employed  by the
            Company and management's  intention to maintain adequate staffing to
            meet customer's needs and keep pace with expected growth.

Merger with 1st State Bancorp, Inc.

On June 29, 2005,  the Company  announced  that it had entered into a definitive
agreement  with  1st  State  Bancorp,  Inc.,  ("1st  State"),  headquartered  in
Burlington,  North  Carolina  whereby 1st State will be merged with and into the
Company.  1st State  shareholders  will  receive  approximately  $37.15 (in cash
and/or stock) per share of 1st State common  stock.  The Company filed a Current
Report  on Form 8-K on June  29,  2005  which  among  other  things  more  fully
describes the proposed transaction and attaches the definitive agreement.

Financial Condition

Total  consolidated  assets of the Company at June 30, 2005 were $917.4  million
compared to $882.3  million at December 31, 2004, an increase of $35.1  million,
or almost  4%.  Overall  growth in the  balance  sheet was due to growth of core
deposits, especially demand deposits and money market deposits.

Loan balances during the quarter remained  relatively constant and down slightly
from year-end 2004 levels. At June 30, 2005,  investment  securities were $161.8
million,  up $1.2 million from December 31, 2004. The increase reflects a slight
investment of proceeds from the growth in deposits. Federal funds sold and short
term investments were $22.0 million, up $22.0 million from December 31, 2004. At
year  end,  the  Company  was in a federal  funds  purchased  position,  however
increases in deposits and a decrease in the loan  portfolio  have resulted in an
increase in short term liquidity at June 30, 2005.

Earning  assets  represented  91.6% of total  assets  as of June 30,  2005.  The
allowance for loan losses as of June 30, 2005 was $10.1 million and  represented
approximately  1.55% of total loans and 1.57% of loans  excluding those held for
sale at the end of the period. The allowance for loan losses decreased $646,000,
from the December 31, 2004 balance of $10.7  million.  Management  believes that
the amount of the allowance is adequate to absorb  probable  losses  inherent in
the current loan portfolio.  See "Asset  Quality" for further  discussion of the
allowance for loan losses.

Deposits as of June 30, 2005 were $690.0 million,  an increase of $35.0 million,
or 5%, from  December 31, 2004.  The overall net growth was primarily the result
of strong internal growth fueled by a successful core deposit  campaign.  One of
the Company's  highest  priorities for 2005 is the growth of non-time  deposits,
including demand deposit accounts ("DDA") and money


                                      -19-
<PAGE>

market accounts.  During the first six months of 2005, the Company experienced a
net  decrease of $5.3  million,  or 1.3%,  in  certificates  of deposit  ("CDs")
compared to December 31, 2004.  Approximately  $2.2 million of this  decrease is
attributable  to brokered  CDs. In  addition,  the Company has not  aggressively
priced certain maturing CDs where the customer has no other banking relationship
with the Company.  Time deposits represented 56.6% of total deposits at June 30,
2005 compared to 60.4% at December 31, 2004.

Noninterest  bearing  DDAs  increased  to $81.8  million  at June 30,  2005,  an
increase of $16.1  million,  or 25%, from $65.7 million at December 31, 2004. In
addition,  the average balance of DDA accounts increased $6.3 million during the
second  quarter 2005 compared to the first  quarter  2005.  The Company has also
focused on gathering money market accounts and,  accordingly,  the Bank began an
advertising and promotional  campaign designed to attract more of those types of
deposits. As a result of the campaign, savings, interest bearing DDAs, and money
market  accounts  increased to $217.6  million at June 30, 2005,  an increase of
$24.2  million,  or 13%, from $193.4  million at December 31, 2004.  The average
balance of these accounts also increased significantly during the second quarter
with the  average  balance  being  $194.5  million for the second  quarter  2005
compared to $174.1 million for the first quarter 2005.

Total consolidated  shareholders'  equity was $79.5 million as of June 30, 2005,
an increase of $1.8 million from December 31, 2004.  Retained earnings increased
by $2.4 million reflecting the net income during the six month period ended June
30, 2005 less dividends paid during that same time, offset by a $448,000 decline
in accumulated other comprehensive income due to declines in the market value of
the  investment  portfolio.  Common  stock  decreased by $157,000 as a result of
repurchases  of the  Company's  stock  pursuant to an approved  repurchase  plan
during the first  quarter of 2005 offset by the issuance of shares under various
plans. See Item 1. Financial Statements - Consolidated  Statements of Changes in
Shareholders' Equity for additional information.

Results of Operations

Three month period ended June 30, 2005
--------------------------------------

For the three month period ended June 30, 2005, the Company  reported net income
of $1.6 million,  or $.23 per diluted share,  compared to net income of $900,000
or $.13 per diluted  share,  for the three month period ended June 30, 2004. The
improved  net  income  was due to  improved  net  interest  margins  and a lower
provision for loan losses for the comparable periods.

Net interest income increased $929,000,  or approximately 15%, from $6.3 million
for the three month  period  ended June 30,  2004,  to $7.2 million for the same
quarter in 2005.  Average  earning  assets  increased  $7.5 million  period over
period while average interest bearing  liabilities  increased $4.3 million.  The
net  interest  margin on a fully  taxable  equivalent  basis  increased 41 basis
points  quarter-over-quarter  to 3.55% for the three month period ended June 30,
2005 from  3.14% for the same time  period  for 2004.  The  increase  in the net
interest  margin is primarily  attributed to increases in the benchmark  federal
funds rates as determined by the Federal Reserve Open Market Committee ("FOMC"),
resulting in nine corresponding increases in the prime interest rate starting on
June 30, 2004.  The Company's  balance sheet remains  asset-sensitive  and, as a
result,  its interest  earning assets reprice quicker than its interest  bearing
liabilities.  Since June 30, 2004 the Bank has  increased  its prime rate by 225
basis points to 6.25% in


                                      -20-
<PAGE>

response to FOMC rate  increases.  We cannot be certain of the  direction of the
benchmark federal funds rates as set by the FOMC.  Further increases by the FOMC
will affect the level of our prime rate and likely  increase the effective  cost
of interest-bearing liabilities.

The following  table shows the Company's  effective  yield on earning assets and
cost of funds.  Yields and costs are computed by dividing  income or expense for
the year by the respective daily average asset or liability balance.


                                      -21-
<PAGE>

      Average Balances, Interest Earned or Paid, and Interest Yields/Rates
                    Three Months Ended June 30, 2005 and 2004
              (Taxable Equivalent Basis - Dollars in Thousands) (1)

<TABLE>
<CAPTION>
                                                              2005                                 2004
                                               -------------------------------------------------------------------------
                                                Average      Amount      Average      Average      Amount      Average
                                                Balance      Earned       Rate        Balance      Earned       Rate
                                               -------------------------------------------------------------------------
<S>                                            <C>          <C>              <C>     <C>          <C>              <C>
 Assets
 Loans receivable: (2)
   Commercial                                  $ 529,066    $   8,469        6.42%   $ 504,802    $   6,496        5.18%
   Consumer                                       31,309          594        7.61%      39,491          667        6.79%
   Home equity                                    61,755          954        6.20%      60,195          724        4.84%
   Residential mortgages (3)                      26,139          388        5.95%      47,586          685        5.79%
                                               -------------------------------------------------------------------------
 Total loans                                     648,269       10,405        6.44%     652,074        8,572        5.29%
 Investment securities (4)                       160,955        1,890        4.71%     154,244        1,720        4.48%
 Federal funds sold and other
     interest on short term investments           17,137          116        2.72%      12,531           39        1.25%
                                               -------------------------------------------------------------------------
 Total interest earning assets                   826,361    $  12,411        6.02%     818,849    $  10,331        5.07%
                                                            ======================                ======================
 Cash and due from banks                          23,278                                18,812
 Other assets                                     57,844                                51,813
 Allowance for loan losses                       (10,305)                              (11,391)
                                               ---------                             ---------
 Total assets                                  $ 897,178                             $ 878,083
                                               =========                             =========

 Liabilities and Equity
 Savings deposits                              $  17,239    $      31        0.72%   $  17,785    $      11        0.25%
 Interest-bearing demand deposits                194,511          848        1.75%     187,029          522        1.12%
 Time deposits                                   391,244        2,797        2.87%     401,755        2,380        2.38%
                                               -------------------------------------------------------------------------
 Total interest bearing deposits                 602,994        3,676        2.45%     606,569        2,913        1.93%
 Borrowed funds                                  100,819        1,027        4.09%      97,698          796        3.28%
 Trust preferred debt                             20,620          305        5.93%      20,620          214        4.17%
 Repurchase agreements                            14,332           80        2.24%       9,563            9        0.38%
                                               -------------------------------------------------------------------------
   Total interest-bearing liabilities            738,765    $   5,088        2.76%     734,450    $   3,932        2.15%
                                                            ======================                ======================
 Non-interest bearing deposits                    68,313                                60,293
 Other liabilities                                11,394                                 9,039
                                               ---------                             ---------
 Total liabilities                               818,472                               803,782
 Shareholders' equity                             78,706                                74,301
                                               ---------                             ---------
  Total liabilities and shareholders' equity   $ 897,178                             $ 878,083
                                               =========                             =========

 Net interest spread (5)                                                     3.26%                                 2.92%

 Tax equivalent adjustment                                  $     163                             $     168

 Net interest income and net
   interest margin (6)                                      $   7,323        3.55%                $   6,399        3.14%
</TABLE>

(1)   The taxable equivalent basis is computed using a blended federal and state
      tax rate of approximately 38%.

(2)   Loans  receivable  include  nonaccrual loans for which accrual of interest
      has not been recorded.

(3)   Includes loans held for sale.

(4)   The average balance for investment  securities exclude the effect of their
      mark-to-market adjustment, if any.

(5)   Net interest spread represents the difference between the average yield on
      interest-earning   assets  and  the  average   cost  of   interest-bearing
      liabilities.

(6)   Net interest margin  represents the net interest income divided by average
      interest-earning assets.


                                      -22-
<PAGE>

Yields on commercial, home equity and consumer loans increased 124 basis points,
136 basis points and 82 basis  points,  respectively,  in the second  quarter of
2005  compared to the same  period in 2004.  Higher  yields in 2005  reflect the
increase  in the prime  rate  charged  by the Bank  between  those two  periods.
Variable  rate loans made up  approximately  70% of the total loan  portfolio at
June 30, 2005 compared to 70% at June 30, 2004.

The yield on investment  securities on a  tax-equivalent  basis  increased  from
4.48% in the second  quarter of 2004 to 4.71% in the second quarter of 2005. The
investment yield in 2004 was negatively affected by higher premium amortizations
on mortgage backed  securities  ("MBS") as the average expected lives of the MBS
portfolio  were  shortened  due to  significant  prepayments  of the  underlying
mortgage loans. MBS premium  amortizations  were  approximately  $229,000 in the
second quarter of 2004 compared to approximately  $86,000 for the same period in
the current year. Longer term rates have increased much less  significantly than
short-term rates. The majority of the investment  portfolio is in medium to long
term maturity  investments and, as a result,  the Company's yield on investments
will not increase rapidly if long term rates begin to increase.

The rate  paid on time  deposits  increased  from  2.39% to 2.87%  for the three
months ended June 30, 2004 compared to the same period in 2005, a 48 basis point
rise, as new certificates were opened at higher rates due to the rising interest
rate  environment.  Rates on shorter  maturity CDs have increased  significantly
with the FOMC interest rate increases and management  anticipates  the Bank's CD
funding costs will increase on a quarterly basis going forward for the remainder
of 2005.

The rate on borrowings  for the three month period ended June 30, 2005 increased
year over year to 4.09%  from  3.28%.  In July of 2003,  the Bank  entered  into
interest rate swap agreements on $25.0 million of the  outstanding  Federal Home
Loan Bank  advances to swap fixed rate  borrowings to a variable  rate.  The net
effect  of the  swaps  has been to reduce  interest  and,  accordingly,  the net
effective  rate  paid on those  advances.  As  short-term  interest  rates  have
increased  following the FOMC rate  increases,  the overall  effective  yield on
borrowings has increased. The increases in short-term rates are also responsible
for the increase in the cost of the Company's subordinated debentures.

For the three month period ended June 30, 2005,  the credit  provision  for loan
losses was $(156,000) compared to a provision of $297,000 for the same period in
2004, a decrease of  approximately  $453,000.  The decline in 2005 was primarily
due to a strong  loan growth in the second  quarter of 2004  compared to minimal
loan growth in 2005,  improvements in the risk rating classifications of certain
loans contained in the portfolio and other factors as discussed more fully below
under the "Asset Quality" section.

Noninterest income for the three month periods ended June 30, 2004 and 2005 were
flat. Deposit service charges declined as mature branches were sold in September
2004 despite new branches  being opened which don't  generate as much fee income
as mature  branches.  Other  income  increased  largely  from  retail  brokerage
commissions  and higher levels of bank owned life insurance.  Mortgage  revenues
increased to their highest level since 2003 during the quarter with increases in
mortgage production.

Noninterest  expense  for the three  month  period  ended June 30, 2005 was $6.5
million compared to $6.1 million for the corresponding  period in 2004. Salaries
and employee benefits,


                                      -23-
<PAGE>

representing the largest noninterest expense category, increased to $3.5 million
for the three month period  ended June 30, 2005,  from $3.1 million for the same
period in 2004.  Approximately 50% of the increase was attributable to severance
payments  for an  executive  officer  that left the Company in April  2005.  The
remaining  increase was  primarily due to an increase in the number of personnel
employed by the Company and management's intention to maintain adequate staffing
to meet  customer's  needs and keep pace with  expected  growth.  As of June 30,
2005, the Company had 244 full-time  equivalent  employees  ("FTEs") compared to
216 for the same date in 2004 and 227 at December 31, 2004. Substantially all of
the  increase  from June 30, 2004 through  year-end was related to  commissioned
mortgage  originators  and  brokerage  representatives  while the increase  from
year-end through June 30, 2005 was for additional staffing in other areas of the
bank including loan officers and other sales positions.

Increases in other  expenses  related to a new director  retirement  program and
increased  director fees in 2005 were offset by lower equipment costs. The lower
equipment costs were attributable to higher expenses in 2004 associated with the
purchase  of  non-capitalized  equipment  for the  opening  of new  branches  in
Greensboro and Asheville.

As previously  disclosed,  in  contemplation of the proposed merger of 1st State
with and into the  Company,  which is  subject  to  regulatory  and  shareholder
approval as well as other customary closing conditions and which is discussed in
more detail in the Company's Current Report on Form 8-K as filed with the SEC on
June 29, 2005, the Company plans to consolidate  its state-wide  operations into
1st State's  headquarters  building in Burlington,  North Carolina.  The Company
anticipates that such  consolidation  will include data processing  services and
item  processing,  which to date have been provided by FiServe.  In  conjunction
with processing  in-house,  the Company will be required to purchase  additional
software and  equipment.  The Company will continue to utilize  FiServe for item
processing  and data  processing  on a  month-to-month  basis after its contract
expires at the end of 2005,  until the  conversion  is  completed.  The  Company
estimates the total cost of the conversion to be  approximately  $1.8 million to
$2.5 million.

The  Company's  effective  tax rate for the  second  quarter  of 2005 was  33.4%
compared to 36.7% for the comparable  period of 2004.  The Company  forecasts it
taxable and  non-taxable  income and  calculates  the effective tax rate for the
entire year, which is then applied to the three month period. The changes in the
effective  tax rate are due to changes in  forecasted  levels of taxable and tax
exempt income and the decline for these comparable  periods  primarily  reflects
the addition of nontaxable income as the result of a purchase of bank owned life
insurance in the latter part of 2004 and again in May 2005.

The Company  recorded  an income tax expense of $803,000  during the three month
period  ended June 30, 2005  compared to an expense of $517,000  during the same
period in 2004.  At June 30,  2005,  the Company had net  deferred tax assets of
$6.1 million  resulting from timing  differences  associated  primarily with the
deductibility of certain expenses reflected on the financial  statements such as
the allowance  for loan losses and the  mark-to-market  of  unrealized  security
losses.

Results of Operations

Six month period ended June 30, 2005
------------------------------------

For the six month period ended June 30, 2005, the Company reported net income of
$3.2 million,


                                      -24-
<PAGE>

or $.46 per diluted share,  compared to net income of $2.3 million,  or $.33 per
diluted  share,  for the six month period ended June 30, 2004.  The improved net
income was due to improved net interest  margins and a lower  provision for loan
losses for the comparable periods.

Net interest  income  increased  $1,566,000,  or  approximately  13%, from $12.5
million for the six month period ended June 30, 2004,  to $14.1  million for the
same period in 2005.  Average earning assets  increased $7.0 million period over
period while average interest bearing  liabilities  increased only $0.5 million.
The net interest margin on a fully taxable  equivalent  basis increased 37 basis
points  quarter-over-quarter  to 3.54% for the six month  period  ended June 30,
2005 from  3.17% for the same time  period  for 2004.  The  increase  in the net
interest  margin is primarily  attributed to increases in the benchmark  federal
funds rates as  determined by the FOMC and the asset  sensitive  position of the
Company's balance sheet.

The following  table shows the Company's  effective  yield on earning assets and
cost of funds.  Yields and costs are computed by dividing  income or expense for
the year by the respective daily average asset or liability balance.


                                      -25-
<PAGE>

      Average Balances, Interest Earned or Paid, and Interest Yields/Rates
                     Six Months Ended June 30, 2005 and 2004
              (Taxable Equivalent Basis - Dollars in Thousands) (1)


<TABLE>
<CAPTION>
                                                             2005                                  2004
                                              -------------------------------------------------------------------------
                                               Average      Amount      Average      Average      Amount      Average
                                               Balance      Earned       Rate        Balance      Earned       Rate
                                              -------------------------------------------------------------------------
<S>                                           <C>          <C>              <C>     <C>          <C>              <C>
Assets
Loans receivable: (2)
  Commercial                                  $ 531,156    $  16,396        6.22%   $ 493,823    $  12,840        5.21%
  Consumer                                       31,566        1,161        7.42%      39,320        1,330        6.78%
  Home equity                                    61,834        1,828        5.96%      59,747        1,446        4.85%
  Residential mortgages (3)                      25,793          762        5.96%      47,779        1,427        5.99%
                                              -------------------------------------------------------------------------
Total loans                                     650,349       20,147        6.25%     640,669       17,043        5.33%
Investment securities (4)                       159,459        3,751        4.74%     158,267        3,606        4.57%
Federal funds sold and other
    interest on short term investments            9,854          133        2.72%      13,689           81        1.19%
                                              -------------------------------------------------------------------------
Total interest earning assets                   819,662    $  24,031        5.91%     812,625    $  20,730        5.12%
                                                           ======================                ======================
Cash and due from banks                          22,872                                21,417
Other assets                                     56,595                                51,789
Allowance for loan losses                       (10,584)                              (11,553)
                                              ---------                             ---------
Total assets                                  $ 888,545                             $ 874,278
                                              =========                             =========

Liabilities and Equity
Savings deposits                              $  16,495    $      41        0.50%   $  17,536    $      22        0.25%
Interest-bearing demand deposits                184,322        1,486        1.63%     185,629        1,015        1.10%
Time deposits                                   393,585        5,331        2.73%     394,676        4,738        2.41%
                                              -------------------------------------------------------------------------
Total interest bearing deposits                 594,402        6,858        2.33%     597,841        5,775        1.94%
Borrowed funds                                  103,680        2,046        3.98%     103,752        1,661        3.21%
Trust preferred debt                             20,620          581        5.68%      20,620          430        4.18%
Repurchase agreements                            14,906          153        2.07%      10,850           28        0.52%
                                              -------------------------------------------------------------------------
  Total interest-bearing liabilities            733,608    $   9,638        2.65%     733,063    $   7,894        2.16%
                                                           ======================                ======================
Non-interest bearing deposits                    65,145                                58,106
Other liabilities                                11,201                                 8,719
                                              ---------                             ---------
Total liabilities                               809,954                               799,888
Shareholders' equity                             78,591                                74,390
                                              ---------                             ---------
 Total liabilities and shareholders' equity   $ 888,545                             $ 874,278
                                              =========                             =========

Net interest spread (5)                                                     3.26%                                 2.96%

Tax equivalent adjustment                                  $     327                             $     336

Net interest income and net
  interest margin (6)                                      $  14,393        3.54%                $  12,836        3.17%
</TABLE>

(1)   The taxable equivalent basis is computed using a blended federal and state
      tax rate of approximately 38%.

(2)   Loans  receivable  include  nonaccrual loans for which accrual of interest
      has not been recorded.

(3)   Includes loans held for sale.

(4)   The average balance for investment  securities exclude the effect of their
      mark-to-market adjustment, if any.

(5)   Net interest spread represents the difference between the average yield on
      interest-earning   assets  and  the  average   cost  of   interest-bearing
      liabilities.

(6)   Net interest margin  represents the net interest income divided by average
      interest-earning assets.


                                      -26-
<PAGE>

For the six month  period  ended June 30, 2005,  the credit  provision  for loan
losses was $(406,000) compared to a provision of $413,000 for the same period in
2004, a decrease of  approximately  $819,000.  The decline in 2005 was primarily
due to a reduction  in charge offs  during the six month  period  ended June 30,
2005,  which dropped to $237,000 from $609,000  recorded in same period in 2004,
improvements  in the risk rating  classifications  of certain loans contained in
the portfolio and overall  reduction of the loan  portfolio as discussed  above.
See "Asset  Quality"  below for further  discussion  of the  allowance  for loan
losses.

Noninterest  income  for the six month  period  ended  June 30,  2005,  was $2.9
million  compared to $3.1  million  for the same  period in 2004,  a decrease of
$226,000,  or 7%. The largest single component of this decrease was a decline of
$124,000,  or 23%, in deposit service  charges and fees largely  attributable to
the sale of three  mature  branches in the  northern  part of North  Carolina in
September  2004.  Mortgage  production,  another large  component of noninterest
income, was impacted by industry wide lower origination volumes caused by higher
mortgage  interest rates.  Mortgage revenues fell 6% during the first six months
of 2005 compared to the same period of 2004. As noted above,  mortgage  revenues
did rebound slightly during the second quarter of 2005.

Noninterest  expense  for the six month  period  ended  June 30,  2005 was $12.6
million compared to $11.7 million for the corresponding period in 2004. Salaries
and employee benefits,  representing the largest  noninterest  expense category,
increased to $6.6  million for the six month  period  ended June 30, 2005,  from
$5.9 million for the same period in 2004. This increase  reflects an increase in
the number of personnel  employed by the Company  consistent  with  management's
intention to maintain  adequate  staffing levels to meet customer needs and keep
pace with expected growth.

Occupancy  costs and  equipment  expenses for the six months ended June 30, 2005
and 2004 were impacted by changes in the Company's branch network and the timing
of expenses associated with those changes.  Occupancy expense has increased from
2004  levels  largely  due to new  locations  opened  that  have a  higher  cost
structure than those branch  locations  disposed of in late 2004.  Furniture and
equipment  expense  has  declined  from 2004  levels  because  of the  amount of
equipment  expense  associated  with the initial startup of these new locations.
The Company added a new location in Pittsboro  during the second quarter of 2005
while branches were opened during May through  August 2004 in  Greensboro,  Wake
Forest, and Asheville, North Carolina.

Increases in noninterest  expense also reflect an increase in professional fees.
Professional  fees  increased  31%, or  $127,000,  to $532,000 for the six month
period ended June 30, 2005 from $405,000 for the same period in 2004. During the
second quarter 2005  professional fees declined slightly from first quarter 2005
levels as fees associated with Sarbanes-Oxley compliance declined.

The Company's effective tax rate for the year to date 2005 was 33.5% compared to
35.5% for the  comparable  period of 2004. The changes in the effective tax rate
are due to changes in forecasted levels of taxable and tax exempt income and the
decline  for  these  comparable  periods  primarily  reflects  the  addition  of
nontaxable  income as the result of a purchase of bank owned life  insurance  in
the latter part of 2004 and during the second quarter of 2005.

The Company  recorded an income tax expense of $1.6 million and $1.3 million for
the six months ended June 30, 2005 and 2004,  respectively.  The increase is due
to increases in pre-tax  income  despite the decline in the  effective  tax rate
discussed above.


                                      -27-
<PAGE>

Asset Quality

Determining the allowance for loan losses is based on a number of factors,  many
of which are subject to judgments made by management. At the origination of each
commercial loan, management assesses the relative risk of the loan and assigns a
corresponding  risk grade.  To ascertain  that the credit  quality is maintained
after the loan is booked, the Bank has a procedure whereby a loan review officer
performs  an annual  review of all loans that exceed a  predetermined  threshold
amount,  all unsecured  loans over a  predetermined  loan amount,  a sampling of
loans within a lender's authority, and a sampling of the entire loan pool. Loans
are  reviewed  for  credit   quality,   sufficiency  of  credit  and  collateral
documentation,  proper loan approval,  covenant, policy and procedure adherence,
and continuing  accuracy of the loan grade. This officer reports directly to the
Chief  Credit  Officer  and will report on a sampling of loans each month to the
Loan Committee of the Bank's Board of Directors. On an as needed basis, the Bank
will hire an outside  third  party firm to review the Bank's loan  portfolio  to
ensure quality standards and reasonableness of risk assessment.

The Company  calculates the amount of allowance  needed to cover probable losses
in the portfolio by applying a reserve  percentage to each risk grade.  Consumer
loans and mortgages are not risk graded,  but a percentage is reserved for these
loans based on historical  losses.  The reserve  percentages have been developed
based on historical losses and industry trends. In addition to this quantitative
analysis,  a qualitative  assessment of the general economic  trends,  portfolio
concentration and the trend of delinquencies are taken into  consideration.  The
allowance is adjusted  accordingly to an amount that management believes will be
adequate  to  absorb   probable   losses  on  existing  loans  that  may  become
uncollectible.

During the second  quarter of 2005,  the Company  adjusted its  methodology  for
estimating  the allowance  for loan losses  associated  with certain  commercial
loans  greater than  $750,000.  In prior  periods,  the Company  generally  used
standard percentage  allocations based on the risk rating of the commercial loan
if the loan was risk  rated  below a "pass"  credit.  Commencing  in the  second
quarter,  the Company began estimating a specific  allowance for loan losses for
these loans. We determine the level of specific allowance based on the facts and
circumstances  of each loan which include among other factors,  payment history,
collateral values,  guarantor liquidity, and net worth. The effect of the change
in  methodology  on the second  quarter was to reduce the overall amount of loan
loss  reserves   associated   with  non-pass  loans  greater  than  $750,000  by
approximately $200,000 to $225,000.

The allowance for loan losses is established through a provision for loan losses
charged to expense. Loans are charged against the allowance for loan losses when
management believes that the collectibility of the principal is unlikely.  Based
on this  allowance  calculation,  management  recorded  a  credit  provision  of
$156,000 for the three month  period ended June 30, 2005  compared to an expense
of $297,000 for the same period in the prior year. In addition, to the change in
methodology with large non-pass loans, the Company saw an overall improvement in
delinquencies  and the risk ratings of the  portfolio  during the quarter  which
also contributed to the reduction in provision expense.  Loan loss reserves were
1.55% and 1.64% of gross loans,  respectively,  as of June 30, 2005 and December
31, 2004. Loan loss reserves as a percent of loans excluding loans held for sale
were 1.57% and 1.65% as of June 30, 2005 and December  31,  2004,  respectively.
The  following  table  presents an analysis of changes in the allowance for loan
losses for the three month period ended June 30, 2005 and 2004, respectively:


                                      -28-
<PAGE>

<TABLE>
<CAPTION>
                                                             Three Months             Six Months
                                                            Ended June 30,          Ended June 30,
                                                          2005         2004        2005         2004
                                                        --------     --------------------     --------
(Dollars in thousands)
<S>                                                     <C>          <C>         <C>          <C>
Allowance for loan losses, beginning of period          $ 10,372     $ 11,221    $ 10,721     $ 11,613
Net charge-offs:
      Loans charged off:
      Commercial                                              --           14          96          461
      Consumer                                               121          134         280          319
      Mortgage                                                59           70         110           70
                                                        --------     --------------------     --------
           Total charge-offs                                 180          218         486          850
                                                        --------     --------------------     --------
      Recoveries of loans previously charged off:
      Commercial                                              23           33         224           87
      Consumer                                                19           58          25           62
      Mortgage                                                --           26          --           92
                                                        --------     --------------------     --------
           Total recoveries                                   42          117         249          241
                                                        --------     --------------------     --------
           Total net charge-offs                             138          101         237          609
                                                        --------     --------------------     --------
      Loss provisions (credits) charged to operations       (159)         297        (409)         413
                                                        --------     --------------------     --------
Allowance for loan losses, end of period                $ 10,075     $ 11,417    $ 10,075     $ 11,417
                                                        ========     ====================     ========

Net charge-offs to average loans during the
period (annualized)                                         0.09%        0.06%       0.07%        0.19%
Allowance as a percent of gross loans                       1.55%        1.74%
Allowance as a percent of gross loans excluding
      loans held for sale                                   1.57%        1.75%
</TABLE>

Net charge-offs have declined, as management has allocated significant resources
to  improving  the  overall  credit  quality of the loan  portfolio.  Management
believes these efforts will result in lower net charge-offs  during 2005 than in
2004 and 2003,  however,  material  changes in economic and other  factors could
effect net charge-offs for 2005.

The following table presents an analysis of nonperforming  assets as of June 30,
2005 and 2004 and December 31, 2004:


                                      -29-
<PAGE>

                                                    June 30,        December 31,
                                                2005        2004        2004
                                              --------    --------  ------------
(Dollars in thousands)
Nonaccrual loans:
      Commercial and commercial real estate   $  6,094    $  3,740    $  3,964
      Mortgage                                   2,014       1,837       1,898
      Construction                               1,674         580       1,622
      Consumer                                     645         561         312
      Equity lines                                  --          --         415
                                              --------    --------    --------
           Total nonaccrual loans               10,427       6,718       8,211
      Foreclosed property held                   1,508         412         418
                                              --------    --------    --------
           Total nonperforming assets         $ 11,935    $  7,130    $  8,629
                                              ========    ========    ========

Nonperforming loans to total loans                1.61%       1.02%       1.32%
Nonperforming assets to total assets              1.30%       0.80%       0.98%
Allowance coverage of nonperforming loans           97%        170%        131%

On June 30, 2005,  nonperforming  assets were $10.4 million, an increase of $2.2
million  from  year-end  and a decrease of  $100,000  from March 31,  2005.  The
majority of the Company's  nonperforming loans are secured by real estate and to
a lesser  extent the Company  relies on the support of  guarantors.  The Company
monitors  the  value  of the  underlying  collateral  and the  liquidity  of the
guarantors on a periodic basis.  Based on this review and analysis,  the Company
does not currently  anticipate  significant  losses associated with the June 30,
2005  nonperforming  loans or from the  increase  during the  second  quarter in
nonperforming loans.

The increase in nonperforming loans during the year was largely  attributable to
four  customers.  These loans are primarily  secured by real estate and, in some
instances the Company is receiving some payments on the loans.

A loan is considered impaired, based on current information and events, if it is
probable  that the Bank will be unable to  collect  the  scheduled  payments  of
principal and interest when due according to the  contractual  terms of the loan
agreement.  Uncollateralized  loans are  measured  for  impairment  based on the
present  value of  expected  future  cash  flows  discounted  at the  historical
effective interest rate, while all  collateral-dependent  loans are measured for
impairment  based  on the fair  value of the  collateral.  Impaired  loans  were
$1,758,000  at June 30,  2005  compared to none at December  31,  2004.  Average
impaired loans during the second quarter of 2005 were $1,758,000.

The Bank uses several  factors in  determining  if a loan is impaired.  Internal
asset  classification  procedures  include  a review  of  significant  loans and
lending relationships by both management and third party credit review firms and
includes  the  accumulation  of  related  data  such  as  loan  payment  status,
borrowers'  financial data and borrowers'  operating factors such as cash flows,
operating income or loss. The Company's  determination of the allowance for loan
losses is subject to  management's  judgment and  analysis of many  internal and
external  factors.  While  management  is  comfortable  with the adequacy of the
current allowance,  changes in factors and management's future evaluation of the
adequacy of the allowance for loan losses will change.


                                      -30-
<PAGE>

Foreclosed  property  increased to  $1,508,000 at June 30, 2005 from $418,000 at
December 31, 2004. The increase is largely  attributable  to the  foreclosure of
certain  nonaccrual loans during the quarter.  The Company is actively marketing
all of its foreclosed property.  All foreclosed assets are recorded at the lower
of cost or market.

Liquidity and Capital Resources

The  Company's  liquidity  management  involves  planning to meet the  Company's
anticipated funding needs at a reasonable cost.  Liquidity  management is guided
by  policies   formulated   by  the   Company's   senior   management   and  the
Asset/Liability  Management  Committee of the Company's Board of Directors.  The
Company had $54.2 million in its most liquid assets,  cash and cash equivalents,
as of June  30,  2005.  The  Company's  principal  sources  of  funds  are  loan
repayments,  deposits,  Federal Home Loan Bank  borrowings and capital and, to a
lesser  extent,  investment  repayments.  Core  deposits  (total  deposits  less
certificates  of deposits  in the amount of  $100,000 or more),  one of the most
stable sources of liquidity, together with equity capital, funded 75.7% of total
assets at June 30, 2005 compared to 67.7% at December 31, 2004. In addition, the
Company has the ability to take  advantage  of various  other  funding  programs
available  from the  Federal  Home  Loan Bank of  Atlanta,  as well as access to
funding  through  various  brokered  deposit  programs,  federal funds lines and
security repurchase agreements.

The  management  of equity is a  critical  aspect of capital  management  in any
business. The determination of the appropriate amount of equity is affected by a
wide number of factors. The primary factor for a regulated financial institution
is the amount of capital needed to meet regulatory requirements,  although other
factors,  such as the "risk  equity" the  business  requires  and balance  sheet
leverage, also affect the determination.

During  the  second  quarter of 2004,  the Board of  Directors  approved a stock
repurchase  plan  authorizing  the  repurchase  of up to  50,000  shares  of the
Company's  stock.  In  December  2004,  the  Board  of  Directors  approved  the
repurchase  of an  additional  100,000  shares in December  2004.  The principal
purpose of the stock repurchase  program is to manage equity capital relative to
the  growth  of  the  Company,   to  offset  the  dilutive  effect  of  employee
equity-based  compensation  and to  enhance  long term  shareholder  value.  The
Company plans to effect the repurchase  program through  open-market  purchases.
During the first  quarter of 2005,  the Company  repurchased  50,000 shares at a
weighted average price of $17.84 per share. There were no repurchases during the
second quarter 2005.

To be  categorized as well  capitalized,  the Company and the Bank must maintain
minimum amounts and ratios.  The Company's  actual capital amounts and ratios as
of June 30, 2005 and the minimum  requirements  are  presented in the  following
table:


                                      -31-
<PAGE>

<TABLE>
<CAPTION>
                                                                                           Minimum
                                                                                      Requirements To Be
                                                              Actual                   Well Capitalized
                                                   -----------------------------  -----------------------------
(Dollars in thousands)                                Amount          Ratio          Amount          Ratio
                                                   -------------   -------------  -------------   -------------
<S>                                                  <C>               <C>          <C>               <C>
             Capital Bank Corporation
             ------------------------
Total Capital (to Risk Weighted Assets)              $ 96,067          12.62%       $ 76,100          10.00%
Tier I Capital (to Risk Weighted Assets)               86,542          11.37%         45,660           6.00%
Tier I Capital (to Average Assets)                     86,542           9.89%         43,773           5.00%

                   Capital Bank
                   ------------
Total Capital (to Risk Weighted Assets)              $ 90,329          11.90%       $ 75,931          10.00%
Tier I Capital (to Risk Weighted Assets)               80,825          10.64%         45,558           6.00%
Tier I Capital (to Average Assets)                     80,825           9.16%         44,125           5.00%
</TABLE>

Consolidated  capital ratios improved from December 31, 2004 due to the increase
in capital  associated  with the  Company's  retention  of earnings  for the six
months  ended June 30, 2005 in excess of  dividends  and balance  sheet  growth.
Total capital to risk weighted  assets,  Tier I capital to risk weighted  assets
and Tier I capital to average assets on a consolidated  basis as of December 31,
2004 were 12.33%, 11.08% and 9.61%, respectively.

Shareholders'  equity was $79.5 million,  or $10.04 per share, at June 30, 2005.
Management believes this level of shareholders' equity provides adequate capital
to support the Company's growth and to maintain a well capitalized position.

The merger  agreement  with 1st State  calls for the payment of a portion (up to
35%) of the total merger  consideration  in cash.  While the Company has not yet
finalized  its plans with respect to the  financing of that portion of the total
merger  consideration,  it does not expect the  payment of cash in the merger to
have a material adverse effect on the Companies liquidity position.

Item 3 Quantitative and Qualitative Disclosures about Market Risk
       ----------------------------------------------------------

The Company has not experienced any material change in the risk of its portfolio
of interest  earning assets and interest  bearing  liabilities from December 31,
2004 to June 30, 2005.

Item 4 Controls and Procedures
       -----------------------

The Company  maintains  disclosure  controls and procedures that are designed to
ensure that information  required to be disclosed in our Exchange Act reports is
recorded, processed, summarized and reported within the time periods required by
the SEC's  rules  and  forms,  and that  such  information  is  accumulated  and
communicated to the Company's management,  including its Chief Executive Officer
("CEO") and Chief Financial  Officer  ("CFO"),  as appropriate,  to allow timely
decisions regarding disclosure.  Management  necessarily applied its judgment in
assessing  the costs and benefits of such  controls and  procedures,  which,  by
their  nature,  can provide only  reasonable  assurance  regarding  management's
control objectives.

As  required  by  paragraph  (b) of Rule  13a-15  under  the  Exchange  Act,  an
evaluation was carried out under the supervision and with the  participation  of
the Company's management, including the CEO and CFO, of the effectiveness of the
design and operation of the Company's  disclosure  controls and procedures as of
the end of the period covered by this report. Based upon that


                                      -32-
<PAGE>

evaluation, the CEO and CFO concluded that the Company's disclosure controls and
procedures  are  effective  in  timely  alerting  them to  material  information
relating to the Company  that is  required  to be included in our  Exchange  Act
filings.

Changes in Internal Control

There were no changes in the Company's internal control over financial reporting
(as defined in Rules  13a-15(f) and 15d-15(f) of the Exchange Act) that occurred
during the period  covered by this report that have  materially  affected or are
reasonably  likely to materially  affect,  the Company's  internal  control over
financial reporting.  Management has implemented changes in internal controls as
a result of  remediation  of matters  identified  through its review of internal
controls over financial  reporting as required under Section 404 of the Sarbanes
Oxley Act,  however it does not  believe  any of the  changes  implemented  were
material in nature.

Part II - Other Information

Item 1 Legal Proceedings
       -----------------

There are no material pending legal  proceedings to which the Company is a party
or to which any of its  property is  subject.  In  addition,  the Company is not
aware of any threatened litigation,  unasserted claims or assessments that could
have a material adverse effect on the Company's  business,  operating results or
condition.

Item 2 Unregistered Sale of Equity Securities and Use of Proceeds
       ----------------------------------------------------------

None

Item 3 Defaults Upon Senior Securities
       -------------------------------

None

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

On May 26, 2005, the Company held its annual shareholder meeting to consider and
vote upon three issues:  (i) election of nominees to serve as Class II directors
with terms  continuing  until the Annual Meeting of  Shareholders  in 2008, (ii)
approval  of  the  amended  and  restated  Capital  Bank  Corporation   Deferred
Compensation Plan for Outside  Directors,  (iii) ratification of the appointment
of Grant Thornton LLP as the Company's independent  registered public accounting
firm for the fiscal year ending  December 31,  2005.  Each item  considered  was
approved by the  Company's  shareholders.  Of the 6,566,486  shares  eligible to
vote,  5,548,212,  (of which 2,236,790  broker  non-votes were registered on the
deferred compensation proposal) were voted as shown on the following tables:


                                      -33-
<PAGE>

                                       For      Against/Withheld      Abstain
                                  ----------------------------------------------
Class II Directors:
John F. Grimes, III                 5,495,471        52,740               --
Robert L. Jones                     5,495,262        52,949               --
J. Rex Thomas                       5,495,755        52,456               --
Samuel J. Wornom, III               5,495,262        52,949               --

Deferred Compensation Plan          2,573,604       714,501           23,315

Ratification of Auditors            5,525,860        18,057            4,295

The term of office of William C. Burkhardt, Leopold I. Cohen, O. A. Keller, III,
Carl H.  Ricker,  Jr., and George R.  Perkins,  III  continued  after the annual
shareholder  meeting until 2006.  In addition,  the term of office of Charles F.
Atkins,  Oscar A. Keller,  Jr., James D. Moser,  Jr., Don W. Perry, and B. Grant
Yarber continued after the annual shareholder meeting until 2007.

Item 5 Other Information
       -----------------
None

Item 6 Exhibits
       --------

   Exhibit 2.1    Merger Agreement,  dated June 29, 2005, by and between Capital
                  Bank  Corporation  and 1st State Bancorp,  Inc.  (incorporated
                  herein  by  reference  to  Exhibit  2.1  to the  Capital  Bank
                  Corporation  Current  Report  on Form 8-K,  as filed  with the
                  Securities and Exchange Commission on June 29, 2005)

   Exhibit 2.2    List of Schedules Omitted from Merger Agreement  referenced in
                  Exhibit  2.1  above.  (incorporated  herein  by  reference  to
                  Exhibit 2.2 to the Capital Bank Corporation  Current Report on
                  Form 8-K, as filed with the Securities and Exchange Commission
                  on June 29, 2005)

   Exhibit 4.1    In accordance with Item  601(b)(4)(iii)(A)  of Regulation S-K,
                  certain   instruments   respecting   long-term   debt  of  the
                  registrant  have been  omitted  but will be  furnished  to the
                  Commission upon request.

   Exhibit 10.1   Agreement  between  Capital Bank and Karen H.  Priester  dated
                  April 25, 2005  (incorporated  herein by  reference to Exhibit
                  10.1 to the Capital Bank  Corporation  Current  Report on Form
                  8-K, as filed with the Securities Exchange Commission on April
                  28, 2005)

   Exhibit 10.2   Capital Bank Defined Benefit Supplemental Executive Retirement
                  Plan effective May 24, 2005 (incorporated  herein by reference
                  to Exhibit 10.1 to the Capital Bank Corporation Current Report
                  on Form 8-K, as filed with the Securities  Exchange Commission
                  on May 27, 2005)

   Exhibit 10.3   Capital  Bank  Supplemental   Retirement  Plan  for  Directors
                  effective  May 24, 2005  (incorporated  herein by reference to
                  Exhibit 10.1 to the Capital Bank Corporation Current Report on
                  Form 8-K, as filed with the Securities  Exchange Commission on
                  May 27, 2005)


                                      -34-
<PAGE>

   Exhibit 31.1   Certification  of B. Grant Yarber  pursuant to Rule  13a-14(a)
                  and  15d-14(a),  as adopted  pursuant  to  Section  302 of the
                  Sarbanes-Oxley Act of 2002

   Exhibit 31.2   Certification of William R. Lampley pursuant to Rule 13a-14(a)
                  and  15d-14(a),  as adopted  pursuant  to  Section  302 of the
                  Sarbanes-Oxley Act of 2002

   Exhibit 32.1   Certification of B. Grant Yarber pursuant to 18 U.S.C. Section
                  1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley
                  Act of 2002  [This  exhibit  is being  furnished  pursuant  to
                  Section 906 of the Sarbanes-  Oxley Act of 2002 and shall not,
                  except to the  extent  required  by that act,  be deemed to be
                  incorporated  by reference into any document or filed herewith
                  for purposes of liability under the Securities Exchange Act of
                  1934, as amended or the Securities Act of 1933, as amended, as
                  the case may be.]

   Exhibit 32.2   Certification  of William  R.  Lampley  pursuant  to 18 U.S.C.
                  Section  1350,  as  Adopted  Pursuant  to  Section  906 of the
                  Sarbanes-Oxley  Act of 2002 [This  exhibit is being  furnished
                  pursuant to Section 906 of the Sarbanes- Oxley Act of 2002 and
                  shall  not,  except to the  extent  required  by that act,  be
                  deemed to be  incorporated  by reference  into any document or
                  filed herewith for purposes of liability  under the Securities
                  Exchange  Act of 1934,  as  amended or the  Securities  Act of
                  1933, as amended, as the case may be.]


                                      -35-
<PAGE>

                                   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.

                                         CAPITAL BANK CORPORATION


Date: August 8, 2005                         By:   /s/ B. Grant Yarber
                                                  ---------------------
                                             B. Grant Yarber
                                             Chief Executive Officer


                                      -36-
<PAGE>

                                  Exhibit Index

<TABLE>
-----------------------------------------------------------------------------------------------------------------
<S>                <C>
Exhibit 2.1        Merger Agreement, dated June 29, 2005, by and between Capital Bank Corporation and 1st State
                   Bancorp, Inc.  (incorporated herein by reference to Exhibit 2.1 to the Capital Bank
                   Corporation  Current  Report on Form 8-K,  as filed with
                   the Securities and Exchange Commission on June 29, 2005)
-----------------------------------------------------------------------------------------------------------------
Exhibit 2.2        List of Schedules Omitted from Merger Agreement referenced in Exhibit 2.1 above.
                   (incorporated herein by reference to Exhibit 2.2 to the Capital Bank Corporation Current
                   Report on Form 8-K, as filed with the Securities and Exchange Commission on June 29, 2005)
-----------------------------------------------------------------------------------------------------------------
Exhibit 4.1        In accordance with Item 601(b)(4)(iii)(A) of Regulation S-K, certain instruments respecting
                   long-term debt of the registrant have been omitted but will be furnished to the Commission
                   upon request.
-----------------------------------------------------------------------------------------------------------------
Exhibit 10.1       Agreement between Capital Bank and Karen H. Priester dated April 25, 2005 (incorporated
                   herein by reference to Exhibit 10.1 to the Capital Bank Corporation Current Report on Form
                   8-K, as filed with the Securities Exchange Commission on April 28, 2005)
-----------------------------------------------------------------------------------------------------------------
Exhibit 10.2       Capital Bank Defined Benefit Supplemental Executive Retirement Plan effective May 24, 2005
                   (incorporated herein by reference to Exhibit 10.1 to the Capital Bank Corporation Current
                   Report on Form 8-K, as filed with the Securities Exchange Commission on May 27, 2005)
-----------------------------------------------------------------------------------------------------------------
Exhibit 10.3       Capital Bank Supplemental Retirement Plan for Directors effective May 24, 2005 (incorporated
                   herein by reference to Exhibit 10.1 to the Capital Bank Corporation Current Report on Form
                   8-K, as filed with the Securities Exchange Commission on May 27, 2005)
-----------------------------------------------------------------------------------------------------------------
Exhibit 31.1       Certification of B. Grant Yarber pursuant to Rule 13a-14(a) and 15d-14(a), as adopted
                   pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
-----------------------------------------------------------------------------------------------------------------
Exhibit 31.2       Certification of William R. Lampley pursuant to Rule 13a-14(a) and 15d-14(a), as adopted
                   pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
-----------------------------------------------------------------------------------------------------------------
Exhibit 32.1       Certification of B. Grant Yarber pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to
                   Section 906 of the Sarbanes-Oxley Act of 2002 [This exhibit is being furnished pursuant to
                   Section 906 of the Sarbanes-Oxley Act of 2002 and shall not, except to the extent required
                   by that act, be deemed to be incorporated by reference into any document or filed herewith
                   for purposes of liability under the Securities Exchange Act of 1934, as amended, or the
                   Securities Act of 1933, as amended, as the case may be.]
-----------------------------------------------------------------------------------------------------------------
Exhibit 32.2       Certification of William R. Lampley pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant
                   to Section 906 of the Sarbanes-Oxley Act of 2002 [This exhibit is being furnished pursuant
                   to Section 906 of the Sarbanes-Oxley Act of 2002 and shall not, except to the extent
                   required by that act, be deemed to be incorporated by reference into any document or filed
                   herewith for purposes of liability under the Securities Exchange Act of 1934, as amended, or
                   the Securities Act of 1933, as amended, as the case may be.]
-----------------------------------------------------------------------------------------------------------------
</TABLE>


                                      -37-