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 September 30, 2005

                                       or

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

                  For the Transition Period From _____ to ____

                         Commission File Number 0-30062

                            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 rganization)            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

Indicate by check mark whether the  registrant is a shell company (as defined in
Rule 12b-2 of the Exchange Act). [_] Yes [X] No


As  of  November  2,  2005  there  were  6,845,313  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 September 30, 2005
        (Unaudited) and December 31, 2004                                                1
   Condensed consolidated statements of income for the three months
        ended September 30, 2005 and 2004 (Unaudited)                                    2
   Condensed consolidated statements of income for the nine months
        ended September 30, 2005 and 2004 (Unaudited)                                    3
   Condensed consolidated statements of changes in shareholders' equity for
        the nine months ended September 30, 2005 and 2004 (Unaudited)                    4
   Condensed consolidated statements of cash flows for the nine months
        ended September 30, 2005 and 2004 (Unaudited)                                5 - 6
   Notes to condensed consolidated financial statements                             7 - 12

   Item 2. Management's Discussion and Analysis of Financial Condition and
        Results of Operations                                                      12 - 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

   Item 5. Other Information                                                            33

   Item 6. Exhibits                                                                33 - 34

   Signatures                                                                           35

</TABLE>
<PAGE>

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

<TABLE>
<CAPTION>

CAPITAL BANK CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
September 30, 2005 and December 31, 2004
                                                              September 30,    December 31,
                                                                  2005            2004
------------------------------------------------------------------------------------------
<S>                                                           <C>             <C>
               (Dollars in thousands, except share data)      (Unaudited)
ASSETS
Cash and due from banks:
     Interest earning                                         $     30,445    $        971
     Noninterest earning                                            26,756          22,036
Federal funds sold and short term investments                        9,014               4
Investment securities - available for sale, at fair value          142,421         140,946
Investment securities - held to maturity, at amortized cost         12,623          13,336
Federal Home Loan Bank stock                                         6,345           6,298
Loans - net of unearned income and deferred fees                   646,448         654,867
Allowance for loan losses                                           (9,844)        (10,721)
                                                              ------------    ------------
        Net loans                                                  636,604         644,146
                                                              ------------    ------------
Premises and equipment, net                                         15,783          15,608
Bank owned life insurance                                           19,618          13,500
Deposit premium and goodwill, net                                   12,905          13,065
Deferred tax assets                                                  5,882           5,985
Accrued interest receivable and other assets                         8,639           6,399
                                                              ------------    ------------
           Total assets                                       $    927,035    $    882,294
                                                              ============    ============

LIABILITIES
Deposits:
     Demand, noninterest bearing                              $     80,827    $     65,673
     Savings and interest bearing demand deposits                  236,065         193,435
     Time deposits                                                 386,291         395,868
                                                              ------------    ------------
        Total deposits                                             703,183         654,976
                                                              ------------    ------------
Repurchase agreements and federal funds purchased                   12,620          16,755
Federal Home Loan Bank advances                                     98,525         102,320
Subordinated debentures                                             20,620          20,620
Accrued interest payable and other liabilities                       9,819           9,885
                                                              ------------    ------------
           Total liabilities                                       844,767         804,556
                                                              ------------    ------------

SHAREHOLDERS' EQUITY
Common stock, no par value; 20,000,000 shares authorized;
     6,795,704 and 6,612,787 issued and outstanding as of
     September 30, 2005 and December 31, 2004, respectively         70,278          68,341
Retained earnings                                                   12,785           9,092
Accumulated other comprehensive (loss) income                         (795)            305
                                                              ------------    ------------
           Total shareholders' equity                               82,268          77,738
                                                              ------------    ------------
           Total liabilities and shareholders' equity         $    927,035    $    882,294
                                                              ============    ============
</TABLE>

See Notes to Condensed Consolidated Financial Statements

                                      -1-
<PAGE>
<TABLE>
<CAPTION>

CAPITAL BANK CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF INCOME
Three Months Ended September 30, 2005 and 2004
(Unaudited)                                                                 2005           2004
--------------------------------------------------------------------------------------------------
<S>                                                                     <C>            <C>
         (Dollars in thousands, except share and per share data)
Interest income:
      Loans and loan fees                                               $    10,993    $     9,162
      Investment securities                                                   1,720          1,597
      Federal funds and other interest income                                   365             37
                                                                        -----------    -----------
         Total interest income                                               13,078         10,796
                                                                        -----------    -----------
Interest expense:
      Deposits                                                                4,157          2,971
      Borrowings and repurchase agreements                                    1,492          1,136
                                                                        -----------    -----------
         Total interest expense                                               5,649          4,107
                                                                        -----------    -----------
         Net interest income                                                  7,429          6,689
Provision (credit) for loan losses                                              (28)           268
                                                                        -----------    -----------
         Net interest income after provision (credit) for loan losses         7,457          6,421
                                                                        -----------    -----------
Noninterest income:
      Service charges and other fees                                            771            755
      Mortgage banking revenues                                                 554            305
      Net gain on sale of securities                                             --              1
      Gain on sale of branches                                                   --          1,130
      Loss on sale of mortgage loan portfolio                                    --           (354)
      Bank owned life insurance                                                 161             68
      Other noninterest income                                                  304            375
                                                                        -----------    -----------
         Total noninterest income                                             1,790          2,280
                                                                        -----------    -----------
Noninterest expenses:
      Salaries and employee benefits                                          3,536          3,130
      Occupancy                                                                 666            624
      Furniture and equipment                                                   356            447
      Data processing                                                           301            212
      Advertising                                                               217            226
      Amortization of deposit premium                                            53             61
      Professional fees                                                         207            335
      Telecommunications                                                        145            148
      Other expenses                                                          1,163            996
                                                                        -----------    -----------
         Total noninterest expenses                                           6,644          6,179
                                                                        -----------    -----------
            Income before income tax expense                                  2,603          2,522
Income tax expense                                                              869            872
                                                                        -----------    -----------
            Net income                                                  $     1,734    $     1,650
                                                                        ===========    ===========

Earnings per share - basic                                              $      0.26    $      0.25
                                                                        ===========    ===========
Earnings per share - diluted                                            $      0.25    $      0.24
                                                                        ===========    ===========

Weighted average shares
      Basic                                                               6,800,813      6,720,211
                                                                        ===========    ===========
      Fully diluted                                                       6,904,321      6,883,322
                                                                        ===========    ===========
</TABLE>

See Notes to Condensed Consolidated Financial Statements

                                      -2-
<PAGE>
<TABLE>
<CAPTION>

CAPITAL BANK CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF INCOME
Nine Months Ended September 30, 2005 and 2004
(Unaudited)                                                                 2005          2004
--------------------------------------------------------------------------------------------------
<S>                                                                     <C>            <C>
          (Dollars in thousands, except share and per share data)
Interest income:
      Loans and loan fees                                               $    31,140    $    26,205
      Investment securities                                                   5,144          4,867
      Federal funds and other interest income                                   498            118
                                                                        -----------    -----------
         Total interest income                                               36,782         31,190
                                                                        -----------    -----------
Interest expense:
      Deposits                                                               11,015          8,746
      Borrowings and repurchase agreements                                    4,272          3,255
                                                                        -----------    -----------
         Total interest expense                                              15,287         12,001
                                                                        -----------    -----------
         Net interest income                                                 21,495         19,189
Provision (credit) for loan losses                                             (434)           681
                                                                        -----------    -----------
         Net interest income after provision (credit) for loan losses        21,929         18,508
                                                                        -----------    -----------
Noninterest income:
      Service charges and other fees                                          2,142          2,250
      Mortgage banking revenues                                               1,212          1,007
      Net gain on sale of securities                                              7             14
      Gain on sale of branches                                                   --          1,130
      Loss on sale of mortgage loan portfolio                                    --           (354)
      Bank owned life insurance                                                 385            196
      Other noninterest income                                                  963          1,182
                                                                        -----------    -----------
         Total noninterest income                                             4,709          5,425
                                                                        -----------    -----------
Noninterest expenses:
      Salaries and employee benefits                                         10,164          9,033
      Occupancy                                                               1,906          1,778
      Furniture and equipment                                                 1,093          1,286
      Data processing                                                           930            835
      Advertising                                                               596            650
      Amortization of deposit premium                                           160            187
      Professional fees                                                         739            740
      Telecommunications                                                        428            387
      Other expenses                                                          3,267          2,990
                                                                        -----------    -----------
         Total noninterest expenses                                          19,283         17,886
                                                                        -----------    -----------
            Income before income tax expense                                  7,355          6,047
Income tax expense                                                            2,463          2,126
                                                                        -----------    -----------
            Net income                                                  $     4,892    $     3,921
                                                                        ===========    ===========

Earnings per share - basic                                              $      0.72    $      0.59
                                                                        ===========    ===========
Earnings per share - diluted                                            $      0.71    $      0.57
                                                                        ===========    ===========

Weighted average shares
      Basic                                                               6,762,292      6,706,018
                                                                        ===========    ===========
      Fully diluted                                                       6,905,809      6,884,400
                                                                        ===========    ===========
</TABLE>

See Notes to Condensed Consolidated Financial Statements

                                      -3-
<PAGE>
<TABLE>
<CAPTION>

Capital Bank Corporation
Consolidated Statements of Changes in Shareholders' Equity
For the Nine Months Ended September 30, 2005 and 2004
(Unaudited)

                                   (Dollars in thousands, except share data)

                                          Shares of                    Other
                                           Common        Common    Comprehensive    Retained
                                           Stock         Stock         Income       Earnings       Total
                                         ----------    ----------    ----------    ----------    ----------
<S>                <C>                    <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                   51,321           500            --            --           500
Issuance of common stock
     for compensation                         1,522            16                                        16
Net income                                       --            --            --         3,921         3,921
Other comprehensive income                       --            --            (2)           --            (2)
                                                                                                 ----------
     Comprehensive income                                                                             3,919
                                                                                                 ----------
Dividends ($0.15 per share)                      --            --            --          (988)         (988)
                                         ----------    ----------    ----------    ----------    ----------
Balance at September 30, 2004             6,594,338    $   67,897    $      375    $    8,098    $   76,370
                                         ==========    ==========    ==========    ==========    ==========

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 compensation                        99,258         1,588            --            --         1,588
Issuance of common stock
     for options exercised                  133,659         1,241            --            --         1,241
Net income                                       --            --            --         4,892         4,892
Other comprehensive income                       --            --        (1,100)           --        (1,100)
                                                                                                 ----------
     Comprehensive income                                                                             3,792
                                                                                                 ----------
Dividends ($0.18 per share)                      --            --            --        (1,199)       (1,199)
                                         ----------    ----------    ----------    ----------    ----------
Balance at September 30, 2005             6,795,704    $   70,278    $     (795)   $   12,785    $   82,268
                                         ==========    ==========    ==========    ==========    ==========
</TABLE>

See Notes to Condensed Consolidated Financial Statements

                                      -4-
<PAGE>
<TABLE>
<CAPTION>

CAPITAL BANK CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
Nine Months Ended September 30, 2005 and 2004
(Unaudited)                                                         2005          2004
-----------------------------------------------------------------------------------------
<S>                                                              <C>           <C>
                                  (Dollars in thousands)
Cash Flows From Operating Activities:
     Net income                                                  $    4,892    $    3,921
     Adjustments to reconcile net income to net cash
        used in operating activities:
        Amortization of deposit premium                                 160           187
        Depreciation                                                  1,082         1,110
        Net gains on sale of securities available for sale               (7)          (14)
        Change in held for sale loans, net                           (5,310)      (18,544)
        Amortization of premiums on securities, net                     235           519
        Deferred income tax expense                                     794           273
        Issuance of stock for compensation                            1,588            --
        Provision (credit) for loan losses                             (434)          681
        Changes in assets and liabilities:
           Accrued interest receivable and other assets              (6,941)          670
           Accrued interest payable and other liabilities              (166)          389
        Other operating activities, net                                  --        (1,060)
                                                                 ----------    ----------
              Net cash used for operating activities                 (4,107)      (11,868)
                                                                 ----------    ----------
Cash Flows From Investing Activities:
     Loan repayments (originations), net                             11,958       (27,246)
     Additions to premises and equipment                             (1,984)       (2,785)
     Purchase of securities available for sale                      (24,309)      (36,252)
     Purchase of securities held to maturity                         (1,560)       (6,987)
     Proceeds from maturities of securities available for sale       16,370        27,743
     Proceeds from sales of securities available for sale             4,399        24,206
     Proceeds from maturities of securities held to maturity          2,273         2,000
     Proceeds from sales of property and equipment                      726           645
     Cash paid for sale of branches                                      --       (23,054)
                                                                 ----------    ----------
              Net cash provided by (used in)
              investing activities                                    7,873       (41,730)
                                                                 ----------    ----------
Cash Flows From Financing Activities:
     Net increase in deposits                                        48,207        56,972
     Net (decrease) increase in repurchase agreements                (4,135)        8,998
     Net decrease in borrowings                                      (3,795)      (13,203)
     Dividends paid                                                  (1,188)         (987)
     Issuance of common stock for options and other plans             1,241           500
     Repurchase of common stock                                        (892)           --
     Other financing activities, net                                     --            16
                                                                 ----------    ----------
              Net cash provided by financing activities              39,438        52,296
                                                                 ----------    ----------
              Net change in cash and cash equivalents                43,204        (1,302)
     Cash and cash equivalents:
        Beginning of period                                          23,011        25,610
                                                                 ----------    ----------
        Ending at September 30                                   $   66,215    $   24,308
                                                                 ==========    ==========

                                                                 (continued on next page)
</TABLE>

See Notes to Condensed Consolidated Financial Statements

                                      -5-
<PAGE>
<TABLE>
<CAPTION>

CAPITAL BANK CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)
Nine Months Ended September 30, 2005 and 2004
(Unaudited)                                                         2005         2004
----------------------------------------------------------------------------------------
<S>                                                              <C>          <C>
                                (Dollars in thousands)

Supplemental Disclosure of Cash Flow Information
      Transfer from loans to real estate acquired
         through foreclosure                                     $    1,417   $      574
                                                                 ==========   ==========

      Dividends payable                                          $      408   $      325
                                                                 ==========   ==========

      Cash paid for:
         Income taxes                                            $    2,379   $      988
                                                                 ==========   ==========

         Interest                                                $   15,123   $   11,815
                                                                 ==========   ==========
</TABLE>

See Notes to Condensed Consolidated Financial Statements

                                      -6-
<PAGE>

Notes to Condensed Consolidated Financial Statements (Unaudited)

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 interests 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.

The preparation of financial statements in conformity with accounting principles
generally  accepted in the United States of America requires  management to make
estimates and assumptions that affect reported amounts of assets and liabilities
as well as the  amounts of income and  expenses  during  the  reporting  period.
Actual results could differ from those estimates.

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.  All such adjustments are of a normal and recurring
nature.  Certain  amounts  reported in prior periods have been  reclassified  to
conform to the current presentation.  Such  reclassifications  have no effect on
net  income or  shareholders'  equity as  previously  reported.  The  results of
operations  for  the  nine  month  period  ended  September  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.

In May 2005, the Financial  Accounting Standards Board ("FASB") issued Statement
of Financial Accounting Standards ("SFAS") No. 154, Accounting Changes and Error
Corrections ("SFAS 154"), which replaces APB No 20, Accounting Changes, and SFAS
No. 3, Reporting  Accounting Changes in Interim Financial  Statements.  SFAS 154
applies  to  all  voluntary  changes  in  accounting   principles  and  requires
retrospective  application  of changes in  accounting  principle to prior period
financial  statements,  unless  it is  impracticable  to  determine  either  the
period-specific  effects  or the  cumulative  effects  of the  change.  SFAS 154
carries  forward  without change the guidance  contained in APB 20 for reporting
the  correction  of an error and a change in  accounting  estimate.  SFAS 154 is
effective for accounting  changes and corrections of errors made in fiscal years
beginning  after  December 15, 2005.  The Company will adopt SFAS

                                      -7-
<PAGE>

154  effective  January 1, 2006.  SFAS 154 will have no impact on the  Company's
financial position or results of operations upon adoption.

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 nine month
periods  ended  September  30,  2005 and  2004  are as  shown  in the  Company's
Consolidated  Statements of Changes in Shareholders'  Equity for the nine months
ended September 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:

<TABLE>
<CAPTION>

CAPITAL BANK CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE
      INCOME (LOSS)
Three and Nine Months Ended September 30, 2005 and 2004
(Unaudited)                                                           2005          2004
-------------------------------------------------------------------------------------------
<S>                                                                <C>           <C>
                                    (Dollars in thousands)

Three month period ended September 30, 2005 and 2004:
      Net income                                                   $    1,734    $    1,650
      Reclassification of gains recognized in net income                   --            (1)
      Unrealized gains (losses) on securities available for sale       (1,060)        3,848
      Income tax benefit (expense)                                        408        (1,484)
                                                                   ----------    ----------
          Comprehensive income                                     $    1,082    $    4,013
                                                                   ==========    ==========


Nine month period ended September 30, 2005 and 2004:
      Net income                                                   $    4,892    $    3,921
      Reclassification of gains recognized in net income                   (7)          (14)
      Unrealized gains (losses) on securities available for sale       (1,783)           23
      Income tax benefit (expense)                                        690           (11)
                                                                   ----------    ----------
          Comprehensive income                                     $    3,792    $    3,919
                                                                   ==========    ==========
</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 nine
month periods ended September 30, 2005 and 2004:

                                      -8-
<PAGE>
<TABLE>
<CAPTION>

                                                                   2005         2004
                                                                -----------------------
<S>                                                             <C>          <C>
(Dollars in thousands, except share data)
Three month periods ended September 30, 2005 and 2004:

      Income available to shareholders - basic and diluted      $    1,734   $    1,650
                                                                ==========   ==========
Shares used in the computation of earnings per share:
      Weighted average number of shares outstanding - basic      6,800,813    6,720,211
      Incremental shares from assumed exercise of stock
          options                                                  103,508      163,111
                                                                ----------   ----------
      Weighted average number of shares outstanding - diluted    6,904,321    6,883,322
                                                                ==========   ==========

Nine month periods ended September 30, 2005 and 2004:

      Income available to shareholders - basic and diluted      $    4,892   $    3,921
                                                                ==========   ==========
Shares used in the computation of earnings per share:
      Weighted average number of shares outstanding - basic      6,762,292    6,706,018
      Incremental shares from assumed exercise of stock
          options                                                  143,517      178,382
                                                                ----------   ----------
      Weighted average number of shares outstanding - diluted    6,905,809    6,884,400
                                                                ==========   ==========
</TABLE>

Options to purchase  approximately  458,015  shares of common stock were used in
the diluted calculation. An aggregate of 80,850 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 SFAS No.  123 ,  Accounting  for  Stock-Based  Compensation("SFAS
123"),  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 ("SFAS 148"),  Accounting  for  Stock-Based  Compensation  --
Transition  and  Disclosure,  companies are required to disclose for each period
for which an income

                                      -9-
<PAGE>

statement is 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 SFAS
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 SFAS 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 SFAS 123 for recognition purposes.

The  Company  granted  options to  purchase  9,600  shares of common  stock at a
weighted  average price of $16.84 during the first nine months of 2005.  For the
three and nine month  periods ended  September 30, 2005 and 2004,  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:

<TABLE>
<CAPTION>

                                                                    2005         2004
                                                                 ----------------------
<S>                                                              <C>          <C>
(Dollars in thousands, except per share data)
Three month periods ended September 30, 2005 and 2004:

Net income, as reported                                          $   1,734    $   1,650
Deduct:  Total stock-based employee compensation expense
      determined under fair value based method for all awards,
      net of related tax effects                                       (33)         (26)
                                                                 ----------------------
Pro forma net income                                             $   1,701    $   1,624
                                                                 ======================

Earnings per share:
Basic - as reported                                              $    0.26    $    0.25
Basic - pro forma                                                $    0.25    $    0.24
Diluted - as reported                                            $    0.25    $    0.24
Diluted - pro forma                                              $    0.25    $    0.24

Nine month periods ended September 30, 2005 and 2004:

Net income, as reported                                          $   4,892    $   3,921
Deduct:  Total stock-based employee compensation expense
      determined under fair value based method for all awards,
      net of related tax effects                                      (119)         (77)
                                                                 ----------------------
Pro forma net income                                             $   4,773    $   3,844
                                                                 ======================

Earnings per share:
Basic - as reported                                              $    0.72    $    0.58
Basic - pro forma                                                $    0.71    $    0.57
Diluted - as reported                                            $    0.71    $    0.57
Diluted - pro forma                                              $    0.70    $    0.56

</TABLE>

                                      -10-
<PAGE>

In  December  2004,  the FASB issued SFAS No. 123  (revised  2004),  Share Based
Payment ("SFAS 123R"), which replaces SFAS 123, and supercedes APB 25. SFAS 123R
requires   companies  to  expense  at  fair  value  all  costs   resulting  from
shared-based  compensation  transactions,  except for equity instruments held by
employee share ownership plans. SFAS 123R as issued by the FASB was effective as
of the  beginning of the first period that begins after June 15, 2005.  On March
29, 2005, the Securities and Exchange Commission ("SEC") issued Staff Accounting
Bulletin  No.  107,  which  summarizes  the  views  of  the  SEC  regarding  the
interaction between SFAS 123R and certain SEC rules and regulations and provides
the SEC's views on the valuation of share-based payment  arrangements for public
companies. The Company will consider this guidance in its adoption of SFAS 123R.
On April 14,  2005,  the SEC adopted a rule that amended the  effective  date of
SFAS 123R.  The SEC's new rules allows  companies to implement  SFAS 123R at the
beginning  of the next  fiscal  year.  The  Company  plans to  adopt  SFAS  123R
effective  January 1, 2006.  Additional  details on the  expected  impact on the
Company as a result of implementation of SFAS 123R are 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 September 30, 2005:

<TABLE>
<CAPTION>

(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     $   24,926   $      185   $   18,405   $      600   $   43,331   $      785
Municipal bonds                   1,847           20        2,107           79        3,954           99
Mortgage-backed securities       54,276          735       11,830          378       66,106        1,113
                             ---------------------------------------------------------------------------
                                 81,049          940       32,342        1,057      113,391        1,997
                             ---------------------------------------------------------------------------
Held to maturity
Direct obligations of U.S.
     government agencies          2,561           30        1,957           39        4,518           69
Municipal bonds                     294            6           --           --          294            6
Mortgage-backed securities        7,603          133           --           --        7,603          133
                             ---------------------------------------------------------------------------
                                 10,458          169        1,957           39       12,415          208
                             ---------------------------------------------------------------------------
                             $   91,507   $    1,109   $   34,299   $    1,096   $  125,806   $    2,205
                             ===========================================================================
</TABLE>

The unrealized losses on the Company's investments in direct obligations of U.S.
government agencies and mortgage-backed  securities were primarily the result of
interest rate changes.  Mortgage-backed  securities include securities issued by
government  agencies  and  corporate  entities.  The Company has the ability and
intent to hold these  investments  until a recovery of fair value,  which may be
maturity.  Accordingly,  the Company does not consider  these  investments to be
other-than-temporarily impaired at September 30, 2005.

                                      -11-
<PAGE>

6. Loans

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

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

Commercial                                       $      525,005   $      531,834
Consumer                                                 31,435           34,865
Home equity lines                                        62,502           61,925
Residential mortgages                                    27,198           26,020
                                                 --------------   --------------
                                                        646,140          654,644
Plus deferred loan costs, net                               308              223
                                                 --------------   --------------
                                                 $      646,448   $      654,867
                                                 ==============   ==============

Loans held for sale as of  September  30, 2005 and  December  31, 2004 were $8.6
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 nine month period ended September 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").

                                      -12-
<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

                                      -13-
<PAGE>

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 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

                                      -14-
<PAGE>

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.

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. In addition,  it may become more difficult and more
expensive to obtain director and officer liability  insurance.  As a result, our
ability to  attract  and  retain  executive  officers  and  qualified  Board and
committee members could be more difficult.

                                      -15-
<PAGE>

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

Our proposed  transaction with 1st State Bancorp,  Inc. ("1st State') 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).
If the merger  agreement is terminated,  the proposed  transaction  would not be
completed, and, in certain circumstances,  1st State 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.

We May Not Be  Able to  Successfully  Integrate  1st  State  or to  Realize  the
Anticipated Benefits of the Proposed Merger

Our proposed  merger with 1st State involves the combination of two bank holding
companies that previously have operated independently.  A successful combination
of the operations of the two entities will depend  substantially  on our ability
to consolidate operations,  systems and procedures and to eliminate redundancies
and costs.  We may not be able to combine the  operations  of 1st State with our
operations without encountering difficulties, such as:

      o     the loss of key employees and customers;

      o     the disruption of operations and business;

      o     inability to maintain and increase competitive presence;

      o     deposit attrition, customer loss and revenue loss;

      o     possible  inconsistencies  in  standards,   control  procedures  and
            policies;

      o     unexpected problems with costs,  operations,  personnel,  technology
            and credit; and/or

      o     problems  with  the   assimilation  of  new  operations,   sites  or
            personnel,   which  could  divert  resources  from  regular  banking
            operations.

Further,  although  meaningful  cost savings are  anticipated as a result of the
merger,  such  expected  cost  savings may not be  realized.  Finally,  any cost
savings that are  realized may be offset by losses in revenues or other  charges
to earnings.

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

                                      -16-
<PAGE>

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.

The 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.

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:

                                      -17-
<PAGE>

      o     The Company  reported net income for the third  quarter 2005 of $1.7
            million compared to $1.6 million in the third quarter of 2004. Fully
            diluted  earnings  per  share  were  $0.25  and  $0.24 for the third
            quarter of 2005 and 2004,  respectively.  The third  quarter of 2004
            includes two non-recurring transactions; a $1.1 million pre-tax gain
            from the sale of three branch  locations and a $0.3 million  pre-tax
            loss  from  the  sale  of a  portion  of the  Bank's  mortgage  loan
            portfolio. There were no non-recurring transactions during the third
            quarter of 2005.

      o     For the nine months  ended  September  30, 2005 and 2004 the Company
            reported net income of $4.9 million and $3.9 million,  respectively.
            Fully  diluted  earnings per share were $0.71 and $0.57 for the nine
            months ended September 30, 2005 and 2004, respectively.

      o     The (credit)  provision  for loan losses was  $(28,000) and $268,000
            for  the  third  quarter  of  2005  and  2004,   respectively.   Net
            charge-offs  for the third  quarter  of 2005 were $0.1  million,  or
            0.07% of average loans compared to $0.4 million, or 0.22% of average
            loans,  for the third  quarter of 2004.  For the nine  months  ended
            September 30, 2005, the (credit) provision for loan losses was $(0.4
            million)  compared  to  $0.7  million  for  the  nine  months  ended
            September  30,  2004.  Net  charge-offs  for the nine  months  ended
            September  30, 2005 were $0.4  million,  or 0.07% of average  loans,
            compared to $1.0 million,  or 0.20% of average  loans,  for the nine
            months ended  September 30, 2004.  The decrease in the provision for
            loan  losses  and net  charge-offs  reflects  the  improving  credit
            quality of the underlying loan portfolio.

      o     Net interest  income was $7.4 million for the third  quarter of 2005
            and $21.5  million  for the nine  months  ended  September  30, 2005
            compared  to $6.7  million  and  $19.2  million  for the  comparable
            periods  in  2004.  The  Company's  net  interest  margin  increased
            compared to the third quarter of 2004 by 26 basis points to 3.57% in
            the third quarter of 2005.  For the nine months ended  September 30,
            2005  and  2004,  the net  interest  margin  was  3.55%  and  3.22%,
            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  eight
            times since  September  30, 2004,  reaching  3.75% at September  30,
            2005.

      o     Noninterest  income was $1.8  million for the third  quarter of 2005
            and $4.7 million for the nine months ended September 30, 2005 versus
            $2.3  million and $5.4 million for the  comparable  periods of 2004.
            The  decrease was  primarily  due to a gain of $1.1 million from the
            sale of  certain  branches  offset by a loss of $0.3  million on the
            sale of certain  mortgages in the third  quarter of 2004.  Excluding
            the effects of these two transactions, noninterest income would have
            been $1.5  million and $4.7  million for the third  quarter and nine
            months ender September 30, 2004, respectively.

      o     Noninterest  expense was $6.6 million for the third  quarter of 2005
            and $19.3  million  for the nine  months  ended  September  30, 2005
            compared to $6.2 million and $17.9  million,  respectively,  for the
            same periods of 2004.  Salaries and employee  benefits  increased by
            $0.4 million and $1.1  million in the third  quarter and nine months
            ender September 30, 2005, respectively, compared to the same periods
            in 2004. Approximately 17% of the increase for the nine months ended
            September  30, 2005 was  attributable  to severance  payments for an
            executive officer that left the Company in April 2005. The remaining

                                      -18-
<PAGE>

            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,  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 or a combination of both) per
share of 1st State  common  stock.  On  September  9, 2005 the  Company  filed a
Registration  Statement  on Form S-4 with the SEC to  register  up to  4,966,612
shares of  Company  common  stock that  could be issued in  connection  with the
proposed   transaction.   The   Company   mailed   the   related   joint   proxy
statement/prospectus  to its shareholders on or about October 14, 2005,  setting
forth  matters  relating  to the  transaction  to be voted upon at the  upcoming
Special  Meeting of  Shareholders  to be held on November 29, 2005. The Form S-4
describes the proposed  transaction in detail and provides,  among other things,
highlights and terms of the proposed merger and pro forma financial  information
on the Company and 1st State.

On  September  26,  2005,  the Federal  Reserve  Bank of Richmond  approved  the
Company's  application to acquire 1st State  pursuant to Section  3(a)(5) of the
Bank  Holding  Company Act. On October 31,  2005,  the Regional  Director of the
Atlanta Regional Office of the Federal Deposit  Insurance  Corporation  approved
the Bank's  application  to merge  with 1st State  Bank.  The Bank is  presently
awaiting approval from the North Carolina Banking Commission with respect to the
merger of the Bank and 1st State  Bank.  Subject to  receipt of such  regulatory
approvals,  consummation  of the merger of the Company and 1st State,  and other
customary  closing  conditions,  the Company plans to consummate  the subsidiary
bank merger in the first quarter of 2006.

Financial Condition

Total  consolidated  assets of the  Company at  September  30,  2005 were $927.0
million  compared to $882.3  million at December 31, 2004,  an increase of $44.7
million,  or approximately  5.1%. Overall growth in the balance sheet was due to
growth of core deposits,  especially  demand deposits and money market deposits,
which  increased  from $249.0  million at December 31, 2004 to $307.7 million at
September 30, 2005.

Total  earning  assets were $847.3  million at  September  30, 2005  compared to
$816.4 million at December 31, 2004.  Earning assets represented 91.4% and 92.5%
of total  assets as of September  30, 2005 and December 31, 2004,  respectively.
Loan  balances  were $646.4  million at  September  30, 2005, a decrease of $8.5
million from  December 31, 2004. At September  30, 2005,  investment  securities
were $161.3  million,  an increase  of $0.8  million  from  December  31,  2004.
Interest-earning  cash, federal funds sold and short term investments were $39.5
million at September  30, 2005,  an increase of $38.5  million from December 31,
2004. The Company has increased its holdings of short-term  investment assets to
maintain  liquidity for loan  fundings and future  commitments.  Earning  assets
exclude  bank owned  life  insurance,  which  increased  from  $13.5  million at
December 31, 2004 to $19.6 million at September 30, 2005.

                                      -19-
<PAGE>

The  allowance  for loan losses as of  September  30, 2005 was $9.8  million and
represented  approximately  1.52% of total  loans and  1.54% of loans  excluding
those  held for sale at  September  30,  2005.  The  allowance  for loan  losses
decreased  $0.9 million  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.

Total  deposits as of  September  30, 2005 were $703.2  million,  an increase of
$48.2 million,  or 7.4%,  from December 31, 2004. The increase was primarily the
result of strong internal  growth fueled by a successful core deposit  campaign.
For 2005,  the Company  prioritized  the growth of savings and interest  bearing
demand deposit accounts, which increased by $42.6 million from December 31, 2004
to $236.1 million at September 30, 2005.  The average  balance of these accounts
also  increased  significantly  with the average  balance  being $230.7  million
during the third quarter of 2005 compared to $189.9  million and $211.8  million
during the first and second  quarter of 2005,  respectively.  At  September  30,
2005,  the Company  experienced  a net  decrease of $9.6  million,  or 2.6%,  in
certificates  of deposit  ("CDs")  compared to December 31, 2004.  Approximately
$10.5 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 54.9%
of total deposits at September 30, 2005 compared to 60.4% at December 31, 2004.

Noninterest  bearing DDAs were $80.8  million at September 30, 2005, an increase
of $15.2  million,  or 23.1%,  from  December 31, 2004.  This  increase was also
attributable  to the  Company's  aforementioned  core  deposit  campaign,  which
resulted in over 2,500 new accounts being opened through September 30, 2005. The
average  balance of noninterest  DDA accounts was $76.7 million during the third
quarter of 2005 compared to $62.0 million and $68.3 million during the first and
second quarter of 2005, respectively.

Total  consolidated  shareholders'  equity was $82.2 million as of September 30,
2005,  an increase of $4.5 million from  December  31, 2004.  Retained  earnings
increased by $3.7 million reflecting the net income during the nine month period
ended September 30, 2005 less dividends paid during that same time,  offset by a
$1.1 million decrease in accumulated other comprehensive  income due to declines
in the market value of available for sale  investment  securities as a result of
the  increase in interest  rates.  Common  stock  increased by $1.9 million 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 September 30, 2005
-------------------------------------------

For the three month period ended  September 30, 2005,  the Company  reported net
income of $1.7 million,  or $0.25 per diluted  share,  compared to net income of
$1.6  million,  or $0.24 per diluted  share,  for the three month  period  ended
September 30, 2004. Net income  increased by $0.1 million  between  periods as a
result of an increase in net interest  income,  primarily due to an improved net
interest margin,  offset by a decrease in noninterest  income and an increase in
noninterest expenses (such increase in noninterest expenses was primarily due to
higher  salary and  benefit  expenses).  Noninterest  income for the three month
period ended September 30, 2004

                                      -20-
<PAGE>

includes a $1.1 million gain related to the sale of three branch locations and a
$0.3  million loss related to the sale of certain  residential  mortgage  loans.
There were no non-recurring transactions in same period for 2005.

Net interest income increased $0.7 million,  or approximately  11.1%,  from $6.7
million for the three month period ended September 30, 2004, to $7.4 million for
the three  month  period  ended  September  30,  2005.  Average  earning  assets
increased  $20.7  million to $844.0  million  for the three month  period  ended
September  30,  2005 from  $823.3  million  for the  three  month  period  ended
September 30, 2004. Average interest bearing liabilities increased $13.6 million
to $753.4  million for the three month ended  September 30, 2005 from $739.8 for
the three month period ended  September 30, 2004.  The net interest  margin on a
fully taxable  equivalent basis increased 26 basis points to 3.57% for the three
month  period  ended  September  30, 2005 from 3.31% for the three month  period
ended  September 30, 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  eight
corresponding  increases in the Bank's prime interest rate starting on September
30, 2004. The Company's balance sheet remains  asset-sensitive and, as a result,
its  interest   earning  assets  re-price  faster  than  its  interest   bearing
liabilities.  Since September 30, 2004, the Bank has increased its prime rate by
200 basis points to 6.75% in response to FOMC rate increases. The Company 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 the Company's 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>
<TABLE>
<CAPTION>

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

                                                           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                                $519,300    $  8,920       6.81%   $515,969    $  7,121      5.49%
   Consumer                                    31,686         635       7.95%     37,886         627      6.58%
   Home equity                                 60,697       1,011       6.61%     59,807         757      5.04%
   Residential mortgages (3)                   26,060         427       6.50%     46,966         657      5.57%
                                             ------------------------------------------------------------------
 Total loans                                  637,743      10,993       6.84%    660,628       9,162      5.52%
 Investment securities (4)                    162,282       1,884       4.61%    152,648       1,762      4.59%
 Federal funds sold and other
     interest on short term investments        43,967         365       3.29%     10,023          37      1.47%
                                             ------------------------------------------------------------------
 Total interest earning assets                843,992    $ 13,242       6.22%    823,299    $ 10,961      5.30%
                                                         ====================               ===================
 Cash and due from banks                       24,759                             22,887
 Other assets                                  63,453                             50,226
 Allowance for loan losses                    (10,062)                           (11,559)
                                             ---------                          --------
 Total assets                                $922,142                           $884,853
                                             =========                          ========

 Liabilities and Equity
 Savings deposits                            $ 16,831    $     22       0.52%   $ 17,098      $   13      0.30%
 Interest-bearing demand deposits             213,824       1,090       2.02%    197,725         589      1.19%
 Time deposits                                389,925       3,045       3.10%    393,377       2,369      2.40%
                                             ------------------------------------------------------------------
 Total interest bearing deposits              620,580       4,157       2.66%    608,200       2,971      1.94%
 Borrowed funds                                99,648       1,073       4.27%     99,063         872      3.50%
 Trust preferred debt                          20,620         331       6.37%     20,620         238      4.59%
 Repurchase agreements                         12,605          88       2.77%     11,942          26      0.87%
                                             ------------------------------------------------------------------
   Total interest-bearing liabilities         753,453    $  5,649       2.97%    739,825    $  4,107      2.21%
                                                         ====================               ===================
 Non-interest bearing deposits                 76,731                             61,121
 Other liabilities                             10,352                              9,463
                                             --------                           --------
 Total liabilities                            840,536                            810,409
 Shareholders' equity                          81,606                             74,444
                                             --------                           --------
  Total liabilities and shareholders' equity $922,142                           $884,853
                                             ========                           ========

 Net interest spread (5)                                                3.25%                             3.09%

 Tax equivalent adjustment                               $    164                           $    165

 Net interest income and net
   interest margin (6)                                   $  7,593       3.57%               $  6,854      3.31%

</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,  consumer, and home equity increased 132 basis points, 137
basis points and 157 basis  points,  respectively,  in the third 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  69% of the total loan  portfolio at September  30,
2005 compared to 70% at September 30, 2004.

The yield on investment  securities on a  tax-equivalent  basis  increased  from
4.59% in the third  quarter of 2004 to 4.61% in the third  quarter of 2005.  The
slight increase is due to higher yields on new investment  securities  purchased
during  2005.  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 average  rate paid on time  deposits  increased  from 2.40% to 3.10% for the
three months ended  September 30, 2005 compared to the same period in 2004, a 70
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  September  30, 2005
increased  to 4.27% from 3.50% for the three month period  ended  September  30,
2004. In July of 2003,  the Bank entered into  interest rate swap  agreements on
$25.0 million of its  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  September 30, 2005,  the credit  provision for
loan  losses was  $(28,000)  compared to a  provision  of $268,000  for the same
period in 2004, a decrease of approximately  $296,000.  The decrease in 2005 was
primarily  due to  improvements  in the risk rating  classifications  of certain
loans contained in the portfolio and other factors as discussed more fully below
under "Asset Quality".

Noninterest income for the three month period ended September 30, 2005, was $1.8
million compared to $2.3 million for the same period in 2004, a decrease of $0.5
million,  or 21.5%.  The decrease was  primarily due to the sale of three branch
locations  and certain  residential  mortgage  loans during the third quarter of
2004.  These two  transactions  resulted in a net gain of $0.8  million.  Absent
these non-recurring  transactions,  noninterest income would have increased $0.3
million for the three month period ended September 30, 2005 compared to the same
period in 2004.  This increase was primarily due to an  improvement  in mortgage
banking revenues as a result of higher period-over-period loan production.

Noninterest expense for the three month period ended September 30, 2005 was $6.6
million compared to $6.2 million for the corresponding  period in 2004. Salaries
and employee benefits,  representing the largest  noninterest  expense category,
increased to $3.5 million for the three month period ended  September  30, 2005,
from $3.1 million for the same period in 2004. The increase was primarily due to
the change in the number of personnel  employed by the Company and  management's
intention to maintain  adequate  staffing to meet customer's needs and keep

                                      -23-
<PAGE>

pace with  expected  growth.  As of  September  30,  2005,  the  Company had 247
full-time  equivalent  employees  ("FTEs")  compared to 223 for the same date in
2004 and 227 at December 31, 2004. Other expenses  increased to $1.2 million for
the three month period ended  September 30, 2005,  from $1.0 million in the same
period in 2004.  The increase was primarily due to costs  associated  with a new
director retirement program and higher director fees in 2005 partially offset by
lower equipment costs.

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 an outside  vendor.  In
conjunction with processing  in-house,  the Company will be required to purchase
additional  software and  equipment.  The Company  will  continue to utilize the
outside vendor 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 between
$1.8 million to $2.5 million.

The  Company's  effective  tax  rate for the  third  quarter  of 2005 was  33.3%
compared to 34.6% for the comparable  period of 2004. Income tax expense for the
third  quarter of 2005 and 2004 was $0.9  million.  The  Company  forecasts  its
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 change in the
effective  tax rate was 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.

Results of Operations

Nine month period ended September 30, 2005
------------------------------------------

For the nine month period ended  September  30, 2005,  the Company  reported net
income of $4.9 million,  or $0.71 per diluted  share,  compared to net income of
$3.9  million,  or $0.57 per  diluted  share,  for the nine month  period  ended
September 30, 2004. The $1.0 million increase in net income was the result of an
increase in net  interest  income,  primarily  due to an improved  net  interest
margin,  and a  decrease  in the loan  loss  provision,  partially  offset  by a
decrease  in  noninterest  income  and  an  increase  in  noninterest  expenses,
primarily due to higher salary and benefit expenses.  Noninterest income for the
nine month period ended  September 30, 2004 includes a $1.1 million gain related
to the sale of three  branch  locations  and a $0.3  million loss related to the
sale  of  certain  residential  mortgage  loans.  There  were  no  non-recurring
transactions during the same period in 2005.

Net interest income  increased $2.3 million,  or  approximately  12%, from $19.2
million for the nine month period ended September 30, 2004, to $21.5 million for
the same period in 2005.  Average earning assets for the nine month period ended
September 30, 2005 increased $11.6 million  compared to the same period in 2004,
while average interest bearing liabilities increased $4.9 million.  Average loan
balances for the nine month  period  ended  September  30, 2005  decreased  $1.2
million  compared to the same  period in 2004 while the  average  rate earned on

                                      -24-
<PAGE>

loans increased by 103 basis points to 6.44%.  Average interest bearing deposits
for the nine month  period  ended  September  30, 2005  increased  $1.8  million
compared to the same period in 2004 and the average  rate paid  increased  by 50
basis points to 2.44%.  The net interest  margin on a fully  taxable  equivalent
basis  increased  33 basis  points  to 3.55%  for the nine  month  period  ended
September 30, 2005 from 3.22% 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.  Further  increases  by the FOMC will  likely
increase the effective cost of interest-bearing  liabilities and have a negative
effect on net interest margins.

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>
<TABLE>
<CAPTION>

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

                                                             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                                $ 527,204     $ 25,316       6.42%   $ 501,205    $ 19,961        5.32%
   Consumer                                     31,606        1,796       7.60%      38,842       1,957        6.73%
   Home equity                                  61,455        2,839       6.18%      59,767       2,203        4.92%
   Residential mortgages (3)                    25,882        1,189       6.14%      47,508       2,084        5.86%
                                             -----------------------------------------------------------------------
 Total loans                                   646,147       31,140       6.44%     647,322      26,205        5.41%
 Investment securities (4)                     160,400        5,635       4.70%     156,394       5,368        4.58%
 Federal funds sold and other
     interest on short term investments         21,225          498       3.14%      12,467         118        1.26%
                                             -----------------------------------------------------------------------
 Total interest earning assets                 827,772     $ 37,273       6.02%     816,183    $ 31,691        5.19%
                                                           ====================                =====================
 Cash and due from banks                        23,501                               21,907
 Other assets                                   58,881                               51,268
 Allowance for loan losses                     (10,410)                             (11,555)
                                             ---------                            ---------
 Total assets                                $ 899,744                            $ 877,803
                                             =========                            =========

 Liabilities and Equity
 Savings deposits                            $  16,607      $    63       0.51%   $  17,390    $     35        0.27%
 Interest-bearing demand deposits              194,156        2,576       1.77%     189,661       1,604        1.13%
 Time deposits                                 392,365        8,376       2.85%     394,243       7,107        2.41%
                                             -----------------------------------------------------------------------
 Total interest bearing deposits               603,128       11,015       2.44%     601,294       8,746        1.94%
 Borrowed funds                                102,336        3,119       4.07%     102,175       2,533        3.30%
 Trust preferred debt                           20,620          912       5.91%      20,620         668        4.33%
 Repurchase agreements                          14,139          241       2.28%      11,228          54        0.64%
                                             -----------------------------------------------------------------------
   Total interest-bearing liabilities          740,223     $ 15,287       2.76%     735,317    $ 12,001        2.18%
                                                           ====================                =====================
 Non-interest bearing deposits                  69,007                               59,111
 Other liabilities                              10,918                                8,967
                                             ---------                            ---------
 Total liabilities                             820,148                              803,395
 Shareholders' equity                           79,596                               74,408
                                             ---------                            ---------
  Total liabilities and shareholders' equity $ 899,744                            $ 877,803
                                             =========                            =========

 Net interest spread (5)                                                  3.26%                                3.01%

 Tax equivalent adjustment                                 $    491                            $    501

 Net interest income and net
   interest margin (6)                                     $ 21,986       3.55%                $ 19,690        3.22%

</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 nine month period ended  September  30, 2005,  the credit  provision for
loan losses was $(0.4  million)  compared to a provision of $0.7 million for the
same period in 2004, a decrease of approximately  $1.1 million.  The decrease in
2005 was  primarily  due to a  reduction  in charge  offs  during the nine month
period ended September 30, 2005, which dropped to $0.4 million from $1.0 million
recorded  in  same  period  in  2004  and   improvements   in  the  risk  rating
classifications of certain loans contained in the portfolio. See "Asset Quality"
below for further discussion of the allowance for loan losses.

Noninterest  income for the nine month period ended September 30, 2005, was $4.7
million compared to $5.4 million for the same period in 2004, a decrease of $0.7
million,  or 13.2%.  The decrease was  primarily due to the sale of three branch
locations  and certain  residential  mortgage  loans during the third quarter of
2004.  These two  transactions  resulted in a net gain of $0.8  million.  Absent
these non-recurring transactions,  noninterest income increased $0.1 million for
the nine month period ended  September  30, 2005  compared to the same period in
2004. This increase was primarily due to a $0.2 million  improvement in mortgage
banking revenues as a result of higher  period-over-period loan production and a
$0.2  million  increase in bank owned life  insurance  income due to  additional
purchases  in 2005.  Service  charges and other fees  decreased  by $0.1 million
which are primarily attributable to the three branch locations sold in September
2004.

Noninterest expense for the nine month period ended September 30, 2005 was $19.3
million compared to $17.9 million for the corresponding period in 2004. Salaries
and employee  benefits  increased  by $1.2 million to $10.2  million in the nine
month  period ended  September  30, 2005 from $9.0 million in the same period in
2004.  This increase  reflects an increase of 24 FTE's since September 30, 2004,
which is consistent with  management's  intention to maintain  adequate staffing
levels to meet  customer  needs and keep pace with  expected  growth.  Occupancy
expense for the nine month period  ended  September  30, 2005  increased by $0.1
million from the same period in 2004 largely due to the opening of new locations
that have a higher cost structure than those branch  locations sold in September
2004.  The Company added a new branch 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.  Furniture and equipment expense for
the nine month period ended  September 30, 2005  decreased $0.2 million from the
same  period  in  2004  primarily  due to of the  amount  of  equipment  expense
associated with the initial  startup of these new locations.  Other expenses for
the nine month period ended  September  30, 2005  increased by $0.3 million from
the same period in 2004 primarily due to higher  director fees partially  offset
by lower equipment costs

The Company  recorded an income tax expense of $2.5 million and $2.1 million for
the nine months ended September 30, 2005 and 2004,  respectively.  The Company's
effective  tax rate for the nine  months  ended  September  30,  2005 was  33.5%
compared  to 35.2%  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.

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

                                      -27-
<PAGE>

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 estimates the amount of allowance needed to cover probable losses in
the portfolio by applying a loss allowance  factor to each risk grade.  Consumer
loans  and  mortgages  are not risk  graded,  but a loss  allocation  factor  is
utilized for these loans based on historical losses. The loss allocation factors
have been developed based on the Bank's  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 loan loss allowance is adjusted to an amount
that  management  believes is adequate to absorb probable losses inherent in the
loan portfolio as of the balance sheet date presented.

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,  including  among other factors,  payment  history,
collateral values, guarantor liquidity, and net worth. The effect of the revised
methodology used in the estimation of the allowance for loan losses on the third
quarter was to reduce the overall amount of loan loss allocation associated with
non-pass loans greater than $750,000 by approximately  $90,000 and approximately
$400,000 for the nine months ended September 30, 2005.

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  (credit)  provisions  of
$(28,000) and  $(434,000)  for the three and nine month periods ended  September
30,  2005,  respectively,  compared  to an expense  of  $268,000  and  $681,000,
respectively,  for the same periods 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.  The allowance for loan
losses was 1.52% and 1.64% of gross loans,  respectively,  as of  September  30,
2005 and December 31, 2004.  The allowance for loan losses as a percent of loans
excluding  loans held for sale was 1.54% and 1.65% as of September  30, 2005 and
December 31, 2004,  respectively.  The following  table  presents an analysis of
changes in the  allowance  for loan losses for the three and nine month  periods
ended September 30, 2005 and 2004, respectively:

                                      -28-
<PAGE>
<TABLE>
<CAPTION>

                                                            Three Months             Nine Months
                                                         Ended September 30,      Ended September 30,
                                                          2005         2004        2005         2004
                                                        --------     --------    --------     --------
<S>                                                     <C>          <C>         <C>          <C>
(Dollars in thousands)
Allowance for loan losses, beginning of period          $ 10,075     $ 11,417    $ 10,721     $ 11,613
Net charge-offs:
      Loans charged off:
      Commercial                                             116          147         212          608
      Consumer                                                12           37         292          356
      Mortgage                                                34          266         144          336
                                                        --------     --------    --------     --------
           Total charge-offs                                 162          450         648        1,300
                                                        --------     --------    --------     --------
      Recoveries of loans previously charged off:
      Commercial                                              27           61         251          148
      Consumer                                                17           26          42           88
      Mortgage                                                --           --          --           92
                                                        --------     --------    --------     --------
           Total recoveries                                   44           87         293          328
                                                        --------     --------    --------     --------
           Total net charge-offs                             118          363         355          972
                                                        --------     --------    --------     --------
      Loss provisions (credits) charged to operations       (113)         268        (522)         681
                                                        --------     --------    --------     --------
Allowance for loan losses, end of period                $  9,844     $ 11,322    $  9,844     $ 11,322
                                                        ========     ========    ========     ========

Net charge-offs to average loans during the
period (annualized)                                         0.07%        0.22%       0.07%        0.20%
Allowance as a percent of gross loans                       1.52%        1.72%
Allowance as a percent of gross loans excluding
      loans held for sale                                   1.54%        1.79%

</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,  unforeseen changes in economic and other factors could
effect net charge-offs during the fourth quarter of 2005.

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

                                      -29-
<PAGE>
<TABLE>
<CAPTION>

                                                    September 30,        December 31,
                                                 2005          2004          2004
                                              ----------    ----------    ----------
<S>                                           <C>           <C>           <C>
(Dollars in thousands)
Nonaccrual loans:
      Commercial and commercial real estate   $    3,915    $    4,401    $    3,964
      Mortgage                                     1,711         2,034         1,898
      Construction                                 1,302         1,314         1,622
      Equity lines                                   592           363           415
      Consumer                                       239           151           312
                                              ----------    ----------    ----------
           Total nonaccrual loans                  7,759         8,263         8,211
      Foreclosed property held                     1,608           825           418
                                              ----------    ----------    ----------
           Total nonperforming assets         $    9,367    $    9,088    $    8,629
                                              ==========    ==========    ==========

Nonperforming loans to total loans                  1.20%         1.26%         1.32%
Nonperforming assets to total assets                1.01%         1.04%         0.98%
Allowance coverage of nonperforming loans            127%          137%          131%

</TABLE>

On September 30, 2005,  nonperforming  assets were $9.4 million,  an increase of
$0.8 million from December 31, 2004. 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.  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  any  material  losses
associated with the September 30, 2005 nonperforming 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.  There were no  impaired
loans at September 30, 2005 and December 31, 2004.

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.

Foreclosed  property  increased to $1.6 million at September  30, 2005 from $0.4
million at  December  31,  2004.  The  increase is largely  attributable  to the
foreclosure of certain nonaccrual

                                      -30-
<PAGE>

loans during the year.  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 $66.2 million in its most liquid assets,  cash and cash equivalents,
as of September  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 70.1% of total
assets at  September  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.  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 and third quarters
of 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  September  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)         $ 99,482       12.80%    $ 77,694       10.00%
Tier I Capital (to Risk Weighted Assets)          89,764       11.55%      46,616        6.00%
Tier I Capital (to Average Assets)                89,764       10.13%      44,323        5.00%

           Capital Bank
           ------------
Total Capital (to Risk Weighted Assets)         $ 92,246       11.91%    $ 77,461       10.00%
Tier I Capital (to Risk Weighted Assets)          82,556       10.66%      46,477        6.00%
Tier I Capital (to Average Assets)                82,556        9.10%      45,344        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 nine
months ended September 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 $82.3 million,  or $12.11 per share,  at September 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.  This cash  consideration  is
currently  anticipated  to be obtained by the Company  through a combination  of
short-term  financing  and the issuance  (by a  to-be-formed  subsidiary  of the
Company) of additional  trust  preferred  securities.  Such  subsidiary  will be
formed for the sole purpose of the issuance transaction and will only have those
assets and operations  that are incidental to such issuance.  It is not expected
that the financing  transactions  and/or  payment of cash  consideration  to the
shareholders  of 1st State will have a material  adverse effect on the Company's
post-merger liquidity position or capital ratios.

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 September 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 its 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.


                                      -32-
<PAGE>

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  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 its 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 control over
financial reporting as a result of remediation of matters identified through its
review of internal  control 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
         ---------------------------------------------------

None

Item 5   Other Information
         -----------------

None

Item 6   Exhibits
         --------

                                      -33-
<PAGE>

            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 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.]




                                      -34-
<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:  November 4, 2005                               By:   /s/B. Grant Yarber
                                                           ---------------------
                                                      B. Grant Yarber
                                                      Chief Executive Officer


                                      -35-
<PAGE>


                                  Exhibit Index

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 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.]

                                      -36-