UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                              Washington, DC 20549


                                    FORM 10-Q

(Mark One)

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

         For the quarterly period ended June 30, 2004

         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: 0-25859

                             1st STATE BANCORP, INC.
             ------------------------------------------------------
             (Exact Name of Registrant as Specified in Its Charter)


               Virginia                                56-2130744
-------------------------------------------       --------------------
(State or Other Jurisdiction of                     (I.R.S. Employer
 Incorporation or Organization)                    Identification No.)

445 S. Main Street, Burlington, North Carolina             27215
-----------------------------------------------       --------------
(Address of Principal Executive Offices)                (Zip Code)


                                 (336) 227-8861
               --------------------------------------------------
               Registrant's Telephone Number, Including Area Code

                                 Not Applicable
             -------------------------------------------------------
             (Former Name, Former Address and Former Fiscal Year, if
                           Changed Since Last Report)

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

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

     As of August 6,  2004,  the  issuer had  2,962,323  shares of common  stock
issued and outstanding.


<PAGE>

                                    CONTENTS
<TABLE>
<CAPTION>

                                                                                                               PAGE
                                                                                                               ----
<S>                                                                                                             <C>
PART I.  FINANCIAL INFORMATION

Item 1.  Financial Statements

         Consolidated Balance Sheets as of June 30, 2004 (unaudited) and September 30, 2003.......................2

         Consolidated Statements of Income for the Three Months Ended June 30, 2004 and
                  2003 (unaudited)................................................................................3

         Consolidated Statements of Income for the Nine Months Ended June 30, 2004 and
                  2003 (unaudited)................................................................................4

         Consolidated Statements of Stockholders' Equity and Comprehensive Income for the Nine
                  Months Ended June 30, 2004 and 2003 (unaudited).................................................5

         Consolidated Statements of Cash Flows for the Nine Months Ended June 30, 2004 and
                  2003 (unaudited)................................................................................6

         Notes to Consolidated Financial Statements...............................................................8

Item 2.   Management's Discussion and Analysis of Financial Condition and Results of Operations..................11

Item 3.  Quantitative and Qualitative Disclosures About Market Risk..............................................21

Item 4.  Controls and Procedures.................................................................................21


PART II.  OTHER INFORMATION

Item 1.  Legal Proceedings.......................................................................................22

Item 2.  Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities........................22

Item 3.  Defaults Upon Senior Securities.........................................................................22

Item 4.  Submission of Matters to a Vote of Security Holders.....................................................22

Item 5.  Other Information.......................................................................................22

Item 6.  Exhibits and Reports on Form 8-K........................................................................23


SIGNATURES

</TABLE>

                                       1
<PAGE>

                     1st STATE BANCORP, INC. AND SUBSIDIARY
                           CONSOLIDATED BALANCE SHEETS
                      JUNE 30, 2004 AND SEPTEMBER 30, 2003
                        (IN THOUSANDS, EXCEPT SHARE DATA)
<TABLE>
<CAPTION>
                                                                                    AT               AT
                                                                                JUNE 30,       SEPTEMBER 30,
                                                                                  2004              2003
                                                                           ------------------   ------------
                                                                             (Unaudited)
<S>                                                                               <C>               <C>
                                     ASSETS

Cash and cash equivalents                                                   $    10,735          $    9,359
Investment securities:
     Held to maturity (fair value of $22,780 and $19,397
         at June 30, 2004 and September 30, 2003, respectively)                  23,228              19,462
     Available for sale (cost of $100,365 and $92,971
         at June 30, 2004 and September 30, 2003, respectively)                  97,604              91,709
Loans held for sale, at lower of cost or fair value                               1,222                 645
Loans receivable (net of allowance for loan losses of $3,910
    and $3,856 at June 30, 2004 and September 30, 2003,
    respectively)                                                               230,377             225,725
Real estate owned                                                                    26                  95
Federal Home Loan Bank stock, at cost                                             2,425               1,675
Premises and equipment                                                            8,038               8,413
Accrued interest receivable                                                       2,229               1,967
Other assets                                                                      4,501               3,590
                                                                            -----------          ----------
             Total assets                                                   $   380,385          $  362,640
                                                                            ===========          ==========

                LIABILITIES AND STOCKHOLDERS' EQUITY

Liabilities:
  Deposit accounts                                                              263,838             262,712
  Advances from Federal Home Loan Bank                                           47,500              31,500
  Advance payments by borrowers for property taxes and insurance                    288                  57
  Dividend payable                                                                  296                 297
  Other liabilities                                                               4,693               5,373
                                                                            -----------          ----------
          Total liabilities                                                     316,615             299,939
                                                                            -----------          ----------

Stockholders' Equity:
   Preferred stock, $0.01 par value, 1,000,000 shares authorized;
         none issued                                                                 --                  --
   Common stock, $0.01 par value, 7,000,000 shares authorized;
         2,962,323 and 2,971,977 shares issued and outstanding
         at June 30, 2004 and September 30, 2003, respectively                       33                  33
   Additional paid-in capital                                                    35,987              35,778
   Unallocated ESOP shares                                                       (2,712)             (3,141)
   Deferred compensation payable in treasury stock                                6,252               5,466
   Treasury stock                                                               (13,897)            (12,785)
   Retained income - substantially restricted                                    39,787              38,118
   Accumulated other comprehensive loss - net unrealized
        loss on investment securities available for sale                         (1,680)               (768)
                                                                            -----------          ----------
Total stockholders' equity                                                       63,770              62,701
                                                                            -----------          ----------
        Total liabilities and stockholders' equity                          $   380,385          $  362,640
                                                                            ===========          ==========
</TABLE>

See accompanying notes to the consolidated financial statements.

                                       2
<PAGE>


                     1st STATE BANCORP, INC. AND SUBSIDIARY
                        CONSOLIDATED STATEMENTS OF INCOME
                FOR THE THREE MONTHS ENDED JUNE 30, 2004 AND 2003
                      (IN THOUSANDS, EXCEPT PER SHARE DATA)

                                   (UNAUDITED)
<TABLE>
<CAPTION>

                                                                         FOR THE THREE MONTHS ENDED
                                                                                  JUNE 30,
                                                                       -----------------------------
                                                                          2004                2003
                                                                       ----------         ----------
<S>                                                                       <C>                  <C>
Interest income:
   Interest and fees on loans                                          $   2,812          $   3,097
   Interest and dividends on investments                                   1,288                982
   Overnight deposits                                                          6                 43
                                                                       ---------          ---------
         Total interest income                                             4,106              4,122
                                                                       ---------          ---------

Interest expense:
    Deposit accounts                                                         824              1,040
    Borrowings                                                               346                273
                                                                       ---------          ---------
         Total interest expense                                            1,170              1,313
                                                                       ---------          ---------

         Net interest income                                               2,936              2,809

Provision for loan losses                                                     60                 60
                                                                       ---------          ---------
         Net interest income after provision for loan losses               2,876              2,749
                                                                       ---------          ---------

Other income:
   Customer service fees                                                     253                218
   Commissions from sales of annuities and mutual funds                       99                100
   Mortgage banking income, net                                              126                422
   Securities gains, net                                                      --                103
   Other                                                                     208                 65
                                                                       ---------          ---------
         Total other income                                                  686                908
                                                                       ---------          ---------

Operating expenses:
   Compensation and related benefits                                       1,351              1,313
   Occupancy and equipment                                                   351                353
   Real estate operations, net                                                (4)                (2)
   Other expenses                                                            375                443
                                                                       ---------          ---------
         Total operating expenses                                          2,073              2,107
                                                                       ---------          ---------

         Income before income taxes                                        1,489              1,550

Income taxes                                                                 516                562
                                                                       ---------          ---------

         Net income                                                    $     973           $    988
                                                                       =========          =========

         Earnings per share:

         Basic                                                         $    0.35          $    0.35
         Diluted                                                       $    0.33          $    0.34
</TABLE>

See accompanying notes to the consolidated financial statements.

                                       3

<PAGE>
                    1st STATE BANCORP, INC. AND SUBSIDIARY
                        CONSOLIDATED STATEMENTS OF INCOME
                FOR THE NINE MONTHS ENDED JUNE 30, 2004 AND 2003
                      (IN THOUSANDS, EXCEPT PER SHARE DATA)

                                   (UNAUDITED)
<TABLE>
<CAPTION>

                                                                        FOR THE NINE MONTHS ENDED
                                                                                  JUNE 30,
                                                                       ----------------------------
                                                                          2004               2003
                                                                       ----------         ---------
<S>                                                                        <C>                <C>
Interest income:
   Interest and fees on loans                                          $   8,495          $   9,764
   Interest and dividends on investments                                   3,588              3,194
   Overnight deposits                                                         24                128
                                                                       ---------          ---------
         Total interest income                                            12,107             13,086
                                                                       ---------          ---------

Interest expense:
    Deposit accounts                                                       2,629              3,500
    Borrowings                                                               965                825
                                                                       ---------          ---------
         Total interest expense                                            3,594              4,325
                                                                       ---------          ---------
         Net interest income                                               8,513              8,761

Provision for loan losses                                                    180                180
                                                                       ---------          ---------
         Net interest income after provision for loan losses               8,333              8,581
                                                                       ---------          ---------

Other income:
   Customer service fees                                                     699                648
   Commissions from sales of annuities and mutual funds                      263                346
   Mortgage banking income, net                                              337              1,259
   Securities gains, net                                                     185                103
   Other                                                                     318                183
                                                                       ---------          ---------
         Total other income                                                1,802              2,539
                                                                        --------          ---------

Operating expenses:
   Compensation and related benefits                                       3,999              4,058
   Occupancy and equipment                                                 1,034              1,088
   Real estate operations, net                                                (9)                 7
   Other expenses                                                          1,208              1,282
                                                                       ---------          ---------
         Total operating expenses                                          6,232              6,435
                                                                       ---------          ---------

         Income before income taxes                                        3,903              4,685

Income taxes                                                               1,393              1,717
                                                                       ---------          ---------

Net income                                                             $   2,510          $   2,968
                                                                       =========          =========

Earnings per share:
         Basic                                                         $    0.89          $    1.06
         Diluted                                                       $    0.85          $    1.01
</TABLE>

See accompanying notes to the consolidated financial statements.

                                       4
<PAGE>


                     1st STATE BANCORP, INC. AND SUBSIDIARY
                    CONSOLIDATED STATEMENTS OF STOCKHOLDERS'
                         EQUITY AND COMPREHENSIVE INCOME
                   FOR THE NINE MONTHS ENDED JUNE 30, 2004 AND
                                2003 (UNAUDITED)
                                 (IN THOUSANDS)
<TABLE>
<CAPTION>

                                                                                        DEFERRED
                                                                                      COMPENSATION
                                                           ADDITIONAL  UNALLOCATED     PAYABLE IN
                                                COMMON      PAID-IN       ESOP          TREASURY        TREASURY       RETAINED
                                                 STOCK      CAPITAL      SHARES           STOCK          STOCK          INCOME
                                                 -----      -------    -----------        -----          -----          ------
<S>                                              <C>          <C>          <C>             <C>             <C>            <C>
Balance at September 30, 2002                 $      33       35,623       (3,739)         5,466        (11,899)          35,258

Comprehensive income:
     Net income                                      --           --           --             --             --            2,968
     Other comprehensive loss-unrealized
       loss on securities available-for-sale
       net of income tax benefit of $252             --           --           --             --             --               --

     Total comprehensive income
Allocation of ESOP shares                            --          107          448             --             --               --
Acquisition of treasury stock                        --           --           --             --           (796)              --
Cash dividends declared ($0.28 per share)            --           --           --             --             --             (834)
Cash dividends on unallocated ESOP shares            --           --           --             --             --               53
                                              ---------   ----------   ----------    -----------     ----------    -------------
Balance at June 30, 2003                      $      33       35,730       (3,291)         5,466        (12,695)          37,445
                                              =========   ==========   ==========    ===========     ==========    =============

Balance at September 30, 2003                 $      33       35,778       (3,141)         5,466        (12,785)          38,118

Comprehensive income:
     Net income                                      --           --           --             --             --            2,510
     Other comprehensive loss-unrealized
       loss on securities available-for-sale
       net of income tax benefit of $587             --           --           --             --             --               --

     Total comprehensive income
Allocation of ESOP shares                            --          190          429             --             --               --
Acquisition of treasury stock                        --           --           --             --         (1,112)              --
Deferred compensation                                --           --           --            786             --               --
Exercise of stock options                            --           19           --             --             --               --
Cash dividends declared ($0.30 per share)            --           --           --             --             --             (889)
Cash dividends on unallocated ESOP shares            --           --           --             --             --               48
                                              ---------   ----------   ----------    -----------     ----------     ------------
Balance at June 30, 2004                      $      33       35,987       (2,712)         6,252        (13,897)          39,787
                                              =========   ==========   ==========    ===========     ==========     ============

<CAPTION>
                                                   ACCUMULATED
                                                      OTHER          TOTAL
                                                  COMPREHENSIVE   STOCKHOLDERS'
                                                  INCOME (LOSS)      EQUITY
                                                  -------------   -----------
<S>                                                     <C>              <C>
Balance at September 30, 2002                           827           61,569

Comprehensive income:
     Net income                                          --            2,968
     Other comprehensive loss-unrealized
       loss on securities available-for-sale
       net of income tax benefit of $252               (392)            (392)
                                                                     -------
     Total comprehensive income                                        2,576
Allocation of ESOP shares                                --              555
Acquisition of treasury stock                            --             (796)
Cash dividends declared ($0.28 per share)                --             (834)
Cash dividends on unallocated ESOP shares                --               53
                                                   --------          -------
Balance at June 30, 2003                                435           63,123
                                                   ========          =======

Balance at September 30, 2003                          (768)          62,701

Comprehensive income:
     Net income                                          --            2,510
     Other comprehensive loss-unrealized
       loss on securities available-for-sale
       net of income tax benefit of $587               (912)            (912)
                                                                     -------
     Total comprehensive income                                        1,598
Allocation of ESOP shares                                --              619
Acquisition of treasury stock                            --           (1,112)
Deferred compensation                                    --              786
Exercise of stock options                                --               19
Cash dividends declared ($0.30 per share)                --             (889)
Cash dividends on unallocated ESOP shares                --               48
                                                   --------          -------
Balance at June 30, 2004                             (1,680)          63,770
                                                   ========          =======


</TABLE>

      See accompanying notes to the consolidated financial statements.


                                       5
<PAGE>



                     1st STATE BANCORP, INC. AND SUBSIDIARY
                      CONSOLIDATED STATEMENTS OF CASH FLOWS
                FOR THE NINE MONTHS ENDED JUNE 30, 2004 AND 2003
                                   (UNAUDITED)
                                 (IN THOUSANDS)

<TABLE>
<CAPTION>

                                                                                     FOR THE NINE MONTHS ENDED
                                                                                              JUNE 30,
                                                                                   ----------------------------
                                                                                      2004              2003
                                                                                   ---------          ---------
<S>                                                                                   <C>                <C>
Cash flows from operating activities:
   Net income                                                                   $    2,510           $   2,968
   Adjustment to reconcile net income to net cash provided by
       operating activities:
           Provision for loan losses                                                   180                 180
           Depreciation                                                                514                 557
           Deferred tax expense (benefit)                                             (135)                137
           Amortization of premiums and discounts, net                                   8                 (34)
           Deferred compensation                                                       180                 180
           Release of ESOP shares                                                      619                 555
           Loan origination fees and unearned discounts
               deferred, net of current amortization                                   (49)                (66)
           Loss (gain) on sale of other real estate                                    (22)                 11
           Gain on sale of investment securities available for sale                   (185)               (103)
           Net (gain) loss on sale of loans                                             39                (302)
            Proceeds from loans held for sale                                       21,072              73,457
           Originations of loans held for sale                                     (21,688)            (75,841)
           Decrease (increase) in other assets                                        (190)                208
           Decrease (increase) in accrued interest receivable                         (262)                723
           Increase (decrease) in other liabilities                                    (74)              2,835
                                                                                ----------           ---------
                      Net cash provided by operating activities                      2,517               5,465
                                                                                ----------           ---------

Cash flows provided by (used in) investing activities:
           Proceeds from redemption of FHLB stock                                    2,500               1,018
           Purchases of FHLB stock                                                  (3,250)               (268)
           Purchases of investment securities held to maturity                      (9,776)             (5,998)
           Purchases of investment securities available for sale                   (48,504)            (80,239)
           Proceeds from sales of investment securities available for sale          10,993               1,103
           Proceeds from maturities and issuer calls of investment securities
               available for sale                                                   30,302              96,473
           Proceeds from maturities and issuer calls of investment securities
               held to maturity                                                      6,002               2,003
           Net increase in loans receivable                                         (4,965)             (3,728)
           Purchase of real estate acquired in settlement of loans                    (255)                 --
           Proceeds from sales of REO                                                  528                  92
           Purchases of premises and equipment net of disposals                       (139)             (1,033)
                                                                                ----------           ---------
                   Net cash provided by (used in) investing activities             (16,564)              9,423
                                                                                ----------           ---------

                                                                                                     (Continued)
</TABLE>

                                       6

<PAGE>


                     1st STATE BANCORP, INC. AND SUBSIDIARY
                CONSOLIDATED STATEMENTS OF CASH FLOWS - CONTINUED
                FOR THE NINE MONTHS ENDED JUNE 30, 2004 AND 2003
                                   (UNAUDITED)
                                 (IN THOUSANDS)
<TABLE>
<CAPTION>

                                                                                    FOR THE NINE MONTHS ENDED
                                                                                               JUNE 30,
                                                                                -------------------------------
                                                                                   2004                 2003
                                                                                -----------          ----------
<S>                                                                                  <C>                   <C>
Cash flows from financing activities:
   Net increase (decrease) in deposits                                          $    1,126           $    (456)
   Advances from the Federal Home Loan Bank                                         90,000              13,000
   Repayments of advances from the Federal Home Loan Bank                          (74,000)            (13,000)
   Purchase of treasury stock                                                       (1,112)               (796)
   Exercise of stock options                                                            19                  --
   Dividends paid on common stock                                                     (841)               (725)
   Increase in advance payments by borrowers for
     property taxes and insurance                                                      231                 282
                                                                                ----------           ---------

   Net cash provided by (used in) financing activities                              15,423              (1,695)
                                                                                ----------           ----------

        Net increase in cash and cash equivalents                                    1,376              13,193

Cash and cash equivalents at beginning of period                                     9,359              18,865
                                                                                ----------           ---------

Cash and cash equivalents at end of period                                      $   10,735           $  32,058
                                                                                ==========           =========

Payments are shown below for the following:
       Interest                                                                 $    3,566           $   4,343
                                                                                ==========           =========

       Income taxes                                                             $    1,397           $   1,133
                                                                                ==========           =========

Noncash investing and financing activities:

     Unrealized losses on investment securities
          available for sale                                                    $   (1,499)          $    (644)
                                                                                ==========           =========

     Cash dividends declared but not paid                                       $      280           $     278
                                                                                ==========           =========

     Cash dividends on unallocated ESOP shares                                  $       48           $      53
                                                                                ==========           =========

     Transfer from loans to real estate acquired in settlement of loans         $      182           $       0
                                                                                ==========           =========
</TABLE>

See accompanying notes to the consolidated financial statements.

                                       7
<PAGE>


                     1st STATE BANCORP, INC. AND SUBSIDIARY
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                JUNE 30, 2004 (UNAUDITED) AND SEPTEMBER 30, 2003


NOTE 1.  NATURE OF BUSINESS

     1st State Bancorp,  Inc. (the "Company") was incorporated under the laws of
the Commonwealth of Virginia for the purpose of becoming the holding company for
1st State Bank (the  "Bank") in  connection  with the Bank's  conversion  from a
North Carolina-chartered mutual savings bank to a North Carolina-chartered stock
savings bank (the  "Converted  Bank")  pursuant to its Plan of  Conversion  (the
"Stock Conversion"). Upon completion of the Stock Conversion, the Converted Bank
converted from a North Carolina-chartered stock savings bank to a North Carolina
commercial bank (the "Bank Conversion"),  retaining the name 1st State Bank (the
"Commercial  Bank"),  and the Commercial Bank succeeded to all of the assets and
liabilities of the Converted Bank. The Stock  Conversion and the Bank Conversion
were  consummated  on April 23,  1999.  The common  stock of the  Company  began
trading on the Nasdaq  National  Market  System under the symbol "FSBC" on April
26, 1999.

NOTE 2.  BASIS OF PRESENTATION

     The accompanying  consolidated  financial  statements (which are unaudited,
except for the  consolidated  balance  sheet at  September  30,  2003,  which is
derived from the September 30, 2003 audited consolidated  financial  statements)
have been prepared in accordance with accounting  principles  generally accepted
in the  United  States of  America  and with the rules  and  regulations  of the
Securities and Exchange Commission.  Accordingly, they do not include all of the
information and footnotes required by accounting  principles  generally accepted
in the United  States of  America  for  complete  financial  statements.  In the
opinion of  management,  all  adjustments  (none of which were other than normal
recurring  accruals) necessary for a fair presentation of the financial position
and results of operations for the periods presented have been included.

     The results of  operations  for the three and nine month periods ended June
30, 2004 are not necessarily indicative of the results of operations that may be
expected for the year ending September 30, 2004. The preparation of consolidated
financial statements in accordance with accounting principles generally accepted
in the United States of America requires  management to make certain  estimates.
These amounts may be revised in future  periods  because of changes in the facts
and circumstances underlying their estimation.

NOTE 3.  EARNINGS PER SHARE

     For purposes of computing  basic and diluted  earnings per share,  weighted
average shares outstanding  excludes  unallocated ESOP shares that have not been
committed to be released. The deferred compensation obligation discussed in Note
5 that is funded with shares of the Company's  common stock has no net impact on
the  Company's  earnings  per share  computations.  Diluted  earnings  per share
include the potentially  dilutive effects of the Company's  stock-based  benefit
plans.  There were no anti-dilutive  stock options for the three and nine months
ended June 30, 2004 and 2003. A reconciliation  of the denominators of the basic
and diluted earnings per share computations is as follows:
<TABLE>
<CAPTION>

                                                                            THREE MONTHS ENDED
                                                                                   JUNE 30,
                                                                       ------------------------------
                                                                          2004                2003
                                                                       ----------         -----------
<S>                                                                       <C>                  <C>
Average shares issued and outstanding                                   2,962,323           2,976,652
Less: Unallocated ESOP shares                                            (142,207)           (176,174)
                                                                        ---------           ---------
Average basic shares for earnings per share                             2,820,116           2,800,478
Add: Potential common stock pursuant to stock option plan                 145,534             123,595
                                                                        ---------           ---------
Average dilutive shares for earnings per share                          2,965,560           2,924,073
                                                                        =========           =========
</TABLE>

                                       8
<PAGE>

<TABLE>
<CAPTION>

                                                                             NINE MONTHS ENDED
                                                                                  JUNE 30,
                                                                       ------------------------------
                                                                          2004                2003
                                                                       ----------         -----------
<S>                                                                       <C>                  <C>
Average shares issued and outstanding                                   2,965,045           2,991,761
Less: Unallocated ESOP shares                                            (149,527)           (181,034)
                                                                        ---------           ---------
Average basic shares for earnings per share                             2,815,518           2,810,727
Add: Potential common stock pursuant to stock option plan                 150,436             124,192
                                                                        ---------           ---------
Average dilutive shares for earnings per share                          2,965,954           2,934,919
                                                                        =========           =========
</TABLE>

NOTE 4.  EMPLOYEE STOCK OWNERSHIP PLAN ("ESOP")

     The Company  sponsors an employee stock ownership plan (the "ESOP") whereby
an aggregate  number of shares amounting to 253,050 or 8% of the stock issued in
the  conversion was purchased for future  allocation to employees.  The ESOP was
funded by an 11-year term loan from the Company in the amount of $4,899,000. The
loan is secured by the shares of stock  purchased by the ESOP.  During the three
and nine  months  ended June 30,  2004 and 2003,  7,280 and 7,644 and 21,920 and
22,932 shares of stock were committed to be released and approximately  $199,000
and $185,000 and $619,000 and $555,000,  respectively,  of compensation  expense
was recognized.

NOTE 5.  DEFERRED COMPENSATION

     Directors  and  certain  executive  officers   participate  in  a  deferred
compensation plan, which was approved by the Board of Directors on September 24,
1997.  This plan  generally  provides  for fixed  payments  beginning  after the
participant  retires.  Each  participant is fully vested in his account  balance
under the plan. Directors may elect to defer their directors' fees and executive
officers may elect to defer 25% of their salary and 100% of bonus compensation.

     Prior  to the  Stock  Conversion,  amounts  deferred  by  each  participant
accumulated interest at a rate equal to the highest rate of interest paid on the
Bank's  one-year   certificates  of  deposit.   In  connection  with  the  Stock
Conversion, participants in the plan were given the opportunity to prospectively
elect to have their deferred compensation balance earn a rate of return equal to
the total return of the Company's stock.  All  participants  elected this option
concurrent with the Stock Conversion,  so the Company purchases its common stock
to fund this obligation.  Refer to the Company's notes to consolidated financial
statements,  incorporated  by reference in the  Company's  2003 Annual Report on
Form 10-K for a discussion  of the Company's  accounting  policy with respect to
this deferred  compensation plan and the related treasury stock purchased by the
Company to fund this obligation.

     The expense  related to this plan for the three and nine months  ended June
30,  2004  and  2003  was  $60,000  and  $60,000  and  $180,000  and   $180,000,
respectively. This expense is included in compensation expense.

NOTE 6.  STOCK OPTION AND INCENTIVE PLAN

     On June 6, 2000, the Company's stockholders approved the 1st State Bancorp,
Inc. 2000 Stock Option and Incentive Plan (the "Plan"). The purpose of this plan
is to  advance  the  interests  of the  Company  through  providing  select  key
employees and directors of the Bank with the opportunity to acquire  shares.  By
encouraging  such stock  ownership,  the Company  seeks to  attract,  retain and
motivate  the  best   available   personnel   for   positions   of   substantial
responsibility  and to provide  incentives to the key  employees and  directors.
Under the Plan, the Company  granted  316,312  options to purchase its $0.01 par
value common  stock.  The  exercise  price per share is equal to the fair market
value per share on the date of the grant. Options granted under the Stock Option
Plan are 100% vested on the date of the grant,  and all options  expire 10 years
from the date of the grant.  As a result of the one-time  cash dividend of $5.17
paid on October 2, 2000, the exercise price for the options repriced from $18.44
to $14.71.  There were 2,077 options exercised during the nine months ended June
30, 2004.  No options  were granted  during the three and nine months ended June
30, 2004 and 2003. At June 30, 314,235 options are outstanding, all of which are
exercisable.



                                       9
<PAGE>

NOTE 7.  MORTGAGE SERVICING RIGHTS

     The rights to service  mortgage  loans for  others  are  included  in other
assets on the consolidated balance sheet. Mortgage servicing rights ("MSRs") are
capitalized  based on the allocated cost that is determined  when the underlying
loans are sold. MSRs are amortized over a period that  approximates  the life of
the underlying loan as an adjustment of servicing income.  Impairment reviews of
MSRs are performed on a quarterly  basis.  As of June 30, 2004 and September 30,
2003,  MSRs  totaled  $508,000  and  $547,000,  respectively,  and no  valuation
allowance was required.

     Amortization expense totaled $85,000 and $126,000 for the nine months ended
June 30, 2004 and 2003, respectively.

NOTE 8.  STANDBY LETTERS OF CREDIT

     In  November  2002,  the  FASB  issued  Interpretation  No.  45  (FIN  45),
"Guarantor's  Accounting and Disclosure  Requirements for Guarantees,  Including
Indirect  Guarantees of Indebtedness of Others",  which addressed the disclosure
to be made by a guarantor in its interim and annual  financial  statements about
its obligations under  guarantees.  FIN 45 requires the guarantor to recognize a
liability  for  the  non-contingent  component  of the  guarantee,  such  as the
obligation  to stand  ready to perform in the event  that  specified  triggering
events or conditions  occur.  The initial  measurement  of this liability is the
fair value of the guarantee at inception.  The  recognition  of the liability is
required even if it is not probable  that  payments  will be required  under the
guarantee or if the guarantee was issued with a premium  payment or as part of a
transaction  with  multiple  events.  The initial  recognition  and  measurement
provisions are effective for all guarantees within the scope of FIN 45 issued or
modified  after June 30,  2003.  The Company  issues  standby  letters of credit
whereby the Company  guarantees  performance if a specified  triggering event or
condition occurs (primarily  nonperformance under construction contracts entered
into by construction customers). The guarantees generally expire within one year
and may be automatically  renewed  depending on the terms of the guarantee.  The
maximum  potential  amount of undiscounted  future  payments  related to standby
letters  of credit  at June 30,  2004 is $2.0  million.  At June 30,  2004,  the
Company has recorded no liability for the  obligation to perform as a guarantor.
In addition, no contingent liability is considered necessary as such amounts are
not deemed probable.  Substantially all standby letters of credit are secured by
real estate  and/or  guaranteed by third parties in the event the Company had to
advance funds to fulfill the guarantee.

                                       10
<PAGE>



ITEM 2. MANAGEMENT'S  DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS

FORWARD-LOOKING STATEMENTS

     When used in this Form 10-Q,  the words or phrases  "will  likely  result,"
"are expected to," "will continue," "is anticipated,"  "estimate,"  "project" or
similar expressions are intended to identify "forward-looking statements" within
the  meaning of the  Private  Securities  Litigation  Reform  Act of 1995.  Such
statements are subject to certain risks and  uncertainties  including changes in
economic  conditions  in our market  area,  changes in  policies  by  regulatory
agencies,  fluctuations in interest rates,  demand for loans in our market area,
and  competition  that could  cause  actual  results to differ  materially  from
historical  earnings and those  presently  anticipated or projected.  We wish to
caution you not to place undue reliance on any such forward-looking  statements,
which  speak  only as of the date made.  We wish to advise you that the  factors
listed above could affect our financial  performance  and could cause our actual
results for future periods to differ  materially from any opinions or statements
expressed with respect to future periods in any current statements.

     We do not undertake, and specifically disclaim any obligation,  to publicly
release  the result of any  revisions  which may be made to any  forward-looking
statements to reflect events or circumstances  after the date of such statements
or to reflect the occurrence of anticipated or unanticipated events.

GENERAL

     1st State Bancorp,  Inc. was formed in November 1998 and became the holding
company for 1st State Bank on April 23, 1999.

     Our business consists  principally of attracting  deposits from the general
public and investing these funds in loans secured by  single-family  residential
and commercial real estate,  secured and unsecured commercial loans and consumer
loans. Our profitability  depends primarily on our net interest income, which is
the  difference  between  the  income  we  receive  on our loan  and  investment
securities  portfolios and our cost of funds, which consists of interest paid on
deposits  and  borrowed  funds.  Net  interest  income  also is  affected by the
relative amounts of interest-earning  assets and  interest-bearing  liabilities.
When interest-earning assets approximate or exceed interest-bearing liabilities,
any  positive  interest  rate spread will  generate  net  interest  income.  Our
profitability  is also  affected  by the  level of other  income  and  operating
expenses.  Other income consists of miscellaneous  fees related to our loans and
deposits,  mortgage  banking income and commissions  from sales of annuities and
mutual funds. Operating expenses consist of compensation and benefits, occupancy
related  expenses,   federal  deposit  insurance   premiums,   data  processing,
advertising and other expenses.

     Our operations are influenced  significantly  by local economic  conditions
and by policies of financial  institution  regulatory  authorities.  Our cost of
funds is  influenced  by interest  rates on competing  investments  and by rates
offered on similar investments by competing financial institutions in our market
area,  as well as  general  market  interest  rates.  These  factors  can  cause
fluctuations in our net interest income and other income. Lending activities are
affected  by the demand for  financing  of real estate and other types of loans,
which in turn is affected by the interest  rates at which such  financing may be
offered.  In addition,  local economic  conditions can impact the credit risk of
our loan  portfolio,  in that  local  employers  may be  required  to  eliminate
employment  positions of many of our borrowers,  and small  businesses and other
commercial  borrowers may experience a downturn in their  operating  performance
and become unable to make timely payments on their loans.  Management  evaluates
these factors in estimating its allowance for loan losses,  and changes in these
economic  conditions could result in increases or decreases to the provision for
loan losses.

     Our business emphasis has been to operate as a well capitalized, profitable
and independent  community-oriented financial institution dedicated to providing
quality customer service. We are committed to meeting the financial needs of the
communities  in which we operate.  We believe  that we can be more  effective in
servicing our  customers  than many of our nonlocal  competitors  because of our
ability to quickly  and  effectively  provide  senior  management  responses  to
customer needs and inquiries.  Our ability to provide these services is enhanced
by the stability of our senior management team.

     Over the years, we have sought to gradually  increase the percentage of our
assets invested in commercial real estate loans,  commercial  loans and consumer
loans,  which  have  shorter  terms and  adjust  more  frequently  to changes in
interest  rates than  single-family  residential  mortgage  loans.  These  loans


                                       11
<PAGE>

generally carry added risk when compared to a single-family residential mortgage
loan, so we have concurrently increased our allowance for loan losses as we have
originated these loans.

     Due to a general  slowdown in the economy  beginning  in 2000,  the Federal
Reserve acted to provide a stimulus through a series of interest rate reductions
that  lowered  the prime rate from 9.50% in January  2001 to 4.00% in June 2003.
These reductions in prime tended to negatively impact the Company's net interest
margin and net interest  spread which resulted in lower net interest  income for
the  Company.  The  Company's  asset growth has been slower as a result of heavy
refinancing  as  customers  have taken  advantage of these  attractive  interest
rates. The fee income associated with the heavy refinancing  volume has replaced
some of the  lost net  interest  income.  Now as the  refinancing  activity  has
slowed, the Company is looking to replace lost net interest income possibly with
leverage  strategies.  During periods of slow loan demand, the Company purchases
more investments,  and the Company uses short-term  borrowings as an alternative
to deposits for funding certain assets. The Company's balance sheet is currently
asset   sensitive,   that  is,  rate  sensitive  assets  exceed  rate  sensitive
liabilities.  We expect an increase in net  interest  income  during  periods of
rising  interest  rates and  decreased  net interest  income  during  periods of
falling interest rates.

CRITICAL ACCOUNTING POLICIES

     The Company's  significant  accounting  policies are set forth in Note 1 of
the consolidated  financial statements as of September 30, 2003, which was filed
on the Company's  Annual Report on Form 10-K for the fiscal year ended September
30, 2003. Of these significant  accounting  policies,  the Company considers its
policy  regarding  the  allowance  for  loan  losses  to be  its  most  critical
accounting policy,  because it requires management's most subjective and complex
judgments.  In addition,  changes in economic  conditions can have a significant
impact on the  allowance  for loan losses and  therefore  the provision for loan
losses and results of operations. The Company has developed appropriate policies
and  procedures  for  assessing  the adequacy of the  allowance for loan losses,
recognizing  that this process  requires a number of  assumptions  and estimates
with respect to its loan portfolio. The Company's assessments may be impacted in
future  periods by  changes in  economic  conditions,  the impact of  regulatory
examinations, and the discovery of information with respect to borrowers that is
not  known  to  management  at the  time  of the  issuance  of the  consolidated
financial statements.


                                       12
<PAGE>


COMPARISON OF FINANCIAL CONDITION AT JUNE 30, 2004 AND SEPTEMBER 30, 2003

     Total assets  increased  $17.8 million from  September 30, 2003 to June 30,
2004. Assets increased to $380.4 million at June 30, 2004 from $362.6 million at
September 30, 2003. The Company grew both loans  receivable,  net and loans held
for sale as well as investment securities.  Asset growth was funded by increased
borrowings  from the Federal  Home Loan Bank of Atlanta  and to a lesser  extent
deposits.

     Investment  securities available for sale increased $5.9 million from $91.7
million at September 30, 2003 to $97.6 million at June 30, 2004. During the nine
months  ended June 30,  2004,  we  purchased  $48.5  million of  securities  and
received  $41.3 million in proceeds from sales,  maturities  and issuer calls of
investment  securities  available for sale.  Interest rates increased during the
nine months ended June 30, 2004 which caused the Company's gross unrealized loss
on  investment  securities  available  for sale to increase from $1.3 million at
September 30, 2003 to $2.8 million at June 30, 2004.  Investment securities held
to maturity  increased  $3.7 million from $19.5 million at September 30, 2003 to
$23.2  million at June 30, 2004.  During the nine months ended June 30, 2004, we
purchased  $9.8 million of securities and received $6.0 million in proceeds from
maturities and issuer calls of investment securities held to maturity.

     Loans  held for sale  increased  to $1.2  million  at June  30,  2004  from
$645,000 at September 30, 2003.  Loans  receivable,  net  increased  from $225.7
million at September 30, 2003 to $230.4  million at June 30, 2004.  The increase
in loans held for sale resulted from timing  differences  in the funding of loan
sales.  During the nine months ended June 30, 2004,  mortgage  originations were
considerably  slower than in previous quarters as refinance activity slowed down
in response to higher  mortgage  interest  rates.  During this same period,  the
Company saw growth in commercial loans and equity lines.

     Stockholders'  equity  increased  by $1.1  million  from  $62.7  million at
September  30, 2003 to $63.8  million at June 30, 2004 as a result of net income
of $2.5 million and the release of ESOP shares of $619,000. These increases were
partially  offset  by cash  dividends  to  stockholders  declared  of  $841,000,
purchases of treasury  stock of $326,000,  and an increase in the net unrealized
loss on  available  for sale  securities  of  $912,000.  The increase in the net
unrealized  loss on available for sale  securities  was a result of increases in
interest rates which caused bond prices to decrease.

COMPARISON  OF  OPERATING  RESULTS FOR THE THREE  MONTHS ENDED JUNE 30, 2004 AND
2003

     NET INCOME.  We recorded net income of $973,000 for the quarter  ended June
30,  2004,  as  compared  to  $988,000  for the  quarter  ended  June 30,  2003,
representing a decrease of $15,000, or 1.5%. For the three months ended June 30,
2004, basic and diluted  earnings per share were $0.35 and $0.33,  respectively,
compared to the basic and diluted  earnings per share for the quarter ended June
30, 2003 of $0.35 and $0.34,  respectively.  The decrease in net income resulted
primarily from decreased other income that was offset partially by increased net
interest income,  decreased operating expenses and decreased income tax expense.
The increase in net interest income  resulted from increased  volumes which were
offset partially by lower net interest margins.  The average prime interest rate
for the  quarter  ended June 30, 2004 was 4.00%,  a decrease of 24 basis  points
from 4.24%, which was the average prime for the quarter ended June 30, 2003. The
repricing of loans and investments  decreased the Company's  average asset yield
by 47 basis  points  whereas the average cost of funds  decreased  only 41 basis
points for the quarter ended June 30, 2004 compared to the prior year.

     NET INTEREST INCOME.  Net interest income,  the difference between interest
earned  on  loans  and  investments   and  interest  paid  on   interest-bearing
liabilities,  increased  by $127,000 or 4.5% for the three months ended June 30,
2004, compared to the same quarter in the prior year. This increase results from
a $143,000  decrease in interest  expense that was partially offset by a $16,000
decrease  in total  interest  income.  The  average  net  interest  rate  spread
decreased 6 basis  points from 3.07% for the three months ended June 30, 2003 to
3.01% for the quarter ended June 30, 2004.

     INTEREST INCOME. The decrease in interest income for the three months ended
June 30, 2004 was the result of a decrease in yield on  interest-earning  assets
of 47 basis  points from 5.08% for the three months ended June 30, 2003 to 4.61%
for the three months ended June 30, 2004. This decrease was partially  offset by
an increase of $32.3 million in average  interest-earning assets compared to the
same quarter in the prior year.  Average investment  securities  increased $40.5
million,  average  interest-bearing  overnight funds decreased $11.9 million and
average  loans  receivable  increased  $3.7  million.  The  increase  in average
interest-earning  assets increased interest income by approximately $499,000 and
the  decrease  in  the  average  asset  yield   decreased   interest  income  by
approximately $515,000.



                                       13
<PAGE>

     INTEREST EXPENSE. Interest expense decreased in the three months ended June
30, 2004 due to a decrease  in the cost of  interest-bearing  liabilities  of 41
basis  points from 2.01% for the three  months  ended June 30, 2003 to 1.60% for
the three months ended June 30, 2004.  This decrease was partially  offset by an
increase  in average  interest-bearing  liabilities  of $31.7  million.  Average
interest-bearing  deposits increased by $7.7 million while average FHLB advances
increased $24.0 million for the three months ended June 30, 2004 compared to the
same  quarter  in the prior  year.  The  increase  in  average  interest-bearing
liabilities  increased  interest  expense  by  approximately  $359,000  and  the
decrease in the average cost of interest-bearing  liabilities decreased interest
expense by approximately $502,000.

     The following table presents average balances and average rates earned/paid
by the Company for the quarter ended June 30, 2004 compared to the quarter ended
June 30, 2003.
<TABLE>
<CAPTION>

                                                             THREE MONTHS ENDED                       THREE MONTHS ENDED
                                                               JUNE 30, 2004                             JUNE 30, 2003
                                                 ------------------------------------------------------------------------------
                                                                               (DOLLARS IN THOUSANDS)
                                                     AVERAGE                     AVERAGE     AVERAGE                    AVERAGE
                                                     BALANCE        INTEREST   YIELD/COST    BALANCE      INTEREST    YIELD/COST
                                                  ------------    -----------  ---------- -----------    ----------   ----------
<S>                                                     <C>           <C>           <C>       <C>           <C>            <C>
Assets:
Loans receivable (1).........................     $    231,111    $   2,812       4.87%   $   227,367  $   3,097           5.45%
Investment securities (2)....................          122,717        1,288       4.20         82,245        982           4.78
Interest-bearing overnight deposits .........            2,796            6       0.93         14,687         43           1.17
                                                  ------------    ---------     ------    -----------  ---------           ----
  Total interest-earning assets (3)..........          356,624        4,106       4.61        324,299      4,122           5.08
Noninterest-earning assets...................           20,466                                 20,109
                                                  ------------                            -----------
  Total assets...............................     $    377,090                            $   344,408
                                                  ============                            ===========

Liabilities and stockholders' equity:
Interest bearing checking....................           36,805           19       0.21         34,322         27           0.31
Money market investment accounts.............           19,884           33       0.67         23,876         55           0.92
Passbook and statement savings...............           30,943           47       0.61         30,823         65           1.85
Certificates of deposit......................          160,827          725       1.80        151,748        894           2.36
FHLB advances................................           43,967          346       3.14         20,000        272           5.45
                                                  ------------    ---------     ------    -----------  ---------           ----
  Total interest-bearing liabilities.........          292,426        1,170       1.60        260,769      1,313           2.01
Noninterest-bearing liabilities..............           21,411                                 20,797
                                                  ------------                            -----------
  Total liabilities..........................          313,837                                281,566
Stockholders' equity.........................           63,253                                 62,842
                                                  ------------                            -----------
  Total liabilities and stockholders' equity      $    377,090                            $   344,408
                                                  ============                            ===========

Net interest income..........................                     $   2,936                            $   2,809
                                                                  =========                            =========
Interest rate spread.........................                                     3.01%                                    3.07%
                                                                                ======                                     ====
Net interest margin (4)......................                                     3.29%                                    3.46%
                                                                                ======                                     ====
Ratio of average interest-earning assets to
 Average interest-bearing liabilities........                                   121.95%                                  124.36%
                                                                                ======                                   ======
</TABLE>

--------
(1)  Includes  nonaccrual  loans and loans held for sale,  net of discounts  and
     allowance for loan losses.
(2)  Includes FHLB of Atlanta stock.
(3)  Due to immateriality, the interest income and yields related to certain tax
     exempt assets have not been adjusted to reflect a fully taxable  equivalent
     yield.
(4)  Represents  net  interest   income  divided  by  the  average   balance  of
     interest-earning assets.


     PROVISION FOR LOAN LOSSES. We charge provisions for loan losses to earnings
to maintain the total allowance for loan losses at a level we consider  adequate
to provide for probable loan losses,  based on existing loan levels and types of
loans outstanding,  nonperforming loans, prior loss experience, general economic
conditions and other factors.  We



                                       14
<PAGE>

estimate the allowance using an allowance for loan losses model which takes into
considerations  all of these factors.  Our policies require the review of assets
on a regular  basis,  and we assign risk  grades to loans based on the  relative
risk of the credit,  considering such factors as repayment experience,  value of
collateral,  guarantors, etc. Our credit management systems have resulted in low
loss experience;  however,  there can be no assurances that such experience will
continue.   We  believe  we  use  the  best  information  available  to  make  a
determination  with respect to the allowance for loan losses,  recognizing  that
future  adjustments  may be  necessary  depending  upon  a  change  in  economic
conditions.

     The provision for loan losses was $60,000 and net charge-offs  were $42,000
for the three months ended June 30, 2004  compared  with a provision of $60,000,
and net  charge-offs  of  $8,000  for the  three  months  ended  June 30,  2003.
Nonperforming  loans at June 30, 2004 and  September  30, 2003 were $4.0 million
and  $4.2  million,  respectively.  The  majority  of the  non-performing  loans
resulted  from  two  unrelated,  distinct  credits  which  are  not  necessarily
indicative  of  the  credit  quality  of  the  entire  portfolio.  There  was no
significant  impact on the provision as these loans are well secured by property
and equipment.

     OTHER INCOME.  Other income decreased  $222,000 from $908,000 for the three
months ended June 30, 2003 to $686,000 for the three months ended June 30, 2004.
Mortgage  banking  income,  net  decreased  $296,000 from $422,000 for the three
months ended June 30, 2003 to $126,000 for the three months ended June 30, 2004.
This decrease  results from a decrease in volume of mortgage  loan  originations
and sales.  We sold loans  totaling  $7.5 million in the three months ended June
30,  2004  compared  with sales of $24.7  million in the  previous  year for the
comparable  period. The increase in mortgage interest rates slowed the volume of
mortgage  originations and sales.  Given the current level of mortgage  interest
rates,  the Company  believes  that  mortgage  banking  income will  continue to
decrease  in future  quarters  due to lower  refinancing  activity.  The Company
relocated its Mebane  branch to a new location in September  2003. In June 2004,
the Company sold the real estate that had previously served as the Bank's Mebane
office.  A gain of $143,000 was recognized on this sale and is included in other
income and accounts  for the  increase in other  income for the current  quarter
compared to the  previous  year.  Customer  fees  increased  $35,000 or 16.1% to
$253,000 for the quarter ended June 30, 2004 compared with the $218,000 reported
in the prior year.  This  increase was the result of increased  deposit  service
charges  compared with the prior year.  The Company  recorded  gains on sales of
investments  of $103,000 in the three  months ended June 30, 2003 which were not
present in the current year.

     OPERATING EXPENSES.  Total operating expenses were $2.1 million for each of
the three  months  ended June 30, 2004 and 2003,  respectively.  The Company has
been able to control  expenses  during  this  period of slower  loan and deposit
growth.

     INCOME TAX EXPENSE.  Income tax expense  decreased $46,000 from tax expense
of $562,000  for the three  months ended June 30, 2003 to $516,000 for the three
months ended June 30, 2004. The effective tax rates were 34.7% and 36.3% for the
three  months  ended June 30, 2004 and 2003,  respectively.  The decrease in the
effective tax rate was primarily due to an increase in the ratio of  non-taxable
income as a percentage of net income before taxes.

COMPARISON OF OPERATING RESULTS FOR THE NINE MONTHS ENDED JUNE 30, 2004 AND 2003

     NET  INCOME.  We  recorded  net income of $2.5  million for the nine months
ended June 30,  2004,  a decrease of  $500,000,  or 16.7% over the $3.0  million
reported in the nine months ended June 30, 2003.  For the nine months ended June
30,  2004,   basic  and  diluted  earnings  per  share  were  $0.89  and  $0.85,
respectively.  The Company reported basic and diluted earnings per share for the
nine months ended June 30, 2003 of $1.06 and $1.01,  respectively.  The decrease
in net  income  resulted  primarily  from  decreased  net  interest  income  and
decreased  other  income.  These  decreases in income were  partially  offset by
decreased operating expenses and decreased income taxes. The decrease in the net
interest  income  resulted  from lower net interest  margins.  The average prime
interest  rate for the nine months ended June 30, 2004 was 4.00%,  a decrease of
32 basis points from 4.32% which was the average prime for the nine months ended
June 30, 2003. The rate decrease caused a greater reduction in the average yield
on earning assets than the average rate paid on interest-bearing liabilities.

     NET INTEREST INCOME.  Net interest income,  the difference between interest
earned  on  loans  and  investments   and  interest  paid  on   interest-bearing
liabilities,  decreased  by $248,000 or 2.8% for the nine months  ended June 30,
2004, compared to the same nine months in the prior year. This decrease reflects
a $979,000 decrease in interest income that was partially offset by the $731,000
decrease  in total  interest  expense.  The  average  net  interest  rate spread
decreased  20 basis points from 3.17% for the nine months ended June 30, 2003 to
2.97% for the nine months ended June 30, 2004.



                                       15
<PAGE>

     INTEREST INCOME.  The decrease in interest income for the nine months ended
June, 2004 was due to a decrease in yield on interest-earning assets of 70 basis
points from 5.37% for the nine months  ended June 30, 2003 to 4.67% for the nine
months  ended June 30,  2004 that was  partially  offset by an increase of $20.7
million in average  interest-earning  assets  compared to the same period in the
prior year. The increased  volume of average  interest-earning  assets increased
interest income by approximately  $1.1 million and the decreased yield decreased
interest income by approximately  $2.1 million.  Average  investment  securities
increased  $30.1 million and average  loans  receivable  increased  $1.1 million
compared with the prior year.  These increases were offset in part by a decrease
of $10.5 million in average interest bearing overnight funds.

     INTEREST EXPENSE.  Interest expense decreased in the nine months ended June
30, 2004 due to a decrease  in the cost of  interest-bearing  liabilities  of 50
basis points from 2.20% for the nine months ended June 30, 2003 to 1.70% for the
nine  months  ended June 30,  2004 that was  partially  offset by an increase of
$19.9  million  in  average  interest-bearing   liabilities.   Average  deposits
increased by $4.8 million and average FHLB advances  increased $15.2 million for
the nine  months  ended June 30,  2004  compared  to the same nine months in the
prior year.  The  increase  in average  interest-bearing  liabilities  increased
interest expense by approximately  $673,000 and the decrease in the average cost
of interest-bearing liabilities decreased interest expense by approximately $1.4
million.

     The following table presents average balances and average rates earned/paid
by the  Company for the nine  months  ended June 30,  2004  compared to the nine
months ended June 30, 2003.
<TABLE>
<CAPTION>

                                                                NINE MONTHS ENDED                  NINE MONTHS ENDED
                                                                   JUNE 30, 2004                      JUNE 30, 2003
                                                     -----------------------------------  -------------------------------------
                                                                              (DOLLARS IN THOUSANDS)
                                                     AVERAGE                    AVERAGE     AVERAGE                    AVERAGE
                                                     BALANCE       INTEREST   YIELD/COST    BALANCE      INTEREST    YIELD/COST
                                                  ------------    ---------   ----------  ----------   ----------    ----------
<S>                                                     <C>         <C>         <C>           <C>           <C>          <C>
Assets:
Loans receivable (5).........................     $    228,827    $   8,495       4.95%   $  227,694   $   9,764       5.72%
Investment securities (6)....................          113,480        3,588       4.22        83,352       3,194       5.11
Interest-bearing overnight deposits .........            3,556           24       0.89        14,088         128       1.21
                                                  ------------    ---------     ------    ----------   ---------       ----
  Total interest-earning assets (7)..........          345,863       12,107       4.67       325,134      13,086       5.37
Noninterest-earning assets...................           20,896                                20,094
                                                  ------------                            ----------
  Total assets...............................     $    366,759                            $  345,228
                                                  ============                            ==========

Liabilities and stockholders' equity:
Interest bearing checking....................           36,148           57       0.21        33,686         101       0.40
Money market investment accounts.............           19,565           98       0.67        22,649         167       0.98
Passbook and statement savings...............           30,377          139       0.61        29,784         227       1.01
Certificates of deposit......................          160,476        2,335       1.94       155,675       3,005       2.57
FHLB advances................................           35,883          965       3.58        20,718         825       5.31
                                                  ------------    ---------     ------    ----------   ---------       ----
  Total interest-bearing liabilities.........          282,449        3,594       1.70       262,512       4,325       2.20
Non interest-bearing liabilities.............           21,060                                20,517
                                                  ------------                            ----------
  Total liabilities..........................          303,509                               283,029
Stockholders' equity.........................           63,250                                62,199
                                                  ------------                            ----------
  Total liabilities and stockholders' equity      $    366,759                            $  345,228
                                                  ============                            ==========

Net interest income..........................                     $    8,513                           $   8,761
                                                                  ==========                           =========
Interest rate spread.........................                                     2.97%                                3.17%
                                                                                ======                                 ====
Net interest margin (8)......................                                     3.28%                                3.59%
                                                                                ======                                 ====
Ratio of average interest-earning assets to
 average interest-bearing liabilities........                                   122.45%                              123.85%
                                                                                ======                               ======
</TABLE>
                                       16
<PAGE>

--------
(5)  Includes  nonaccrual  loans and loans held for sale,  net of discounts  and
     allowance for loan losses.
(6)  Includes FHLB of Atlanta stock.
(7)  Due to immateriality, the interest income and yields related to certain tax
     exempt assets have not been adjusted to reflect a fully taxable  equivalent
     yield.
(8)  Represents  net  interest   income  divided  by  the  average   balance  of
     interest-earning assets.

     PROVISION  FOR LOAN  LOSSES.  The  provision  for loan losses is charged to
earnings to maintain the total  allowance for loan losses at a level  considered
adequate to absorb  estimated  probable  losses  inherent in the loan  portfolio
based on  existing  loan  levels and types of loans  outstanding,  nonperforming
loans,  prior  loan  loss  experience,  general  economic  conditions  and other
factors.  The  provision for loan losses was $180,000 and net  charge-offs  were
$126,000  for the nine months ended June 30, 2004  compared  with a provision of
$180,000,  and net  charge-offs  of $10,000 for the nine  months  ended June 30,
2003.  The provision for loan losses was impacted by the continued  shift in the
portfolio to commercial loans which require a larger allocation of allowance for
loan losses. The effects of this continued shift in the portfolio were offset to
a certain degree in 2004 by a decrease in  nonperforming  loans. The Company has
completed the  foreclosure on some of the  nonperforming  loans and has sold the
majority of its real estate owned.

     OTHER  INCOME.  Other income  decreased  $700,000 from $2.5 million for the
nine months  ended June 30, 2003 to $1.8  million for the nine months ended June
30, 2004.  Mortgage banking income, net decreased $922,000 from $1.3 million for
the nine months  ended June 30, 2003 to $337,000  for the nine months ended June
30,  2004.  This  decrease  results  from a decrease in volume of mortgage  loan
originations  and sales. We sold loans totaling $21.7 million in the nine months
ended June 30, 2004  compared  with sales of $75.8  million in the previous year
for the comparable  period.  The increase in mortgage  interest rates slowed the
volume of mortgage  originations and sales.  Given the current level of mortgage
interest rates,  the Company believes that mortgage banking income will continue
to decrease in future quarters due to lower  refinancing  activity.  Commissions
from sales of annuities and mutual funds decreased $83,000 from $346,000 for the
nine months  ended June 30, 2003 to $263,000  for the nine months ended June 30,
2004.  This decrease  results from lower sales of annuities.  Sales of annuities
and mutual  funds  totaled  $150,000  and $4.9 million and $1.9 million and $4.6
million for the nine  months  ended June 30,  2004 and 2003,  respectively.  The
Company  recorded  gains on sales of  investments of $185,000 in the nine months
ended June 30, 2004  compared  to gains of  $103,000  in the prior  year.  Other
income increased  $135,000 from $183,000 for the nine months ended June 30, 2003
to $318,000 for the nine months ended June 30, 2004. The increase was the result
of the  $143,000  gain on the sale of the  Mebane  real  estate  in the  current
quarter.

     OPERATING  EXPENSES.  Total  operating  expenses were $6.2 million and $6.4
million for the nine  months  ended June 30,  2004 and 2003,  respectively.  The
Company has been able to control  expenses during this period of slower loan and
deposit growth.

     INCOME TAX EXPENSE.  Income tax expense decreased $300,000 from tax expense
of $1.7  million for the nine months ended June 30, 2003 to $1.4 million for the
nine months ended June 30, 2004.  The  effective  tax rates were 35.7% and 36.7%
for the nine months ended June 30, 2004 and 2003, respectively.  The decrease in
the effective  rate was primarily due to an increase in the ratio of non-taxable
income as a percentage of net income before taxes.

COMMITMENTS, CONTINGENCIES AND OFF-BALANCE SHEET RISK

     The Company is a party to financial instruments with off-balance sheet risk
including  commitments  to extend  credit  under  existing  lines of credit  and
commitments  to sell  loans.  These  instruments  involve,  to varying  degrees,
elements of credit and interest rate risk in excess of the amount  recognized in
the consolidated balance sheets.


                                       17
<PAGE>

     Off-balance  sheet financial  instruments  whose contract amounts represent
credit and interest rate risk are summarized as follows:
<TABLE>
<CAPTION>

                                                                   JUNE 30, 2004    SEPTEMBER 30, 2003
                                                                   -------------    ------------------
                                                                        (Dollars in thousands)
            <S>                                                         <C>               <C>
         Commitments to originate new loans                            $ 4,563          $  1,552
         Commitments to originate new loans held for sale                   --               278
         Unfunded commitments to extend credit under existing
              equity line and commercial lines of credit                56,172            57,237
         Commercial letters of credit                                    1,994               326
         Commitments to sell loans held for sale                         1,532             1,630
</TABLE>

     Commitments  to originate  new loan include two unrelated  commercial  real
estate  loans  totaling  $3.7  million.  The  Company  does not have any special
purpose  entities  or  other  similar  forms  of  off-balance   sheet  financing
arrangements.

     Commitments  to originate new loans or to extend  credit are  agreements to
lend to a customer as long as there is no violation of any condition established
in the contract.  Loan  commitments  generally expire within 30 to 45 days. Most
equity line  commitments  are for a term of 15 years,  and  commercial  lines of
credit are generally  renewable on an annual basis.  Commitments  generally have
fixed expiration dates or other termination clauses and may require payment of a
fee.  Since many of the  commitments  are expected to expire without being drawn
upon, the total  commitment  amounts do not  necessarily  represent  future cash
requirements.  The  Company  evaluates  each  customer's  creditworthiness  on a
case-by-case basis. The amounts of collateral  obtained,  if deemed necessary by
the Company upon extension of credit, is based on management's credit evaluation
of the borrower.

     Commitments  to sell loans held for sale are  agreements to sell loans to a
third party at an agreed upon price.  At June 30, 2004, the aggregate fair value
of these commitments exceeded the book value of the loans to be sold.

CONTRACTUAL OBLIGATIONS

<TABLE>
<CAPTION>
As of June 30, 2004:
                                                               PAYMENTS DUE BY PERIOD
                                                               (DOLLARS IN THOUSANDS)
                                     LESS THAN
                                       1 YEAR          1-3 YEARS         4-5 YEARS      OVER 5 YEARS     TOTAL
                                    -----------        ---------         ---------      ------------     -----
<S>                                     <C>             <C>                 <C>             <C>           <C>
Deposits                            $  228,919         $ 23,112          $ 11,807        $   --          $263,838
Advances from FHLB                      27,500               --            20,000            --            47,500
Lease obligations                           18               41                42            26               127
                                    ----------         --------          --------        ------          --------
Total contractual cash
    obligations                     $  256,437         $ 23,153          $ 31,849        $   26          $311,465
                                    ==========         ========          ========        ======          ========
</TABLE>

ASSET QUALITY

     At  June  30,  2004,  the  Company  had   approximately   $4.0  million  in
nonperforming  assets (nonaccrual loans and real estate owned) or 1.06% of total
assets. At September 30, 2003,  nonperforming  assets were $4.2 million or 1.17%
of total assets. At June 30, 2004 and September 30, 2003, impaired loans totaled
$3.6  million  and $3.8  million,  respectively,  as  defined  by  Statement  of
Financial  Accounting Standards No. 114, "Accounting by Creditors for Impairment
of a Loan." The impaired  loans at June 30, 2004 and  September  30, 2003 result
from two and three,  respectively,  unrelated commercial loan customers, each of
which have loans  secured  by  commercial  real  estate and  business  assets in
Alamance County. At June 30, 2004, the entire $3.6 million of the impaired loans
are on  non-accrual  status,  and their related  reserve for loan losses totaled
$160,000.  The average  carrying value of impaired loans was $3.7 million during
the nine  months  ended June 30,  2004.  Interest  income of  $148,000  has been
recorded on impaired  loans in the nine months ended June 30,  2004.  The Bank's
net chargeoffs for the nine months ended June 30, 2004 were $126,000. The Bank's
allowance  for loan losses was $3.9 million at June 30, 2004 and  September  30,
2003,  and the



                                       18
<PAGE>

ratio of the allowance  for loan losses to total loans,  net of loans in process
and deferred  loan fees was 1.67% and 1.68% at June 30, 2004 and  September  30,
2003, respectively.

     The following table presents an analysis of our nonperforming assets:
<TABLE>
<CAPTION>

                                                      AT                           AT                      AT
                                                   JUNE 30,                  SEPTEMBER 30,              JUNE 30,
                                                     2004                         2003                    2003
                                              --------------------         -------------------        -------------
<S>                                                     <C>                        <C>                       <C>
Nonperforming loans:
Nonaccrual loans                              $       4,007                $        4,153             $     4,501
Loans 90 days past due and accruing                      --                            --                      --
Restructured loans                                       --                            --                      --
                                              -------------                --------------             -----------
Total nonperforming loans                             4,007                         4,153                   4,501
Other real estate                                        26                            95                      80
                                              -------------                --------------             -----------
Total nonperforming assets                    $       4,033                $        4,248             $     4,581
                                              =============                ==============             ===========

Nonperforming loans to loans receivable, net           1.74%                         1.84%                   2.01%
Nonperforming assets as a percentage
 of loans and other real estate owned                  1.75%                         1.88%                   2.05%
Nonperforming assets to total assets                   1.06%                         1.17%                   1.29%
</TABLE>

     Regulations  require that we classify our assets on a regular basis.  There
are three classifications for problem assets: substandard, doubtful and loss. We
regularly   review  our  assets  to   determine   whether  any  assets   require
classification  or  re-classification.  At June 30, 2004, we had $4.8 million in
classified  assets  consisting of $4.8 million in substandard  loans,  $7,000 in
loss loans and $26,000 in real estate owned.  At September 30, 2003, we had $4.9
million in substandard assets consisting of $4.8 million in loans and $95,000 in
real estate owned. At June 30, 2003, we had $4.9 million in substandard and loss
loans and $80,000 in real estate owned.

     In addition to  regulatory  classifications,  we also  classify as "special
mention" and "watch"  assets that are currently  performing  in accordance  with
their contractual terms but may become classified or nonperforming assets in the
future.  At June 30,  2004,  we have  identified  approximately  $4.8 million in
assets  classified as special  mention and $28.0  million as watch.  At June 30,
2003,  we had  identified  approximately  $1.1 million in assets  classified  as
special mention and $36.5 million as watch.

     Included  in the total of  special  mention  assets  are five loans with an
aggregate outstanding balance of $4.0 million at June 30, 2004 to borrowers,  of
which one of our directors along with family members, is a majority stockholder.
In  addition,  one of the  borrowers  has the  ability  to borrow an  additional
$124,000  from us under a line of credit.  All the loans are  secured by a first
lien  on  all  assets,  including  accounts  receivable,  inventory,  equipment,
furniture and real property occupied by the borrower. In addition,  the director
and his spouse have  personally  guaranteed  repayment of the loans. At June 30,
2004, such loans were current with respect to their payment terms.

     Subsequent  to June 30, 2004,  the  borrowers  sold a division and used the
proceeds  from  such  sale to repay a  significant  portion  of the  outstanding
principal balance of such loans,  reducing the aggregate  outstanding balance of
the loans to $580,000 at August 12, 2004. However, the minority  stockholders of
the  borrower,  Roger W.  Overman,  Jack D. Overman and Larry D.  Overman,  have
brought a lawsuit in the  Superior  Court of Guilford  County,  North  Carolina,
against  the  majority  stockholders,  as well as  others,  including  the Bank,
seeking money damages. Included in part of plaintiffs' complaint are allegations
related to loans made by the Bank to the  borrowers.  Although  the time for the
Bank to formally  respond in court to the  complaint  has not yet  arrived,  the
Bank's  attorneys  have asked that the  plaintiffs'  attorney drop the Bank as a
party to the lawsuit.  If the plaintiffs do not do so, the Bank will  vigorously
defend the  lawsuit and seek its  dismissal  by the court.  Management  does not
anticipate  that  this  lawsuit  will  have a  material  adverse  impact  on the
Company's financial condition or results of operations.

LIQUIDITY AND CAPITAL RESOURCES

     The Bank must meet certain liquidity requirements  established by the State
of North Carolina Office of the Commissioner of Banks (the  "Commissioner").  At
June 30, 2004, the Bank's liquidity ratio exceeded such requirements.  Liquidity
generally refers to the Bank's ability to generate  adequate amounts of funds to
meet its cash needs.  Adequate  liquidity  guarantees that sufficient  funds are
available to meet deposit withdrawals, fund loan commitments,  maintain adequate
reserve  requirements,  pay operating expenses,  provide funds for debt service,
pay dividends to stockholders and meet other general commitments.



                                       19
<PAGE>

     Our primary sources of funds are deposits,  principal and interest payments
on loans, proceeds from the sale of loans, and to a lesser extent, advances from
the FHLB of Atlanta.  While  maturities and scheduled  amortization of loans are
predictable sources of funds, deposit flows and mortgage prepayments are greatly
influenced by general interest rates, economic conditions and local competition.

     Our most liquid assets are cash and cash  equivalents.  The levels of these
assets  are  dependent  on  our  operating,  financing,  lending  and  investing
activities  during any given period. At June 30, 2004, cash and cash equivalents
totaled  $10.7  million.  We have  other  sources  of  liquidity  should we need
additional funds.  During the three and nine months ended June 30, 2004, we sold
loans totaling $7.5 million and $21.1 million, respectively.  Additional sources
of funds include FHLB of Atlanta  advances.  Other sources of liquidity  include
loans and investment  securities designated as available for sale, which totaled
$97.6 million at June 30, 2004.

     We  anticipate  that we will have  sufficient  funds  available to meet our
current  commitments.  At June 30, 2004, we had $5.1 million in  commitments  to
originate  new loans,  $56.2  million in unfunded  commitments  to extend credit
under existing  equity lines and commercial  lines of credit and $2.0 million in
standby letters of credit. At June 30, 2004,  certificates of deposit, which are
scheduled to mature within one year,  totaled $124.9 million.  We believe that a
significant portion of such deposits will remain with us.

     The Federal Deposit  Insurance  Corporation  ("FDIC")  requires the Bank to
meet a minimum leverage capital requirement of Tier I capital to assets ratio of
4%.  The  FDIC  also  requires  the Bank to meet a ratio  of  total  capital  to
risk-weighted  assets of 8%, of which 4% must be in the form of Tier I  capital.
The  Commissioner  requires  the Bank at all times to maintain  certain  minimum
capital levels. The Bank was in compliance with all capital  requirements of the
FDIC  and  the  Commissioner  at  June  30,  2004  and  is  deemed  to be  "well
capitalized."

     The Federal Reserve also mandates capital  requirements on all bank holding
companies,  including 1st State  Bancorp,  Inc. These capital  requirements  are
similar to those imposed by the FDIC on the Bank. At June 30, 2004,  the Company
was in compliance with the capital requirements of the Federal Reserve.

     The  Company's  equity  to  asset  ratio at June 30,  2004 was  16.8%.  The
Company's capital level is sufficient to support future growth.

     The Company has declared cash  dividends per common share of $0.10 for each
of the three months ended June 30, 2004,  September  30, 2003 and June 30, 2003.
The Company's ability to pay dividends is dependent upon earnings. The Company's
dividend  payout ratio for the three months ended June 30, 2004,  September  30,
2003 and June 30, 2003 was 30.3%, 31.2% and 29.4%, respectively.

ACCOUNTING MATTERS

     In March  2004,  the SEC  released  Staff  Accounting  Bulletin  No.  105 -
Application of Accounting Principles to Loan Commitments. This bulletin requires
all registrants to begin accounting for their issued loan commitments (including
interest rate lock  commitments)  subject to Statement  133 as written  options.
Treatment  as a written  option  would  require  those  loan  commitments  to be
reported as liabilities  until either they are exercised (and a loan is made) or
they expire  unexercised.  Staff Accounting  Bulletin No. 105 must be applied to
loan  commitments  that are issued after March 31,  2004.  The adoption of Staff
Accounting  Bulletin No. 105 did not have a material impact on the  consolidated
financial statements.

     In January 2003, FASB  Interpretation  No. 46,  "Consolidation  of Variable
Interest  Entities,  an interpretation of ARB No. 51",  (Interpretation  46) was
issued. Interpretation 46 addresses the consolidation by business enterprises of
variable interest entities as defined in the  Interpretation.  Interpretation 46
applies  immediately to variable interests in variable interest entities created
after January 31, 2003, and to variable  interests in variable interest entities
obtained  after  January  31,  2003.  In  December  2003,  the FASB  issued FASB
Interpretation  No. 46  (revised  December  2003),  "Consolidation  of  Variable
Interest  Entities",  which addresses how a business  enterprise should evaluate
whether it has a controlling financial interest in an entity through means other
than voting  rights and  accordingly  should  consolidate  the  entity.  FIN 46R
replaces  FASB  Interpretation  No.  46,  "Consolidation  of  Variable  Interest
Entities",  which was issued in January  2003.  The Company  will be required to
apply FIN 46R to variable interests in VIEs created after December 31, 2003. The
application  of this revised  interpretation  is not expected to have a material
effect on the consolidated financial statements.



                                       20
<PAGE>

ITEM 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

     Market  risk is the  possible  chance of loss from  unfavorable  changes in
market prices and rates.  These changes may result in a reduction of current and
future period net interest income, which is the favorable spread earned from the
excess of interest income on  interest-earning  assets over interest  expense on
interest-bearing liabilities.

     The Company considers  interest rate risk to be its most significant market
risk, which could  potentially  have the greatest impact on operating  earnings.
The  structure  of the  Company's  loan and  deposit  portfolios  is such that a
significant decline in interest rates may adversely impact net market values and
net interest income.

     The Company  monitors whether material changes in market risk have occurred
since September 30, 2003. The Company does not believe that any material adverse
changes in market risk exposures have occurred since September 30, 2003.

ITEM 4.  CONTROLS AND PROCEDURES

     As of the end of the  period  covered  by this  report,  management  of the
Company  carried  out  an  evaluation,   under  the  supervision  and  with  the
participation  of  the  Company's  principal  executive  officer  and  principal
financial officer, of the effectiveness of the Company's disclosure controls and
procedures.  Based on this evaluation, the Company's principal executive officer
and principal financial officer concluded that the Company's disclosure controls
and  procedures  are  effective  in  ensuring  that  information  required to be
disclosed  by the  Company  in  reports  that it  files  or  submits  under  the
Securities Exchange Act of 1934, as amended, is recorded, processed,  summarized
and reported,  within the time periods  specified in the Securities and Exchange
Commission's  rules  and  forms.  It  should  be noted  that the  design  of the
Company's  disclosure  controls  and  procedures  is based in part upon  certain
reasonable  assumptions about the likelihood of future events,  and there can be
no reasonable  assurance  that any design of disclosure  controls and procedures
will  succeed  in  achieving  its  stated  goals  under  all  potential   future
conditions,  regardless of how remote, but the Company's principal executive and
financial  officers have  concluded that the Company's  disclosure  controls and
procedures are, in fact, effective at a reasonable assurance level.

     In addition,  there have been no changes in the Company's  internal control
over financial reporting  identified in connection with the evaluation described
in the above  paragraph that occurred  during the Company's last fiscal quarter,
that has materially affected,  or is reasonably likely to materially affect, the
Company's internal control over financial reporting.


                                       21
<PAGE>



                           PART II. OTHER INFORMATION

ITEM 1.  LEGAL PROCEEDINGS

     From time to time, we are a party to various legal proceedings  incident to
our business.  There currently are no legal proceedings to which we are a party,
or to  which  any of our  property  was  subject,  except  as  described  in the
following  paragraph,  and none which are expected to result in a material loss.
There are no pending regulatory  proceedings to which we are a party or to which
any of our  properties  is subject  which are  expected  to result in a material
loss.

     A civil action was filed  against 1st State Bank and Brokers,  Incorporated
by Michael  Locklar in Davidson  County  Superior  Court,  in the State of North
Carolina on May 16, 2003.  Mr.  Locklar has alleged in the action that 1st State
Bank granted him an option to purchase certain real property located in Davidson
County,  North  Carolina,  which  1st State  Bank  wrongfully  sold to  Brokers,
Incorporated  for $150,000 in breach of the option granted to Mr.  Locklar.  Mr.
Locklar  is  seeking  to set  aside  the  conveyance  of  property  to  Brokers,
Incorporated  and to purchase  the  property  from 1st State Bank for the option
price.  Brokers,  Incorporated  has filed a  cross-claim  against 1st State Bank
seeking  indemnification  in the form of return of the purchase  price they paid
for the  property,  damages and attorneys  fees should  Locklar be successful in
setting aside the real estate  conveyance.  1st State Bank intends to vigorously
contest Mr. Locklar's allegations.

     The Bank has been named as a  defendant  in a lawsuit  brought by  minority
stockholders  of  a  corporation  against  the  majority   stockholders  of  the
corporation.  A director of the Company and the Bank, along with family members,
is the majority stockholder of the corporation, which has loans outstanding from
the Bank. For further information  regarding this lawsuit, see "Part I Financial
Information  --  Item 2.  Management's  Discussion  and  Analysis  of  Financial
Condition and Results of  Operations -- Comparison of Operating  Results for the
Nine Months Ended June 30, 2004 and 2003 -- Asset Quality."

ITEM  2.  CHANGES  IN  SECURITIES,  USE OF  PROCEEDS  AND  ISSUER  PURCHASES  OF
SECURITIES

        (a) Not applicable

        (b) Not applicable

        (c) Not applicable

        (d) Not applicable

        (e) The Company did not repurchase any of its Common Stock during the
            quarter ended June 30, 2004.

ITEM 3.  DEFAULTS UPON SENIOR SECURITIES

         None.

ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

         None.

ITEM 5.  OTHER INFORMATION

         None.

                                       22
<PAGE>

ITEM 6.  EXHIBITS AND REPORTS ON FORM 8-K

         (a)      EXHIBITS.
                  ---------

                  31.1   Rule 13a-14(a) Certification of Chief Executive Officer

                  31.2   Rule 13a-14(a) Certification of Chief Financial Officer

                  32     Section 1350 Certification

         (b)      REPORTS ON FORM 8-K.

                  The Registrant filed the following Current Reports on Form 8-K
                  during the quarter ended June 30, 2004:
<TABLE>
<CAPTION>

                  Date of Report            Item(s) Reported           Financial Statements Filed
                  --------------            ----------------           --------------------------
                        <S>                     <C>                                 <C>
                  April 26, 2004                 7, 12                            N/A
</TABLE>

                                       23
<PAGE>


                                   SIGNATURES


     Pursuant to the  requirements  of the Securities  Exchange Act of 1934, the
registrant  caused  this  report to be signed on its behalf by the  undersigned,
thereunto duly authorized.

                                        1st STATE BANCORP, INC.


Date:  August 12, 2004                  /s/ James C. McGill
                                        ----------------------------------------
                                        James C. McGill
                                        President and Chief Executive Officer
                                        (Principal Executive Officer)


Date:  August 12, 2004                  /s/ A. Christine Baker
                                        ----------------------------------------
                                        A. Christine Baker
                                        Executive Vice President
                                        Treasurer and Secretary
                                        (Principal Financial and Accounting
                                        Officer)