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 March 31, 2005

      OR

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

      For the transition period from ______ to ______

                         Commission file number: 0-25859

                             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 May 3, 2005, the issuer had 2,898,637  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 March 31, 2005 (unaudited) and September 30, 2004.........1

         Consolidated Statements of Income for the Three Months Ended March 31, 2005 and
               2004 (unaudited)......................................................................2

         Consolidated Statements of Income for the Six Months Ended March 31, 2005 and
               2004 (unaudited)......................................................................3

         Consolidated Statements of Stockholders' Equity and Comprehensive Income for the Six
               Months Ended March 31, 2005 and 2004 (unaudited)......................................4

         Consolidated Statements of Cash Flows for the Six Months Ended March 31, 2005 and
               2004 (unaudited)......................................................................5

         Notes to Consolidated Financial Statements..................................................7

Item 2.  Management's Discussion and Analysis of Financial Condition and Results of Operations......10

Item 3.  Quantitative and Qualitative Disclosures About Market Risk.................................20

Item 4.  Controls and Procedures....................................................................20

PART II. OTHER INFORMATION
         -----------------

Item 1.  Legal Proceedings..........................................................................21

Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds................................21

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...................................................................................22

SIGNATURES
</TABLE>

<PAGE>

                     1st State Bancorp, Inc. and Subsidiary
                           Consolidated Balance Sheets
                      March 31, 2005 and September 30, 2004
                        (In Thousands, except share data)

<TABLE>
<CAPTION>
                                                                       At             At
                                                                    March 31,    September 30,
                                                                      2005           2004
                                                                  -------------  -------------
                                                                   (Unaudited)
<S>                                                                 <C>            <C>
                        ASSETS

Cash and cash equivalents                                           $   9,030      $   9,854
Investment securities:
   Held to maturity (fair value of $24,067 and $22,884
     at March 31, 2005 and September 30, 2004, respectively)           24,500         22,919
   Available for sale (cost of $88,444 and $97,386
     at March 31, 2005 and September 30, 2004, respectively)           86,134         96,693
Loans held for sale, at lower of cost or fair value                     1,975            930
Loans receivable (net of allowance for loan losses of $3,695
  and $3,956 at March 31, 2005 and September 30, 2004,
  respectively)                                                       234,418        231,763
Real estate owned                                                         168             17
Federal Home Loan Bank stock, at cost                                   1,798          2,325
Premises and equipment                                                  7,628          7,884
Accrued interest receivable                                             2,138          2,124
Other assets                                                            4,964          3,205
                                                                    ---------      ---------
     Total assets                                                   $ 372,753      $ 377,714
                                                                    =========      =========

        LIABILITIES AND STOCKHOLDERS' EQUITY

Liabilities:
  Deposit accounts                                                    278,769        262,734
  Advances from Federal Home Loan Bank                                 23,500         44,000
  Advance payments by borrowers for property taxes and insurance          201             39
  Dividend payable                                                        290            296
  Other liabilities                                                     5,262          4,731
                                                                    ---------      ---------
     Total liabilities                                                308,022        311,800
                                                                    ---------      ---------

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;
    2,903,517 and 2,962,323 shares issued and outstanding
    at March 31, 2005 and September 30, 2004, respectively                 33             33
 Additional paid-in capital                                            36,240         36,038
 Unallocated ESOP shares                                               (2,293)        (2,571)
 Deferred compensation payable in treasury stock                        6,700          6,440
 Treasury stock                                                       (16,181)       (14,086)
 Retained income - substantially restricted                            41,638         40,462
 Accumulated other comprehensive loss - net unrealized
    loss on investment securities available for sale                   (1,406)          (402)
                                                                    ---------      ---------
Total stockholders' equity                                             64,731         65,914
                                                                    ---------      ---------
     Total liabilities and stockholders' equity                     $ 372,753      $ 377,714
                                                                    =========      =========
</TABLE>

See accompanying notes to the consolidated financial statements.


                                       1
<PAGE>

                     1st State Bancorp, Inc. and Subsidiary
                        Consolidated Statements of Income
               For the Three Months Ended March 31, 2005 and 2004
                      (In Thousands, Except per Share Data)

                                   (Unaudited)

<TABLE>
<CAPTION>
                                                               For the Three Months Ended
                                                                       March 31,
                                                               --------------------------
                                                                   2005         2004
                                                                 --------     --------
<S>                                                              <C>          <C>
Interest income:
  Interest and fees on loans                                     $  3,339     $  2,830
  Interest and dividends on investments                             1,152        1,116
  Overnight deposits                                                   21            8
                                                                 --------     --------
    Total interest income                                           4,512        3,954
                                                                 --------     --------

Interest expense:
   Deposit accounts                                                 1,154          886
   Borrowings                                                         304          303
                                                                 --------     --------
    Total interest expense                                          1,458        1,189
                                                                 --------     --------
        Net interest income                                         3,054        2,765

Provision for loan losses                                              60           60
                                                                 --------     --------
        Net interest income after provision for loan losses         2,994        2,705
                                                                 --------     --------

Other income:
   Customer service fees                                              245          240
   Commissions from sales of annuities and mutual funds                57           93
   Mortgage banking income, net                                        88          113
   Securities (losses) gains, net                                      (2)          88
   Other                                                               72           56
                                                                 --------     --------
     Total other income                                               460          590
                                                                 --------     --------

Operating expenses:
   Compensation and related benefits                                1,254        1,316
   Occupancy and equipment                                            355          340
   Real estate operations, net                                         (2)          (1)
   Other expenses                                                     470          401
                                                                 --------     --------

     Total operating expenses                                       2,077        2,056
                                                                 --------     --------

        Income before income taxes                                  1,377        1,239

Income taxes                                                          493          460
                                                                 --------     --------

        Net income                                               $    884     $    779
                                                                 ========     ========

        Net income per share:

        Basic                                                    $   0.31     $   0.28
        Diluted                                                  $   0.30     $   0.26
</TABLE>

See accompanying notes to the consolidated financial statements.


                                       2
<PAGE>

                     1st State Bancorp, Inc. and Subsidiary
                        Consolidated Statements of Income
                For the Six Months Ended March 31, 2005 and 2004
                      (In Thousands, Except per Share Data)

                                   (Unaudited)

<TABLE>
<CAPTION>
                                                               For the Six Months Ended
                                                                       March 31,
                                                               ------------------------
                                                                  2005         2004
                                                                --------     --------
<S>                                                             <C>          <C>
Interest income:
   Interest and fees on loans                                   $  6,461     $  5,684
   Interest and dividends on investments                           2,350        2,300
   Overnight deposits                                                 39           17
                                                                --------     --------
     Total interest income                                         8,850        8,001
                                                                --------     --------

Interest expense:
    Deposit accounts                                               2,068        1,805
    Borrowings                                                       660          619
                                                                --------     --------
     Total interest expense                                        2,728        2,424
                                                                --------     --------
         Net interest income                                       6,122        5,577

Provision for loan losses                                            390          120
                                                                --------     --------
         Net interest income after provision for loan losses       5,732        5,457
                                                                --------     --------

Other income:
   Customer service fees                                             542          446
   Commissions from sales of annuities and mutual funds              124          165
   Mortgage banking income, net                                      210          211
   Securities (losses) gains, net                                     (2)         185
   Other                                                             232          109
                                                                --------     --------
     Total other income                                            1,106        1,116
                                                                --------     --------

Operating expenses:
   Compensation and related benefits                               2,538        2,648
   Occupancy and equipment                                           709          683
   Real estate operations, net                                        (8)          (5)
   Other expenses                                                    903          833
                                                                --------     --------

     Total operating expenses                                      4,142        4,159
                                                                --------     --------

         Income before income taxes                                2,696        2,414

Income taxes                                                         960          877
                                                                --------     --------

         Net income                                             $  1,736     $  1,537
                                                                ========     ========

         Net income per share:

         Basic                                                  $   0.62     $   0.55
         Diluted                                                $   0.58     $   0.52
</TABLE>

See accompanying notes to the consolidated financial statements.


                                       3
<PAGE>

                     1st State Bancorp, Inc. and Subsidiary
    Consolidated Statements of Stockholders' Equity and Comprehensive Income
          For the Six Months Ended March 31, 2005 and 2004 (Unaudited)
                                 (In Thousands)

<TABLE>
<CAPTION>
                                                                                    Deferred
                                                                                  compensation
                                                        Additional   Unallocated   payable in
                                              Common      paid-in       ESOP        treasury     Treasury
                                               stock      capital      Shares        stock        stock
                                               -----      -------      ------        -----        -----
<S>                                           <C>          <C>          <C>           <C>        <C>
Balance at September 30, 2003                 $    33      35,778       (3,141)       5,466      (12,785)

Comprehensive income:
  Net income                                       --          --           --           --           --
  Other comprehensive income-unrealized
    gain on securities available-for-sale,
    net of income taxes of $338                    --          --           --           --           --

        Total comprehensive income
Allocation of ESOP shares                          --         133          287           --           --
Acquisition of treasury stock                      --          --           --           --         (663)
Deferred compensation                              --          --           --          336           --
Exercise of stock options                          --          19           --           --           --
Cash dividends declared  ($0.20 per share)         --          --           --           --           --
Cash dividends on unallocated ESOP shares          --          --           --           --           --
                                              -------     -------      -------      -------      -------
Balance at March 31, 2004                     $    33      35,930       (2,854)       5,802      (13,448)
                                              =======     =======      =======      =======      =======

Balance at September 30, 2004                 $    33      36,038       (2,571)       6,440      (14,086)

Comprehensive income:

  Net income                                       --          --           --           --           --
  Other comprehensive income-unrealized
    loss on securities available-for-sale,
    net of income tax benefit of ($613)            --          --           --           --           --

            Total comprehensive income

Allocation of ESOP shares                          --         122          278           --           --

Acquisition of treasury stock                      --          --           --           --       (2,095)

Deferred compensation                              --          --           --          260           --

Exercise of stock options                          --          80           --           --           --

Cash dividends declared ($0.20 per share)          --          --           --           --           --

Cash dividends on unallocated ESOP shares          --          --           --           --           --
                                              -------     -------      -------      -------      -------

Balance at March 31, 2005                     $    33      36,240       (2,293)       6,700      (16,181)
                                              =======     =======      =======      =======      =======

<CAPTION>

                                                            Accumulated
                                                               other         Total
                                                Retained   comprehensive  stockholders'
                                                 income    income (loss)     equity
                                                 ------    -------------     ------
<S>                                              <C>           <C>           <C>
Balance at September 30, 2003                    38,118          (768)       62,701

Comprehensive income:
  Net income                                      1,537            --         1,537
  Other comprehensive income-unrealized
    gain on securities available-for-sale,
    net of income taxes of $338                      --           525           525
                                                                            -------
        Total comprehensive income                                            2,062
Allocation of ESOP shares                            --            --           420
Acquisition of treasury stock                        --            --          (663)
Deferred compensation                                --            --           336
Exercise of stock options                            --            --            19
Cash dividends declared  ($0.20 per share)         (593)           --          (593)
Cash dividends on unallocated ESOP shares            32            --            32
                                                -------       -------       -------
Balance at March 31, 2004                        39,094          (243)       64,314
                                                =======       =======       =======

Balance at September 30, 2004                    40,462          (402)       65,914

Comprehensive income:

  Net income                                      1,736            --         1,736
  Other comprehensive income-unrealized
    loss on securities available-for-sale,
    net of income tax benefit of ($613)              --        (1,004)       (1,004)
                                                                            -------
            Total comprehensive income                                          732

Allocation of ESOP shares                            --            --           400

Acquisition of treasury stock                        --            --        (2,095)

Deferred compensation                                --            --           260

Exercise of stock options                            --            --            80

Cash dividends declared ($0.20 per share)          (586)           --          (586)

Cash dividends on unallocated ESOP shares            26            --            26
                                                -------       -------       -------

Balance at March 31, 2005                        41,638        (1,406)       64,731
                                                =======       =======       =======
</TABLE>

        See accompanying notes to the consolidated financial statements.


                                       4
<PAGE>

                     1st State Bancorp, Inc. and Subsidiary
                      Consolidated Statements of Cash Flows
                For the Six Months Ended March 31, 2005 and 2004
                                   (Unaudited)
                                 (In Thousands)

<TABLE>
<CAPTION>
                                                                                 For the Six Months Ended
                                                                                        March 31,
                                                                                 ------------------------
                                                                                    2005          2004
                                                                                  --------      --------
<S>                                                                               <C>           <C>
Cash flows from operating activities:
   Net income                                                                     $  1,736      $  1,537
   Adjustment to reconcile net income to net cash provided by
     operating activities:
       Provision for loan losses                                                       390            60
       Depreciation                                                                    324           342
       Deferred tax benefit                                                           (212)          (51)
       Amortization of premiums and discounts, net                                     (22)            6
       Deferred compensation                                                           120           120
       Release of ESOP shares                                                          400           420
       Loan origination fees and unearned discounts
         deferred, net of current amortization                                         (23)          (26)
       Gain on sale of other real estate                                                (9)          (12)
       Loss (gain) on sale of investment securities available for sale                   2          (185)
       Net loss on sale of loans                                                        26            27
       Proceeds from loans held for sale                                            11,504        13,544
       Originations of loans held for sale                                         (12,575)      (14,170)
       Decrease (increase) in other assets                                            (934)          (12)
       Decrease (increase) in accrued interest receivable                              (14)           81
       Increase (decrease) in other liabilities                                        673           (26)
                                                                                  --------      --------

          Net cash provided by operating activities                                  1,386         1,655
                                                                                  --------      --------

Cash flows provided by (used in) investing activities:
       Proceeds from redemption of FHLB stock                                        4,045         1,975
       Purchases of FHLB stock                                                      (3,518)       (1,725)
       Purchases of investment securities held to maturity                          (4,564)       (6,368)
       Purchases of investment securities available for sale                            --       (30,575)
       Proceeds from sales of investment securities available for sale               1,944        10,993
       Proceeds from maturities and issuer calls of investment securities
           available for sale                                                        7,000        26,969
       Proceeds from maturities and issuer calls of investment securities
           held to maturity                                                          3,001         4,002
       Net increase in loans receivable                                             (3,190)       (5,121)
       Purchase of real estate acquired in settlement of loans                          --          (250)
       Purchases of premises and equipment net of disposals                            (68)         (182)
         Proceeds from disposal of real estate acquired in settlement of loans          18            --
                                                                                  --------      --------

          Net cash provided by (used in) investing activities                        4,668          (282)
                                                                                  --------      --------

</TABLE>
                                                                     (Continued)


                                       5
<PAGE>

                     1st State Bancorp, Inc. and Subsidiary
                Consolidated Statements of Cash Flows - Continued
                For the Six Months Ended March 31, 2005 and 2004
                                   (Unaudited)
                                 (In Thousands)

<TABLE>
<CAPTION>
                                                                           For the Six Months Ended
                                                                                   March 31,
                                                                           ------------------------
                                                                              2005          2004
                                                                           ----------    ----------
<S>                                                                        <C>           <C>
Cash flows from financing activities:
   Net increase in deposits                                                $   16,035    $    1,701
   Advances from the Federal Home Loan Bank                                    80,000        54,000
   Repayments of advances from the Federal Home Loan Bank                    (100,500)      (57,000)
   Purchase of treasury stock                                                  (2,095)         (663)
   Exercise of stock options                                                       80            19
   Dividends paid on common stock                                                (560)         (562)
   Increase in advance payments by borrowers for
     property taxes and insurance                                                 162           158
                                                                           ----------    ----------

   Net cash used in financing activities                                       (6,878)       (2,347)
                                                                           ----------    ----------

        Net decrease in cash and cash equivalents                                (824)         (974)

Cash and cash equivalents at beginning of period                                9,854         9,359
                                                                           ----------    ----------

Cash and cash equivalents at end of period                                 $    9,030    $    8,385
                                                                           ==========    ==========

Payments are shown below for the following:
       Interest                                                            $    2,702    $    2,420
                                                                           ==========    ==========

       Income taxes                                                        $    1,355    $    1,276
                                                                           ==========    ==========

Noncash investing and financing activities:

     Unrealized gains (losses) on investment securities
          available for sale                                               $   (1,617)   $      863
                                                                           ==========    ==========

     Cash dividends declared but not paid                                  $      290    $      280
                                                                           ==========    ==========

     Cash dividends on unallocated ESOP shares                             $       26    $       32
                                                                           ==========    ==========

     Transfer from loans to real estate acquired in settlement of loans    $      168    $       --
                                                                           ==========    ==========
</TABLE>

See accompanying notes to the consolidated financial statements.


                                       6
<PAGE>

                     1st State Bancorp, Inc. and Subsidiary
                   Notes to Consolidated Financial Statements
                March 31, 2005 (unaudited) and September 30, 2004

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,  2004,  which is
derived from the September 30, 2004 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 sixth month  periods  ended
March 31, 2005 are not necessarily  indicative of the results of operations that
may be expected for the year ending  September  30,  2005.  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 six months
ended March 31, 2005 and 2004. A reconciliation of the denominators of the basic
and diluted earnings per share computations is as follows:

<TABLE>
<CAPTION>
                                                                 Three Months Ended
                                                                      March 31,
                                                             -------------------------
                                                                2005           2004
                                                             ----------     ----------
<S>                                                           <C>            <C>
Average shares issued and outstanding                         2,932,338      2,963,492
Less: Unallocated ESOP share                                   (120,627)      (149,487)
                                                             ----------     ----------
Average basic shares for earnings per share                   2,811,711      2,814,005
Add: Potential common stock pursuant to stock option plan       150,722        157,118
                                                             ----------     ----------
Average dilutive shares for earnings per share                2,962,433      2,971,123
                                                             ==========     ==========
</TABLE>


                                       7
<PAGE>

<TABLE>
<CAPTION>
                                                                 Six Months Ended
                                                                     March 31,
                                                             -------------------------
                                                                2005           2004
                                                             ----------     ----------
<S>                                                           <C>            <C>
Average shares issued and outstanding                         2,946,344      2,966,391
Less: Unallocated ESOP shares                                  (124,254)      (153,167)
                                                             ----------     ----------
Average basic shares for earnings per share                   2,822,090      2,813,224
Add: Potential common stock pursuant to stock option plan       147,840        152,782
                                                             ----------     ----------
Average dilutive shares for earnings per share                2,969,930      2,966,006
                                                             ==========     ==========
</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 six months  ended  March 31,  2005 and 2004,  7,020 and 7,280 and 14,196 and
14,640 shares of stock were committed to be released and approximately  $202,000
and $215,000 and $401,000 and $420,000,  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  2004 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 each of the  three and six  months
ended  March 31,  2005 and 2004 was $60,000  and  $120,000,  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 5,423 options  exercised during each of the three and six
months ended March 31, 2005,  respectively.  No options were granted  during the
three and six months ended March 31, 2005 and 2004.  At March 31, 2005,  308,812
options are outstanding, all of which are exercisable.


                                       8
<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 March 31, 2005 and September 30,
2004,  MSRs  totaled  $469,000  and  $493,000,  respectively,  and no  valuation
allowance was required.

      Amortization  expense totaled $48,000 and $57,000 for the six months ended
March 31, 2005 and 2004, 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 March 31,  2005 is $1.9  million.  At March 31,  2005,  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.

Note 9. Investments

The following table provides additional  information regarding unrealized losses
as of March 31, 2005,  none of which relate to securities  that are deemed to be
other than temporarily  impaired.  The table is segregated into investments that
have been in a continuous  unrealized  loss position for less than 12 months and
those that have been in a continuous  unrealized  loss position for more than 12
months.

<TABLE>
<CAPTION>
                            Less than 12 months       12 months or more              Total
                           ---------------------    ---------------------    ---------------------
                             Fair     Unrealized      Fair     Unrealized      Fair     Unrealized
                             value      losses        value      losses        value      losses
                           --------   ----------    --------   ----------    --------   ----------
<S>                        <C>             <C>        <C>           <C>        <C>           <C>
Held to maturity:
  U.S. Government and
    agency securities$       11,388        (199)       6,794        (199)      18,182        (398)
  Municipal bonds             2,182         (77)          --          --        2,182         (77)
  Collaterized mortgage
    obligations                  --          --           --          --           --          --
                           --------    --------     --------    --------     --------    --------
              Total        $ 13,570        (276)       6,794        (199)      20,364        (475)
                           ========    ========     ========    ========     ========    ========
Available for sale:
  U.S. Government and
    agency securities      $ 41,596        (851)      44,538      (1,459)      86,134      (2,310)
                           ========    ========     ========    ========     ========    ========
</TABLE>

In the above table, all of the unrealized  losses are the result of increases in
the interest rates and not because of credit quality  concerns.  Therefore,  the
Company expects to collect the full par value of each bond upon maturity with no
accounting loss.


                                       9
<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 home
equity lines of credit,  which have shorter terms and adjust more  frequently to
changes in interest rates than single-family  residential  mortgage loans. These
loans 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.


                                       10
<PAGE>

      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.  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, 2004, which was filed
on the Company's  Annual Report on Form 10-K for the fiscal year ended September
30, 2004. 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.

Comparison of Financial Condition at March 31, 2005 and September 30, 2004

      Total assets  decreased  $4.9 million from $377.7 million at September 30,
2004 to $372.8 million at March 31, 2005.  During the six months ended March 31,
2005,  the  Company's  loan  growth  was  more  than  offset  by a  decrease  in
investments.  The Company shrank its investment  portfolio by applying  proceeds
from investment calls to reduce overnight borrowings.  The Company grew deposits
by $16.0  million  during the six months ended March 31,  2005,  the proceeds of
which  were also  applied  to  reduce  overnight  borrowings.  The  Company  was
successful in attracting  retail  certificates  of deposit as an  alternative to
short term  borrowings  from the FHLB of Atlanta as part of its asset  liability
strategy.

      Investment  securities  available  for sale  decreased  $10.6 million from
$96.7 million at September  30, 2004 to $86.1 million at March 31, 2005.  During
the six months ended March 31, 2005,  we received  $8.9 million in proceeds from
maturities,  sales and issuer calls of investment  securities available for sale
and  did not  purchase  any  investments  available  for  sale.  Interest  rates
increased  during the six months ended March 31, 2005 which caused the Company's
gross  unrealized loss on investment  securities  available for sale to increase
from  $693,000  at  September  30,  2004 to $2.3  million  at  March  31,  2005.
Investment securities held to maturity increased $1.6 million from $22.9 million
at September 30, 2004 to $24.5 million at March 31, 2005.  During the six months
ended March 31, 2005, we purchased  $4.6 million of securities and received $3.0
million in proceeds from  maturities  and issuer calls of investment  securities
held to maturity.  As interest rates have  increased,  the Company has purchased
fewer fixed-rate securities.

      Loans  held for sale  increased  to $2.0  million  at March 31,  2005 from
$930,000 at  September  30, 2004.  The increase in loans held for sale  resulted
from timing  differences  in the funding of loan sales.  Loans  receivable,  net
increased  from $231.8  million at September 30, 2004 to $234.4 million at March
31, 2005.  The  Company's  mortgage  originations  have been slower this year 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.

      Other assets  increased  from $3.2  million at September  30, 2004 to $5.0
million at March 31, 2005.  Included in other assets is the  Company's  deferred
tax asset  which  increased  from $2.6  million at  September  30,  2004 to $3.4
million at March 31, 2005. Most of this increase was related to the deferred tax
on the  increase  in the  unrealized  increase in the gross  unrealized  loss on
investment securities available for sale.

      Stockholders'  equity  decreased  by $1.2  million  from $65.9  million at
September  30, 2004 to $64.7 million at March 31, 2005 as a result of net income
of $1.7  million and the release of ESOP shares of $400,000 and $80,000 from the
exercise  of stock  options.  These  increases  were  partially  offset  by cash
dividends to stockholders  declared of $560,000,  purchases of treasury stock of
$1.8 million,  and an increase in the net unrealized  loss on available for sale
securities of $1.0


                                       11
<PAGE>

million.  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 March 31, 2005 and
2004

      Net Income. We recorded net income of $884,000 for the quarter ended March
31,  2005,  as  compared  to $779,000  for the  quarter  ended  March 31,  2004,
representing an increase of $105,000, or 13.5%. For the three months ended March
31,  2005,   basic  and  diluted  earnings  per  share  were  $0.31  and  $0.30,
respectively,  compared  to the basic  and  diluted  earnings  per share for the
quarter ended March 31, 2004 of $0.28 and $0.26,  respectively.  The increase in
net income  resulted  primarily  from  increased  net interest  income which was
offset partially by decreased other income and increased income tax expense. The
increase in net interest  income  resulted  from growth in net  interest-earning
assets and higher net interest margins.  The average prime interest rate for the
quarter  ended  March 31, 2005 was 5.58%,  an increase of 158 basis  points from
4.00%,  which was the average  prime for the quarter  ended March 31, 2004.  The
repricing of loans and investments  increased the Company's  average asset yield
by 51 basis points  whereas the average cost of funds  increased 36 basis points
during the quarter ended March 31, 2004.

      Net Interest Income.  Net interest income, the difference between interest
earned  on  loans  and  investments   and  interest  paid  on   interest-bearing
liabilities, increased by $289,000 or 10.5% for the three months ended March 31,
2005, compared to the same quarter in the prior year. This increase results from
a $558,000 increase in interest income that was partially offset by the $269,000
increase  in total  interest  expense.  The  average  net  interest  rate spread
increased  15 basis  points from 2.93% for the three months ended March 31, 2004
to 3.08% for the quarter ended March 31, 2005.

      Interest  Income.  The  increase in interest  income for the three  months
ended March 31,  2005 was the result of a increase in yield on  interest-earning
assets of 51 basis  points from 4.64% for the three  months ended March 31, 2004
to 5.15% for the three  months  ended  March 31,  2005 as well as an increase of
$9.8 million in average  interest-earning assets compared to the same quarter in
the prior  year.  Average  loans  receivable  increased  $4.6  million,  average
investment  securities  increased  $5.4  million,  and average  interest-bearing
overnight funds  decreased  $246,000.  The increase in average  interest-earning
assets increased  interest income by approximately  $112,000 and the increase in
the average asset yield increased interest income by approximately $446,000.

      Interest  Expense.  Interest  expense  increased in the three months ended
March 31, 2005 due to an increase in the cost of interest-bearing liabilities of
36 basis  points from 1.71% for the three  months  ended March 31, 2004 to 2.07%
for the three months ended March 31, 2005 which was combined with an increase in
average  interest-bearing  liabilities of $3.9 million. Average interest-bearing
deposits  increased by $9.0 million while average FHLB advances  decreased  $5.1
million for the three months  ended March 31, 2005  compared to the same quarter
in the prior year.  The average  cost of the FHLB  advances  increased  82 basis
points to 4.83% for the three months ended March 31, 2005 from the 4.01% for the
three months ended March 31, 2004. This increase  reflects the increase in short
term interest rates as well and the impact of lower short term borrowings during
the quarter ended March 31, 2005 compared to the same quarter in the prior year.
Short term borrowings averaged $5.2 million for the quarter ended March 31, 2005
compared to an average of $10.3  million for the quarter  ended March 31,  2004.
The cost of the short term  borrowings  is less than the average cost of the $20
million long term advance. The increase in average interest-bearing  liabilities
increased  interest  expense by  approximately  $16,000 and the  increase in the
average  cost of  interest-bearing  liabilities  increased  interest  expense by
approximately $253,000.


                                       12
<PAGE>

         The following table presents average balances and average rates
earned/paid by the Company for the quarter ended March 31, 2005 compared to the
quarter ended March 31, 2004.

<TABLE>
<CAPTION>
                                                              Three Months Ended                   Three Months Ended
                                                                March 31, 2005                       March 31, 2004
                                                       ---------------------------------    ---------------------------------
                                                                              (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) ..............................    $234,306    $  3,339        5.70%    $229,683    $  2,830        4.93%
Investment securities (2) .........................     113,207       1,152        4.07      107,811       1,116        4.14
Interest-bearing overnight deposits ...............       3,310          21        2.52        3,556           8        0.91
                                                       --------    --------    --------     --------    --------    --------
     Total interest-earning assets (4) ............     350,823       4,512        5.15      341,050       3,954        4.64
Non interest-earning assets .......................      20,750                               20,970
                                                       --------                             --------
     Total assets .................................    $371,573                             $362,020
                                                       ========                             ========

Liabilities and stockholders' equity
Interest bearing checking .........................      35,073          23        0.27       35,538          18        0.21
Money market investment accounts ..................      16,818          40        0.95       19,212          32        0.66
Passbook and statement savings ....................      29,375          53        0.72       29,834          45        0.60
Certificates of deposit ...........................     175,835       1,038        2.36      163,530         791        1.93
FHLB advances .....................................      25,150         304        4.83       30,280         303        4.01
                                                       --------    --------    --------     --------    --------    --------
     Total interest-bearing liabilities ...........     282,251       1,458        2.07      278,394       1,189        1.71
Non interest-bearing liabilities ..................      23,553                               19,822
                                                       --------                             --------
     Total liabilities ............................     305,804                              298,216
Stockholders' equity ..............................      65,769                               63,804
                                                       --------                             --------
     Total liabilities and stockholders' equity ...    $371,573                             $362,020
                                                       ========                             ========

Net interest income ...............................                $  3,054                             $  2,765
                                                                   ========                             ========
Interest rate spread ..............................                                3.08%                                2.93%
                                                                               ========                             ========
Net interest margin (3) ...........................                                3.48%                                3.24%
                                                                               ========                             ========
Ratio of average interest-earning assets to
  average interest-bearing liabilities . ..........                              124.89%                              122.51%
                                                                               ========                             ========
</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)   Represents  net  interest   income  divided  by  the  average  balance  of
      interest-earning assets.

(4)   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.

      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 estimate  the  allowance  using an
allowance  for loan losses  model which  takes into  consideration  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
$350,000 for the three months ended March 31, 2005  compared with a provision of
$60,000,  and net  charge-offs  of $36,000 for the three  months ended March 31,
2005. The  charge-offs  for the three months ended March 31, 2005 related to two
unrelated  non-performing  loans  with  total  exposure  at  March  31,  2005 of
$170,000. Nonperforming loans at March 31, 2005 and September 30, 2004 were $2.6
million  and  $4.0  million,   respectively.   Approximately   $2.2  million  of
nonperforming  loans at March 31, 2005  consist of one


                                       13
<PAGE>

commercial  relationship  which  is not  necessarily  indicative  of the  credit
quality of the entire portfolio. See "- Asset Quality" for further information.

      Other Income.  Other income decreased $130,000 from $590,000 for the three
months  ended March 31, 2004 to $460,000  for the three  months  ended March 31,
2005. Mortgage banking income, net decreased $25,000 from $113,000 for the three
months  ended  March 31, 2004 to $88,000  for the three  months  ended March 31,
2005. The lower fee income  reflects lower loan volumes.  We sold loans totaling
$5.4  million in the three months  ended March 31, 2005  compared  with sales of
$6.7 million in the previous year for the comparable  period.  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 $36,000
to $57,000  for the  quarter  ended  March 31,  2005  compared  with the $93,000
reported in the prior year for the  comparable  period.  This  decrease  was the
result of decreased  sales of annuities and mutual funds compared with the prior
year. The Company recorded gains on sales of investments of $88,000 in the three
months  ended March 31, 2004  compared to a loss of $2,000 for the three  months
ended March 31, 2005

      Operating Expenses. Total operating expenses were $2.1 million for each of
the three  months  ended March 31,  2005 and 2004.  The Company has been able to
control  expenses  during this period of slower asset  growth and lower  lending
volumes.

      Income Tax Expense.  Income tax expense increased $33,000 from tax expense
of $460,000  for the three months ended March 31, 2004 to $493,000 for the three
months ended March 31, 2005.  The  effective  tax rates were 35.8% and 37.1% for
the three  months ended March 31, 2005 and 2004,  respectively.  The decrease in
the effective tax rate was primarily due to a relative decrease in nondeductible
expenses and an increase in tax exempt income compared to the prior year.

Comparison of Operating Results for the Six Months Ended March 31, 2005 and 2004

      Net  Income.  We  recorded  net income of $1.7  million for the six months
ended March 31, 2005,  an increase of  $200,000,  or 13.3% over the $1.5 million
reported in the six months ended March 31, 2004.  For the six months ended March
31,  2005,   basic  and  diluted  earnings  per  share  were  $0.62  and  $0.58,
respectively.  The Company reported basic and diluted earnings per share for the
six months ended March 31, 2004 of $0.55 and $0.52,  respectively.  The increase
in net income  resulted  primarily from increased net interest  income which was
partially  offset by increased  provision for loan losses and  increased  income
taxes.  The  increase in the net  interest  income  resulted  from  improved net
interest  margins and increased net interest  earning assets.  The average prime
interest rate for the six months ended March 31, 2005 was 5.25%,  an increase of
125 basis  points  from 4.00%,  which was the  average  prime for the six months
ended March 31, 2004. The rate increase caused a greater increase 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,  increased  by $545,000 or 9.8% for the six months  ended March 31,
2005,  compared to the same six months in the prior year. This increase reflects
an  $849,000  increase  in  interest  income  that was  partially  offset by the
$304,000  increase in total  interest  expense.  The average net  interest  rate
spread  increased  15 basis points from 2.95% for the six months ended March 31,
2004 to 3.10% for the six months ended March 31, 2005.

      Interest Income.  The increase in interest income for the six months ended
March 31, 2005 was due to a increase in yield on  interest-earning  assets of 33
basis points from 4.70% for the six months ended March 31, 2004 to 5.03% for the
six months ended March 31, 2005  combined  with an increase of $11.3  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  $263,000 and the increased  yield  increased  interest
income by  approximately  $586,000.  Average  loans  receivable  increased  $5.7
million and average investment  securities  increased $5.7 million compared with
the prior  year.  This  increase  was offset in part by a decrease  of  $150,000
million in average interest-bearing overnight funds.

      Interest Expense. Interest expense increased in the six months ended March
31, 2005 due to an increase in the cost of  interest-bearing  liabilities  of 18
basis points from 1.75% for the six months ended March 31, 2004 to 1.93% for the
six months  ended March 31, 2005  combined  with an increase of $4.7  million in
average interest-bearing liabilities. Average deposits increased by $6.7 million
and average FHLB advances  decreased $2.1 million for the six months ended March
31,


                                       14
<PAGE>

2005 compared to the same six months in the prior year.  The increase in average
interest-bearing liabilities increased interest expense by approximately $10,000
and the increase in the average cost of interest-bearing  liabilities  increased
interest expense by approximately $294,000.

      The  following   table  presents   average   balances  and  average  rates
earned/paid  by the Company for the six months ended March 31, 2005  compared to
the six months ended March 31, 2004.

<TABLE>
<CAPTION>
                                                                  Six Months Ended                       Six Months Ended
                                                                   March 31, 2005                         March 31, 2004
                                                        ------------------------------------    ------------------------------------
                                                                                  (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) ...............................    $ 233,431    $   6,461         5.54%    $ 227,691    $   5,684         4.99%
Investment securities (2) ..........................      114,578        2,350         4.10       108,883        2,300         4.22
Interest-bearing overnight deposits ................        3,636           39         2.14         3,786           17         0.91
                                                        ---------    ---------    ---------     ---------    ---------    ---------
     Total interest-earning assets (4) .............      351,645        8,850         5.03       340,360        8,001         4.70
Non interest-earning assets ........................       20,229                                  20,879
                                                        ---------                               ---------
     Total assets ..................................    $ 371,874                               $ 361,239
                                                        =========                               =========

Liabilities and stockholders' equity
Interest bearing checking ..........................       35,645           47         0.26        35,822           38         0.21
Money market investment accounts ...................       17,734           83         0.94        19,406           65         0.67
Passbook and statement savings .....................       29,846          102         0.69        30,095           92         0.61
Certificates of deposit ............................      169,125        1,836         2.17       160,301        1,610         2.01
FHLB advances ......................................       29,813          660         4.43        31,863          619         3.89
                                                        ---------    ---------    ---------     ---------    ---------    ---------
     Total interest-bearing liabilities ............      282,163        2,728         1.93       277,487        2,424         1.75
Non interest-bearing liabilities ...................       23,766                                  20,401
                                                        ---------                               ---------
     Total liabilities .............................      305,929                                 297,888
Stockholders' equity ...............................       65,945                                  63,351
                                                        ---------                               ---------
     Total liabilities and stockholders' equity ....    $ 371,874                               $ 361,239
                                                        =========                               =========

Net interest income ................................                 $   6,122                               $   5,577
                                                                     =========                               =========
Interest rate spread ...............................                                   3.10%                                   2.95%
                                                                                  =========                               =========
Net interest margin (3) ............................                                   3.48%                                   3.28%
                                                                                  =========                               =========
Ratio of average interest-earning assets to
  average interest-bearing liabilities .............                                 124.62%                                 122.66%
                                                                                  =========                               =========
</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)   Represents  net  interest   income  divided  by  the  average  balance  of
      interest-earning assets.

(4)   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.

      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,  non-performing
loans,  prior  loan  loss  experience,  general  economic  conditions  and other
factors.  Provisions for loan losses  totaled  $390,000 and $120,000 for the six
months  ended  March 31, 2005 and 2004,  respectively.  The  provision  for loan
losses was impacted by the increase the loan  charge-offs.  Net loan charge-offs
for the six months  ended March 31,  2005 and 2004 were  $650,000  and  $84,000,
respectively.  The most significant  chargeoff during the six months ended March
31, 2005 totaled  $620,000  related to one credit,  the balance of which has now
been reduced to $40,000.


                                       15
<PAGE>

      Other  Income.  Other  income was $1.1  million for each of the six months
ended March 31, 2005 and 2004, respectively.  Customer fees increased $96,000 to
$542,000  for the six months  ended March 31, 2005  compared  with the  $446,000
reported in the prior year.  This  increase was the result of increased  deposit
service charges and loan late charges compared with the prior year.  Commissions
from sales of annuities and mutual funds decreased $41,000 from $165,000 for the
six months  ended March 31, 2004 to $124,000  for the six months ended March 31,
2005. This decrease  results from lower sales of annuities and mutual funds. The
Company  recorded  gains on sales of  investments  of $185,000 in the six months
ended March 31, 2004  compared to a loss of $2,000 in the six months ended March
31, 2005.  Included in other income for the six months ended March 31, 2005 is a
recovery of $85,000 for a non-credit loss that had been charged to earnings in a
prior  year  that  did not  result  in any  loss to the  Company.  Other  income
increased  from $109,000 for the six months ended March 31, 2004 to $232,000 for
the six months ended March 31, 2005 primarily as a result of this recovery.

      Operating  Expenses.  Total operating  expenses were $4.1 million and $4.2
million  for the six months  ended March 31,  2005 and 2004,  respectively.  The
Company has been able to control  expenses  during  this period of slower  asset
growth.

      Income Tax Expense.  Income tax expense increased $83,000 from tax expense
of $877,000  million for the six months ended March 31, 2004 to $960,000 for the
six months ended March 31, 2005.  The  effective  tax rates were 35.6% and 36.3%
for the six months ended March 31, 2005 and 2004, respectively.  The decrease in
the  effective  rate was  primarily  due to an  increase  in the  ratio of state
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.

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

<TABLE>
<CAPTION>
                                                      March 31, 2005   September 30, 2004
                                                      --------------   ------------------
                                                               (In thousands)
<S>                                                       <C>               <C>
Commitments to originate new loans                        $ 6,754           $ 2,177
Commitments to originate new loans held for sale              158                --
Unfunded commitments to extend credit under existing
   equity line and commercial lines of credit              59,205            55,357
Commercial letters of credit                                1,871             2,055
Commitments to sell loans held for sale                     1,762             2,174
</TABLE>

      Commitments  to originate new loan include two unrelated  commercial  real
estate  loans  totaling  $6.0  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 amount 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 March 31, 2005, the aggregate fair value
of these commitments exceeded the book value of the loans to be sold.


                                       16
<PAGE>

Contractual Obligations

As of March 31, 2005:

<TABLE>
<CAPTION>
                                               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                     $ 243,492    $  24,550    $  10,727    $       0    $ 278,769
Advances from
   Federal Home Loan Bank        3,500       20,000            0            0       23,500
Lease obligations                   20           42           42            5          109
                             ---------    ---------    ---------    ---------    ---------
Total contractual cash
    obligations              $ 247,012    $  44,592    $  10,769    $       5    $ 302,378
                             =========    =========    =========    =========    =========
</TABLE>

Asset Quality

      At  March  31,  2005,  the  Company  had  approximately  $2.8  million  in
nonperforming  assets (nonaccrual loans and real estate owned) or 0.75% of total
assets. At September 30, 2004,  nonperforming  assets were $4.0 million or 1.05%
of total  assets.  At March 31, 2005 and  September  30,  2004,  impaired  loans
totaled $2.4 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 most significant impaired loans at March 31, 2005 results from a
commercial  loan customer who has loans  secured by  commercial  real estate and
business assets in Alamance  County.  At March 31, 2005,  these balances totaled
$2.2 million.  At March 31, 2005,  the entire $2.4 million of the impaired loans
are on non-accrual status. The average carrying value of impaired loans was $2.8
million during the six months ended March 31, 2005.  Interest  income of $63,000
has been recorded on impaired  loans in the six months ended March 31, 2005. The
Bank's net  charge-offs  for the six months ended March 31, 2005 were  $650,000.
The Bank's  allowance for loan losses was $3.7 million and $4.0 million at March
31, 2005 and  September 30, 2004,  respectively,  and the ratio of the allowance
for loan losses to total loans,  net of loans in process and deferred  loan fees
was 1.55% and 1.68% at March 31, 2005 and September 30, 2004, respectively.  The
ratio decrease is appropriate in light of the decrease in  nonperforming  assets
at March 31, 2005 compared to September 30.2004.

      The following table presents an analysis of our nonperforming assets:

<TABLE>
<CAPTION>
                                                        Dollars in thousands

                                                    At            At            At
                                                 March 31,   September 30,   March 31,
                                                   2005          2004          2004
                                                  ------        ------        ------
<S>                                               <C>           <C>           <C>
Non-performing loans:
  Nonaccrual loans                                $2,615        $3,962        $3,951
  Loans 90 days past due and accruing                 --            --            --
  Restructured loans                                  --            --            --
                                                  ------        ------        ------
    Total non-performing loans                     2,615         3,962         3,951
Other real estate                                    168            17           513
                                                  ------        ------        ------
    Total non-performing assets                   $2,783        $3,979        $4,464
                                                  ======        ======        ======

Non-performing loans to loans receivable, net       1.19%         1.72%         1.71%
Non-performing assets as a percentage
  of loans and other real estate owned              1.19%         1.72%         1.93%
Non-performing assets to total assets               0.75%         1.05%         1.23%

</TABLE>

                                       17
<PAGE>

      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 March 31, 2005, we had $3.2 million in
classified  assets  consisting of $3.1 million in substandard  loans,  $7,000 in
loans  classified  as loss and $168,000 in real estate  owned.  At September 30,
2004,  we had $4.7 million in  classified  assets  consisting of $4.7 million in
substandard  loans and $17,000 in real estate  owned.  At March 31, 2004, we had
$5.0 million in  classified  assets  consisting  of $4.5 million in  substandard
loans, $24,000 in loss loans and $513,000 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 March 31, 2005,  we have  identified  approximately  $4.9 million in
assets  classified as special  mention and $25.2 million as watch.  At March 31,
2004,  we had  identified  approximately  $5.3 million in assets  classified  as
special mention and $29.3 million as watch.

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
March 31, 2005, 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.

      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 March 31, 2005, cash and cash equivalents
totaled  $9.0  million.  We have  other  sources  of  liquidity  should  we need
additional funds.  During the three and six months ended March 31, 2005, we sold
loans totaling $5.4 million and $11.5 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
$88.1 million at March 31, 2005.

      We anticipate  that we will have  sufficient  funds  available to meet our
current  commitments.  At March 31, 2005, we had $6.9 million in  commitments to
originate  new loans,  $59.2  million in unfunded  commitments  to extend credit
under existing  equity lines and commercial  lines of credit and $1.9 million in
standby letters of credit. At March 31, 2005, certificates of deposit, which are
scheduled to mature within one year,  totaled $145.1 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  March  31,  2005  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 March 31, 2005, the Company
was in compliance with the capital requirements of the Federal Reserve.

      The  Company's  equity to asset  ratio at March 31,  2005 was  17.4%.  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 March 31, 2005,  December 31, 2004 and March 31, 2004.
The Company's ability to pay dividends is dependent upon earnings.


                                       18
<PAGE>

The Company's  dividend  payout ratio for the three months ended March 31, 2005,
September 30, 2004 and March 31, 2004 was 33.3%, 31.3% and 38.5%, 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.
FASB deferred the effective date of FIN 46 to no later than the end of the first
reporting period that ends after March 15, 2004. The application of this revised
interpretation  is not  expected to have a material  effect on the  consolidated
financial statements.

      On  September  30,  2004,  the FASB  issued  FASB Staff  Position  ("FSP")
Emerging Issues Task Force ("EITF") Issue No. 03-1-1 delaying the effective date
of  paragraphs  10-20  of  EITF  03-1,  "The  meaning  of   Other-Than-Temporary
Impairment and Its Application to Certain Investments",  which provides guidance
for  determining  the  meaning  of  "other-than-temporarily  impaired"  and  its
application to certain debt and equity  securities  within the scope of SFAS No.
115,  "Accounting for Certain  Investments in Debt and Equity  Securities",  and
investments  accounted  for under the cost method.  The guidance  requires  that
investments which have declined in value due to credit concerns or solely due to
changes in interest  rates must be recorded as other than  temporarily  impaired
unless the Company can  demonstrate  its  intention  to hold the  security for a
period of time  sufficient to allow for a recovery of fair value up to or beyond
the cost of the investment which might mean maturity. The delay of the effective
date of EITF 03-1 will be  superceded  concurrent  with the  final  issuance  of
proposed  FSP Issue  03-1-a.  Proposed  FSP Issue  03-1-a is intended to provide
implementation  guidance with respect to all securities  analyzed for impairment
under paragraphs 10-20 of EITF 03-1. Management continues to closely monitor and
evaluate how the  provisions of EITF 03-1 and proposed  Issue 03-1-a will affect
the Company.

      On  December  16,  2004,  the  FASB  issued  SFAS No.  123R,  "Share-Based
Payment," which is an Amendment of FASB Statement Nos. 123 and 95. SFAS No. 123R
changes, among other things, the manner in which share-based compensation,  such
as  stock  options,  will be  accounted  for and  will  be  effective  as of the
beginning of the first interim or annual reporting period that begins after June
15,  2005.  The cost of  employee  services  received  in  exchange  for  equity
instruments  including  options and  restricted  stock awards  generally will be
measured  at fair  value at the grant  date.  The grant  date fair value will be
estimated using option-pricing models adjusted for the unique characteristics of
those options and instruments,  unless  observable market prices for the same or
similar  options are available.  The cost will be recognized  over the requisite
service period, often the vesting period, and will be remeasured subsequently at
each reporting date through settlement date.

      The changes in accounting will replace  existing  requirements  under SFAS
No. 123,  "Accounting  for  Stock-Based  Compensation,"  and will  eliminate the
ability to account for share-based  compensation  transactions using ABP Opinion
No. 25,  "Accounting  for Stock  Issued to  Employees,"  which does not  require
companies to expense options if the exercise price is equal to the trading price
at the date of grant. The accounting for similar transactions  involving parties
other than employees or the accounting for employee stock  ownership  plans that
are subject to American  Institute of  Certified  Public  Accountants  ("AICPA")
Statement of Position 93-6,  "Employers' Accounting for Employee Stock Ownership
Plans," would remain unchanged.


                                       19
<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, 2004. The Company does not believe that any material changes
in market risk exposures have occurred since September 30, 2004.

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.

      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.


                                       20
<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.  Management  does not anticipate  that this
lawsuit will have a material adverse impact on the Company's financial condition
or results of operations.

      The Bank has been named as a co-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 had previously had loans
outstanding  from the Bank.  During the quarter ended  December 31, 2004,  these
loans  were paid off in full.  Included  in part of  plaintiffs'  complaint  are
allegations  related to loans made by the Bank to the  borrowers.  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.

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

      (a)   Not applicable

      (b)   Not applicable

      (c)   The following table sets forth  information  regarding the Company's
            repurchases  of its common stock during the quarter  ended March 31,
            2005.


                                       21
<PAGE>

<TABLE>
<CAPTION>
                                                                                        (d)
                                                                    (c)               Maximum
                                                                   Total             Number of
                                    (a)                          Number of         Shares that May
                                   Total           (b)        Shares Purchased    Yet Be Purchased
                                 Number of       Average     as Part of Publicly       Under
                                   Shares      Price Paid      Announced Plans      the Plans or
         Period                  Purchased      per Share        or Programs         Programs
         ------                  ---------      ---------        -----------         --------
<S>                                 <C>           <C>               <C>              <C>
January 2005                        6,154         $28.59            6,154            284,128(1)
Beginning date: January 1
Ending date: January 31

February 2005                      33,132         $29.03           33,132            250,996(1)
Beginning date: February 1
Ending date: February 28

March 2005                         18,993         $28.03           18,993            232,003(1)
Beginning date: March 1
Ending date: March 31

Total                              58,279         $28.66           58,279
</TABLE>

(1) On November 17, 2004, the Company  announced a 10% stock repurchase  program
to  acquire  up to  296,232  shares of the  company's  stock over a period of 24
months. These share purchases were a part of this repurchase program.

Item 3. Defaults Upon Senior Securities

      None.

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

      The Company's Annual Meeting of Stockholders was held on February 8, 2005.
At this meeting, 2,580,427 shares of the Company's common stock were represented
in person or by proxy.

      Stockholders  voted  in  favor  of the  election  of  three  nominees  for
director. The voting results for each nominee were as follows:

                                     Votes In Favor            Votes
             Nominee                  Of Election             Withheld
      ------------------------    --------------------    ----------------
      Richard C. Keziah                2,511,716               68,711
      Ernest A. Koury, Jr.             2,523,918               56,509
      Richard H. Shirley               2,529,112               48,184

      There were no broker non-votes on the matter.

Item 5. Other Information

      None.

Item 6. Exhibits

      The following exhibits are filed herewith:

      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


                                       22
<PAGE>

                                   SIGNATURES

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

                               1st STATE BANCORP, INC.

Date:  May 13, 2005            /s/ James C. McGill
                               -------------------------------------------------
                               James C. McGill
                               President and Chief Executive Officer
                               (Principal Executive Officer)

Date:  May 13, 2005            /s/ A. Christine Baker
                               -------------------------------------------------
                               A. Christine Baker
                               Executive Vice President, Treasurer and Secretary
                               (Principal Financial and Accounting Officer)