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 December 31, 2004

      OR

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

      For the transition period from ______ to ______

                         Commission file number: 0-25859
                                                 -------

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

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

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

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

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

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

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

      As of February 8, 2005,  the issuer had  2,940,119  shares of common stock
issued and outstanding.

<PAGE>

                                    CONTENTS

                                                                            PAGE
                                                                            ----

PART I. FINANCIAL INFORMATION
        ---------------------

Item 1. Financial Statements

        Consolidated Balance Sheets as of December 31, 2004 (unaudited)
             and September 30, 2004 .......................................    2

        Consolidated Statements of Income for the Three Months Ended
             December 31, 2004 and 2003 (unaudited) .......................    3

        Consolidated Statements of Stockholders' Equity and Comprehensive
             Income for the Three Months Ended December 31, 2004 and 2003
             (unaudited) ..................................................    4

        Consolidated Statements of Cash Flows for the Three Months Ended
             December 31, 2004 and 2003 (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 ........   18

Item 4. Controls and Procedures ...........................................   18


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

Item 1. Legal Proceedings .................................................   19

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds .......   19

Item 3. Defaults Upon Senior Securities ...................................   20

Item 4. Submission of Matters to a Vote of Security Holders ...............   20

Item 5. Other Information .................................................   20

Item 6. Exhibits ..........................................................   20

SIGNATURES


                                       1
<PAGE>

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

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

Cash and cash equivalents                                                 $  11,162        $   9,854
Investment securities:
     Held to maturity (fair value of $20,765 and $22,884
         at December 31, 2004 and September 30, 2004, respectively)          20,902           22,919
     Available for sale (cost of $91,388 and $97,386
         at December 31, 2004 and September 30, 2004, respectively)          90,499           96,693
Loans held for sale, at lower of cost or fair value                             913              930
Loans receivable (net of allowance for loan losses of $3,985
     and $3,956 at December 31, 2004 and September 30, 2004,
     respectively)                                                          231,942          231,763
Real estate owned                                                                17               17
Federal Home Loan Bank stock, at cost                                         2,227            2,325
Premises and equipment                                                        7,749            7,884
Accrued interest receivable                                                   2,243            2,124
Other assets                                                                  5,293            3,205
                                                                          ---------        ---------
             Total assets                                                 $ 372,947        $ 377,714
                                                                          =========        =========

             LIABILITIES AND STOCKHOLDERS' EQUITY

Liabilities:
  Deposit accounts                                                          268,432          262,734
  Advances from Federal Home Loan Bank                                       33,500           44,000
  Advance payments by borrowers for property taxes and insurance                123               39
  Dividend payable                                                              296              296
  Other liabilities                                                           4,219            4,731
                                                                          ---------        ---------
           Total liabilities                                                306,570          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;
         2,956,373 and 2,962,323 shares issued and outstanding
         at December 31, 2004 and September 30, 2004, respectively               33               33
   Additional paid-in capital                                                36,096           36,038
   Unallocated ESOP shares                                                   (2,430)          (2,571)
   Deferred compensation payable in treasury stock                            6,700            6,440
   Treasury stock                                                           (14,512)         (14,086)
   Retained income - substantially restricted                                41,031           40,462
   Accumulated other comprehensive loss - net unrealized
         loss on investment securities available for sale                      (541)            (402)
                                                                          ---------        ---------
Total stockholders' equity                                                   66,377           65,914
                                                                          ---------        ---------
         Total liabilities and stockholders' equity                       $ 372,947        $ 377,714
                                                                          =========        =========
</TABLE>

See accompanying notes to the consolidated financial statements.


                                       2
<PAGE>

                     1st State Bancorp, Inc. and Subsidiary
                        Consolidated Statements of Income
              For the Three Months Ended December 31, 2004 and 2003
                      (In Thousands, Except per Share Data)

                                   (Unaudited)

<TABLE>
<CAPTION>
                                                                    For the Three Months Ended
                                                                           December 31
                                                                    --------------------------
                                                                        2004        2003
                                                                       -------     -------
<S>                                                                    <C>         <C>
Interest income:
   Interest and fees on loans                                          $ 3,121     $ 2,854
   Interest and dividends on investments                                 1,198       1,184
   Overnight deposits                                                       18           9
                                                                       -------     -------
           Total interest income                                         4,337       4,047
                                                                       -------     -------

Interest expense:
    Deposit accounts                                                       914         919
    Borrowings                                                             356         316
                                                                       -------     -------
           Total interest expense                                        1,270       1,235
                                                                       -------     -------

           Net interest income                                           3,067       2,812

Provision for loan losses                                                  330          60
                                                                       -------     -------
           Net interest income after provision for loan losses           2,737       2,752
                                                                       -------     -------

Other income:
   Customer service fees                                                   298         205
   Commissions from sales of annuities and mutual funds                     67          72
   Mortgage banking income, net                                            123          98
   Securities gains, net                                                    --          97
   Other                                                                   160          54
                                                                       -------     -------
           Total other income                                              648         526
                                                                       -------     -------

Operating expenses:
   Compensation and related benefits                                     1,283       1,332
   Occupancy and equipment                                                 355         342
   Real estate operations, net                                              (5)         (3)
   Other expenses                                                          433         432
                                                                       -------     -------
           Total operating expenses                                      2,066       2,103
                                                                       -------     -------

           Income before income taxes                                    1,319       1,175

Income taxes                                                               467         417
                                                                       -------     -------

           Net income                                                  $   852     $   758
                                                                       =======     =======

           Earnings per share:

           Basic                                                       $  0.30     $  0.27
           Diluted                                                     $  0.29     $  0.26
</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 Three Months Ended December 31, 2004 and 2003 (Unaudited)
                                 (In Thousands)

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

Comprehensive income:
     Net income                                             --           --            --            --
     Other comprehensive income-unrealized
       Gain on securities available-for-sale, net
       of income taxes of $88                               --           --            --            --

     Total comprehensive income
Allocation of ESOP shares                                   --           61           144            --
Acquisition of treasury stock                               --           --            --            --
Cash dividends declared  ($0.10 per share)                  --           --            --            --
Cash dividends on unallocated ESOP shares                   --           --            --            --
                                                       -------      -------       -------       -------
Balance at December 31, 2003                           $    33       35,839        (2,997)        5,466
                                                       =======      =======       =======       =======

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

Comprehensive income:
     Net income                                             --           --            --            --
     Other comprehensive loss-unrealized
       loss on securities available for sale net
       of income tax benefit of $57                         --           --            --            --

     Total comprehensive income
Allocation of ESOP shares                                   --           58           141            --
Acquisition of treasury stock                               --           --            --            --
Deferred compensation                                                                               260
Cash dividends declared ($0.10 per share)                   --           --            --            --
Cash dividends on unallocated ESOP shares                   --           --            --            --
                                                       -------      -------       -------       -------

Balance at December 31, 2004                           $    33       36,096        (2,430)        6,700
                                                       =======      =======       =======       =======

<CAPTION>
                                                                                 Accumulated
                                                                                    other           Total
                                                      Treasury     Retained     comprehensive   stockholders'
                                                       stock        Income      income (loss)       equity
                                                      --------     --------     -------------   -------------
<S>                                                   <C>            <C>             <C>            <C>
Balance at September 30, 2003                         (12,785)       38,118          (768)          62,701

Comprehensive income:
     Net income                                            --           758            --              758
     Other comprehensive income-unrealized
       Gain on securities available-for-sale, net
       of income taxes of $88                              --            --           135              135
                                                                                                   -------
     Total comprehensive income                                                                        893
Allocation of ESOP shares                                  --            --            --              205
Acquisition of treasury stock                            (161)           --            --             (161)
Cash dividends declared  ($0.10 per share)                 --          (297)           --             (297)
Cash dividends on unallocated ESOP shares                  --            17            --               17
                                                      -------       -------       -------          -------
Balance at December 31, 2003                          (12,946)       38,596          (633)          63,358
                                                      =======       =======       =======          =======

Balance at September 30, 2004                         (14,086)       40,462          (402)          65,914

Comprehensive income:
     Net income                                            --           852            --              852
     Other comprehensive loss-unrealized
       loss on securities available for sale net
       of income tax benefit of $57                        --            --          (139)            (139)
                                                                                                   -------
     Total comprehensive income                                                                        713
Allocation of ESOP shares                                  --            --            --              199
Acquisition of treasury stock                            (166)           --            --             (166)
Deferred compensation                                    (260)                                          --
Cash dividends declared ($0.10 per share)                  --          (296)           --             (296)
Cash dividends on unallocated ESOP shares                  --            13            --               13
                                                      -------       -------       -------          -------

Balance at December 31, 2004                          (14,512)       41,031          (541)          66,377
                                                      =======       =======       =======          =======
</TABLE>

See accompanying notes to the consolidated financial statements.


                                       4
<PAGE>

                     1st State Bancorp, Inc. and Subsidiary
                      Consolidated Statements of Cash Flows
               For the Three Months Ended December, 2004 and 2003
                                   (Unaudited)
                                 (In Thousands)

<TABLE>
<CAPTION>
                                                                                  For the Three Months Ended
                                                                                         December 31,
                                                                                  --------------------------
                                                                                     2004           2003
                                                                                   --------       --------
<S>                                                                                <C>            <C>
Cash flows from operating activities:
   Net income                                                                      $    852       $    758
   Adjustment to reconcile net income to net cash used in
       operating activities:
           Provision for loan losses, net of writeoffs                                   30             12
           Depreciation                                                                 164            227
           Deferred tax expense (benefit)                                              (153)             2
           Amortization of premiums and discounts, net                                  (19)            (2)
           Deferred compensation                                                         60             60
           Release of ESOP shares                                                       199            205
           Loan origination fees and unearned discounts
               deferred, net of current amortization                                     (5)           (16)
           Gain on sale of other real estate                                             (6)            --
           Gain on sale of investment securities available for sale                      --            (97)
           Net (gain) loss on sale of loans                                              (1)            28
           Proceeds from loans held for sale                                          6,056          6,845
           Originations of loans held for sale                                       (6,038)        (7,399)
           Increase in other assets                                                  (1,878)          (320)
           Increase in accrued interest receivable                                     (119)           (85)
           Decrease in other liabilities                                               (306)        (1,241)
                                                                                   --------       --------
                      Net cash used in operating activities                          (1,164)        (1,023)
                                                                                   --------       --------

Cash flows provided by investing activities:
           Proceeds from redemption of FHLB stock                                     2,335          1,025
           Purchases of FHLB stock                                                   (2,237)        (1,250)
           Purchases of investment securities held to maturity                         (966)        (2,373)
           Purchases of investment securities available for sale                         --        (15,828)
           Proceeds from sales of investment securities available for sale               --          3,979
           Proceeds from maturities and issuer calls of investment securities
               available for sale                                                     6,000         17,019
           Proceeds from maturities and issuer calls of investment securities
               held to maturity                                                       3,000              1
           Net increase in loans receivable                                            (204)          (669)
           Purchase of real estate acquired in settlement of loans                       --           (108)
           Purchases of premises and equipment net of disposals                         (29)          (180)
                                                                                   --------       --------

                   Net cash provided by investing activities                          7,899          1,616
                                                                                   --------       --------
</TABLE>

                                                                     (Continued)


                                       5
<PAGE>

                     1st State Bancorp, Inc. and Subsidiary
                Consolidated Statements of Cash Flows - Continued
              For the Three Months Ended December 31, 2004 and 2003
                                   (Unaudited)
                                 (In Thousands)

<TABLE>
<CAPTION>
                                                                            For the Three Months Ended
                                                                                   December 31,
                                                                            --------------------------
                                                                               2004           2003
                                                                             --------       --------
<S>                                                                          <C>            <C>
Cash flows from financing activities:
   Net increase (decrease) in deposits                                       $  5,698       $ (6,333)
   Advances from the Federal Home Loan Bank                                    38,000         32,000
   Repayments of advances from the Federal Home Loan Bank                     (48,500)       (25,500)
   Purchase of treasury stock                                                    (426)          (161)
   Dividends paid on common stock                                                (283)          (280)
   Increase in advance payments by borrowers for
     property taxes and insurance                                                  84             72
                                                                             --------       --------

   Net cash used in financing activities                                       (5,427)          (202)
                                                                             --------       --------

        Net increase in cash and cash equivalents                               1,308            391

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

Cash and cash equivalents at end of period                                   $ 11,162       $  9,750
                                                                             ========       ========

Payments are shown below for the following:
       Interest                                                              $  1,272       $  1,591
                                                                             ========       ========

       Income taxes                                                          $    350       $    269
                                                                             ========       ========

Noncash investing and financing activities:

     Unrealized gains (losses) on investment securities
          available for sale                                                 $   (196)      $    223
                                                                             ========       ========

     Cash dividends declared but not paid                                    $    296       $    280
                                                                             ========       ========

     Cash dividends on unallocated ESOP shares                               $     13       $     17
                                                                             ========       ========

     Transfer from loans to real estate acquired in settlement of loans      $     --       $     70
                                                                             ========       ========
</TABLE>

See accompanying notes to the consolidated financial statements.


                                       6
<PAGE>

                     1st State Bancorp, Inc. and Subsidiary
                   Notes to Consolidated Financial Statements
              December 31, 2004 (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 month period ended  December 31,
2004 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  months ended
December 31, 2004 and 2003. A  reconciliation  of the  denominators of the basic
and diluted earnings per share computations is as follows:

<TABLE>
<CAPTION>
                                                                  Three Months Ended
                                                                     December 31,
                                                              --------------------------
                                                                 2004            2003
                                                              ----------      ----------
<S>                                                            <C>             <C>
Average shares issued and outstanding                          2,959,899       2,969,258
Less: Unallocated ESOP shares                                   (127,764)       (156,807)
                                                              ----------      ----------
Average basic shares for earnings per share                    2,832,135       2,812,451
Add: Potential common stock pursuant to stock option plan        147,440         149,240
                                                              ----------      ----------
Average dilutive shares for earnings per share                 2,979,575       2,961,691
                                                              ==========      ==========
</TABLE>


                                       7
<PAGE>

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
months ended  December  31, 2004 and 2003,  7,176 and 7,360 shares of stock were
committed to be released and approximately $199,000 and $205,000,  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  months  ended
December 31, 2004 and 2003 was $60,000. 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.  No options were  exercised or granted  during the three months ended
December  31,  2004  and  2003.  At  December  31,  2004,  314,235  options  are
outstanding, all of which are exercisable.

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 December 31, 2004 and September
30, 2004,  MSRs totaled  $488,000 and $493,000,  respectively,  and no valuation
allowance was required.

      Amortization  expense  totaled  $23,000 and  $29,000 for the three  months
ended December 31, 2004 and 2003, respectively.


                                       8
<PAGE>

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 December  31, 2004 is $1.9  million.  At December 31, 2004,
the  Company  has  recorded  no  liability  for the  obligation  to perform as a
guarantor.  In addition, no contingent liability is considered necessary as such
amounts are not deemed probable. Substantially all standby letters of credit are
secured  by real  estate  and/or  guaranteed  by third  parties in the event the
Company had to advance funds to fulfill the guarantee.


                                       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


                                       10
<PAGE>

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.

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

Critical Accounting Policies

      The Company's  significant  accounting policies are set forth in Note 1 of
the consolidated  financial statements as of September 30, 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 December 31, 2004 and September 30, 2004

      Total assets  decreased  $4.8 million from $377.7 million at September 30,
2004 to $372.9  million at December 31, 2004.  During the quarter ended December
31, 2004,  loan growth was flat and the Company shrank its investment  portfolio
by applying proceeds from investment calls to reduce overnight  borrowings.  The
Company grew deposits by $5.7 million during the quarter,  the proceeds of which
were also applied to reduce overnight borrowings.

      Investment securities available for sale decreased $6.2 million from $96.7
million at September 30, 2004 to $90.5 million at December 31, 2004.  During the
three months ended  December 31, 2004, we received $6.0 million in proceeds from
maturities  and issuer calls of  investment  securities  available  for sale and
purchased no  investments  available for sale during this time.  Interest  rates
increased  during the three  months  ended  December  31, 2004 which  caused the
Company's gross unrealized loss on investment  securities  available for sale to
increase  from  $693,000 at September 30, 2004 to $889,000 at December 31, 2004.
Investment securities held to maturity decreased $2.0 million from $22.9 million
at September  30, 2004 to $20.9  million at December 31, 2004.  During the three
months ended December 31, 2004, we purchased $966,000 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  decreased  to  $913,000  at  December  31,  2004 from
$930,000 at  September  30, 2004.  The decrease 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 $231.9  million at
December 31, 2004.  During the three  months ended  December 31, 2004,  mortgage
originations  were  considerably  slower than in previous  quarters as refinance
activity continues to slow.


                                       11
<PAGE>

      Stockholders' equity increased by $463,000 from $65.9 million at September
30,  2004 to $66.4  million at  December  31,  2004 as a result of net income of
$852,000  and the  release of ESOP  shares of  $199,000.  These  increases  were
partially  offset  by cash  dividends  to  stockholders  declared  of  $283,000,
purchases of treasury  stock of $166,000,  and an increase in the net unrealized
loss on  available  for sale  securities  of  $139,000.  The increase in the net
unrealized  loss on available for sale  securities  was a result of increases in
interest rates which caused bond prices to decrease.

Comparison of Operating Results for the Three Months Ended December 31, 2004 and
2003

      Net Income.  We  recorded  net income of  $852,000  for the quarter  ended
December 31, 2004,  as compared to $758,000 for the quarter  ended  December 31,
2003,  representing an increase of $94,000, or 12.4%. For the three months ended
December  31, 2004,  basic and diluted  earnings per share were $0.30 and $0.29,
respectively,  compared  to the basic  and  diluted  earnings  per share for the
quarter ended December 31, 2003 of $0.27 and $0.26,  respectively.  The increase
in net  income  resulted  primarily  from  increased  net  interest  income  and
increased  other income that were offset  partially by increased  provision  for
loan losses and  increased  income tax  expense.  The  increase in net  interest
income  resulted  from higher net  interest  margins and  increased  net earning
assets.  The average prime interest rate for the quarter ended December 31, 2004
was 4.93%, an increase of 93 basis points from 4.00% which was the average prime
for the quarter ended  December 31, 2003.  The repricing of loans  increased the
Company's  average  asset yield by 15 basis  points  whereas the average cost of
funds increased only 1 basis point during the quarter ended December 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 $255,000 or 9.1% for the three months ended  December
31, 2004,  compared to the same quarter in the prior year. This increase results
from a $290,000  increase in interest  income that was  partially  offset by the
$35,000 increase in total interest expense. The average net interest rate spread
increased 14 basis  points from 2.98% for the three  months  ended  December 31,
2003 to 3.12% for the quarter ended December 31, 2004.

      Interest  Income.  The  increase in interest  income for the three  months
ended   December   31,   2004  was  the  result  of  an  increase  in  yield  on
interest-earning assets of 15 basis points from 4.77% for the three months ended
December 31, 2003 to 4.92% for the three months ended December 31, 2004. Average
interest-earning  assets increased $12.6 million compared to the same quarter in
the prior year.  Average  loans  receivable  and average  investment  securities
increased $6.9 million and $6.0 million,  respectively,  while  interest-bearing
overnight funds  decreased  $234,000.  The increase in average  interest-earning
assets increased  interest income by approximately  $150,000 and the increase in
the average asset yield increased interest income by approximately $140,000.

      Interest  Expense.  Interest  expense  increased in the three months ended
December 31, 2004 due to an increase in average interest-bearing  liabilities of
$5.5 million and an increase in the cost of  interest-bearing  liabilities  of 1
basis point from 1.79% for the three months ended December 31, 2003 to 1.80% for
the three months ended  December 31,  2004.  Average  interest-bearing  deposits
increased by $4.5 million while average FHLB advances increased $946,000 for the
three months ended  December 31, 2004  compared to the same quarter in the prior
year. The increase in average  interest-bearing  liabilities  increased interest
expense  by  approximately  $26,000  and the  increase  in the  average  cost of
interest-bearing liabilities increased interest expense by approximately $9,000.


                                       12
<PAGE>

      The  following   table  presents   average   balances  and  average  rates
earned/paid  by the Company for the quarter ended  December 31, 2004 compared to
the quarter ended December 31, 2003.

<TABLE>
<CAPTION>
                                                         Three Months Ended                      Three Months Ended
                                                         December 31, 2004                       December 31, 2003
                                                 -----------------------------------     ----------------------------------
                                                                          (Dollars in Thousands)
                                                 Average                    Average      Average                    Average
                                                 Balance      Interest    Yield/Cost     Balance      Interest    Yield/Cost
                                                 --------     --------    ----------     --------     --------    ----------
<S>                                              <C>          <C>            <C>         <C>          <C>            <C>
Assets:
Loans receivable (1)                             $232,575     $  3,121         5.37%     $225,723     $  2,854         5.06%
Investment securities (2)                         115,919        1,198         4.13       109,942        1,184         4.31
Interest-bearing overnight deposits                 3,779           18         1.92         4,013            9         0.91
                                                 --------     --------     --------      --------     --------     --------
  Total interest-earning assets (4)               352,273        4,337         4.92       339,678        4,047         4.77
Non interest-earning assets                        19,896                                  20,406
                                                 --------                                --------
  Total assets                                    372,169                                $360,084
                                                 ========                                ========

Liabilities and stockholders' equity
Interest bearing checking                          36,205           23         0.26        36,102           19         0.21
Money market investment accounts                   18,630           43         0.92        19,599           33         0.68
Passbook and statement savings                     30,306           50         0.66        30,352           47         0.62
Certificates of deposit                           162,560          798         1.96       157,108          820         2.09
FHLB advances                                      34,375          356         4.14        33,429          316         3.78
                                                 --------     --------     --------      --------     --------     --------
  Total interest-bearing liabilities              282,076        1,270         1.80       276,590        1,235         1.79
Non interest-bearing liabilities                   23,863                                  20,594
                                                 --------                                --------
  Total liabilities                               305,939                                 297,184
Stockholders' equity                               66,230                                  62,900
                                                 --------                                --------
  Total liabilities and stockholders' equity     $372,169                                $360,084
                                                 ========                                ========

Net interest income                                           $  3,067                                $  2,812
                                                              ========                                ========
Interest rate spread                                                           3.12%                                   2.98%
                                                                           ========                                ========
Net interest margin (3)                                                        3.48%                                   3.31%
                                                                           ========                                ========
Ratio of average interest-earning assets to
 average interest-bearing liabilities                                        124.89%                                 122.81%
                                                                           ========                                ========
</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.


                                       13
<PAGE>

      The  provision  for loan  losses was  $330,000  and net  charge-offs  were
$300,000 for the three months ended  December 31, 2004 compared with a provision
of $60,000,  and net  charge-offs  of $8,000 for the three months ended December
31, 2003.  Nonperforming  loans at December 31, 2004 and September 30, 2004 were
$3.6 million and $4.0 million,  respectively. The majority of the non-performing
loans resulted from two unrelated,  distinct  credits which are not  necessarily
indicative of the credit quality of the entire portfolio.  See "- Asset Quality"
for further information.

      Other Income.  Other income increased $122,000 from $526,000 for the three
months ended  December 31, 2003 to $648,000 for the three months ended  December
31, 2004.  Mortgage banking income,  net increased  $25,000 from $98,000 for the
three  months  ended  December  31, 2003 to $123,000  for the three months ended
December  31, 2004  despite  lower loan  volumes.  We sold loans  totaling  $6.1
million in the three months ended  December 31, 2004 compared with sales of $6.8
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.
Customer  fees  increased  $93,000 or 45.4% to $298,000  for the  quarter  ended
December 31, 2004  compared with the $205,000  reported in the prior year.  This
increase was the result of increased  deposit service charges  compared with the
prior year. The Company recorded gains on sales of investments of $97,000 in the
three months ended December 31, 2003 which were not present in the current year.
Included in other income for the quarter  ended  December 31, 2004 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
$54,000  for the quarter  ended  December  31, 2003 to $160,000  for the quarter
ended December 31, 2004 primarily as a result of this recovery.

      Operating Expenses. Total operating expenses were $2.1 million for each of
the three months ended December 31, 2004 and 2003, respectively. The Company has
been able to control expenses during this period of slower asset growth.

      Income Tax Expense.  Income tax expense increased $50,000 from tax expense
of $417,000  for the three  months  ended  December 31, 2003 to $467,000 for the
three months ended  December 31, 2004.  The  effective  tax rates were 35.4% and
35.5% for the three months ended December 31, 2004 and 2003, respectively.

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>
                                                                  December 31, 2004   September 30, 2004
                                                                  -----------------   ------------------
                                                                             (In thousands)
<S>                                                                    <C>                 <C>
      Commitments to originate new loans                               $ 8,150             $ 2,177
      Commitments to originate new loans held for sale                     113                  --
      Unfunded commitments to extend credit under existing
         equity line and commercial lines of credit                     54,335              55,357
      Commercial letters of credit                                       1,904               2,055
      Commitments to sell loans held for sale                            1,132               2,174
</TABLE>

      Commitments to originate new loan include three unrelated  commercial real
estate  loans  totaling  $6.3  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


                                       14
<PAGE>

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 December 31, 2004,  the aggregate  fair
value of these commitments exceeded the book value of the loans to be sold.

Contractual Obligations

As of December 31, 2004:

<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                       $235,201      $ 22,938      $ 10,293      $     --      $268,432
Advances from
   Federal Home Loan Bank        13,500            --        20,000            --        33,500
Lease obligations                    20            42            42             5           109
                               --------      --------      --------      --------      --------
Total contractual cash
    obligations                $248,721      $ 22,980      $ 30,335      $      5      $302,041
                               ========      ========      ========      ========      ========
</TABLE>

Asset Quality

      At  December  31,  2004,  the Company had  approximately  $3.7  million in
nonperforming  assets (nonaccrual loans and real estate owned) or 0.98% of total
assets. At September 30, 2004,  nonperforming  assets were $4.0 million or 1.05%
of total assets.  At December 31, 2004 and September  30, 2004,  impaired  loans
totaled $3.0 million and $3.8 million,  respectively, as defined by Statement of
Financial  Accounting Standards No. 114, "Accounting by Creditors for Impairment
of a Loan." The  impaired  loans at  December  31, 2004 and  September  30, 2004
result from two unrelated  commercial loan  customers,  each of which have loans
secured by commercial  real estate and business  assets in Alamance  County.  At
December  31,  2004,  the  entire  $3.0  million  of the  impaired  loans are on
non-accrual  status, and their related reserve for loan losses totaled $300,000.
The average  carrying  value of impaired loans was $3.4 million during the three
months ended December 31, 2004.  Interest income of $30,000 has been recorded on
impaired  loans in the three  months ended  December  31,  2004.  The Bank's net
chargeoffs  for the three months  ended  December  31, 2004 were  $300,000.  The
Bank's  allowance  for loan  losses was $4.0  million at  December  31, 2004 and
September  30,  2004,  and the ratio of the  allowance  for loan losses to total
loans,  net of loans in process  and  deferred  loan fees was 1.69% and 1.68% at
December 31, 2004 and September 30, 2004, respectively.

      The following table presents an analysis of our nonperforming assets:

<TABLE>
<CAPTION>
                                                                Dollars in thousands

                                                        At               At               At
                                                   December 31,     September 30,    December 31,
                                                       2004             2004             2003
                                                   ------------     -------------    ------------
<S>                                                   <C>              <C>              <C>
Nonperforming loans:
  Nonaccrual loans                                    $3,644           $3,962           $4,057
  Loans 90 days past due and accruing                     --               --               --
  Restructured loans                                      --               --               --
                                                      ------           ------           ------
    Total nonperforming loans                          3,644            3,962            4,057
Other real estate                                         17               17              273
                                                      ------           ------           ------
    Total nonperforming assets                         3,661           $3,979           $4,330
                                                      ======           ======           ======

Nonperforming loans to loans receivable, net            1.57%            1.72%            1.79%
Nonperforming assets as a percentage
 of loans and other real estate owned                   1.58%            1.72%            1.91%
Nonperforming assets to total assets                    0.98%            1.05%            1.19%
</TABLE>


                                       15
<PAGE>

      Included in nonperforming  assets at December 31, 2004 were loans totaling
$748,000  to  a  local  borrower  secured  by  real  estate  and  loans  to  his
transportation business secured by operating assets. These loans are in default,
and the Company is working with the  borrower and their  business on a voluntary
liquidation.  The Company charged off $300,000 on this  relationship  during the
current  quarter  and has a specific  reserve  of  $300,000  for these  loans at
December 31, 2004. We project the resolution of these nonperforming loans during
the next several months with minimal additional loss, if any.

      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 December 31, 2004, we had $4.1 million
in classified assets consisting of $4.0 million in substandard loans and $17,000
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 December 31, 2003, we had $4.6 million in substandard loans and
$273,000 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 December 31, 2004, we have identified  approximately  $5.3 million in
assets classified as special mention and $24.1 million as watch. At December 31,
2003, we had identified  approximately  $935,000 in assets classified as special
mention and $34.7 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
December  31, 2004,  the Bank's  liquidity  ratio  exceeded  such  requirements.
Liquidity generally refers to the Bank's ability to generate adequate amounts of
funds to meet its cash needs.  Adequate  liquidity  guarantees  that  sufficient
funds are available to meet deposit withdrawals, fund loan commitments, maintain
adequate reserve  requirements,  pay operating expenses,  provide funds for debt
service, pay dividends to stockholders and meet other general commitments.

      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  December  31,  2004,  cash and cash
equivalents  totaled $11.2 million. We have other sources of liquidity should we
need additional funds.  During the three months ended December 31, 2004, we sold
loans totaling $6.1 million. 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 $90.5 million at December 31,
2004.

      We anticipate  that we will have  sufficient  funds  available to meet our
current commitments. At December 31, 2004, we had $8.3 million in commitments to
originate  new loans,  $54.3  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 December 31, 2004,  certificates of deposit, which
are scheduled to mature within one year, totaled $134.6 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  December  31,  2004 and is  deemed  to be "well
capitalized."

      The Federal Reserve also mandates capital requirements on all bank holding
companies,  including 1st State  Bancorp,  Inc. These capital  requirements  are
similar to those  imposed by the FDIC on the Bank.  At December  31,  2004,  the
Company was in compliance with the capital requirements of the Federal Reserve.


                                       16
<PAGE>

      The  Company's  equity to asset ratio at December 31, 2004 was 17.8%.  The
Company's capital level is sufficient to support future growth.

      The Company has declared cash dividends per common share of $0.10 for each
of the three months ended  December  31, 2004,  September  30, 2004 and June 30,
2004. The Company's  ability to pay dividends is dependent  upon  earnings.  The
Company's  dividend  payout ratio for the three months ended  December 31, 2004,
September  30,  2004  and  December  31,  2003  was  34.5%,   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


                                       17
<PAGE>

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.

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 adverse
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.

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


                                       18
<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  December
            31, 2004.


                                       19
<PAGE>

<TABLE>
<CAPTION>
                                                                                                (d)
                                                                         (c)                  Maximum
                                      (a)                          Total Number of       Number of Shares
                                     Total             (b)        Shares Purchased       that May Yet Be
                                   Number of         Average     as Part of Publicly     Purchased Under
                                     Shares        Price Paid      Announced Plans         the Plans or
          Period                   Purchased        per Share        or Programs             Programs
          ------                   ---------        ---------        -----------             --------
<S>                                   <C>            <C>                <C>                 <C>
October 2004                             --               --               --                    --
Beginning date: October 1
Ending date: October 31

November 2004                         3,500          $ 27.50            3,500               292,732(1)
Beginning date: November 1
Ending date: November 30

December 2004                         2,450          $ 28.52            2,450               290,282(1)
Beginning date: December 1
Ending date: December 31

Total                                 5,950          $ 27.92            5,950
</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  common  stock over a
      period of 24 months.  These share  purchases were part of this  repurchase
      program.

Item 3. Defaults Upon Senior Securities

      None.

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

      None.

Item 5. Other Information

      None.

Item 6. Exhibits

      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


                                       20
<PAGE>

                                   SIGNATURES

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

                                        1st STATE BANCORP, INC.

Date: February 11, 2005                 /s/ James C. McGill
                                        ----------------------------------------
                                        James C. McGill
                                        President and Chief Executive Officer
                                        (Principal Executive Officer)

Date: February 11, 2005                 /s/ A. Christine Baker
                                        ----------------------------------------
                                        A. Christine Baker
                                        Executive Vice President
                                        Treasurer and Secretary
                                        (Principal Financial and Accounting
                                        Officer)