**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


**Washington,
      D.C. 20549**





**FORM
      10-Q**





T QUARTERLY
      REPORT PURSUANT TO SECTION 13 OR 15(d)


OF
      THE
      SECURITIES EXCHANGE ACT OF 1934




**For
      the Quarterly Period Ended June 30, 2006**





or





£
      TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)


OF
      THE
      SECURITIES EXCHANGE ACT OF 1934





For
      the
      Transition Period from
 to







**CAPITAL
      BANK CORPORATION**


*(Exact
      name of registrant as specified in its charter)*








**North
                Carolina**
            
            **000-30062**
            
            **56-2101930***(State
                or other jurisdiction of incorporation or
                organization)*
            
            *(Commission*
              *File
                Number)*
            
            *(I.R.S.
                Employer*
              *Identification
                Number)*





**333
      Fayetteville Street, Suite 700**


**Raleigh,
      North Carolina 27601**


*(Address
      of principal executive offices)*





**(919)
      645-6400**


*(Registrant’s
      telephone number, including area code)*








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 T No £





Indicate
      by check mark whether the registrant is a large accelerated filer, an
      accelerated filer, or a non-accelerated filer. See definition of “accelerated
      filer and large accelerated filer” in Rule 12b-2 of the Exchange
      Act.


(Check
      one):





Large
                accelerated filer£
            Accelerated
                filerT
            Non-accelerated
                filer£





Indicate
      by check mark whether the registrant is a shell company (as defined in Rule
      12b-2 of the Exchange Act).


Yes £ No T





As
      of
      August 7, 2006 there were 11,562,494 shares outstanding of the registrant’s
      common stock, no par value.





**Capital
      Bank Corporation**


**Form
      10-Q for the Quarterly Period Ended June 30, 2006**





**INDEX**





**PART
                  I - FINANCIAL INFORMATION**
              Page
                  No.Item
                  1.Financial
                  StatementsCondensed
                  consolidated statements of financial condition at June 30, 2006
                  (Unaudited) and December 31, 2005
              1Condensed
                  consolidated statements of income for the three months ended June
                  30, 2006
                  and 2005 (Unaudited)
              2Condensed
                  consolidated statements of income for the six months ended June
                  30, 2006
                  and 2005 (Unaudited)
              3Condensed
                  consolidated statements of changes in shareholders’ equity for the six
                  months ended June 30, 2006 and 2005 (Unaudited)
              4Condensed
                  consolidated statements of cash flows for the six months ended
                  June 30,
                  2006 and 2005 (Unaudited)
              5-6Notes
                  to condensed consolidated financial statements (Unaudited)
              7-12Item
                  2.Management’s
                  Discussion and Analysis of Financial Condition and Results of
                  Operations
              12-23Item
                  3.Quantitative
                  and Qualitative Disclosures about Market Risk
              24Item
                  4.Controls
                  and Procedures
              25**PART
                  II - OTHER INFORMATION**Item
                  1.Legal
                  Proceedings
              26Item
                  1A.Risk
                  Factors
              26Item
                  2.Unregistered
                  Sales of Equity Securities and Use of Proceeds
              28Item
                  3.Defaults
                  upon Senior Securities
              29Item
                  4.Submission
                  of Matters to a Vote of Security Holders
              29Item
                  5.Other
                  Information
              29Item
                  6.Exhibits
              30Signatures
              31








**Capital
        Bank Corporation**
 
 **PART
        I - FINANCIAL INFORMATION**
 
 **Item
        1.**  **Financial
        Statements**
 
 **CAPITAL
        BANK CORPORATION**
 **CONDENSED
        CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION**
 **June
        30, 2006 and December 31, 2005**


June
                  30,
                2006
              
              December
                  31,
                2005*(Dollars
                  in thousands)*
              
              *(Unaudited)***ASSETS**Cash
                  and due from banks:Interest
                  earning
              
              $
              6,084
              
              $
              4,603Noninterest
                  earning
              
              
              48,313
              
              
              30,544Cash
                  held in escrow
              
              
              -
              
              
              33,185Federal
                  funds sold and short term investments
              
              
              29,777
              
              
              8,757Investment
                  securities - available for sale, at fair value
              
              
              177,725
              
              
              149,266Investment
                  securities - held to maturity, at amortized cost
              
              
              11,944
              
              
              12,334Loans
                  - net of unearned income and deferred fees
              
              
              965,484
              
              
              668,982Allowance
                  for loan losses
              
              
              (14,007
              )
              
              (9,592
              )Net
                  loans
              
              
              951,477
              
              
              659,390Premises
                  and equipment, net
              
              
              23,005
              
              
              14,868Bank
                  owned life insurance
              
              
              20,157
              
              
              19,857Deposit
                  premium and goodwill, net
              
              
              66,959
              
              
              12,853Accrued
                  interest receivable and other assets
              
              
              28,589
              
              
              15,249**Total
                  assets**
              
              $
              1,364,030
              
              $
              960,906**LIABILITIES**Deposits:Demand,
                  noninterest bearing
              
              $
              105,667
              
              $
              77,847Savings
                  and interest bearing demand deposits
              
              
              340,981
              
              
              237,005Time
                  deposits
              
              
              579,301
              
              
              383,628Total
                  deposits
              
              
              1,025,949
              
              
              698,480Repurchase
                  agreements and federal funds purchased
              
              
              28,004
              
              
              14,514Short-term
                  debt
              
              
              -
              
              
              30,000Federal
                  Home Loan Bank advances
              
              
              107,402
              
              
              93,173Subordinated
                  debentures
              
              
              30,930
              
              
              30,930Accrued
                  interest payable and other liabilities
              
              
              13,975
              
              
              10,317**Total
                  liabilities**
              
              
              1,206,260
              
              
              877,414**SHAREHOLDERS’
                  EQUITY**Common
                  stock, no par value; 20,000,000 authorized; 11,552,494 and 6,852,156
                  issued and outstanding as of June 30, 2006 and December 31, 2005,
                  respectively
              
              
              142,426
              
              
              70,985Retained
                  earnings
              
              
              18,605
              
              
              14,179Accumulated
                  other comprehensive loss
              
              
              (3,261
              )
              
              (1,672
              )**Total
                  shareholders’ equity**
              
              
              157,770
              
              
              83,492**Total
                  liabilities and shareholders’ equity**
              
              $
              1,364,030
              
              $
              960,906




See
        accompanying Notes to Condensed Consolidated Financial Statements
  -
            1
            -
  **CAPITAL
        BANK CORPORATION**
 **CONDENSED
        CONSOLIDATED STATEMENTS OF INCOME**
 **Three
        Months Ended June 30, 2006 and 2005 (Unaudited)**
 2006
              
              2005*(Dollars
                  in thousands except share and per share data)*Interest
                  income:Loans
                  and loan fees
              
              $
              18,646
              
              $
              10,405Investment
                  securities
              
              
              2,155
              
              
              1,727Federal
                  funds and other interest income
              
              
              308
              
              
              116**Total
                  interest income**
              
              
              21,109
              
              
              12,248Interest
                  expense:Deposits
              
              
              7,328
              
              
              3,676Borrowings
                  and repurchase agreements
              
              
              2,173
              
              
              1,412**Total
                  interest expense**
              
              
              9,501
              
              
              5,088**Net
                  interest income**
              
              
              11,608
              
              
              7,160Provision
                  (credit) for loan losses
              
              
              249
              
              
              (156
              )**Net
                  interest income after provision for loan losses**
              
              
              11,359
              
              
              7,316Noninterest
                  income:Service
                  charges and other fees
              
              
              1,061
              
              
              714Mortgage
                  fees and revenues
              
              
              654
              
              
              386Net
                  gain on sale of securities
              
              
              -
              
              
              1Bank
                  owned life insurance
              
              
              183
              
              
              143Other
                  noninterest income
              
              
              714
              
              
              335**Total
                  noninterest income**
              
              
              2,612
              
              
              1,579Noninterest
                  expenses:Salaries
                  and employee benefits
              
              
              4,851
              
              
              3,479Occupancy
              
              
              938
              
              
              626Furniture
                  and equipment
              
              
              562
              
              
              370Data
                  processing
              
              
              111
              
              
              318Director
                  fees
              
              
              283
              
              
              347Advertising
              
              
              324
              
              
              163Amortization
                  of deposit premium
              
              
              343
              
              
              53Professional
                  fees
              
              
              354
              
              
              210Telecommunications
              
              
              209
              
              
              143Other
                  expenses
              
              
              1,366
              
              
              780**Total
                  noninterest expenses**
              
              
              9,341
              
              
              6,489**Income
                  before income tax expense**
              
              
              4,630
              
              
              2,406Income
                  tax expense
              
              
              1,579
              
              
              803**Net
                  income**
              
              $
              3,051
              
              $
              1,603Earnings
                  per share - basic
              
              $
              0.26
              
              $
              0.24Earnings
                  per share - diluted
              
              $
              0.26
              
              $
              0.23Weighted
                  average sharesBasic
              
              
              11,639,000
              
              
              6,731,000Fully
                  diluted
              
              
              11,727,000
              
              
              6,871,000
 
 See
        accompanying Notes to Condensed Consolidated Financial Statements
  -
            2
            -
  **CAPITAL
        BANK CORPORATION**
 **CONDENSED
        CONSOLIDATED STATEMENTS OF INCOME**
 **Six
        Months Ended June 30, 2006 and 2005 (Unaudited)**
 2006
                
                2005*(Dollars
                    in thousands except share and per share data)*Interest
                    income:Loans
                    and loan fees
                
                $
                35,664
                
                $
                20,147Investment
                    securities
                
                
                4,265
                
                
                3,424Federal
                    funds and other interest income
                
                
                850
                
                
                133**Total
                    interest income**
                
                
                40,779
                
                
                23,704Interest
                    expense:Deposits
                
                
                13,438
                
                
                6,858Borrowings
                    and repurchase agreements
                
                
                4,343
                
                
                2,780**Total
                    interest expense**
                
                
                17,781
                
                
                9,638**Net
                    interest income**
                
                
                22,998
                
                
                14,066Provision
                    (credit) for loan losses
                
                
                661
                
                
                (406
                )**Net
                    interest income after provision for loan losses**
                
                
                22,337
                
                
                14,472Noninterest
                    income:Service
                    charges and other fees
                
                
                2,026
                
                
                1,371Mortgage
                    fees and revenues
                
                
                1,018
                
                
                658Net
                    gain on sale of securities
                
                
                -
                
                
                7Bank
                    owned life insurance
                
                
                414
                
                
                266Other
                    noninterest income
                
                
                1,169
                
                
                617**Total
                    noninterest income**
                
                
                4,627
                
                
                2,919Noninterest
                    expenses:Salaries
                    and employee benefits
                
                
                9,393
                
                
                6,628Occupancy
                
                
                1,716
                
                
                1,240Furniture
                    and equipment
                
                
                1,054
                
                
                737Data
                    processing
                
                
                600
                
                
                629Director
                    fees
                
                
                659
                
                
                395Advertising
                
                
                579
                
                
                379Amortization
                    of deposit premium
                
                
                686
                
                
                107Professional
                    fees
                
                
                566
                
                
                532Telecommunications
                
                
                385
                
                
                283Other
                    expenses
                
                
                2,517
                
                
                1,709**Total
                    noninterest expenses**
                
                
                18,155
                
                
                12,639**Income
                    before income tax expense**
                
                
                8,809
                
                
                4,752Income
                    tax expense
                
                
                2,995
                
                
                1,594**Net
                    income**
                
                $
                5,814
                
                $
                3,158Earnings
                    per share - basic
                
                $
                0.50
                
                $
                0.47Earnings
                    per share - diluted
                
                $
                0.50
                
                $
                0.46Weighted
                    average sharesBasic
                
                
                11,628,000
                
                
                6,743.000Fully
                    diluted
                
                
                11,716,000
                
                
                6,906,000
 
 See
          accompanying Notes to Condensed Consolidated Financial Statements
  -
              3
              -
  **CAPITAL
          BANK CORPORATION**
 **CONDENSED
          CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY**
 **Six
          Months Ended June 30, 2006 and 2005 (Unaudited)**
 Shares
                      of
                    Common
                    Stock
                  
                  Common
                    Stock
                  
                  Other
                    Comprehensive
                    Income
                  
                  Retained
                    Earnings
                  
                  Total*(Dollars
                      in thousands except share data)***Balance
                      at January 1, 2005**
                  
                  
                  6,612,787
                  
                  $
                  68,341
                  
                  $
                  305
                  
                  $
                  9,092
                  
                  $
                  77,738Repurchase
                      of outstanding common stock
                  
                  
                  (50,000
                  )
                  
                  (892
                  )
                  
                  -
                  
                  
                  -
                  
                  
                  (892
                  )Issuance
                      of common stock for services
                  
                  
                  40,241
                  
                  
                  380
                  
                  
                  -
                  
                  
                  -
                  
                  
                  380Issuance
                      of common stock for optionsexercised
                  
                  
                  22,842
                  
                  
                  355
                  
                  
                  -
                  
                  
                  -
                  
                  
                  355Net
                      income
                  
                  
                  -
                  
                  
                  -
                  
                  
                  -
                  
                  
                  3,158
                  
                  
                  3,158Other
                      comprehensive loss
                  
                  
                  -
                  
                  
                  -
                  
                  
                  (448
                  )
                  
                  -
                  
                  
                  (448
                  )Comprehensive
                      income
                  
                  
                  -
                  
                  
                  -
                  
                  
                  -
                  
                  
                  -
                  
                  
                  2,710Dividends
                      ($0.12 per share)
                  
                  
                  -
                  
                  
                  -
                  
                  
                  -
                  
                  
                  (792
                  )
                  
                  (792
                  )Balance
                      at June 30, 2005
                  
                  
                  6,625,870
                  
                  $
                  68,184
                  
                  $
                  (143
                  )
                  $
                  11,458
                  
                  $
                  79,499**Balance
                      at January 1, 2006**
                  
                  
                  6,852,156
                  
                  $
                  70,985
                  
                  $
                  (1,672
                  )
                  $
                  14,179
                  
                  $
                  83,492Repurchase
                      of outstanding common stock
                  
                  
                  (217,782
                  )
                  
                  (3,496
                  )
                  
                  -
                  
                  
                  -
                  
                  
                  (3496
                  )Issuance
                      of common stock for acquisition of 1st State Bancorp, Inc.
                  
                  
                  4,882,630
                  
                  
                  74,499
                  
                  
                  -
                  
                  
                  -
                  
                  
                  74,499Issuance
                      of common stock for optionsexercised
                  
                  
                  35,490
                  
                  
                  380
                  
                  
                  -
                  
                  
                  -
                  
                  
                  380Noncash
                      compensation
                  
                  
                  -
                  
                  
                  58
                  
                  
                  -
                  
                  
                  -
                  
                  
                  58Net
                      income
                  
                  
                  -
                  
                  
                  -
                  
                  
                  -
                  
                  
                  5,814
                  
                  
                  5,814Other
                      comprehensive loss
                  
                  
                  -
                  
                  
                  -
                  
                  
                  (1,589
                  )
                  
                  -
                  
                  
                  (1,589
                  )Comprehensive
                      income
                  
                  
                  -
                  
                  
                  -
                  
                  
                  -
                  
                  
                  -
                  
                  
                  4,225Dividends
                      ($0.12 per share)
                  
                  
                  -
                  
                  
                  -
                  
                  
                  -
                  
                  
                  (1,388
                  )
                  
                  (1,388
                  )Balance
                      at June 30, 2006
                  
                  
                  11,552,494
                  
                  $
                  142,426
                  
                  $
                  (3,261
                  )
                  $
                  18,605
                  
                  $
                  157,770
 
 See
            accompanying Notes to Condensed Consolidated Financial Statements
  -
                4
                -
  **CAPITAL
            BANK CORPORATION**
 **CONDENSED
            CONSOLIDATED STATEMENTS OF CASH FLOWS**
 **Six
            Months Ended June 30, 2006 and 2005 (Unaudited)**
 2006
                    
                    2005*(Dollars
                        in thousands)*Cash
                        flows from operating activities:Net
                        income
                    
                    $
                    5,814
                    
                    $
                    3,158Adjustments
                        to reconcile net income to net cash used
                      in
                        operating activities:Amortization
                        of deposit premium
                    
                    
                    686
                    
                    
                    107Depreciation
                    
                    
                    1,019
                    
                    
                    731Net
                        gains on sale of securities available for sale
                    
                    
                    -
                    
                    
                    (7
                    )(Gain)
                        loss on disposal of premises and equipment
                    
                    
                    (138
                    )
                    
                    3Change
                        in held for sale loans, net
                    
                    
                    (3,958
                    )
                    
                    (3,914
                    )Amortization
                        of premiums on securities, net
                    
                    
                    73
                    
                    
                    147Deferred
                        income tax expense
                    
                    
                    3,258
                    
                    
                    136Issuance
                        of stock for compensation
                    
                    
                    -
                    
                    
                    255Provision
                        (credit) for loan losses
                    
                    
                    661
                    
                    
                    (406
                    )Changes
                        in assets and liabilities:Accrued
                        interest receivable and other assets
                    
                    
                    3,101
                    
                    
                    (6,480
                    )Accrued
                        interest payable and other liabilities
                    
                    
                    608
                    
                    
                    960**Net
                        cash provided by (used in) operating activities**
                    
                    
                    11,124
                    
                    
                    (5,310
                    )Cash
                        flows from investing activities:Loan
                        (originations) repayments, net
                    
                    
                    (58,670
                    )
                    
                    8,775Additions
                        to premises and equipment
                    
                    
                    (3,124
                    )
                    
                    (1,324
                    )Net
                        (purchase) sales of Federal Home Loan Bank stock
                    
                    
                    767
                    
                    
                    (47
                    )Purchase
                        of securities available for sale
                    
                    
                    (30,597
                    )
                    
                    (15,761
                    )Purchase
                        of securities held to maturity
                    
                    
                    -
                    
                    
                    (1,560
                    )Proceeds
                        from maturities of securities available for sale
                    
                    
                    6,318
                    
                    
                    10,146Proceeds
                        from sales of securities available for sale
                    
                    
                    102,396
                    
                    
                    4,399Proceeds
                        from maturities of securities held to maturity
                    
                    
                    397
                    
                    
                    711Net
                        cash paid in merger transaction
                    
                    
                    (37,541
                    )
                    
                    -Proceeds
                        from sales of property and equipment
                    
                    
                    1,229
                    
                    
                    19**Net
                        cash (used in) provided by investing activities**
                    
                    
                    (18,825
                    )
                    
                    5,358Cash
                        flows from financing activities:Net
                        increase in deposits
                    
                    
                    55,433
                    
                    
                    35,021Net
                        increase (decrease) in repurchase agreements
                    
                    
                    13,490
                    
                    
                    (1,429
                    )Net
                        decrease in borrowings
                    
                    
                    (19,915
                    )
                    
                    (1,117
                    )Repayment
                        of short-term debt
                    
                    
                    (30,000
                    )
                    
                    -Distribution
                        of cash held in escrow
                    
                    
                    33,185
                    
                    
                    -Dividends
                        paid
                    
                    
                    (1,106
                    )
                    
                    (792
                    )Issuance
                        of common stock for options and other plans
                    
                    
                    380
                    
                    
                    379Repurchase
                        of common stock
                    
                    
                    (3,496
                    )
                    
                    (892
                    )**Net
                        cash provided by financing activities**
                    
                    
                    47,971
                    
                    
                    31,170Net
                        change in cash and cash equivalents
                    
                    
                    40,270
                    
                    
                    31,218Cash
                        and cash equivalents at beginning of period
                    
                    
                    43,904
                    
                    
                    23,011Cash
                        and cash equivalents at end of period
                    
                    $
                    84,174
                    
                    $
                    54,229(continued
                        on next page)
 
 See
              accompanying Notes to Condensed Consolidated Financial
              Statements
  -
                  5
                  -
  **CAPITAL
              BANK CORPORATION**
 **CONDENSED
              CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)**
 **Six
              Months Ended June 30, 2006 and 2005 (Unaudited)**
 2006
                    
                    2005*(Dollars
                        in thousands)***Supplemental
                        Disclosure of Cash Flow Information**Transfer
                        of loans and premises and equipment to other real estate
                        owned
                    
                    $
                    2,327
                    
                    $
                    1,004Dividends
                        payable
                    
                    $
                    693
                    
                    $
                    397Cash
                        paid for:Income
                        taxes
                    
                    $
                    371
                    
                    $
                    1,713Interest
                    
                    $
                    17,489
                    
                    $
                    9,386Acquisition
                        of 1st State BancorpFair
                        value of assets acquired
                    
                    $
                    430,131
                    
                    $
                    -Issuance
                        of common stock
                    
                    $
                    74,499
                    
                    $
                    -Cash
                        paid
                    
                    $
                    46,639
                    
                    $
                    -Liabilities
                        assumed
                    
                    $
                    308,993
                    
                    $
                    -
 
 See
              accompanying Notes to Condensed Consolidated Financial Statements
 
  -
                  6
                  -
  **Notes
              to Condensed Consolidated Financial Statements (Unaudited)**
 
 **1.**  **Significant
              Accounting Policies and Interim Reporting**
 
 The
              accompanying unaudited condensed consolidated financial statements
              include the
              accounts of Capital Bank Corporation (the “Company”) and its wholly owned
              subsidiary, Capital Bank (the “Bank”). In addition, the Company has interests in
              three trusts, Capital Bank Statutory Trust I, II, and III (hereinafter
              collectively referred to as the “Trusts”). The Trusts have not been consolidated
              with the financial statements of the Company. The interim financial
              statements
              have been prepared in accordance with accounting principles generally
              accepted
              in the United States of America. They do not include all of the information
              and
              footnotes required by such accounting principles for complete financial
              statements and therefore should be read in conjunction with the audited
              consolidated financial statements and accompanying footnotes in the
              Company’s
              Annual Report on Form 10-K for the year ended December 31, 2005, as
              amended.
 
 The
              preparation of financial statements in conformity with accounting principles
              generally accepted in the United States of America requires management
              to make
              estimates and assumptions that affect reported amounts of assets and
              liabilities
              as well as the amounts of income and expenses during the reporting
              period.
              Actual results could differ from those estimates.
 
 In
              the
              opinion of management, all adjustments necessary for a fair presentation
              of the
              financial position and results of operations for the periods presented
              have been
              included and all significant intercompany transactions have been eliminated
              in
              consolidation. All such adjustments are of a normal and recurring nature.
              Certain amounts reported in prior periods have been reclassified to
              conform to
              the current presentation. Such reclassifications have no effect on
              net income or
              shareholders’ equity as previously reported. The results of operations for the
              three and six months period ended June 30, 2006 are not necessarily
              indicative
              of the results of operations that may be expected for the year ended
              December
              31, 2006.
 
 The
              balance sheet at December 31, 2005 has been derived from the audited
              consolidated financial statements contained in the Company’s Annual Report on
              Form 10-K for the year ended December 31, 2005, as amended.
 
 The
              accounting policies followed are as set forth in Note 1 of the Notes
              to
              Consolidated Financial Statements in the Company’s Annual Report on Form 10-K
              for the year ended December 31, 2005, as amended.
 
 In
              March
              2006, the Financial Account Standards Board (“FASB’) issued Statement of
              Financial Accounting Standards (“SFAS”) No. 156, *Accounting
              For Servicing of Financial Assets, an Amendment of FASB Statement No.
              140,
              Accounting for Transfers and Servicing of Financial Assets and Extinguishments
              of Liabilities* ,
              (“SFAS
              156”) which requires that all separately recognized servicing assets and
              liabilities be initially measured at fair value, if practicable, and
              requires
              entities to elect either fair value measurement with changes in fair
              value
              reflected in earnings or the amortization and impairment requirements
              of
              Statement 140 for subsequent measurement. SFAS 156 is effective as
              of the
              beginning of an entity’s first fiscal year that begins after September 15, 2006.
              The Company plans to adopt SFAS 156 on January 1, 2007. The adoption
              of SFAS 156
              is not expected to have any material impact on the Company’s financial condition
              or results of operations.
 
 **2.**  **Acquisition
              of 1st State Bancorp**
 
 On
              January 3, 2006, the Company completed its acquisition of all the outstanding
              capital stock of 1st State Bancorp, Inc. (“1st State Bancorp”), the holding
              company for 1st State Bank. (“1st State Bank”). The total purchase price was
              approximately $121.1 million, including transaction costs of $6.3 million.
              The
              Company issued approximately 4.9 million shares of common stock and
              paid $40.1
              million in cash in exchange for 100% of 1st State Bancorp’s outstanding common
              stock and stock options. The transaction was accounted for under the
              purchase
              method of accounting and is intended to qualify as a tax-free reorganization
              under Section 368(a) of the Internal Revenue Code.
 
  -
                  7
                  -
  An
              unaudited summary of the preliminary estimated fair values of assets
              acquired
              and liabilities assumed is as follows:
  (Dollars
                      in thousands)Loans
                        receivable, net of allowance for loan losses
                    
                    $
                    230,600Investment
                        securities
                    
                    
                    110,007Premises
                        and equipment
                    
                    
                    7,925Deposit
                        premium
                    
                    
                    5,331Goodwill
                    
                    
                    49,460Other
                        assets
                    
                    
                    26,808Deposits
                    
                    
                    (272,037
                    )Borrowings
                    
                    
                    (34,144
                    )Other
                        liabilities
                    
                    
                    (2,812
                    )Investment
                        in subsidiary, net of dividends to shareholders and capitalized
                        acquisition costs
                    
                    $
                    121,138
 
 The
              following unaudited pro forma financial information presents the combined
              results of operations of the Company and 1st State Bancorp as if the
              merger had
              occurred as of the beginning of the period for each period presented.
              The pro
              forma financial information does not necessarily reflect the results
              of
              operations that would have occurred had the Company and 1st State Bancorp
              constituted a single entity during such periods.
  Three
                          Month Period
                        Ended
                          June 30, 2005
                      
                      Six
                          Month Period
                        Ended
                          June 30, 2005*(Dollars
                          in thousands except per share data)*Net
                          interest income
                      
                      $
                      10,102
                      
                      $
                      19,828Noninterest
                          income
                      
                      $
                      2,089
                      
                      $
                      3,875Noninterest
                          expenses
                      
                      $
                      9,028
                      
                      $
                      17,735Net
                          income
                      
                      $
                      1,894
                      
                      $
                      3,886Net
                          income per common share-basic
                      
                      $
                      0.16
                      
                      $
                      0.33Net
                          income per common share-diluted
                      
                      $
                      0.16
                      
                      $
                      0.33
 
 **3.**  **Comprehensive
              Income**
 
 Comprehensive
              income includes net income and all other changes to the Company’s equity, with
              the exception of transactions with shareholders (“other comprehensive income”).
              The Company’s comprehensive income for the six months periods ended June 30,
              2006 and 2005 are as shown in the Company’s Condensed Consolidated Statements of
              Changes in Shareholders’ Equity for the six months ended June 30, 2006 and 2005
              (unaudited). The Company’s only components of other comprehensive income relate
              to unrealized gains and losses on available for sale securities, net
              of the
              applicable income tax effect and are as follows:
 
 2006
                    
                    2005*(Dollars
                        in thousands)*
                    
                    *(Unaudited)***Three
                        Month Period Ended June 30, 2006 and 2005**Unrealized
                        gains (losses) on available for sale securities
                    
                    $
                    (2,346
                    )
                    $
                    998Reclassification
                        of gains recognized in net income
                    
                    
                    -
                    
                    
                    (1
                    )Income
                        tax benefit (expense)
                    
                    
                    904
                    
                    
                    (384
                    )Other
                        comprehensive income (loss)
                    
                    $
                    (1,442
                    )
                    $
                    613**Six
                        Month Period Ended June 30, 2006 and 2005**Unrealized
                        losses on available for sale securities
                    
                    $
                    (2,585
                    )
                    $
                    (723
                    )Reclassification
                        of gains recognized in net income
                    
                    
                    -
                    
                    
                    (7
                    )Income
                        tax benefit
                    
                    
                    996
                    
                    
                    282Other
                        comprehensive loss
                    
                    $
                    (1,589
                    )
                    $
                    (448
                    )
 
  -
                  8
                  -
  **4.**  **Earnings
              Per Share**
 
 The
              Company is required to report both basic and diluted earnings per share
              (“EPS”).
              Basic EPS excludes dilution and is computed by dividing income available
              to
              common shareholders by the weighted average number of common shares
              outstanding
              for the period. Diluted EPS assumes the conversion, exercise or issuance
              of all
              potential common stock instruments, such as stock options, unless the
              effect is
              to reduce a loss or increase earnings per share. For the Company, EPS
              is
              adjusted for outstanding stock options using the treasury stock method
              in order
              to compute diluted EPS. The following tables provide a computation
              and
              reconciliation of basic and diluted EPS for the three and six month
              periods
              ended June 30, 2006 and 2005, respectively:
 
 2006
                    
                    2005*(Dollars
                        in thousands except share data)*
                    
                    *(Unaudited)***Three
                        Month Period Ended June 30, 2006 and 2005**Income
                        available to shareholders - basic and diluted
                    
                    $
                    3,051
                    
                    $
                    1,603Shares
                        used in the computation of earnings per share:Weighted
                        average number of shares outstanding - basic
                    
                    
                    11,639,014
                    
                    
                    6,730,979Incremental
                        shares from assumed exercise of stock options
                    
                    
                    87,570
                    
                    
                    139,842Weighted
                        average number of shares outstanding - diluted
                    
                    
                    11,726,584
                    
                    
                    6,870,821**Six
                        Month Period Ended June 30, 2006 and 2005**Income
                        available to shareholders - basic and diluted
                    
                    $
                    5,814
                    
                    $
                    3,158Shares
                        used in the computation of earnings per share:Weighted
                        average number of shares outstanding - basic
                    
                    
                    11,628,015
                    
                    
                    6,742,712Incremental
                        shares from assumed exercise of stock options
                    
                    
                    87,495
                    
                    
                    163,521Weighted
                        average number of shares outstanding - diluted
                    
                    
                    11,715,510
                    
                    
                    6,906,233
 
 For
              the
              three and six month periods ended June 30, 2006 and 2005, options to
              purchase
              approximately 383,000 shares and 572,000 shares, respectively, of common
              stock
              were used in the diluted calculation. For the three and six month periods
              ended
              June 30, 2006 and 2005, approximately 74,000 options and 76,000 options,
              respectively, were not included in the diluted calculation because
              the option
              price exceeded the average fair market value of the associated shares
              of common
              stock.
 
 **5.**  **Stock Based Compensation**
  Effective
              January 1, 2006, the Company adopted the fair value recognition provisions
              of SFAS No. 123R, *Share-Based
              Payments* (“SFAS
              123R”), using the modified-prospective transition method. Under that transition
              method, compensation cost recognized in 2006 includes: (a) compensation
              cost for all share-based payments granted prior to, but not yet vested
              as of
              January 1, 2006, based on the grant date fair value estimated in accordance
              with the original provisions of SFAS No. 123, *Accounting
              for Stock-Based Compensation* (“SFAS
              123”) and (b) compensation cost for all share-based payments granted
              subsequent to December 31, 2005, based on the grant date fair value
              estimated in accordance with the provisions of SFAS 123R.
 
 Beginning
              January 1, 2006, the Company will recognize the cost of all new employee
              share-based awards on a straight-line basis over their respective vesting
              periods, net of estimated forfeitures. The Company previously accounted
              for
              stock options using the intrinsic value method in accordance with the
              provisions
              of APB Opinion No. 25 (“APB 25”), *Accounting
              for Stock Issued to Employees* ,
              and
              SFAS 123. Under SFAS 123, the Company was required to disclose the
              pro forma
              effects on net income as if it had recorded compensation based on the
              fair value
              of options granted. For the three and six month periods ended June
              30, 2005, the
              Company disclosed net income and earnings per share, as reported and
              pro forma,
              as follows:
 
  -
                  9
                  -
  
 **Three
                        month period ended June 30, 2005***(Dollars
                        in thousands except per share data)*Net
                        income
                    
                    
                    As
                        reported
                    
                    $
                    1,603Pro
                        forma
                    
                    $
                    1,565Net
                        income per share - basic
                    
                    
                    As
                        reported
                    
                    $
                    0.24Pro
                        forma
                    
                    $
                    0.24Net
                        income per share - diluted
                    
                    
                    As
                        reported
                    
                    $
                    0.23Pro
                        forma
                    
                    $
                    0.23
 
 **Six
                        month period ended June 30, 2005***(Dollars
                        in thousands except per share data)*Net
                        income
                    
                    
                    As
                        reported
                    
                    $
                    3,158Pro
                        forma
                    
                    $
                    3,072Net
                        income per share - basic
                    
                    
                    As
                        reported
                    
                    $
                    0.47Pro
                        forma
                    
                    $
                    0.46Net
                        income per share - diluted
                    
                    
                    As
                        reported
                    
                    $
                    0.46Pro
                        forma
                    
                    $
                    0.45
 
 On
              December 29, 2005, the Compensation/Human Resources Committee of the
              Board of
              Directors of the Company approved the acceleration of vesting of all
              then
              outstanding unvested stock options awarded under the Company’s Equity Incentive
              Plan. As a result, options to purchase 67,200 shares of the Company’s common
              stock, which would otherwise have vested from time to time over the
              next five
              years, became immediately exercisable on December 30, 2005. As a result
              of the
              acceleration of vesting, approximately $331,000 of future compensation
              expense
              that would have been recognized in operating results under SFAS 123R
              over the
              next five years was eliminated. Accordingly, the adoption of SFAS 123R
              did not
              have a material impact on the Company’s operating results or financial
              condition.
 
 The
              Company has stock option plans providing for the issuance of up to
              650,000
              options to purchase shares of the Company’s common stock to officers and
              directors. At June 30, 2006, options for 186,709 shares of common stock
              remained
              available for future issuance. In addition, there were approximately
              567,000
              options which were assumed under various plans from previously acquired
              financial institutions, of which approximately 192,000 remain outstanding.
              Grants of options are made by the Board of Directors or its Compensation/Human
              Resources Committee. All grants must be at no less than fair market
              value on the
              date of grant, must be exercised no later than 10 years from the date
              of grant,
              and may be subject to certain vesting provisions. There were no new
              stock option
              grants in the six months ended June 30, 2006 and all options outstanding
              as of
              June 30, 2006 were fully vested.
 
 The
              Company also administers the Capital Bank Corporation Deferred Compensation
              Plan
              for Non-Employee Directors (“Deferred Compensation Plan”). Under the Deferred
              Compensation Plan, eligible directors may elect to defer all or part
              of their
              directors’ fees for a calendar year, in exchange for common stock of the
              Company, based on the year-end share price. The amount deferred, if
              elected, is
              equal to 125 percent of their total director’s fees. Each participant is
              fully vested in his account balance. The Deferred Compensation Plan
              generally
              provides for payment of share units either in shares of common stock
              of the
              Company or cash (at the Company’s option) after the participant ceases to serve
              as a director for any reason. The Deferred Compensation Plan is classified
              as a
              liability-based plan under SFAS 123R.
 
 The
              following is a summary of stock option information and the weighted
              average
              exercise price (“WAEP”) for the six months ended June 30, 2006:
 
 Shares
                    
                    WAEPOutstanding
                        at January 1, 2006
                    
                    
                    495,822
                    
                    $
                    11.65Granted
                    
                    
                    -
                    
                    
                    -Exercised
                    
                    
                    (35,490
                    )
                    
                    10.72Terminated
                    
                    
                    (3,000
                    )
                    
                    15.80Outstanding
                        at June 30, 2006
                    
                    
                    457,332
                    
                    $
                    11.69Options
                        exercisable at June 30, 2006
                    
                    
                    457,332
                    
                    $
                    11.69
  -
                  10
                  -
  The
              following table summarizes information about the Company’s stock options at June
              30, 2006:
 Exercise
                          Price
                      NumberOutstanding
                      Weighted
                          Average
                        Remaining
                          Contractual Life in Years
                      Number
                          Exercisable$6.62-$9.00
                      157,278
                      3.46
                      157,278$9.01-$12.00
                      105,201
                      4.81
                      105,201$12.01-$15.00
                      59,692
                      1.98
                      59,692$15.01-$18.00
                      74,911
                      6.72
                      74,911$18.01-$18.37
                      60,250
                      8.49
                      60,250457,332
                      4.77
                      457,332
 
 The
              fair
              values of the options granted prior to January 1, 2006 had been estimated
              on the
              date of the grants using the Black-Scholes option-pricing model. Option
              pricing
              models require the use of highly subjective assumptions, including
              expected
              stock volatility, which when changed can materially affect fair value
              estimates.
              The expected life of the options used in this calculation was the period
              the
              options are expected to be outstanding. Expected stock price volatility
              was
              based on the historical volatility of the Company’s common stock for a period
              approximating the expected life, the expected dividend yield was based
              on the
              Company’s historical annual dividend payout, and the risk-free rate was based
              on
              the implied yield available on U.S. Treasury issues. The following
              weighted-average assumptions were used in the determining fair value
              for options
              granted in the quarter ended June 30, 2006 and 2005:
 
 2006
                    2005Dividend
                        yield
                    -
                    1.26%Expected
                        volatility
                    -
                    27.44%Risk-free
                        interest rate
                    -
                    4.03%Expected
                        life
                    -
                    7
                        years
 **6.**  **Investment
              Securities**
 
 The
              following table shows the gross unrealized losses and fair value of
              the
              Company’s investments with unrealized losses that are not deemed to be
              other-than-temporarily impaired, aggregated by investment category
              and length of
              time that individual securities have been in a continuous unrealized
              loss
              position, at June 30, 2006:
 
 
 Less
                        than 12 Months
                    
                    12
                        Months or Greater
                    
                    Total(*Dollars
                      in thousands)*
                    
                    Fair
                        Value
                    
                    Unrealized
                        Losses
                    
                    Fair
                        Value
                    
                    Unrealized
                        Losses
                    
                    Fair
                        Value
                    
                    Unrealized
                        Losses**Description
                        of Security***Available
                        for sale*Direct
                        obligations of U.S. government agencies
                    
                    $
                    33,635
                    
                    $
                    432
                    
                    $
                    32,181
                    
                    $
                    1,457
                    
                    $
                    65,816
                    
                    $
                    1,889Municipal
                        bonds
                    
                    
                    7,966
                    
                    
                    85
                    
                    
                    3,853
                    
                    
                    198
                    
                    
                    11,819
                    
                    
                    283Mortgage-backed
                        securities
                    
                    
                    33,333
                    
                    
                    818
                    
                    
                    41,726
                    
                    
                    2,595
                    
                    
                    75,059
                    
                    
                    3,41374,934
                    
                    
                    1,335
                    
                    
                    77,760
                    
                    
                    4,250
                    
                    
                    152,694
                    
                    
                    5,585*Held
                        to maturity*Direct
                        obligations of U.S. government agencies
                    
                    
                    -
                    
                    
                    -
                    
                    
                    4,441
                    
                    
                    155
                    
                    
                    4,441
                    
                    
                    155Municipal
                        bonds
                    
                    
                    -
                    
                    
                    -
                    
                    
                    286
                    
                    
                    14
                    
                    
                    286
                    
                    
                    14Mortgage-backed
                        securities
                    
                    
                    1,563
                    
                    
                    77
                    
                    
                    5,148
                    
                    
                    261
                    
                    
                    6,711
                    
                    
                    3381,563
                    
                    
                    77
                    
                    
                    9,875
                    
                    
                    430
                    
                    
                    11,438
                    
                    
                    507Total
                        at June 30, 2006
                    
                    $
                    76,497
                    
                    $
                    1,432
                    
                    $
                    87,635
                    
                    $
                    4,680
                    
                    $
                    164,132
                    
                    $
                    6,092
 -
                  11
                  -
  The
              unrealized losses on the Company‘s investments in direct obligations of U.S.
              government agencies and mortgage-backed securities were primarily the
              result of
              interest rate changes. Mortgage-backed securities include securities
              issued by
              government agencies and corporate entities. The Company has the ability
              and
              intent to hold these investments until a recovery of fair value, which
              may be
              maturity. Accordingly, the Company does not consider these investments
              to be
              other-than-temporarily impaired at June 30, 2006.
 
 **7.**  **Loans**
 
 The
              composition of the loan portfolio by loan classification at June 30,
              2006 and
              December 31, 2005 is as follows:
 June
                            30, 2006
                        
                        December
                            31, 2005*(Dollars
                            in thousands)*Commercial
                        
                        $
                        784,176
                        
                        $
                        555,198Consumer
                        
                        
                        31,662
                        
                        
                        26,222Home
                            equity lines
                        
                        
                        93,330
                        
                        
                        65,566Residential
                            mortgages
                        
                        
                        56,254
                        
                        
                        21,863965,422
                        
                        
                        668,849Plus
                            deferred loan costs, net
                        
                        
                        62
                        
                        
                        133$
                        965,484
                        
                        $
                        668,982
 
 Loans
              held for sale as of June 30, 2006 and December 31, 2005 were $8.2 million
              and
              $4.2 million, respectively, and were included in the residential mortgage
              category.
 
 **8.**  **Financial
              Instruments with Off-Balance Sheet Risk**
 
 To
              meet
              the financial needs of its customers, the Company is party to financial
              instruments with off-balance sheet risk in the normal course of business.
              These
              financial instruments are comprised of unused lines of credit and standby
              letters of credit. These instruments involve, to varying degrees, elements
              of
              credit risk in excess of the amount recognized in the balance
              sheet.
 
 The
              Company’s exposure to credit loss in the event of nonperformance by the other
              party is represented by the contractual amount of those instruments.
              The Company
              uses the same credit policies in making these commitments as it does
              for
              on-balance sheet instruments. 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. Collateral held varies but may include
              trade
              accounts receivable, property, plant, and equipment and income-producing
              commercial properties. Since many unused lines of credit expire without
              being
              drawn upon, the total commitment amounts do not necessarily represent
              future
              cash requirements.
 
 The
              Company’s exposure to credit risk was as follows:
 June
                          30, 2006
                      
                      December
                          31, 2005*(Dollars
                          in thousands)*Unused
                          lines of credit
                      
                      $
                      268,500
                      
                      $
                      188,170Standby
                          letters of credit
                      
                      
                      11,828
                      
                      
                      8,563Total
                          commitments
                      
                      $
                      280,328
                      
                      $
                      196,733
 
 **Item
                2.**  **Management’s
                Discussion and Analysis of Financial Condition and Results of
                Operations**
 
 The
                following discussion presents an overview of the unaudited financial
                statements
                for the three and six months periods ended June 30, 2006 and 2005
                for Capital
                Bank Corporation (the “Company”) and it’s wholly owned subsidiary, Capital Bank
                (the “Bank”). This discussion and analysis is intended to provide pertinent
                information concerning financial position, results of operations,
                liquidity, and
                capital resources for the periods covered and should be read in conjunction
                with
                the unaudited financial statements and related footnotes contained
                in Part I,
                Item 1. of this report.
 
  -
                    12
                    -
  *Information
                set forth below contains various forward-looking statements within
                the meaning
                of Section 27A of the Securities Act of 1933, as amended, and Section
                21E of the
                Securities Exchange Act of 1934, as amended (the “Exchange Act”), which
                statements represent the Company’s judgment concerning the future and are
                subject to risks and uncertainties that could cause the Company’s actual
                operating results to differ materially. Such forward-looking statements
                can be
                identified by the use of forward-looking terminology, such as “may”, “will”,
“expect”, “anticipate”, “estimate”, “believe”, or “continue”, or the negative
                thereof or other variations thereof or comparable terminology. The
                Company
                cautions that such forward-looking statements are further qualified
                by important
                factors that could cause the Company’s actual operating results to differ
                materially from those in the forward-looking statements, as well
                as the factors
                set forth in Part II, Item 1A of this report, and the Company’s periodic reports
                and other filings with the Securities and Exchange Commission (the
                “SEC”).*
 
 ***Overview***
 
 The
                Bank
                is a full-service state chartered community bank conducting business
                throughout
                North Carolina. The Bank’s business consists principally of attracting deposits
                from the general public and investing these funds in loans secured
                by commercial
                real estate, secured and unsecured commercial and consumer loans,
                single-family
                residential mortgage loans, and home equity lines. As a community
                bank, the
                Bank’s profitability depends primarily upon its levels of net interest
                income,
                which is the difference between interest income from interest-earning
                assets and
                interest expense on interest-bearing liabilities. When interest-earning
                assets
                approximate or exceed interest-bearing liabilities, any positive
                interest rate
                spread will generate net interest income. The Bank’s profitability is also
                affected by its provision for loan losses, noninterest income, and
                other
                operating expenses. Noninterest income primarily consists of miscellaneous
                service charges and ATM fees, fees generated from originating mortgage
                loans
                that are sold and the increase in cash surrender value of bank-owned
                life
                insurance. Operating expenses primarily consist of compensation and
                benefits,
                occupancy related expenses, advertising, data processing, professional
                fees,
                telecommunication and other expenses.
 
 The
                Bank’s operations are influenced significantly by local economic conditions
                and
                by policies of financial institution regulatory authorities. The
                Bank’s 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. Lending activities
                are affected
                by the demand for financing, which in turn is affected by the prevailing
                interest rates.
 
 ***Executive
                Summary***
 
 As
                discussed in more detail below, the following is a brief summary
                of certain of
                our significant results for the quarter ended June 30, 2006:
 
 Ÿ
                      The
                          Company reported net income for the quarter ended June
                          30, 2006 of $3.1
                          million compared to$1.6
                          millionfor the quarter ended June 30, 2005. Fully diluted earnings
                          per share were
                          $0.26 and $0.23 for the quarter ended June 30, 2006 and
                          2005,
                          respectively.
 
 Ÿ
                      The
                          increase in net income was primarily due to a $4.4 million
                          increase in net
                          interest income, which reflects the addition of the assets
                          and liabilities
                          acquired in the 1st State Bancorp merger transaction and
                          a 49 basis point
                          increase in the net interest margin, offset by a $2.8 million
                          increase in
                          noninterest expenses, which includes the costs associated
                          with the
                          assimilation of 1st State Bancorp’s employees and operations into the
                          Company.
 
 Ÿ
                      The
                          provision for loan losses for the quarter ended June 30,
                          2006 was $249,000
                          compared to a credit in the quarter ended June 30, 2005
                          of $156,000. The
                          increase in the provision for loan losses is primarily
                          due to a charge-off
                          related to one loan relationship and the estimated inherent
                          losses
                          associated with the net growth in the loan portfolio during
                          the quarter
                          ended June 30, 2006. Net charge-offs for the quarter ended
                          June 30, 2006
                          were $523,000, or 0.22% of average loans, compared to $138,000,
                          or 0.09%
                          of average loans, for the quarter ended June 30,
                          2005.
 
  -
                    13
                    -
  Ÿ
                      Net
                          interest income for the quarter ended June 30, 2006 rose
                          to $11.6 million,
                          a 62% increase over the $7.2 million reported in the quarter
                          ended June
                          30, 2005. The Company’s net interest margin widened to 4.04%, a 49 basis
                          point increase over the second quarter of 2005. The increase
                          in net
                          interest income is primarily due to the incremental effects
                          of 1st State
                          Bancorp’s interest-earning assets and interest-bearing liabilities,
                          organic loan portfolio growth in the quarter and the continued
                          increase in
                          short term rates by the Federal
                          Reserve.
 
 Ÿ
                      Noninterest
                          income for the quarter ended June 30, 2006 increased $1.0
                          million to $2.6
                          million compared to the quarter ended June 30, 2005. This
                          increase is
                          primarily due to higher service charges and other fees
                          as a result of a
                          higher volume of transaction accounts, including those
                          acquired in the 1st
                          State Bancorp transaction, increased mortgage fees and
                          revenues as a
                          result of greater loan volume, and $138,000 in gains realized
                          on the sale
                          of consolidated branch locations.
 
 Ÿ
                      Noninterest
                          expenses were $9.3 million for the quarter ended June 30,
                          2006 compared to
                          $6.5 million for the quarter ended June 30, 2005. The increase
                          is
                          primarily due to higher salaries and employee benefits,
                          which increased by
                          $1.4 million in the quarter ended June 30, 2006 compared
                          to the quarter
                          ended June 30, 2005. The increase in salaries and employee
                          benefits was
                          primarily due to an increase in the number of personnel
                          employed by the
                          Company as a result of the 1st State Bancorp transaction
                          as well as higher
                          costs associated with the Company’s
                          growth.
 
 ***Financial
                Condition***
 
 Total
                consolidated assets of the Company at June 30, 2006 were $1.36 billion
                compared
                to $960.9 million at December 31, 2005, an increase of $403.1 million,
                or
                approximately 42%. The increase in total consolidated assets for
                the six month
                period ended June 30, 2006 is primarily due to a $292.1 million increase
                in the
                Bank’s loan portfolio, net of the allowance for loan losses, since December
                31,
                2005, which includes $230.6 million of net loans acquired in the
                1st State
                Bancorp transaction. Total deposits as of June 30, 2006 were $1.03
                billion,
                which represents growth of $327.5 million from December 31, 2005
                and includes
                $267.0 million of total deposits acquired in the 1st State Bancorp
                transaction.
 
 Total
                earning assets were $1.19 billion at June 30, 2006 compared to $843.9
                million at
                December 31, 2005. Earning assets represented 87.3% and 87.8% of
                total assets as
                of June 30, 2006 and December 31, 2005, respectively. At June 30,
                2006,
                investment securities were $189.7 million, which includes $7.8 million
                of
                investment securities acquired in the 1st State Bancorp transaction,
                compared to
                $161.6 million at December 31, 2005. Interest-earning cash, federal
                funds sold
                and short term investments were $35.9 million at June 30, 2006, an
                increase of
                $22.5 million from December 31, 2005. The Company has increased its
                holdings of
                short-term investment assets to maintain liquidity for loan fundings
                and future
                commitments. As of December 31, 2005, the Company had $33.1 million
                of cash held
                in escrow, which represented funds the Company was required to deposit
                with its
                transfer agent for payment to 1st  State
                Bancorp shareholders as cash consideration in connection with the
                1st State
                Bancorp merger transaction. Earning assets exclude bank owned life
                insurance,
                which increased from $19.9 million at December 31, 2005 to $20.2
                million at June
                30, 2006 due to the increase in cash surrender values.
 
 The
                allowance for loan losses as of June 30, 2006 was $14.0 million and
                represented
                approximately 1.45% of total loans at June 30, 2006. The allowance
                for loan
                losses increased $4.4 million from the December 31, 2005 balance
                of $9.6
                million. The increase is primarily due to the addition of 1st State
                Bank’s
                allowance for loan losses and the provision for loan losses recorded
                during the
                first six months of 2006. Management believes that the amount of
                the allowance
                is adequate to absorb the estimated probable losses inherent in the
                current loan
                portfolio. See *“Asset
                Quality”* for
                further discussion of the allowance for loan losses ***.***
 
 Total
                deposits as of June 30, 2006 were $1.03 billion, an increase of $327.5
                million,
                or 46.9%, from December 31, 2005. The increase was primarily the
                result of
                $267.0 million of deposits acquired in the 1st State Bancorp transaction.
                As of
                June 30, 2006, the Company experienced an increase of $167.7 million,
                or 47.6%,
                in certificates of deposit (“CDs”) compared to December 31, 2005, which includes
                $139.8 million of CDs acquired in the 1st State Bancorp transaction.
                Total time
                deposits represented 56.5% of total deposits at June 30, 2006 compared
                to 54.9%
                at December 31, 2005. The Company introduced a new high yield checking
                account
                product, *Smart
                Checking* ,
                during
                the second quarter of 2006. As of June 30, 2006, there were 1,317 *Smart
                Checking* accounts
                and $7.0 million of deposits associated with this new product.
 
  -
                    14
                    -
  Noninterest
                bearing demand deposit accounts (“DDA”) were $105.7 million at June 30, 2006, an
                increase of $27.8 million, or 35.7%, from December 31, 2005, which
                includes
                $19.8 million of noninterest bearing deposits acquired in the 1st
                State Bancorp
                transaction. The average balance of noninterest DDA accounts was
                $105.5 million
                during the quarter ended June 30, 2006 compared to $68.3 million
                during the
                quarter ended June 30, 2005.
 
 Total
                consolidated shareholders’ equity was $157.8 million as of June 30, 2006, an
                increase of $74.3 million from December 31, 2005. The Company issued
                4.9 million
                shares of common stock valued at $74.5 million in connection with
                the 1st State
                Bancorp transaction. Retained earnings increased by $4.4 million
                reflecting $5.8
                million of net income for the six months period ended June 30, 2006
                less $1.4
                million of dividends paid during the six months ended June 30, 2006.
                Accumulated
                other comprehensive loss, which represents the unrealized loss on
                available for
                sale securities, net of related tax benefits, was $3.3 million, an
                increase of
                $1.6 million for the six months period ended June 30, 2006, which
                is due to the
                effect that rising interest rates have on the fair value of the Company’s
                investment security portfolio. See Item 1. Financial Statements -
                Consolidated
                Statements of Changes in Shareholders’ Equity for additional
                information.
 
 ***Results
                of Operations***
 
 Quarter
                ended June 30, 2006 compared to quarter ended June 30, 2005
 
 For
                the
                quarter ended June 30, 2006, the Company reported net income of $3.1
                million, or
                $0.26 per diluted share, compared to net income of $1.6 million,
                or $0.23 per
                diluted share, for the quarter ended June 30, 2005. Net income increased
                by $1.5
                million primarily due to higher loan and deposit balances on which
                net interest
                income and noninterest income are generated offset by higher operating
                expenses.
                The increased balances were primarily the result of the 1st State
                Bancorp
                transaction combined with organic loan and deposit growth. The Company’s net
                interest margin also improved in the quarter ended June 30, 2006
                compared to the
                quarter ended June 30, 2005 as a result of the increasing interest
                rate
                environment and the Company’s asset-sensitive position.
 
 Net
                interest income increased $4.4 million, or 62.1%, from $7.2 million
                for the
                quarter ended June 30, 2005, to $11.6 million for the quarter ended
                June 30,
                2006. Average earning assets increased $345.3 million to $1.17 billion
                for the
                quarter ended June 30, 2006 from $826.4 million for the quarter ended
                June 30,
                2005. Average interest bearing liabilities increased $311.3 million
                to $1.05
                billion for the quarter ended June 30, 2006 from $738.8 million for
                the quarter
                ended June 30, 2005. The net interest margin on a fully taxable equivalent
                basis
                increased 49 basis points to 4.04% for the quarter ended June 30,
                2006 from
                3.55% for the quarter ended June 30, 2005. The earned yield on average
                interest
                earnings assets was 7.29% and 6.02% for the quarter ended June 30,
                2006 and
                2005, respectively, while the interest rate on average interest bearing
                liabilities for those periods was 3.63% and 2.76%, respectively.
                The increase in
                the net interest margin is primarily attributed to increases in the
                benchmark
                federal funds rates as determined by the Federal Reserve Open Market
                Committee
                (“FOMC”). The Company’s balance sheet remains asset sensitive and, as a result,
                its interest earning assets re-price faster than its interest bearing
                liabilities. The Company cannot be certain of the direction of the
                benchmark
                federal funds rates as set by the FOMC. Further increases by the
                FOMC will
                affect the level of the Company’s prime rate and likely continue to increase the
                effective cost of interest-bearing liabilities.
 
 The
                following table shows the Company’s effective yield on earning assets and cost
                of funds. Yields and costs are computed by dividing income or expense
                for the
                year by the respective daily average asset or liability balance.
 
  -
                    15
                    -
 **Average
                  Balances, Interest Earned or Paid, and Interest
                  Yields/Rates**
 **Quarter
                  Ended June 30, 2006 and 2005**
 Taxable
                  Equivalent Basis 1
 2006
                              
                              2005*(Dollars
                                  in thousands)*
                              
                              AverageBalance
                              
                              AmountEarned
                              
                              AverageRate
                              
                              AverageBalance
                              
                              AmountEarned
                              
                              AverageRate**Assets**Loans
                                  receivable:2Commercial
                              
                              $
                              774,512
                              
                              $
                              15,102
                              
                              
                              7.82%
                              
                              $
                              529,066
                              
                              $
                              8,469
                              
                              
                              6.42%Consumer
                              
                              
                              28,336
                              
                              
                              636
                              
                              
                              9.00%
                              
                              
                              31,309
                              
                              
                              594
                              
                              
                              7.61%Home
                                  equity
                              
                              
                              96,151
                              
                              
                              1,967
                              
                              
                              8.21%
                              
                              
                              61,755
                              
                              
                              954
                              
                              
                              6.20%Residential
                                  mortgages3
                              
                              
                              55,421
                              
                              
                              944
                              
                              
                              6.83%
                              
                              
                              26,139
                              
                              
                              388
                              
                              
                              5.95%Total
                                  loans
                              
                              
                              954,420
                              
                              
                              18,648
                              
                              
                              7.84%
                              
                              
                              648,269
                              
                              
                              10,405
                              
                              
                              6.44%Investment
                                  securities4
                              
                              
                              190,045
                              
                              
                              2,345
                              
                              
                              4.95%
                              
                              
                              160,955
                              
                              
                              1,890
                              
                              
                              4.71%Federal
                                  funds sold and other interest on short-term investments
                              
                              
                              27,183
                              
                              
                              308
                              
                              
                              4.94%
                              
                              
                              17,137
                              
                              
                              116
                              
                              
                              2.72%Total
                                  interest earnings assets
                              
                              
                              1,171,648
                              
                              $
                              21,301
                              
                              
                              7.29%
                              
                              
                              826,361
                              
                              $
                              12,411
                              
                              
                              6.02%Cash
                                  and due from banks
                              
                              
                              32,202
                              
                              
                              
                              
                              
                              
                              
                              
                              23,278Other
                                  assets
                              
                              
                              133,222
                              
                              
                              
                              
                              
                              
                              
                              
                              57,844Allowance
                                  for loan losses
                              
                              
                              (14,291
                              )
                              
                              
                              
                              
                              
                              
                              
                              (10,305
                              )Total
                                  assets
                              
                              $
                              1,322,781
                              
                              
                              
                              
                              
                              
                              
                              $
                              897,178**Liabilities
                                  and Equity**Savings
                                  deposits
                              
                              $
                              41,477
                              
                              $
                              52
                              
                              
                              0.50%
                              
                              $
                              17,239
                              
                              $
                              31
                              
                              
                              0.72%Interest-bearing
                                  demand deposits
                              
                              
                              279,029
                              
                              
                              1,981
                              
                              
                              2.85%
                              
                              
                              194,511
                              
                              
                              848
                              
                              
                              1.75%Time
                                  deposits
                              
                              
                              564,025
                              
                              
                              5,296
                              
                              
                              3.77%
                              
                              
                              391,244
                              
                              
                              2,797
                              
                              
                              2.87%Total
                                  interest-bearing deposits
                              
                              
                              884,531
                              
                              
                              7,329
                              
                              
                              3.32%
                              
                              
                              602,994
                              
                              
                              3,676
                              
                              
                              2.45%Borrowed
                                  funds
                              
                              
                              107,724
                              
                              
                              1,287
                              
                              
                              4.79%
                              
                              
                              100,819
                              
                              
                              1,027
                              
                              
                              4.09%Subordinated
                                  debt
                              
                              
                              30,930
                              
                              
                              596
                              
                              
                              7.73%
                              
                              
                              20,620
                              
                              
                              305
                              
                              
                              5.93%Repurchase
                                  agreements
                              
                              
                              26,884
                              
                              
                              289
                              
                              
                              4.31%
                              
                              
                              14,332
                              
                              
                              80
                              
                              
                              2.24%Total
                                  interest-bearing liabilities
                              
                              
                              1,050,069
                              
                              $
                              9,501
                              
                              
                              3.63%
                              
                              
                              738,765
                              
                              $
                              5,088
                              
                              
                              2.76%Noninterest-bearing
                                  deposits
                              
                              
                              105,506
                              
                              
                              
                              
                              
                              
                              
                              
                              68,313Other
                                  liabilities
                              
                              
                              5,885
                              
                              
                              
                              
                              
                              
                              
                              
                              11,394Total
                                  liabilities
                              
                              
                              1,161,460
                              
                              
                              
                              
                              
                              
                              
                              
                              818,472Shareholders’
                                  equity
                              
                              
                              161,321
                              
                              
                              
                              
                              
                              
                              
                              
                              78,706Total
                                  liabilities and shareholders’ equity
                              
                              $
                              1,322,781
                              
                              
                              
                              
                              
                              
                              
                              $
                              879,178Net
                                  interest spread5
                              
                              
                              
                              
                              
                              
                              
                              
                              3.66%
                              
                              
                              
                              
                              
                              
                              
                              
                              3.26%Tax
                                  equivalent adjustment
                              
                              
                              
                              
                              $
                              192
                              
                              
                              
                              
                              
                              
                              
                              $
                              163Net
                                  interest income and net interest margin6
                              
                              
                              
                              
                              $
                              11,800
                              
                              
                              4.04%
                              
                              
                              
                              
                              $
                              7,323
                              
                              
                              3.55%
 1 The
                  taxable equivalent basis is computed using a blended federal and
                  state tax rate
                  of approximately 38%.
 2 Loans
                  receivable include nonaccrual loans for which accrual of interest
                  has not been
                  recorded.
 3 Includes
                  loans held for sale.
 4 The
                  average balance for investment securities excludes the effect of
                  their
                  mark-to-market adjustment, if any.
 5 Net
                  interest spread represents the difference between the average yield
                  on
                  interest-earning assets and the average cost of interest-bearing
                  liabilities.
 6 Net
                  interest margin represents net interest income divided by average
                  interest-earning assets.
  -
                      16
                      -
 
 Interest
                  income on loans increased from $10.4 million for the quarter ended
                  June 30, 2005
                  to $18.6 million for the quarter ended June 30, 2006. The increase
                  is primarily
                  due to higher average loan balances, which increased by $306.2
                  million primarily
                  due to loan balances acquired in the 1st State Bancorp transaction,
                  and higher
                  loan yields. Yields on commercial, consumer, and home equity increased
                  140 basis
                  points, 139 basis points and 201 basis points, respectively, in
                  the quarter
                  ended June 30, 2006 compared to the quarter ended June 30, 2005.
                  Higher yields
                  in 2006 reflect the increase in the prime rate charged by the Bank
                  between those
                  two periods. Variable rate loans made up approximately 70% of the
                  total loan
                  portfolio at June 30, 2006 and 2005.
 
 Interest
                  income on investment securities increased from $1.7 million for
                  the quarter
                  ended June 30, 2005 to $2.2 million for the quarter ended June
                  30, 2006. The
                  increase is primarily due to an increase in average balances outstanding
                  between
                  the periods, which increased by $29.1 million. The yield on investment
                  securities on a tax-equivalent basis increased from 4.71% in the
                  quarter ended
                  June 30, 2005 to 4.95% in the quarter ended June 30, 2006. The
                  increase is
                  primarily due to higher yields on new investment securities
                  purchases.
 
 Interest
                  expense on deposits increased from $3.7 million for the quarter
                  ended June 30,
                  2005 to $7.3 million for the quarter ended June 30, 2006. The increase
                  is
                  primarily due to an increase in the average balance of interest
                  bearing deposits
                  outstanding, which increased $281.5 million primarily due to deposit
                  balances
                  acquired in the 1st State Bancorp transaction, and higher deposit
                  rates. The
                  average rate paid on time deposits increased from 2.87% for the
                  quarter ended
                  June 30, 2005 to 3.77% for the quarter ended June 30, 2006, a 90
                  basis point
                  rise, as new certificates were opened at higher rates due to the
                  rising interest
                  rate environment. Rates on shorter maturity CDs have increased
                  significantly
                  with the FOMC interest rate increases and management anticipates
                  the Bank’s CD
                  funding costs will increase on a quarterly basis going forward for the remainder
                  of 2006.
  Interest
                  expense on borrowings increased from $1.4 million for the quarter
                  ended June 30,
                  2005 to $2.2 million for the quarter ended June 30, 2006. The increase
                  is
                  primarily due to higher outstanding borrowing and subordinated
                  debt balances and
                  an increase in interest rates. The rate on borrowings and subordinated
                  debentures for the quarter ended June 30, 2006 increased to 4.79%
                  and 7.73%,
                  respectively, from 4.09% and 5.93%, respectively, for the quarter
                  ended June 30,
                  2005. In July of 2003, the Bank entered into interest rate swap
                  agreements on
                  $25.0 million of its outstanding Federal Home Loan Bank advances
                  to swap fixed
                  rate borrowings to a variable rate. In the second quarter of 2005,
                  the net
                  effect of the swaps was a reduction of interest expense, however,
                  as a result of
                  the significant increase in short-term interest rates, the net
                  effect of the
                  swaps was an increase in interest expense for the second quarter
                  of 2006. As
                  short-term interest rates have increased following the FOMC rate
                  increases, the
                  overall effective rate on both borrowings and subordinated debt
                  has
                  increased.
 
 For
                  the
                  quarter ended June 30, 2006, the provision for loan losses was
                  $249,000 compared
                  to a credit of $156,000 for the quarter ended June 30, 2005, an
                  increase of
                  $405,000. The increase in the provision for loan losses was primarily
                  due to a
                  charge-off related to one loan relationship and the estimated inherent
                  losses
                  associated with the net growth in the loan portfolio during the
                  quarter ended
                  June 30, 2006 and other factors as discussed more fully below under
                  “ *Asset
                  Quality.” Net c* harge-offs
                  for the quarter ended June 30, 2006 were $523,000, or 0.22% of
                  average loans,
                  compared to $138,000, or 0.09% of average loans for the quarter
                  ended June 30,
                  2005. Charge-offs for the quarter ended June 30, 2006 includes
                  $491,000 related
                  to a participating loan.
 
 Noninterest
                  income for the quarter ended June 30, 2006 was $2.6 million compared
                  to $1.6
                  million for the quarter ended June 30, 2005, an increase of $1.0
                  million. This
                  increase was primarily due to higher service charges and other
                  fees as a result
                  of a higher volume of transaction accounts, which were acquired
                  in the 1st State
                  Bancorp transaction, increased mortgage fees and revenues due to
                  higher loan
                  volumes and $138,000 in gains from the sale of consolidated branch
                  locations.
 
 Noninterest
                  expenses for the quarter ended June 30, 2006 were $9.3 million
                  compared to $6.5
                  million for the quarter ended June 30, 2005. Salaries and employee
                  benefits,
                  representing the largest noninterest expense category, increased
                  to $4.9 million
                  for the quarter ended June 30, 2006, from $3.5 million for the
                  quarter ended
                  June 30, 2005. The increase was primarily due to an increase in
                  the number of
                  personnel employed by the Company as a result of the 1st State
                  Bancorp
                  transaction and the Company’s overall period-over-period growth. As of June 30,
                  2006, the Company had 326 full-time equivalent employees compared
                  to 244 at June
                  30, 2005 and 256 at December 31, 2005. In addition, noninterest
                  expense for the
                  quarter ended June 30, 2005 included approximately $200,000 attributable
                  to
                  severance payments for an executive officer that left the Company
                  in April
                  2005.
 
 
 -
                        17
                        -
 
 Occupancy
                  costs, the second largest component of noninterest expenses, increased
                  $312,000
                  to $938,000 for the quarter ended June 30, 2006 from $626,000 for
                  the quarter
                  ended June 30, 2005. The increase is primarily due to expenses
                  associated with
                  branches acquired in the 1st State Bancorp transaction and higher
                  rent expense.
                  Furniture and equipment expenses for the quarter ended June 30,
                  2006 increased
                  $192,000 from the same period in 2005 primarily due to higher equipment
                  repair
                  and maintenance costs associated with the increase in branch locations
                  and
                  higher depreciation associated with computer equipment acquired
                  for the
                  Company’s operations center. Data processing expenses for the quarter ended
                  June
                  30, 2006 decreased $207,000 from the same period in 2005 primarily
                  due to
                  cost-savings associated with Company’s operations center. The Company completed
                  the consolidation of its state-wide operations during the first
                  quarter of 2006
                  and now processes data and banking items in-house. The Company
                  anticipates data
                  processing costs will continue to decrease in future periods as
                  a result of
                  consolidating the transaction processing at its operations center
                  in Burlington,
                  North Carolina.
 
 Deposit
                  premium amortization for the quarter ended June 30, 2006 increased
                  $290,000 from
                  the same period in 2005 primarily as a result of the deposit premium
                  intangible
                  associated with the 1st State Bancorp transaction, which was valued
                  at $5.3
                  million as of the closing date and is being amortized over eight
                  years.
                  Advertising costs for the quarter ended June 30, 2006 increased
                  $161,000 from
                  the same period in 2005 primarily due to expenses associated with
                  the promotion
                  of a new checking account product and the opening of the Company’s new
                  headquarters. Professional fees for the quarter ended June 30,
                  2006 increased
                  $144,000 from the same period in 2005 primarily due to higher consulting
                  fees
                  associated with the in-house operations migration. Other expenses
                  for the
                  quarter ended June 30, 2006 increased $586,000 from the same period
                  in 2005
                  primarily due to increased costs associated with printing, office
                  supplies and
                  travel and entertainment.
 
 The
                  Company’s effective tax rate for the second quarter of 2006 was 34.1% compared
                  to 33.3% for the comparable period of 2005. Income tax expense
                  for the quarter
                  ended June 30, 2006 and 2005 was $1.6 million and $0.8 million
                  respectively. The
                  Company forecasts its taxable and non-taxable income and calculates
                  the
                  effective tax rate for the entire year, which is then applied to
                  the three month
                  period.
 
 ***Results
                  of Operations***
 
 Six
                  month periods ended June 30, 2006 and 2005
 
 For
                  the
                  six month period ended June 30, 2006, the Company reported net
                  income of $5.8
                  million, or $.50 per diluted share, compared to net income of $3.2
                  million, or
                  $.46 per diluted share, for the six month period ended June 30,
                  2005. Net income
                  increased by $2.6 million primarily due to higher net interest
                  income, which
                  increased as a result of higher loan and deposit balances acquired
                  in the 1st
                  State Bancorp transaction and an improved net interest margin offset
                  by higher
                  operating expenses.
 
 Net
                  interest income increased $8.9 million, or 63.5%, from $14.1 million
                  for the six
                  month period ended June 30, 2005, to $23.0 million for the six
                  month period
                  ended June 30, 2006. Average earning assets increased $345.6 million
                  to $1.17
                  billion for the six month period ended June 30, 2006 from $819.7
                  million for the
                  six month period ended June 30, 2005. Average interest bearing
                  liabilities
                  increased $306.2 million to $1.04 billion for the six month period
                  ended June
                  30, 2006 from $733.6 million for the six month period ended June
                  30, 2005. The
                  net interest margin on a fully taxable equivalent basis increased
                  51 basis
                  points to 4.05% for the six month period ended June 30, 2006 from
                  3.54% for the
                  six month period ended June 30, 2005. The earned yield on average
                  interest
                  earnings assets was 7.12% and 5.91% for the six month periods ended
                  June 30,
                  2006 and 2005, respectively, while the interest rate on average
                  interest bearing
                  liabilities for those periods was 3.44% and 2.65%, respectively.
                  The increase in
                  the net interest margin is primarily attributed to increases in
                  the benchmark
                  federal funds rates as determined by the FOMC and the asset sensitive
                  position
                  of the Company’s balance sheet.
 
 The
                  following table shows the Company’s effective yield on earning assets and cost
                  of funds. Yields and costs are computed by dividing income or expense
                  for the
                  year by the respective daily average asset or liability balance.
 
 
 -
                        18
                        -
 
 **Average
                  Balances, Interest Earned or Paid, and Interest
                  Yields/Rates**
 **Six
                  Months Ended June 30, 2006 and 2005**
 Taxable
                  Equivalent Basis 1
 
 2006
                        
                        2005*(Dollars
                            in thousands)*
                        
                        AverageBalance
                        
                        AmountEarned
                        
                        AverageRate
                        
                        AverageBalance
                        
                        AmountEarned
                        
                        AverageRate**Assets**Loans
                            receivable:2Commercial
                        
                        $
                        756,337
                        
                        $
                        28,779
                        
                        
                        7.67%
                        
                        $
                        531,156
                        
                        $
                        16,396
                        
                        
                        6.22%Consumer
                        
                        
                        29,953
                        
                        
                        1,276
                        
                        
                        8.59%
                        
                        
                        31,566
                        
                        
                        1,161
                        
                        
                        7.42%Home
                            equity
                        
                        
                        98,235
                        
                        
                        3,789
                        
                        
                        7.78%
                        
                        
                        61,834
                        
                        
                        1,828
                        
                        
                        5.96%Residential
                            mortgages3
                        
                        
                        54,660
                        
                        
                        1,822
                        
                        
                        6.72%
                        
                        
                        25,793
                        
                        
                        762
                        
                        
                        5.96%Total
                            loans
                        
                        
                        939,185
                        
                        
                        35,666
                        
                        
                        7.66%
                        
                        
                        650,349
                        
                        
                        20,147
                        
                        
                        6.25%Investment
                            securities4
                        
                        
                        192,290
                        
                        
                        4,648
                        
                        
                        4.87%
                        
                        
                        159,459
                        
                        
                        3,751
                        
                        
                        4.74%Federal
                            funds sold and other interest on short-term investments
                        
                        
                        33,830
                        
                        
                        850
                        
                        
                        5.07%
                        
                        
                        9,854
                        
                        
                        133
                        
                        
                        2.72%Total
                            interest earnings assets
                        
                        
                        1,165,305
                        
                        $
                        41,164
                        
                        
                        7.12%
                        
                        
                        819,662
                        
                        $
                        24,031
                        
                        
                        5.91%Cash
                            and due from banks
                        
                        
                        31,788
                        
                        
                        
                        
                        
                        
                        
                        
                        22,872Other
                            assets
                        
                        
                        135,454
                        
                        
                        
                        
                        
                        
                        
                        
                        56,595Allowance
                            for loan losses
                        
                        
                        (15,723
                        )
                        
                        
                        
                        
                        
                        
                        
                        (10,584
                        )Total
                            assets
                        
                        $
                        1,316,824
                        
                        
                        
                        
                        
                        
                        
                        $
                        888,545**Liabilities
                            and Equity**Savings
                            deposits
                        
                        $
                        42,646
                        
                        $
                        112
                        
                        
                        0.53%
                        
                        $
                        16,495
                        
                        $
                        41
                        
                        
                        0.50%Interest-bearing
                            demand deposits
                        
                        
                        272,357
                        
                        
                        3,530
                        
                        
                        2.61%
                        
                        
                        184,322
                        
                        
                        1,486
                        
                        
                        1.63%Time
                            deposits
                        
                        
                        556,121
                        
                        
                        9,797
                        
                        
                        3.55%
                        
                        
                        393,585
                        
                        
                        5,331
                        
                        
                        2.73%Total
                            interest-bearing deposits
                        
                        
                        871,124
                        
                        
                        13,439
                        
                        
                        3.11%
                        
                        
                        594,402
                        
                        
                        6,858
                        
                        
                        2.33%Borrowed
                            funds
                        
                        
                        111,043
                        
                        
                        2,613
                        
                        
                        4.75%
                        
                        
                        103,680
                        
                        
                        2,046
                        
                        
                        3.98%Subordinated
                            debt
                        
                        
                        31,752
                        
                        
                        1,193
                        
                        
                        7.58%
                        
                        
                        20,620
                        
                        
                        581
                        
                        
                        5.68%Repurchase
                            agreements
                        
                        
                        25,868
                        
                        
                        536
                        
                        
                        4.18%
                        
                        
                        14,906
                        
                        
                        153
                        
                        
                        2.07%Total
                            interest-bearing liabilities
                        
                        
                        1,039,787
                        
                        $
                        17,781
                        
                        
                        3.44%
                        
                        
                        733,608
                        
                        $
                        9,638
                        
                        
                        2.65%Noninterest-bearing
                            deposits
                        
                        
                        102,741
                        
                        
                        
                        
                        
                        
                        
                        
                        65,145Other
                            liabilities
                        
                        
                        13,715
                        
                        
                        
                        
                        
                        
                        
                        
                        11,201Total
                            liabilities
                        
                        
                        1,156,243
                        
                        
                        
                        
                        
                        
                        
                        
                        809,954Shareholders’
                            equity
                        
                        
                        160,581
                        
                        
                        
                        
                        
                        
                        
                        
                        78,5916Total
                            liabilities and shareholders’ equity
                        
                        $
                        1,316,824
                        
                        
                        
                        
                        
                        
                        
                        $
                        888,545Net
                            interest spread5
                        
                        
                        
                        
                        
                        
                        
                        
                        3.68%
                        
                        
                        
                        
                        
                        
                        
                        
                        3.26%Tax
                            equivalent adjustment
                        
                        
                        
                        
                        $
                        385
                        
                        
                        
                        
                        
                        
                        
                        $
                        327Net
                            interest income and net interest margin6
                        
                        
                        
                        
                        $
                        23,383
                        
                        
                        4.05%
                        
                        
                        
                        
                        $
                        14,393
                        
                        
                        3.54%
 
 1
                        The
                            taxable equivalent basis is computed using a blended
                            federal and state tax
                            rate of approximately 38%.
 2
                        Loans
                            receivable include nonaccrual loans for which accrual
                            of interest has not
                            been recorded.
 3
                        Includes
                            loans held for sale.
 4
                        The
                            average balance for investment securities excludes the
                            effect of their
                            mark-to-market adjustment, if any.
 5
                        Net
                            interest spread represents the difference between the
                            average yield on
                            interest-earning assets and the average cost of interest-bearing
                            liabilities.
 6
                        Net
                            interest margin represents net interest income divided
                            by average
                            interest-earning assets.
 
 
 -
                        19
                        -
 For
                    the
                    six months period ended June 30, 2006, the provision for loan
                    losses was
                    $661,000 compared to a credit provision of $406,000 for the six
                    months period
                    ended June 30, 2005, an increase of approximately $1.1 million.
                    The increase in
                    2005 was primarily due to an increase in charge-offs during the
                    six months
                    period ended June 30, 2006, which rose to $3.9 million from $237,000
                    recorded in
                    same period in 2005 and the estimated inherent losses associated
                    with overall
                    net growth of the loan portfolio. Charge-offs for the six months
                    period ended
                    June 30, 2006 includes $3.3 million related to one 1st State
                    Bank loan
                    relationship that had been fully reserved by 1st State Bank as
                    of December 31,
                    2005 and had no impact on the Bank’s loan loss provision for the six months
                    period ended June 30, 2006. See *“Asset
                    Quality”* below
                    for further discussion of the allowance for loan losses.
 
 Noninterest
                    income for the six months period ended June 30, 2006, was $4.6
                    million compared
                    to $2.9 million for the six months period ended June 30, 2005,
                    an increase of
                    $1.7 million. Deposit service charges and fees increased by $655,000
                    as a result
                    of a higher volume of transaction accounts acquired in the 1st
                    State Bancorp
                    transaction. Mortgage fees and revenues increased by $360,000
                    primarily due to
                    higher loan volumes. Brokerage income increased $160,000 due
                    to higher
                    investment product sales and the Company realized $138,000 in
                    gains on the sale
                    of consolidated branch locations.
 
 Noninterest
                    expense for the six months period ended June 30, 2006 was $18.2
                    million compared
                    to $12.6 million for the six months period ended June 30, 2005.
                    Salaries and
                    employee benefits, representing the largest noninterest expense
                    category,
                    increased to $9.4 million for the six months period ended June
                    30, 2006, from
                    $6.6 million for the six months period ended June 30, 2005. This
                    increase
                    reflects an increase in the number of personnel employed by the
                    Company as a
                    result of the 1st State Bancorp transaction and the Company’s overall growth.
 
 Occupancy
                    costs and furniture and equipment expenses for the six months
                    ended June 30,
                    2006 increased by $476,000 and $317,000, respectively, compared
                    to the six
                    months period ended June 30, 2005 primarily due to the 1st State
                    Bancorp
                    transaction, which increased the number of branches in the Company’s network.
                    Directors’ fees increased $264,000 for the six months period ended June
                    30, 2006
                    compared to the same period in 2005 primarily due to higher expense
                    accruals
                    associated with the directors’ supplemental retirement plan and the directors’
deferred compensation plan as a result of the adoption of SFAS
                    123R. Deposit
                    premium amortization for the six months ended June 30, 2006 increased
                    $579,000
                    from the same period in 2005 primarily due to the deposit premium
                    intangible
                    associated with the 1st State Bancorp transaction. Other expenses
                    for the six
                    months period ended June 30, 2006 increased $808,000 from the
                    same period in
                    2005 primarily due to higher costs associated with postage, office
                    supplies and
                    travel and entertainment.
 
 The
                    Company’s effective tax rate for the six months period ended June 30,
                    2006 and
                    2005 was 34.0% and 33.5%, respectively. The change in the effective
                    tax rate was
                    due to changes in forecasted levels of taxable and tax exempt
                    income and the
                    increase for these comparable periods primarily reflects a lower
                    mix of tax
                    exempt income. The Company recorded income tax expense of $3.0
                    million and $1.6
                    million for the six months periods ended June 30, 2006 and 2005,
                    respectively.
 
 ***Asset
                    Quality***
 
 Determining
                    the allowance for loan losses is based on a number of factors,
                    many of which are
                    subject to judgments made by management. At the origination of
                    each commercial
                    loan, management assesses the relative risk of the loan and assigns
                    a
                    corresponding risk grade. To ascertain that the credit quality
                    is maintained
                    after the loan is booked, the Bank has a procedure whereby a
                    loan review officer
                    performs an annual review of all unsecured loans over a predetermined
                    loan
                    amount, a sampling of loans within a lender’s authority, and a sampling of the
                    entire loan pool. Loans are reviewed for credit quality, sufficiency
                    of credit
                    and collateral documentation, proper loan approval, covenant,
                    policy and
                    procedure adherence, and continuing accuracy of the loan grade.
                    This officer
                    reports directly to the Chief Credit Officer and the Audit Committee
                    of the
                    Company’s Board of Directors. On an as needed basis, the Bank will hire
                    an
                    outside third party firm to review the Bank’s loan portfolio to ensure quality
                    standards and reasonableness of risk assessment.
 
 The
                    Company estimates the amount of allowance needed to cover probable
                    inherent
                    losses in the portfolio by applying a loss allowance factor to
                    each risk grade.
                    Consumer loans and mortgages are not risk graded, but a loss
                    allocation factor
                    is utilized for these loans based on historical losses. The loss
                    allocation
                    factors have been developed based on the Bank’s historical losses and industry
                    trends. In addition to this quantitative analysis, a qualitative
                    assessment of
                    the general economic trends, portfolio concentration and the
                    trend of
                    delinquencies are taken into consideration. The loan loss allowance
                    is adjusted
                    to an amount that management believes is adequate to absorb probable
                    losses
                    inherent in the loan portfolio as of the balance sheet date
                    presented.
  -
                        20
                        -
  Beginning
                    in the second quarter of 2005, the Company began estimating a
                    specific allowance
                    for loan losses associated with certain commercial loans greater
                    than $750,000.
                    Management determines the level of specific allowance based on
                    the facts and
                    circumstances of each loan, including among other factors, payment
                    history,
                    collateral values, guarantor liquidity, and net worth. Of the
                    $14.0 million
                    allowance for loan losses as of June 30, 2006, $2.6 million has
                    been allocated
                    to specific loans.
 
 The
                    allowance for loan losses is established through a provision
                    for loan losses
                    charged to expense. Loans are charged against the allowance for
                    loan losses when
                    management believes that the collectibility of the principal
                    is unlikely. Based
                    on this allowance calculation, management recorded a provision
                    of $249,000 for
                    the quarter ended June 30, 2006, compared to a credit of $156,000
                    for the
                    quarter ended June 30, 2005. The Company added 1st State Bank’s allowance for
                    loan losses, which was $7.6 million as of December 31, 2005,
                    to the Company’s
                    allowance for loan losses. The Company experienced an overall
                    improvement in key
                    risk metrics associated with the loan portfolio during the quarter
                    ended June
                    30, 2006. Past due loans as a percentage of the loan portfolio
                    decreased from
                    1.26% at March 31, 2006 to 0.96% at June 30, 2006. Past dues
                    greater than 90
                    days as a percentage of total loans was 0.47% and 0.46% at June
                    30, 2006 and
                    March 31, 2006, respectively. The following table presents an
                    analysis of
                    changes in the allowance for loan losses for the three and six
                    month periods
                    ended June 30, 2006 and 2005, respectively:
  Three
                                Months Ended June 30
                            
                            Six
                                Months Ended June 302006
                            
                            2005
                            
                            2006
                            
                            2005*(Dollars
                                in thousands)*Allowance
                                for loan losses, beginning of period
                            
                            $
                            14,209
                            
                            $
                            10,372
                            
                            $
                            9,592
                            
                            $
                            10,7211st
                                State Bank loan loss allowance acquired
                            
                            
                            -
                            
                            
                            -
                            
                            
                            7,637
                            
                            
                            -Net
                                charge-offs:Loans
                                charged off:Commercial
                            
                            
                            531
                            
                            
                            -
                            
                            
                            3,847
                            
                            
                            96Consumer
                            
                            
                            30
                            
                            
                            121
                            
                            
                            136
                            
                            
                            280Home
                                equity lines
                            
                            
                            26
                            
                            
                            -
                            
                            
                            26
                            
                            
                            -Mortgage
                            
                            
                            3
                            
                            
                            59
                            
                            
                            34
                            
                            
                            110Total
                                charge-offs
                            
                            
                            590
                            
                            
                            180
                            
                            
                            4,0431
                            
                            
                            486Recoveries
                                of loans previously charged off:Commercial
                            
                            
                            117
                            
                            
                            20
                            
                            
                            125
                            
                            
                            221Consumer
                            
                            
                            22
                            
                            
                            19
                            
                            
                            26
                            
                            
                            25Home
                                equity
                            
                            
                            -
                            
                            
                            -
                            
                            
                            4
                            
                            
                            -Mortgage
                            
                            
                            -
                            
                            
                            -
                            
                            
                            5
                            
                            
                            -Total
                                recoveries
                            
                            
                            139
                            
                            
                            39
                            
                            
                            160
                            
                            
                            246Total
                                net charge-offs
                            
                            
                            451
                            
                            
                            141
                            
                            
                            3,883
                            
                            
                            240Loss
                                provisions (credit) charged to operations
                            
                            
                            249
                            
                            
                            (156
                            )
                            
                            661
                            
                            
                            (406
                            )Allowance
                                for loan losses, end of period
                            
                            $
                            14,007
                            
                            $
                            10,075
                            
                            $
                            14,007
                            
                            $
                            10,075Net
                                charge-offs to average loans during the period
                                (annualized)
                            
                            
                            0.22%
                            
                            
                            0.09%
                            
                            
                            0.83%1
                            
                            
                            0.07%Allowance
                                as a percent of gross loans
                            
                            
                            1.45%
                            
                            
                            1.55%
 
 1 Net
                    charge-offs for the six months period ended June 30, 2006 includes
                    $3.3 million
                    related to one 1st State Bank loan relationship that was fully
                    reserved by 1st
                    State Bank as of December 31, 2005. Excluding the $3.3 million
                    charge-off, the
                    ratio of net charge-offs to average loans during the six months
                    period ending
                    June 30, 2006 was 0.13%.
 
  -
                        21
                        -
  The
                    following table presents an analysis of nonperforming assets
                    as of June 30, 2006
                    and 2005 and December 31, 2005:
  June
                                30, 2006
                            
                            June
                                30, 2005
                            
                            December
                                31, 2006*(Dollars
                                in thousands)*Nonaccrual
                                loans:Commercial
                                and commercial real estate
                            
                            $
                            3,728
                            
                            $
                            6,094
                            
                            $
                            5,040Mortgage
                            
                            
                            1,695
                            
                            
                            2,014
                            
                            
                            1,628Construction
                            
                            
                            193
                            
                            
                            1,674
                            
                            
                            737Equity
                                lines
                            
                            
                            418
                            
                            
                            -
                            
                            
                            497Consumer
                            
                            
                            106
                            
                            
                            645
                            
                            
                            176Total
                                nonaccrual loans
                            
                            
                            6,140
                            
                            
                            10,427
                            
                            
                            8,078Foreclosed
                                property held
                            
                            
                            879
                            
                            
                            1,508
                            
                            
                            771Total
                                nonperforming assets
                            
                            $
                            7,019
                            
                            $
                            11,935
                            
                            $
                            8,849Nonperforming
                                assets to total loans
                            
                            
                            0.73%
                            
                            
                            1.61%
                            
                            
                            1.32%Nonperforming
                                assets to total assets
                            
                            
                            0.51%
                            
                            
                            1.30%
                            
                            
                            0.92%Allowance
                                coverage of nonperforming loans
                            
                            
                            228%
                            
                            
                            97%
                            
                            
                            119%
 
 At
                    June
                    30, 2006, nonperforming assets were $7.0 million, a decrease
                    of $1.8 million
                    from December 31, 2005. The majority of the Company’s nonperforming loans are
                    secured by real estate and to a lesser extent the Company relies
                    on the support
                    of guarantors. The Company monitors the value of the underlying
                    collateral and
                    the liquidity of the guarantors on a periodic basis. Based on
                    this review and
                    analysis, the Company does not currently anticipate any material
                    losses
                    associated with the nonperforming loans existing at June 30,
                    2006.
 
 A
                    loan is
                    considered impaired, based on current information and events,
                    if it is probable
                    that the Bank will be unable to collect the scheduled payments
                    of principal and
                    interest when due according to the contractual terms of the loan
                    agreement.
                    Uncollateralized loans are measured for impairment based on the
                    present value of
                    expected future cash flows discounted at the historical effective
                    interest rate,
                    while all collateral-dependent loans are measured for impairment
                    based on the
                    fair value of the collateral. There were no impaired loans at
                    June 30, 2006 and
                    December 31, 2005.
 
 The
                    Bank uses several factors in determining if a loan is impaired.
                    Internal asset
                    classification procedures include a review of significant loans
                    and lending
                    relationships by both management and third party credit review
                    firms and
                    includes the accumulation of related data such as loan payment
                    status,
                    borrowers’ financial data and borrowers’ operating factors such as cash flows,
                    operating income or loss. The Company’s determination of the allowance for loan
                    losses is subject to management’s judgment and analysis of many internal and
                    external factors. While management is comfortable with the adequacy
                    of the
                    current allowance, changes in factors and management’s future evaluation of the
                    adequacy of the allowance for loan losses will change.
 
 Foreclosed
                    property increased to
                    $879,000 at June 30, 2006 from
                    $771,000 at
                    December 31, 2005. The increase is largely attributable to the
                    foreclosure of
                    certain nonaccrual loans during the quarter. The
                    Company is actively marketing all of its foreclosed property.
                    All foreclosed
                    assets are recorded at the lower of cost or fair value. Foreclosed
                    property excludes $776,000 related to two branch locations that
                    are held for
                    sale and are reported as other real estate owned pursuant to
                    bank regulations
                    and are also recorded at the lower of cost or fair value.
 
  -
                        22
                        -
  ***Liquidity
                    and Capital Resources***
 
 The
                    Company’s liquidity management involves planning to meet the Company’s
                    anticipated funding needs at a reasonable cost. Liquidity management
                    is guided
                    by policies formulated by the Company’s senior management and the
                    Asset/Liability Management Committee of the Company’s Board of Directors. The
                    Company had $84.2 million in its most liquid assets, cash and
                    cash equivalents,
                    as of June 30, 2006. The Company’s principal sources of funds are loan
                    repayments, deposits, Federal Home Loan Bank borrowings and capital
                    and, to a
                    lesser extent, investment repayments. Core deposits (total deposits
                    less
                    certificates of deposits in the amount of $100,000 or more),
                    one of the most
                    stable sources of liquidity, together with equity capital, which
                    totaled $ 953.8
                    million and $652.1 million at June 30, 2006 and December 31,
                    2005, respectively,
                    funded 69.9% of total assets at June 30, 2006 compared to 67.7%
                    at December 31,
                    2005. In addition, the Company has the ability to take advantage
                    of various
                    other funding programs available from the Federal Home Loan Bank
                    of Atlanta, as
                    well as access to funding through various brokered deposit programs,
                    federal
                    funds lines and security repurchase agreements.
 
 The
                    management of equity is a critical aspect of capital management
                    in any business.
                    The determination of the appropriate amount of equity is affected
                    by a wide
                    number of factors. The primary factor for a regulated financial
                    institution is
                    the amount of capital needed to meet regulatory requirements,
                    although other
                    factors, such as the “risk equity” the business requires and balance sheet
                    leverage, also affect the determination.
  On
                    February 27, 2006, the Company announced the Company’s Board of Directors had
                    authorized the Company to acquire in the open market or in any
                    private
                    transaction, from time-to-time and in accordance with applicable
                    laws, rules and
                    regulations, up to 1.0 million shares of the Company’s common stock. Management
                    plans to utilize share repurchases to manage capital levels of
                    the Company. The
                    Company plans to effect the repurchase program through open-market
                    purchases.
                    During the first six months of 2006, the Company repurchased
                    217,782 shares at a
                    weighted average price of $16.05 per share. See Part II - Other
                    Information,
                    Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
                    for more
                    information on the Company’s share repurchases.
 
 To
                    be
                    categorized as well capitalized, the Company and the Bank must
                    maintain minimum
                    amounts and ratios. The Company’s and the Bank’s actual capital amounts and
                    ratios as of June 30, 2006 and the minimum requirements are presented
                    in the
                    following table:
 
 Actual
                          
                          Minimum
                              Requirements
                            To
                              Be Well CapitalizedAmount
                          
                          Ratio
                          
                          Amount
                          
                          Ratio*(Dollars
                              in thousands)***Capital
                              Bank Corporation**Total
                              capital (to risk weighted assets)
                          
                          $
                          135,076
                          
                          
                          11.90%
                          
                          $
                          113,481
                          
                          
                          10.00%Tier
                              I capital (to risk weighted assets)
                          
                          
                          120,889
                          
                          
                          10.65%
                          
                          
                          68,089
                          
                          
                          6.00%Tier
                              1 capital (to average assets)
                          
                          
                          120,889
                          
                          
                          9.65%
                          
                          
                          62,634
                          
                          
                          5.00%**Capital
                              Bank**Total
                              capital (to risk weighted assets)
                          
                          $
                          132,386
                          
                          
                          11.68%
                          
                          $
                          113,384
                          
                          
                          10.00%Tier
                              I capital (to risk weighted assets)
                          
                          
                          118,211
                          
                          
                          10.43%
                          
                          
                          68,030
                          
                          
                          6.00%Tier
                              1 capital (to average assets)
                          
                          
                          118,211
                          
                          
                          9.46%
                          
                          
                          62.507
                          
                          
                          5.00%
 
 Consolidated
                    capital ratios decreased from December 31, 2005 due to the increase
                    in
                    risk-weighted and total assets associated with the Company’s acquisition of 1st
                    State Bancorp exceeding the tangible capital acquired. Total
                    capital to risk
                    weighted assets, Tier I capital to risk weighted assets and Tier
                    I capital to
                    average assets on a consolidated basis as of December 31, 2005
                    were 13.71%,
                    11.73% and 10.64%, respectively.
 
 Shareholders’
                    equity was $157.7 million, or $13.66 per share, at June 30, 2006.
                    Management
                    believes this level of shareholders’ equity provides adequate capital to support
                    the Company’s growth and to maintain a well capitalized position.
 
  -
                        23
                        -
  **Item
                    3.**  **Quantitative
                    and Qualitative Disclosures about Market Risk**
 
 As
                    described in more detail in our Annual Report on Form 10-K for
                    the year ended
                    December 31, 2005, as amended, asset/liability management involves
                    the
                    evaluation, monitoring and management of interest rate risk,
                    liquidity and
                    funding. While the Board of Directors has overall responsibility
                    for the
                    Company’s asset/liability management policies, the Asset and Liability
                    Committee
                    monitors loan, investment, and liability portfolios to ensure
                    comprehensive
                    management of interest rate risk and adherence to the policies.
 
 The
                    Company utilizes an outside asset liability management advisory
                    firm to help
                    management evaluate interest rate risk and develop asset/liability
                    management
                    strategies. One tool used is a computer simulation model which
                    projects the
                    Company‘s performance under different interest rate scenarios. Analyses
                    are
                    prepared quarterly which evaluate the Company’s performance under different
                    interest rate scenarios (flat, rising and declining). The following
                    tables
                    illustrate the output from the Company’s simulation model based on the balance
                    sheets as of June 30, 2006 and December 31, 2005. The tables
                    reflect
                    rate-sensitive positions at June 30, 2006 and December 31, 2005,
                    and are not
                    necessarily indicative of positions on other dates. The projected
                    results as of
                    June 30, 2006 include the impact of the 1st State Bancorp transaction,
                    which was
                    completed on January 3, 2006.
 
 The
                    following table illustrates the Company’s interest rate sensitivity as of June
                    30, 2006 and December 31, 2005. The carrying amounts of interest
                    rate sensitive
                    assets and liabilities are presented in periods in which they
                    next reprice to
                    market rates or mature and are aggregated to show the interest
                    rate sensitivity
                    gap. To reflect anticipated prepayments, certain asset and liability
                    amounts
                    were based on estimated cash flows rather than contractual cash
                    flows. The
                    Company continues to be “asset sensitive” at June 30, 2006 as its assets reprice
                    faster than its liabilities.
 
 Within
                              One Year
                          
                          One-TwoYears
                          
                          Two-FiveYears
                          
                          After
                              FiveYears
                          
                          Total*(Dollars
                              in thousands)***As
                              of June 30, 2006**Total
                              assets
                          
                          $
                          831,428
                          
                          $
                          82,724
                          
                          $
                          199,294
                          
                          $
                          250,584
                          
                          $
                          1,364,030Total
                              liabilities and equity
                          
                          
                          744,759
                          
                          
                          216,904
                          
                          
                          165,599
                          
                          
                          236,768
                          
                          
                          1,364,030Interest
                              rate sensitivity gap
                          
                          $
                          86,669
                          
                          $
                          (134,180
                          )
                          $
                          33,695
                          
                          $
                          13,816
                          
                          $
                          -Cumulative
                              interest rate sensitivity gap
                          
                          $
                          86,669
                          
                          $
                          (47,511
                          )
                          $
                          (13,816
                          )
                          $
                          -**As
                              of December 31, 2005**Total
                              assets
                          
                          $
                          569,081
                          
                          $
                          60,830
                          
                          $
                          182,755
                          
                          $
                          148,240
                          
                          $
                          960,906Total
                              liabilities and equity
                          
                          
                          387,158
                          
                          
                          250,575
                          
                          
                          115,821
                          
                          
                          207,352
                          
                          
                          960,906Interest
                              rate sensitivity gap
                          
                          $
                          181,923
                          
                          $
                          (189,745
                          )
                          $
                          66,934
                          
                          $
                          (59,112
                          )
                          $
                          -Cumulative
                              interest rate sensitivity gap
                          
                          $
                          181,923
                          
                          $
                          (7,822
                          )
                          $
                          59,112
                          
                          $
                          -
 
  -
                        24
                        -
  As
                    of
                    June 30, 2006 and December 31, 2005, under the flat rate scenario,
                    the Company’s
                    projected net interest income for the next twelve months was
                    $46.7 million and
                    $34.9 million, respectively. The table below measures the impact
                    on net interest
                    income of both a gradual and immediate 200 basis point change
                    in interest rates
                    over the twelve months following the interest rate change. Actual
                    results could
                    differ from these estimates.
 
 Change
                              in 12-Months Projected Net Interest Income versus Projected
                            Net
                              Interest Income under No Rate ChangeJune
                              30, 2006
                          
                          December
                              31, 2005Dollar
                              Change
                          
                          Percent
                              Change
                          
                          Dollar
                              Change
                          
                          Percent
                              Change*(Dollars
                              in millions)*Basis
                              point change:+
                              200 gradual
                          
                          $
                          3.8
                          
                          
                          8.1%
                          
                          $
                          2.9
                          
                          
                          8.3%+
                              200 immediate
                          
                          
                          6.0
                          
                          
                          12.8%
                          
                          
                          5.2
                          
                          
                          14.9%No
                              rate change
                          
                          
                          -
                          
                          
                          -
                          
                          
                          -
                          
                          
                          --
                              200 gradual
                          
                          
                          (1.4
                          )
                          
                          (3.0%)
                          
                          
                          (1.7
                          )
                          
                          (4.9%)-
                              200 immediate
                          
                          
                          (2.2
                          )
                          
                          (4.7%)
                          
                          
                          (3.3
                          )
                          
                          (9.5%)
 
 The
                    table
                    does not reflect the impact of hedging strategies discussed in
                    the Company’s
                    Annual Report on Form 10-K for the year ended December 31, 2005,
                    as
                    amended.
 
 **Item
                    4.**  **Controls
                    and Procedures**
 
 The
                    Company maintains disclosure controls and procedures that are
                    designed to ensure
                    that information required to be disclosed in the reports it files
                    or submits
                    under the Exchange Act is recorded, processed, summarized and
                    reported within
                    the time periods specified in the rules and forms of the SEC,
                    and that such
                    information is accumulated and communicated to the Company’s management,
                    including its Chief Executive Officer (“CEO”) and Chief Financial Officer
                    (“CFO”), as appropriate, to allow timely decisions regarding disclosure.
                    Management necessarily applied its judgment in assessing the
                    costs and benefits
                    of such controls and procedures, which, by their nature, can
                    provide only
                    reasonable assurance regarding management’s control objectives.
 
 As
                    required by paragraph (b) of Rule 13a-15 under the Exchange Act,
                    an evaluation
                    was carried out under the supervision and with the participation
                    of the
                    Company’s management, including the CEO and CFO, of the effectiveness
                    of the
                    Company’s disclosure controls and procedures as of the end of the period
                    covered
                    by this report. Based upon that evaluation, the CEO and CFO concluded
                    that, as
                    of the period covered by the report, the Company’s disclosure controls and
                    procedures are effective in that they provide reasonable assurances
                    that the
                    information the Company is required to disclose in the reports
                    it files or
                    submits under the Exchange Act is recorded, processed, summarized
                    and reported
                    within the time periods required by the SEC’s rules and forms.
 
 ***Changes
                    in Internal Control over Financial Reporting***
 
 There
                    were no changes in the Company’s internal control over financial reporting (as
                    defined in Rules 13a-15(f) and 15d-15(f) of the Exchange Act)
                    that occurred
                    during the period covered by this report that have materially
                    affected or are
                    reasonably likely to materially affect, the Company’s internal control over
                    financial reporting. Management has implemented changes in internal
                    control over
                    financial reporting as a result of remediation of matters identified
                    through its
                    review of internal control over financial reporting as required
                    under Section
                    404 of the Sarbanes Oxley Act, however it does not believe any
                    of the changes
                    implemented were material in nature.
 
 
  -
                        25
                        -
  **PART
                    II - OTHER INFORMATION**
 
 **Item
                    1.**  **Legal
                    Proceedings**
 
 There
                    are
                    no material pending legal proceedings to which the Company is
                    a party or to
                    which any of its property is subject. In addition, the Company
                    is not aware of
                    any threatened litigation, unasserted claims or assessments that
                    could have a
                    material adverse effect on the Company’s business, operating results or
                    condition.
 
 **Item
                    1A.**  **Risk
                    Factors**
 
 You
                    should consider the following material risk factors carefully
                    before deciding to
                    invest in the Company’s securities. Additional risks and uncertainties not
                    presently known to us, that we may currently deem to be immaterial
                    or that are
                    similar to those faced by other companies in our industry or
                    business in
                    general, such as competitive conditions, may also impact our
                    business
                    operations. If any of the events described below occur, the Company’s business,
                    financial condition, or results of operations could be materially
                    adversely
                    affected. In that event, the trading price of the Company’s common stock may
                    decline, in which case the value of your investment may decline
                    as well.
 
 ***Our
                    Results Are Impacted by the Economic Conditions of Our Principal
                    Operating
                    Regions***
 
 Our
                    operations are concentrated throughout Central and Western North
                    Carolina. As a
                    result of this geographic concentration, our results may correlate
                    to the
                    economic conditions in these areas. Deterioration in economic
                    conditions in any
                    of these market areas, particularly in the industries on which
                    these geographic
                    areas depend, may adversely affect the quality of our loan portfolio
                    and the
                    demand for our products and services, and accordingly, our results
                    of
                    operations.
 
 ***We
                    Are Exposed to Risks in Connection with the Loans We
                    Make***
 
 A
                    significant source of risk for us arises from the possibility
                    that losses will
                    be sustained because borrowers, guarantors and related parties
                    may fail to
                    perform in accordance with the terms of their loans. We have
                    underwriting and
                    credit monitoring procedures and credit policies, including the
                    establishment
                    and review of the allowance for loan losses, that we believe
                    are appropriate to
                    minimize this risk by assessing the likelihood of nonperformance,
                    tracking loan
                    performance and diversifying our loan portfolio. Such policies
                    and procedures,
                    however, may not prevent unexpected losses that could adversely
                    affect our
                    results of operations.
 
 ***We
                    Compete with Larger Companies for Business***
 
 The
                    banking and financial services business in our market areas continues
                    to be a
                    competitive field and is becoming more competitive as a result
                    of:
 
 Ÿ
                          Changes
                              in regulations;
 Ÿ
                          Changes
                              in technology and product delivery systems;
                              and
 Ÿ
                          The
                              accelerating pace of consolidation among financial
                              services
                              providers.
 
 We
                    may not be able to compete effectively in our markets, and our
                    results of
                    operations could be adversely affected by the nature or pace
                    of change in
                    competition. We compete for loans, deposits and customers with
                    various bank and
                    nonbank financial services providers, many of which have substantially
                    greater
                    resources including higher total assets and capitalization, greater
                    access to
                    capital markets and a broader offering of financial services.
 
 ***Our
                    Trading Volume Has Been Low Compared with Larger
                    Banks***
 
 The
                    trading volume in the Company’s common stock on the NASDAQ Global Select Market
                    has been comparable to other similarly-sized banks. Nevertheless,
                    this trading
                    is relatively low when compared with more seasoned companies
                    listed on the
                    NASDAQ Global Select Market or other consolidated reporting systems
                    or stock
                    exchanges. Thus, the market in the Company’s common stock may be limited in
                    scope relative to other companies.
 
  -
                        26
                        -
  ***We
                    Depend Heavily on Our Key Management Personnel***
 
 The
                    Company’s success depends in part on its ability to retain key executives
                    and to
                    attract and retain additional qualified management personnel
                    who have experience
                    both in sophisticated banking matters and in operating a small
                    to mid-size bank.
                    Competition for such personnel is strong in the banking industry
                    and we may not
                    be successful in attracting or retaining the personnel we require.
                    We expect to
                    effectively compete in this area by offering financial packages
                    that include
                    incentive-based compensation and the opportunity to join in the
                    rewarding work
                    of building a growing bank.
 
 ***Technological
                    Advances Impact Our Business***
 
 The
                    banking industry is undergoing technological changes with frequent
                    introductions
                    of new technology-driven products and services. In addition to
                    improving
                    customer services, the effective use of technology increases
                    efficiency and
                    enables financial institutions to reduce costs. Our future success
                    will depend,
                    in part, on our ability to address the needs of our customers
                    by using
                    technology to provide products and services that will satisfy
                    customer demands
                    for convenience as well as to create additional efficiencies
                    in our operations.
                    Many of our competitors have substantially greater resources
                    than we do to
                    invest in technological improvements. We may not be able to effectively
                    implement new technology-driven products and services or successfully
                    market
                    such products and services to our customers.
 
 ***Government
                    Regulations May Prevent or Impair Our Ability To Pay Dividends,
                    Engage in
                    Acquisitions or Operate in Other Ways***
 
 Current
                    and future legislation and the policies established by federal
                    and state
                    regulatory authorities will affect our operations. We are subject
                    to supervision
                    and periodic examination by the Federal Deposit Insurance Corporation
                    and the
                    North Carolina State Banking Commission. Banking regulations,
                    designed primarily
                    for the protection of depositors, may limit our growth and the
                    return to you,
                    our investors, by restricting certain of our activities, such
                    as:
 
 Ÿ
                          The
                              payment of dividends to our
                              shareholders;
 Ÿ
                          Possible
                              mergers with or acquisitions of or by other
                              institutions;
 Ÿ
                          Our
                              desired investments;
 Ÿ
                          Loans
                              and interest rates on loans;
 Ÿ
                          Interest
                              rates paid on our deposits;
 Ÿ
                          The
                              possible expansion of our branch offices;
                              and/or
 Ÿ
                          Our
                              ability to provide securities or trust
                              services.
 
 We
                    also are subject to capitalization guidelines set forth in federal
                    legislation,
                    and could be subject to enforcement actions to the extent that
                    we are found by
                    regulatory examiners to be undercapitalized. We cannot predict
                    what changes, if
                    any, will be made to existing federal and state legislation and
                    regulations or
                    the effect that such changes may have on our future business
                    and earnings
                    prospects. The cost of compliance with regulatory requirements
                    including those
                    imposed by the Securities and Exchange Commission may adversely
                    affect our
                    ability to operate profitably.
 
 ***There
                    Are Potential Risks Associated with Future Acquisitions and
                    Expansions***
 
 We
                    intend to continue to explore expanding our branch system through
                    selective
                    acquisitions of existing banks or bank branches in the Research
                    Triangle area
                    and other North Carolina markets. We cannot say with any certainty
                    that we will
                    be able to consummate, or if consummated, successfully integrate,
                    future
                    acquisitions, or that we will not incur disruptions or unexpected
                    expenses in
                    integrating such acquisitions. In the ordinary course of business,
                    we evaluate
                    potential acquisitions that would bolster our ability to cater
                    to the small
                    business, individual and residential lending markets in North
                    Carolina. In
                    attempting to make such acquisitions, we anticipate competing
                    with other
                    financial institutions, many of which have greater financial
                    and operational
                    resources. In addition, since the consideration for an acquired
                    bank or branch
                    may involve cash, notes or the issuance of shares of common stock,
                    existing
                    shareholders could experience dilution in the value of their
                    shares of our
                    common stock in connection with such acquisitions. Any given
                    acquisition, if and
                    when consummated, may adversely affect our results of operations
                    or overall
                    financial condition.
 
  -
                        27
                        -
  In
                    addition, we may expand our branch network through de novo branches
                    in existing
                    or new markets. These de novo branches will have expenses in
                    excess of revenues
                    for varying periods after opening, which could decrease our reported
                    earnings.
 
 ***Compliance
                    with Changing Regulation of Corporate Governance and Public Disclosure
                    May
                    Result in Additional Risks and Expenses***
 
 Changing
                    laws, regulations and standards relating to corporate governance
                    and public
                    disclosure, including the Sarbanes-Oxley Act of 2002 and new
                    SEC regulations,
                    are creating uncertainty for companies such as ours. These laws,
                    regulations and
                    standards are subject to varying interpretations in many cases,
                    and as a result,
                    their application in practice may evolve over time as new guidance
                    is provided
                    by regulatory and governing bodies, which could result in continuing
                    uncertainty
                    regarding compliance matters and higher costs necessitated by
                    ongoing revisions
                    to disclosure and governance practices. We are committed to maintaining
                    high
                    standards of corporate governance and public disclosure. As a
                    result, our
                    efforts to comply with evolving laws, regulations and standards
                    have resulted
                    in, and are likely to continue to result in, increased expenses
                    and a diversion
                    of management time and attention. In particular, our efforts
                    to comply with
                    Section 404 of the Sarbanes-Oxley Act of 2002 and the related
                    regulations
                    regarding management’s required assessment of our internal control over
                    financial reporting and our external auditors‘ audit of that assessment has
                    required the commitment of significant financial and managerial
                    resources. We
                    expect these efforts to require the continued commitment of significant
                    resources. Further, the members of our Board of Directors, members
                    of the Audit
                    or Compensation/Human Resources committees, our chief executive
                    officer, our
                    chief financial officer and certain other of our executive officers
                    could face
                    an increased risk of personal liability in connection with the
                    performance of
                    their duties. As a result, our ability to attract and retain
                    executive officers
                    and qualified Board and committee members could be more difficult.
                    In addition,
                    it may become more difficult and more expensive to obtain director
                    and officer
                    liability insurance.
 
 ***We
                    May Not Be Able To Successfully Integrate 1st State Bancorp or
                    To Realize the
                    Anticipated Benefits of Our Recently Completed Merger***
 
 Our
                    recently completed merger with 1st State Bancorp involves the
                    combination of two
                    bank holding companies that previously have operated independently.
                    A successful
                    combination of the operations of the two entities will depend
                    substantially on
                    our ability to consolidate operations, systems and procedures
                    and to eliminate
                    redundancies and costs. We may not be able to combine the operations
                    of 1st
                    State Bancorp with our operations without encountering difficulties,
                    such
                    as:
 
 Ÿ
                          The
                              loss of key employees and
                              customers;
 Ÿ
                          The
                              disruption of operations and
                              business;
 Ÿ
                          Inability
                              to maintain and increase competitive
                              presence;
 Ÿ
                          Deposit
                              attrition, customer loss and revenue
                              loss;
 Ÿ
                          Possible
                              inconsistencies in standards, control procedures and
                              policies;
 Ÿ
                          Unexpected
                              problems with costs, operations, personnel, technology
                              and credit;
                              and/or
 Ÿ
                          Problems
                              with the assimilation of new operations, sites or personnel,
                              which could
                              divert resources from regular banking
                              operations.
 
 Further,
                    although meaningful cost savings are anticipated as a result
                    of the merger, such
                    expected cost savings may not be realized. Finally, any cost
                    savings that are
                    realized may be offset by losses in revenues or other charges
                    to
                    earnings.
 
 **Item
                    2.**  **Unregistered
                    Sales of Equity Securities and Use of Proceeds**
 
 The
                    following table lists all repurchases (both open market and private
                    transactions) during the three months ended June 30, 2006 of
                    any of the
                    Company’s securities registered under Section 12 of the Exchange Act,
                    by or on
                    behalf of the Company, or any affiliated purchaser of the Company:
 
  -
                        28
                        -
  **Issuer
                    Purchase of Equity Securities**
 Month
                            
                            Total
                                Number of Shares Purchased
                            
                            Average
                                Price Paid per Share
                            
                            Total
                                Number of Shares Purchased as Part of Publicly Announced
                                Plans or Programs1
                            
                            Maximum
                                Number of Shares that May Yet Be Purchased under
                                Plans or
                                ProgramsApril
                                2006
                            
                            
                            26,700
                            
                            $
                            16.03
                            
                            
                            26,700
                            
                            
                            857,300May
                                2006
                            
                            
                            40,082
                            
                            $
                            16.28
                            
                            
                            40,082
                            
                            
                            817,218June
                                2006
                            
                            
                            35,000
                            
                            $
                            16.27
                            
                            
                            35,000
                            
                            
                            782,218
 
 1
                          On
                              February 27, 2006, the Company announced that on February
                              23, 2006 the
                              Company’s Board of Directors had authorized a program to repurchase
                              (in
                              the open market or in any private transaction), up
                              to 1.0 million shares
                              of the Company’s outstanding common stock. The repurchase program
                              is for a
                              period of up to two years and supercedes the share
                              repurchase program
                              authorized by the Company’s Board of Directors on December 22, 2004, which
                              authorized the repurchase of up to 100,000 shares.
                              The Company did not
                              acquire any shares under this former repurchase program.
                              As of June 30,
                              2006, there was an aggregate of 782,218 shares remaining
                              authorized for
                              future repurchases.
 
 **Item
                    3.**  **Defaults
                    upon Senior Securities**
 
 None
 
 **Item
                    4.**  **Submission
                    of Matters to a Vote of Security Holders**
 
 On
                    May
                    25, 2006, the Company held its annual shareholders’ meeting to consider and
                    vote on two issues: (i) election of six nominees to serve as
                    Class III directors
                    with terms continuing until the Annual Meeting of Shareholders
                    in 2009; and (ii)
                    ratification of the appointment of Grant Thornton LLP as the
                    Company’s
                    independent registered public accounting firm for the fiscal
                    year ending
                    December 31, 2006. Each item considered was approved by the Company’s
                    shareholders. Of the 11,623,629 shares eligible to vote, 9,490,145
                    shares were
                    voted as shown on the following table:
 
 For
                          Against/Withheld
                          Abstain**Class
                              III Directors:**William
                              C. Burkhardt
                          9,414,173
                          75,972
                          -Leopold
                              I. Cohen
                          9,458,098
                          32,047
                          -O.
                              A. Keller, III
                          9,288,850
                          201,295
                          -Ernest
                              A. Koury, Jr.
                          9,448,334
                          41,811
                          -George
                              R. Perkins, III
                          9,459,801
                          30,344
                          -Carl
                              H. Ricker, Jr.
                          9,393,476
                          96,669
                          --**Ratification
                              of Auditors**
                          9,450,248
                          22,647
                          17,250
 
 The
                    term
                    of office of Charles F. Atkins, Oscar A. Keller, Jr., James G.
                    McClure, Jr.,
                    James D. Moser, Jr., Don W. Perry, and B. Grant Yarber continued
                    after the
                    annual shareholders’ meeting until 2007. In addition, the term of office of
                    James A. Barnwell, Jr., John F. Grimes, III, Robert L. Jones,
                    Richard H.
                    Shirley, J. Rex Thomas and Samuel J. Wornom, III continued after
                    the annual
                    shareholders’ meeting until 2008.
 
 **Item
                    5.**  **Other
                    Information**
 
 None
 
  -
                        29
                        -
  **Item
                    6.**  **Exhibits**
  **Exhibit
                                No.**
                            
                            **Description**Exhibit
                                4.1
                            
                            In
                                accordance with Item 601(b)(4)(iii)(A) of Regulation
                                S-K, certain
                                instruments respecting long-term debt of the registrant
                                have been omitted
                                but will be furnished to the Commission upon request.Exhibit
                                31.1
                            
                            Certification
                                of B. Grant Yarber pursuant to Rule 13a-14(a) and
                                15d-14(a), as adopted
                                pursuant to Section 302 of the Sarbanes-Oxley Act
                                of
                                2002Exhibit
                                31.2
                            
                            Certification
                                of A. Christine Baker pursuant to Rule 13a-14(a)
                                and 15d-14(a), as adopted
                                pursuant to Section 302 of the Sarbanes-Oxley Act
                                of
                                2002Exhibit
                                32.1
                            
                            Certification
                                of B. Grant Yarber pursuant to 18 U.S.C. Section
                                1350, as Adopted Pursuant
                                to Section 906 of the Sarbanes-Oxley Act of 2002
                                [This exhibit is being
                                furnished pursuant to Section 906 of the Sarbanes-
                                Oxley Act of 2002 and
                                shall not, except to the extent required by that
                                act, be deemed to be
                                incorporated by reference into any document or filed
                                herewith for purposes
                                of liability under the Securities Exchange Act of
                                1934, as amended, or the
                                Securities Act of 1933, as amended, as the case may
                                be.]Exhibit
                                32.2
                            
                            Certification
                                of A. Christine Baker pursuant to 18 U.S.C. Section
                                1350, as Adopted
                                Pursuant to Section 906 of the Sarbanes-Oxley Act
                                of 2002 [This exhibit is
                                being furnished pursuant to Section 906 of the Sarbanes-Oxley
                                Act of 2002
                                and shall not, except to the extent required by that
                                act, be deemed to be
                                incorporated by reference into any document or filed
                                herewith for purposes
                                of liability under the Securities Exchange Act of
                                1934, as amended, or the
                                Securities Act of 1933, as amended, as the case may
                                be.]
  -
                        30
                        -
  **Signatures**
 
 Pursuant
                    to the requirements of the Securities Exchange Act of 1934, the
                    registrant has
                    duly caused this report to be signed on its behalf by the undersigned,
                    thereunto
                    duly authorized, in Raleigh, North Carolina, on the 9th day of
                    August
                    2006.
  **CAPITAL
                          BANK CORPORATION**By:
                        /s/ 
*A.
                          Christine Baker*Chief
                          Financial Officer
 -
                      31
                      -
  EXHIBIT
                INDEX
  **Exhibit
                          No.**
                      
                      **Description**Exhibit
                          4.1
                      
                      In
                          accordance with Item 601(b)(4)(iii)(A) of Regulation S-K,
                          certain
                          instruments respecting long-term debt of the registrant
                          have been omitted
                          but will be furnished to the Commission upon request.Exhibit
                          31.1
                      
                      Certification
                          of B. Grant Yarber pursuant to Rule 13a-14(a) and 15d-14(a),
                          as adopted
                          pursuant to Section 302 of the Sarbanes-Oxley Act of
                          2002Exhibit
                          31.2
                      
                      Certification
                          of A. Christine Baker pursuant to Rule 13a-14(a) and 15d-14(a),
                          as adopted
                          pursuant to Section 302 of the Sarbanes-Oxley Act of
                          2002Exhibit
                          32.1
                      
                      Certification
                          of B. Grant Yarber pursuant to 18 U.S.C. Section 1350,
                          as Adopted Pursuant
                          to Section 906 of the Sarbanes-Oxley Act of 2002 [This
                          exhibit is being
                          furnished pursuant to Section 906 of the Sarbanes- Oxley
                          Act of 2002 and
                          shall not, except to the extent required by that act, be
                          deemed to be
                          incorporated by reference into any document or filed herewith
                          for purposes
                          of liability under the Securities Exchange Act of 1934,
                          as amended, or the
                          Securities Act of 1933, as amended, as the case may
                          be.]Exhibit
                          32.2
                      
                      Certification
                          of A. Christine Baker pursuant to 18 U.S.C. Section 1350,
                          as Adopted
                          Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
                          [This exhibit is
                          being furnished pursuant to Section 906 of the Sarbanes-Oxley
                          Act of 2002
                          and shall not, except to the extent required by that act,
                          be deemed to be
                          incorporated by reference into any document or filed herewith
                          for purposes
                          of liability under the Securities Exchange Act of 1934,
                          as amended, or the
                          Securities Act of 1933, as amended, as the case may
                          be.] 
 -
                      32
                      -