UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                              WASHINGTON, DC 20549

                                ________________

                                    FORM 10-Q

(Mark One)

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

         For the quarterly period ended December 31, 2003

                                       OR

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

         For the transition period from ______ to ______

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

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


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


445 S. MAIN STREET, BURLINGTON, NORTH CAROLINA            27215
----------------------------------------------       --------------
(Address of Principal Executive Offices)               (Zip Code)


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

                                       N/A
              ----------------------------------------------------
              (Former Name, Former Address and Former Fiscal Year,
                         if Changed Since Last Report)

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

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

     As of February 6, 2004,  the issuer had  2,962,696  shares of common  stock
issued and outstanding.


<PAGE>

                                    CONTENTS
<TABLE>
<CAPTION>

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

Item 1.   Financial Statements

          Consolidated Balance Sheets as of December 31, 2003 (unaudited) and September 30, 2003...................2

          Consolidated Statements of Income for the Three Months Ended December 31, 2003 and
                  2002 (unaudited).................................................................................3

          Consolidated Statements of Stockholders' Equity and Comprehensive Income for the Three
                  Months Ended December 31, 2003 and 2002 (unaudited)..............................................4

          Consolidated Statements of Cash Flows for the Three Months Ended December 31, 2003 and
                  2002 (unaudited).................................................................................5

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

Item 2.   Management's Discussion and Analysis of Financial Condition and Results of Operations....................9

Item 3.   Quantitative and Qualitative Disclosures About Market Risk..............................................17

Item 4.   Controls and Procedures.................................................................................17


PART II.  OTHER INFORMATION

Item 1.   Legal Proceedings.......................................................................................18

Item 2.   Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities........................18

Item 3.   Defaults Upon Senior Securities.........................................................................18

Item 4.   Submission of Matters to a Vote of Security Holders.....................................................18

Item 5.   Other Information.......................................................................................18

Item 6.   Exhibits and Reports on Form 8-K........................................................................18


SIGNATURES........................................................................................................19
</TABLE>

                                        1


<PAGE>

                     1st STATE BANCORP, INC. AND SUBSIDIARY

                           CONSOLIDATED BALANCE SHEETS
                    DECEMBER 31, 2003 AND SEPTEMBER 30, 2003
                        (IN THOUSANDS, EXCEPT SHARE DATA)
<TABLE>
<CAPTION>

                                                                                   AT                 AT
                                                                             DECEMBER 31,       SEPTEMBER 30,
                                                                                  2003               2003
                                                                             ------------       -------------
                                                                              (Unaudited)
<S>                                                                               <C>                <C>
                                      ASSETS
Cash and cash equivalents                                                   $     9,750               9,359
Investment securities:
     Held to maturity (fair value of $21,781 and $19,397
         at December 31, 2003 and September 30, 2003, respectively)              21,832              19,462
     Available for sale (cost of $87,897 and $92,971
         at December 31, 2003 and September 30, 2003, respectively)              86,859              91,709
Loans held for sale, at lower of cost or fair value                               1,171                 645
Loans receivable (net of allowance for loan losses of $3,868
    and $3,856 at December 31, 2003 and September 30, 2003,
    respectively)                                                               226,280             225,725
Real estate owned                                                                   273                  95
Federal Home Loan Bank stock, at cost                                             1,900               1,675
Premises and equipment                                                            8,366               8,413
Accrued interest receivable                                                       2,052               1,967
Other assets                                                                      3,872               3,590
                                                                            -----------          ----------
             Total assets                                                   $   362,355          $  362,640
                                                                            ===========          ==========
                LIABILITIES AND STOCKHOLDERS' EQUITY

Liabilities:
  Deposit accounts                                                              256,379             262,712
  Advances from Federal Home Loan Bank                                           38,000              31,500
  Advance payments by borrowers for property taxes and insurance                    129                  57
  Dividend payable                                                                  297                 297
  Other liabilities                                                               4,192               5,373
                                                                            -----------          ----------
          Total liabilities                                                     298,997             299,939
                                                                            -----------          ----------

Stockholders' Equity:
   Preferred stock, $0.01 par value, 1,000,000 shares authorized;
         none issued                                                                 --                  --
   Common stock, $0.01 par value, 7,000,000 shares authorized;
         2,966,284 and 2,971,977 shares issued and outstanding
         at  December 31, 2003 and September 30, 2003, respectively                  33                  33
   Additional paid-in capital                                                    35,839              35,778
   Unallocated ESOP shares                                                       (2,997)             (3,141)
   Deferred compensation payable in treasury stock                                5,466               5,466
   Treasury stock                                                               (12,946)            (12,785)
   Retained income - substantially restricted                                    38,596              38,118
   Accumulated other comprehensive income (loss) - net unrealized
        loss on investment securities available for sale                           (633)               (768)
                                                                            -----------           ---------
Total stockholders' equity                                                       63,358              62,701
                                                                            -----------           ---------
        Total liabilities and stockholders' equity                          $   362,355             362,640
                                                                            ===========           =========
</TABLE>

See accompanying notes to the consolidated financial statements.

                                       2
<PAGE>

                     1st STATE BANCORP, INC. AND SUBSIDIARY

                        CONSOLIDATED STATEMENTS OF INCOME
              FOR THE THREE MONTHS ENDED DECEMBER 31, 2003 AND 2002
                      (IN THOUSANDS, EXCEPT PER SHARE DATA)

                                   (UNAUDITED)
<TABLE>
<CAPTION>

                                                                        For the Three Months Ended
                                                                                  December 31,
                                                                        ----------------------------
                                                                          2003              2002
                                                                        --------          --------
<S>                                                                       <C>                <C>
Interest income:
   Interest and fees on loans                                          $   2,854              3,372
   Interest and dividends on investments                                   1,184              1,152
   Overnight deposits                                                          9                 43
                                                                       ---------          ---------
         Total interest income                                             4,047              4,567
                                                                       ---------          ---------

Interest expense:
    Deposit accounts                                                         919              1,291
    Borrowings                                                               316                276
                                                                       ---------          ---------
         Total interest expense                                            1,235              1,567
                                                                       ---------          ---------

         Net interest income                                               2,812              3,000

Provision for loan losses                                                     60                 60
                                                                       ---------          ---------
         Net interest income after provision for loan losses               2,752              2,940
                                                                       ---------          ---------

Other income:
   Customer service fees                                                     205                217
   Commissions from sales of annuities and mutual funds                       72                 86
   Mortgage banking income, net                                               98                401
   Securities gains, net                                                      97                 --
   Other                                                                      54                 56
                                                                       ---------          ---------
         Total other income                                                  526                760
                                                                       ---------          ---------

Operating expenses:
   Compensation and related benefits                                       1,332              1,344
   Occupancy and equipment                                                   342                351
   Real estate operations, net                                                (3)                 6
   Other expenses                                                            432                445
                                                                       ---------          ---------
         Total operating expenses                                          2,103              2,146
                                                                       ---------          ---------

         Income before income taxes                                        1,175              1,554

Income taxes                                                                 417                571
                                                                       ---------          ---------
         Net income                                                    $     758                983
                                                                       =========          =========
         Earnings per share:

         Basic                                                         $    0.27          $    0.35
         Diluted                                                       $    0.26          $    0.33
</TABLE>

See accompanying notes to the consolidated financial statements.

                                       3
<PAGE>

                             1st STATE BANCORP, INC.
    CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY AND COMPREHENSIVE INCOME
        FOR THE THREE MONTHS ENDED DECEMBER 31, 2003 AND 2002 (UNAUDITED)
                                 (IN THOUSANDS)
<TABLE>
<CAPTION>
                                                                                            Deferred
                                                              Additional    Unearned      compensation
                                                   Common      paid-in        ESOP         payable in
                                                    stock      capital       shares      treasury stock
                                                  ---------   -----------   --------     --------------
<S>                                                 <C>         <C>           <C>          <C>

Balance at September 30, 2002                    $      33       35,623        (3,739)         5,466

Comprehensive income:
     Net income                                         --           --            --             --
     Other comprehensive loss-unrealized
       loss on securities available-for-sale,
       net of income taxes of $122                      --           --            --             --

Total comprehensive income
Allocation of ESOP shares                               --           39           151             --
Acquisition of treasury shares                          --           --            --             --
Cash dividends declared                                 --           --            --             --
Cash dividend on unallocated ESOP shares                --           --            --             --
                                                 ---------      -------        ------        -------
Balance at December 31, 2002                     $      33       35,662        (3,588)         5,466
                                                 =========      =======        ======        =======



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

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

Total comprehensive income

Allocation of ESOP shares                               --           61           144             --
Acquisition of treasury shares                          --           --            --             --
Cash dividends declared                                 --           --            --             --
Cash dividend on unallocated ESOP shares                --           --            --             --
                                                 ---------      -------        ------        -------
Balance at December 31, 2003                     $      33       35,839        (2,997)         5,466
                                                 =========      =======        ======        =======

<CAPTION>

                                                                                 Accumulated
                                                                                     other           Total
                                                  Treasury        Retained       comprehensive   stockholders'
                                                   Stock           income        income (loss)       equity
                                                  --------        --------       -------------   -------------
<S>                                                 <C>             <C>               <C>           <C>
Balance at September 30, 2002                    (11,899)           35,258             827         61,569

Comprehensive income:
     Net income                                       --               983              --            983
     Other comprehensive loss-unrealized
       loss on securities available-for-sale,
       net of income taxes of $122                    --               --             (191)          (191)
                                                                                                  -------
Total comprehensive income                                                                            792
Allocation of ESOP shares                             --               --               --            190
Acquisition of treasury shares                      (224)              --               --           (224)
Cash dividends declared                               --             (240)              --           (240)
Cash dividend on unallocated ESOP shares              --               15               --             15
                                                --------          -------           ------        -------
Balance at December 31, 2002                     (12,123)          36,016              636         62,102
                                                ========          =======           ======        =======



Balance at September 30, 2003                    (12,785)          38,118             (768)        62,701

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

See accompanying notes to the consolidated financial statements.

                                       4
<PAGE>

                     1st STATE BANCORP, INC. AND SUBSIDIARY
                      CONSOLIDATED STATEMENTS OF CASH FLOWS
              FOR THE THREE MONTHS ENDED DECEMBER 31, 2003 AND 2002
                                   (UNAUDITED)
                                 (IN THOUSANDS)

<TABLE>
<CAPTION>

                                                                              For the Three Months Ended
                                                                                      December 31,
                                                                              ----------------------------
                                                                                2003                2002
                                                                              --------            --------
<S>                                                                             <C>                  <C>
Cash flows from operating activities:
   Net income                                                              $         758              983
   Adjustment to reconcile net income to net cash used in
       operating activities:
           Provision for loan losses                                                  60               60
           Depreciation                                                              227              178
           Deferred tax expense                                                        2               32
           Amortization of premiums and discounts, net                                (2)             (32)
           Deferred compensation                                                      60               60
           Release of  ESOP shares                                                   205              190
           Loan origination fees and unearned discounts
               deferred, net of current amortization                                 (16)             (15)
           Gain on sale of investment securities available for sale                  (97)              --
           Net (gain) loss on sale of loans                                           28              (10)
           Proceeds from sales of loans held for sale                              6,845           24,839
           Originations of loans held for sale                                    (7,399)         (26,460)
           Decrease (increase) in other assets                                      (368)             335
           Decrease (increase) in accrued interest receivable                        (85)             550
           Decrease in other liabilities                                          (1,241)          (1,261)
                                                                              ----------          -------
                  Net cash used in operating activities                           (1,023)            (551)
                                                                              ----------          -------

Cash flows from investing activities:
    Proceeds from sale of FHLB stock                                               1,025              368
    Purchase of FHLB stock                                                        (1,250)              --
    Purchases of investment securities available for sale                        (15,828)         (32,233)
    Purchases of investment securities held to maturity                           (2,373)              --
    Proceeds from maturities and issuer calls of investment securities
        available for sale                                                        17,019           34,250
    Proceeds from sales of investment securities available for sale                3,979               --
    Proceeds from maturities of investment securities
        held to maturity                                                               1                1
    Net (increase) decrease in loans receivable                                     (669)              87
    Purchase of real estate owned                                                   (108)              --
    Purchases of premises and equipment                                             (180)            (670)
                                                                              ----------          -------

                         Net cash provided by investing activities                 1,616            1,803
                                                                              ----------          -------
</TABLE>

                                                                   (Continued)
                                       5
<PAGE>


                     1st STATE BANCORP, INC. AND SUBSIDIARY
                CONSOLIDATED STATEMENTS OF CASH FLOWS - CONTINUED
              FOR THE THREE MONTHS ENDED DECEMBER 31, 2003 AND 2002
                                   (UNAUDITED)
                                 (IN THOUSANDS)
<TABLE>
<CAPTION>

                                                                               For the Three Months Ended
                                                                                        December 31,
                                                                               ----------------------------
                                                                                2003                  2002
                                                                               ------                ------
<S>                                                                             <C>                   <C>
Cash flows from financing activities:
   Net decrease in deposits                                                $      (6,333)             (9,433)
   Advances from the Federal Home Loan Bank                                       32,000               5,000
   Repayments of advances from the Federal Home Loan Bank                        (25,500)                 --
   Purchase of treasury stock                                                       (161)               (224)
   Dividends paid on common stock                                                   (280)               (225)
   Increase in advance payments by borrowers for
       property taxes and insurance                                                   72                  76
                                                                           -------------       -------------

        Net cash used in financing activities                                       (202)             (4,806)
                                                                           -------------       -------------

        Net increase (decrease) in cash and cash equivalents                         391              (3,554)

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

Cash and cash equivalents at end of period                                 $       9,750       $      15,311
                                                                           =============       =============
Payments are shown below for the following:
       Interest                                                            $       1,591       $       1,583
                                                                           =============       =============
       Income taxes                                                        $         269       $          54
                                                                           =============       =============

Noncash activities:

     Unrealized gains (losses) on investment securities
          available for sale                                               $         223       $        (313)
                                                                           =============       =============
     Cash dividends declared but not paid                                  $         280       $         225
                                                                           =============       =============
     Cash dividends on unallocated ESOP shares                             $          17       $          15
                                                                           =============       =============
Transfer from loans to real estate acquired in settlement of loans         $          70       $          --
                                                                           =============       =============
</TABLE>



See accompanying notes to the consolidated financial statements.

                                       6

<PAGE>

                     1st STATE BANCORP, INC. AND SUBSIDIARY
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
              DECEMBER 31, 2003 (UNAUDITED) AND SEPTEMBER 30, 2003


NOTE 1.  NATURE OF BUSINESS

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

NOTE 2.  BASIS OF PRESENTATION

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

     The results of  operations  for the three month period  ended  December 31,
2003 are not  necessarily  indicative of the results of  operations  that may be
expected for the year ended  September 30, 2004. The preparation of consolidated
financial statements in accordance with accounting principles generally accepted
in the United States of America requires  management to make certain  estimates.
These amounts may be revised in future  periods  because of changes in the facts
and circumstances underlying their estimation.

     Certain amounts in the December 31, 2002 consolidated  financial statements
(which are unaudited) have been  reclassified  to conform with the  presentation
adopted  in  2003.  Such   reclassifications   did  not  change  net  income  or
stockholders' equity as previously reported.

NOTE 3.  EARNINGS PER SHARE

     For purposes of computing  basic and diluted  earnings per share,  weighted
average shares outstanding  excludes  unallocated ESOP shares that have not been
committed to be released. The deferred compensation obligation discussed in Note
5 that is funded with shares of the Company's  common stock has no net impact on
the  Company's  earnings  per share  computations.  Diluted  earnings  per share
includes the potentially  dilutive effects of the Company's benefit plans. There
were no anti-dilutive stock options for the three months ended December 31, 2003
and 2002. A reconciliation of the denominators of the basic and diluted earnings
per share computations is as follows:
<TABLE>
<CAPTION>

                                                                                  2003             2002
                                                                               ----------        ---------
          <S>                                                                    <C>                 <C>
         Average shares issued and outstanding                                  2,969,258        3,002,877
         Less: Unallocated ESOP shares                                           (156,807)        (187,229)
                                                                                ---------        ---------
         Average basic shares for earnings per share                            2,812,451        2,815,648

         Add: Potential common stock pursuant to stock
               option plan  (See Note 6)                                          149,240          126,396
                                                                                ---------        ---------
         Average dilutive shares for earnings per share                         2,961,691        2,942,044
                                                                                =========        =========
</TABLE>

                                       7
<PAGE>

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

     The Company  sponsors an employee stock ownership plan (the "ESOP") whereby
an aggregate  number of shares amounting to 253,050 or 8% of the stock issued in
the  conversion was purchased for future  allocation to employees.  The ESOP was
funded by an 11-year term loan from the Company in the amount of $4,899,000. The
loan is secured by the shares of stock  purchased by the ESOP.  During the three
months ended  December  31, 2003 and 2002,  7,360 and 7,728 shares of stock were
committed to be released and approximately $205,000 and $190,000 of compensation
expense was recognized, respectively.

NOTE 5.  DEFERRED COMPENSATION

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

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

     The  expense  related  to this  plan for  each of the  three  months  ended
December 31, 2003 and 2002 was $60,000. This expense is included in compensation
expense.

NOTE 6.  STOCK OPTION AND INCENTIVE PLAN

     On June 6, 2000, the Company's stockholders approved the 1st State Bancorp,
Inc. 2000 Stock Option and Incentive Plan (the "Plan"). The purpose of this plan
is to  advance  the  interests  of the  Company  through  providing  select  key
employees and directors of the Bank with the opportunity to acquire  shares.  By
encouraging  such stock  ownership,  the Company  seeks to  attract,  retain and
motivate  the  best   available   personnel   for   positions   of   substantial
responsibility  and to provide  incentives to the key  employees and  directors.
Under the Plan, the Company  granted  316,312  options to purchase its $0.01 par
value common  stock.  The  exercise  price per share is equal to the fair market
value per share on the date of the grant. Options granted under the Stock Option
Plan are 100% vested on the date of the grant,  and all options  expire 10 years
from the date of the grant.  As a result of the one-time  cash dividend of $5.17
paid on October 2, 2000, the exercise price for the options repriced from $18.44
to $14.71.  No options were  exercised or granted  during the three months ended
December  31,  2003  and  2002.  At  December  31,  2003,  316,312  options  are
outstanding, all of which are exercisable.

NOTE 7. MORTGAGE SERVICING RIGHTS

     The rights to service  mortgage  loans for  others  are  included  in other
assets on the consolidated balance sheet. Mortgage servicing rights ("MSRs") are
capitalized  based on the allocated cost which is determined when the underlying
loans are sold. MSRs are amortized over a period which  approximates the life of
the underlying loan as an adjustment of servicing income.  Impairment reviews of
MSRs are performed on a quarterly  basis.  As of December 31, 2003 and September
30, 2003,  MSRs totaled  $531,000 and $547,000,  respectively,  and no valuation
allowance was required.

     Amortization expense totaled $29,000 and $42,000 for the three months ended
December 31, 2003 and 2002, respectively.

                                       8
<PAGE>

NOTE 8.  STANDBY LETTERS OF CREDIT

     In  November  2002,  the  FASB  issued  Interpretation  No.  45  (FIN  45),
"Guarantor's  Accounting and Disclosure  Requirements for Guarantees,  Including
Indirect  Guarantees of Indebtedness of Others",  which addressed the disclosure
to be made by a guarantor in its interim and annual  financial  statements about
its obligations under  guarantees.  FIN 45 requires the guarantor to recognize a
liability  for  the  non-contingent  component  of the  guarantee,  such  as the
obligation  to stand  ready to perform in the event  that  specified  triggering
events or conditions  occur.  The initial  measurement  of this liability is the
fair value of the guarantee at inception.  The  recognition  of the liability is
required even if it is not probable  that  payments  will be required  under the
guarantee or if the guarantee was issued with a premium  payment or as part of a
transaction  with  multiple  events.  The initial  recognition  and  measurement
provisions are effective for all guarantees within the scope of FIN 45 issued or
modified after  December 31, 2002. The Company issues standby  letters of credit
whereby the Company  guarantees  performance if a specified  triggering event or
condition occurs (primarily  nonperformance under construction contracts entered
into by construction customers). The guarantees generally expire within one year
and may be automatically  renewed  depending on the terms of the guarantee.  The
maximum  potential  amount of undiscounted  future  payments  related to standby
letters of credit at December 31, 2003 is $1.6 million. At December 31, 2003 the
Company  has  recorded  no  liability  for the  current  carrying  amount of the
obligation to perform as a guarantor  and no contingent  liability is considered
necessary  as such  amounts  are deemed  immaterial.  Substantially  all standby
letters of credit are secured by real estate and/or  guaranteed by third parties
in the event the Company had to advance funds to fulfill the guarantee.

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

FORWARD-LOOKING STATEMENTS

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

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

GENERAL

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

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

                                       9
<PAGE>

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

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

     Over the years, we have sought to gradually  increase the percentage of our
assets invested in commercial real estate loans,  commercial  loans and consumer
loans,  which  have  shorter  terms and  adjust  more  frequently  to changes in
interest  rates than  single-family  residential  mortgage  loans.  These  loans
generally carry added risk when compared to a single family residential mortgage
loan, so we have concurrently increased our allowance for loan losses as we have
originated these loans.

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

CRITICAL ACCOUNTING POLICIES

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

COMPARISON OF FINANCIAL CONDITION AT DECEMBER 31, 2003 AND SEPTEMBER 30, 2003

     Total assets were  relatively  flat from September 30, 2003 to December 31,
2003.  Assets  decreased  $345,000 to $362.4  million at December  31, 2003 from
$362.7  million at September 30, 2003.  Increases in loans  receivable,  net and
loans held for sale were offset by decreases in investment securities.  Deposits
decreased by $6.3 million or 2.4% from $262.7  million at September  30, 2003 to
$256.4 million at December  31,2003.  This decrease  resulted from the runoff of
$5.4  million of  certificates  of deposits  held by  municipalities  which were
replaced with short-term borrowings from the Federal Home Loan Bank of Atlanta.

                                       10
<PAGE>

     Investment  securities available for sale decreased $4.2 million from $91.1
million at September 30, 2003 to $86.9 million at December 31, 2003.  During the
quarter ended  December 31, 2003, we purchased  $15.8 million of securities  and
received  $21.0 million in proceeds from sales,  maturities  and issuer calls of
investment securities available for sale. Investment securities held to maturity
increased $2.4 million from $19.5 million at September 30, 2003 to $21.8 million
at December 31, 2003.  During the quarter ended  December 31, 2003, we purchased
$2.4 million of securities.

     Loans held for sale  increased  to $1.2  million at December  31, 2003 from
$645,000 at September 30, 2003.  Loans  receivable,  net  increased  from $225.7
million at  September  30, 2003 to $226.3  million at  December  31,  2003.  The
increase in loans held for sale resulted from timing  differences in the funding
of loan sales.  During the  quarter,  mortgage  originations  were  considerably
slower than in previous  quarters as refinance  activity slowed down in response
to higher mortgage  interest rates.  During the quarter ended December 31, 2003,
the Company saw growth in commercial loans and equity lines.

     Stockholders'  equity increased by $657,000 from $62.7 million at September
30,  2003 to $63.4  million at  December  31,  2003 as a result of net income of
$758,000,  release of ESOP shares of $205,000 and a decrease in unrealized  loss
on available for sale  securities of $135,000.  These  increases  were partially
offset by cash dividends to  stockholders  declared of $280,000 and purchases of
treasury stock of $161,000.

COMPARISON OF OPERATING RESULTS FOR THE THREE MONTHS ENDED DECEMBER 31, 2003 AND
2002

     NET INCOME.  We  recorded  net income of  $758,000  for the  quarter  ended
December 31, 2003,  as compared to $983,000 for the quarter  ended  December 31,
2002,  representing a decrease of $225,000, or 22.9%. For the three months ended
December  31, 2003,  basic and diluted  earnings per share were $0.27 and $0.26,
respectively,  compared  to the basic  and  diluted  earnings  per share for the
quarter ended December 31, 2002 of $0.35 and $0.33,  respectively.  The decrease
in net  income  resulted  primarily  from  decreased  net  interest  income  and
decreased  other  income  that were  offset  partially  by  decreased  operating
expenses and decreased  income tax expense.  The decrease in net interest income
resulted from lower net interest  margins.  The average prime  interest rate for
the quarter  ended  December  31, 2003 was 4.00%,  a decrease of 46 basis points
from 4.46% which was the average prime for the quarter ended  December 31, 2002.
The repricing of loans and  investments  decreased  the Company's  average asset
yield by 86 basis  points  whereas the average cost of funds  decreased  only 61
basis points during the quarter ended December 31, 2003.

     NET INTEREST INCOME.  Net interest income,  the difference between interest
earned  on  loans  and  investments   and  interest  paid  on   interest-bearing
liabilities,  decreased by $188,000 or 6.3% for the three months ended  December
31, 2003,  compared to the same quarter in the prior year. This decrease results
from a $520,000  decrease in interest  income that was  partially  offset by the
$332,000  decrease in total  interest  expense.  The average net  interest  rate
spread  decreased 25 basis points from 3.23% for the three months ended December
31, 2002 to 2.98% for the quarter ended December 31, 2003.

     INTEREST INCOME. The decrease in interest income for the three months ended
December  31,  2003 was the  result of a decrease  in yield on  interest-earning
assets of 86 basis  points from 5.63% for the three  months  ended  December 31,
2002 to 4.77% for the three months ended  December 31, 2003.  This  decrease was
partially  offset by an  increase of $14.9  million in average  interest-earning
assets  compared  to the same  quarter in the prior  year .  Average  investment
securities increased $25.1 million,  interest-bearing  overnight funds decreased
$8.9 million and average loans receivable  decreased $1.2 million.  The increase
in average  interest-earning  assets increased  interest income by approximately
$292,000 and the decrease in the average asset yield  decreased  interest income
by approximately $812,000.

     INTEREST  EXPENSE.  Interest  expense  decreased  in the three months ended
December 31, 2003 due to a decrease in the cost of interest-bearing  liabilities
of 61 basis points from 2.40% for the three  months  ended  December 31, 2002 to
1.79% for the three months ended December 31, 2003.  This decrease was partially
offset by an increase in average interest-bearing  liabilities of $15.3 million.
Average  interest-bearing  deposits increased by $2.1 million while average FHLB
advances  increased  $13.2 million for the three months ended  December 31, 2003
compared  to the same  quarter  in the  prior  year.  The  increase  in  average
interest-bearing   liabilities   increased  interest  expense  by  approximately
$191,000 and the decrease in the average  cost of  interest-bearing  liabilities
decreased interest expense by approximately $523,000.


                                       11
<PAGE>

     The following table presents average balances and average rates earned/paid
by the Company for the quarter  ended  December 31, 2003 compared to the quarter
ended December 31, 2002.
<TABLE>
<CAPTION>

                                                            Three Months Ended                       Three Months Ended
                                                             December 31, 2003                        December 31, 2002
                                                     ------------------------------------    -----------------------------------
                                                                             (Dollars in Thousands)
                                                     Average                     Average     Average                    Average
                                                     Balance        Interest   Yield/Cost    Balance      Interest    Yield/Cost
                                                     -------        --------  -----------    -------      --------    ----------
<S>                                                     <C>           <C>          <C>        <C>           <C>          <C>
Assets:
Loans receivable (1)                                $  225,723    $   2,854       5.06%     $ 226,969     $3,372           5.94%
Investment securities (2)                              109,942        1,184       4.31         84,869      1,152           5.43
Interest-bearing overnight deposits                      4,013            9       0.91         12,928         43           1.33
                                                    ----------    ---------       ----      ---------     ------           ----
  Total interest-earning assets (4)                    339,678        4,047       4.77        324,766      4,567           5.63
Non interest-earning assets                             20,406                                 19,192
                                                    ----------                              ---------
  Total assets                                      $  360,084                              $ 343,958
                                                    ==========                              =========

Liabilities and stockholders' equity
Interest bearing checking                               36,102           19       0.21         33,712         39           0.46
Money market investment accounts                        19,599           33       0.68         21,595         58           1.08
Passbook and statement savings                          30,352           47       0.62         29,208         81           1.11
Certificates of deposit                                157,108          820       2.09        156,527      1,113           2.84
FHLB advances                                           33,429          316       3.78         20,272        276           5.46
                                                    ----------    ---------       ----      ---------     ------           ----
  Total interest-bearing liabilities                   276,590        1,235       1.79        261,314      1,567           2.40
Non interest-bearing liabilities                        20,594                    ----         20,770                      ----
                                                    ----------                              ---------
  Total liabilities                                    297,184                                282,084
Stockholders' equity                                    62,900                                 61,874
                                                    ----------                              ---------
  Total liabilities and stockholders' equity        $  360,084                              $ 343,958
                                                    ==========                              =========

Net interest income                                               $   2,812                               $3,000
                                                                  =========                               ======
Interest rate spread                                                              2.98%                                    3.23%
                                                                                  ====                                     ====
Net interest margin (3)                                                           3.31%                                    3.69%
                                                                                  ====                                     ====
Ratio of average interest-earning assets to
 average interest-bearing liabilities                                           122.81%                                  124.28%
                                                                                ======                                   ======
</TABLE>
---------

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

     PROVISION FOR LOAN LOSSES. We charge provisions for loan losses to earnings
to maintain the total allowance for loan losses at a level we consider  adequate
to provide for probable loan losses,  based on existing loan levels and types of
loans outstanding,  nonperforming loans, prior loss experience, general economic
conditions and other factors.  We estimate the allowance  using an allowance for
loan losses  model which takes into  considerations  all of these  factors.  Our
policies  require  the review of assets on a regular  basis,  and we assign risk
grades to loans  based on the  relative  risk of the  credit,  considering  such
factors as  repayment  experience,  value of  collateral,  guarantors,  etc. Our
credit management systems have resulted in low loss experience;  however,  there
can be no assurances that such  experience will continue.  We believe we use the
best information available to make a determination with respect to the allowance
for loan losses,  recognizing that future adjustments may be necessary depending
upon a change in economic conditions.  The provision for loan losses was $60,000
and net charge-offs were $48,000 for the year quarter December 31, 2003 compared
with a provision of $60,000, and net charge-offs of $2,000 for the quarter ended
December 31, 2002.  Nonperforming  loans at December 31, 2003 and  September 30,
2003 were $4.1  million  and $4.2  million,  respectively.  The  majority of the
non-performing  loans resulted from three unrelated,  distinct credits which are
not necessarily indicative of the credit quality of the entire portfolio.  There
was no  significant  impact on the  provision as these loans are well secured by
property and

                                       12
<PAGE>

equipment.  The Company made no  significant  changes to the  allowance for loan
losses  methodology  during the period  which  impacted the  provision  for loan
losses.

     OTHER INCOME. Other income decreased $234,000,  or 30.8%, from $760,000 for
the quarter ended  December 31, 2002 to $526,000 for the quarter ended  December
31, 2003. Mortgage banking, net decreased $326,000 from $401,000 for the quarter
ended December 31, 2002 to $98,000 for the quarter ended December 31, 2003. This
decrease  results from a decrease in volume of mortgage  loan  originations  and
sales.  We sold loans  totaling $6.8 million in the quarter  ended  December 31,
2003 compared with sales of $24.8 million in the previous  year. The increase in
mortgage  interest rates slowed the volume of mortgage  originations  and sales.
Given the current level of mortgage  interest rates,  the Company  believes that
mortgage  banking  income will  continue to decrease in future  quarters  due to
lower refinancing  activity.  The Company recorded gains on sales of investments
of $97,000 in the quarter ended  December 31, 2003 which were not present in the
prior year.

     OPERATING EXPENSES. Total operating expenses were $2.1 million for both the
quarters ended December 31, 2003 and 2002.  Expenses  incurred in operating real
estate owned were $6,000 for the three months ended  December 31, 2002  compared
to income of $3,000 for the quarter  ended  December 31,  2003.  The Company has
been able to control expenses during this period of slower asset growth.

     INCOME TAX EXPENSE.  Income tax expense decreased $154,000 from tax expense
of $571,000 for the quarter ended  December 31, 2002 to $417,000 for the quarter
ended  December 31, 2003.  The  effective tax rates were 35.5% and 36.7% for the
quarters  ended  December 31, 2003 and 2002,  respectively.  The decrease in the
effective  rate  was  primarily  due  to an  increase  in  the  ratio  of  state
non-taxable income as a percentage of net income before taxes.

COMMITMENTS, CONTINGENCIES AND OFF-BALANCE SHEET RISK

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

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

                                                              December 31, 2003         September 30, 2003
                                                              -----------------         ------------------
                                                                         (Dollars in thousands)
              <S>                                                     <C>                        <C>
         Commitments to originate new loans                            4,927                     1,552
         Commitments to originate new loans held for sale                154                       278
         Unfunded commitments to extend credit under existing
              equity line and commercial lines of credit              59,083                    57,237
         Commercial letters of credit                                  1,642                       326
         Commitments to sell loans held for sale                       1,839                     1,630
</TABLE>

     The Company  does not have any special  purpose  entities or other  similar
forms of off-balance sheet financing arrangements.

     The  increase in  commitments  at December  31, 2003 are the result of $4.6
million of commitments to originate commercial loans compared to $1.2 million at
September 30, 2003.  These  commitments  are not indicative of any future upward
trend in volume.

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

                                       13
<PAGE>

creditworthiness on a case-by-case basis. The amounts of collateral obtained, if
deemed  necessary  by  the  Company  upon  extension  of  credit,  is  based  on
management's credit evaluation of the borrower.

     Commitments  to sell loans held for sale are  agreements to sell loans to a
third party at an agreed upon price.  At December 31, 2003,  the aggregate  fair
value of these commitments exceeded the book value of the loans to be sold.

CONTRACTUAL OBLIGATIONS

As of December 31, 2003
<TABLE>
<CAPTION>
                                                            PAYMENTS DUE BY PERIOD
                                                            ----------------------
                                                            (DOLLARS IN THOUSANDS)
                                   LESS THAN
                                     1 YEAR           1-3 YEARS        4-5 YEARS      OVER 5 YEARS      TOTAL
                                   ---------          ---------        ---------      ------------      -----
<S>                                     <C>             <C>               <C>             <C>             <C>
Deposits                            $225,899           20,021            10,459                --      256,379
Advances from FHLB                    18,000               --                --            20,000       38,000
Lease obligations                         18               41                42                26          127
                                    --------           ------            ------            ------      -------
Total contractual cash
    obligations                     $243,917           20,062            10,501            20,026      294,506
                                    ========           ======            ======            ======      =======
</TABLE>

ASSET QUALITY

     At  December  31,  2003,  the  Company had  approximately  $4.3  million in
nonperforming  assets (nonaccrual loans and real estate owned) or 1.19% of total
assets. At September 30, 2003,  nonperforming  assets were $4.2 million or 1.17%
of total assets.  At both  December 31, 2003 and  September  30, 2003,  impaired
loans  totaled $3.8  million,  as defined by  Statement of Financial  Accounting
Standards  No. 114,  "Accounting  by Creditors  for  Impairment  of a Loan." The
impaired  loans at December  31, 2003 and  September  30, 2003 result from three
unrelated  commercial  loan  customers,  both of which  have  loans  secured  by
commercial real estate and business assets in Alamance County.  At both December
31, 2003 and September 30, 2003,  the entire $3.8 million of the impaired  loans
are on  non-accrual  status,  and their related  reserve for loan losses totaled
$235,000.  The average  carrying value of impaired loans was $3.8 million during
the three months ended  December 31, 2003.  Interest  income of $41,000 has been
recorded on impaired  loans in the three  months ended  December  31, 2003.  The
Bank's net chargeoffs for the three months ended December 31, 2003 were $48,000.
The Bank's  allowance for loan losses was $3.9 million at both December 31, 2003
and  September  30, 2003 and the ratio of the allowance for loan losses to total
loans, net of loans in process and deferred loan fees was 1.68% at both December
31, 2003 and September 30, 2003.

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

                                                           AT                      AT                      AT
                                                      DECEMBER 31,            SEPTEMBER 30,           DECEMBER 31,
                                                          2003                    2003                    2002
                                                      ------------            --------------          ------------
<S>                                                     <C>                        <C>                    <C>
Nonperforming loans:
Nonaccrual loans                                    $       4,057           $        4,153          $     4,659
Loans 90 days past due and accruing                            --                       --                   --
Restructured loans                                             --                       --                   --
                                                    -------------           --------------          -----------
Total nonperforming loans                                   4,057                    4,153                4,659
Other real estate                                             273                       95                  183
                                                    -------------           --------------          -----------
Total nonperforming assets                          $       4,330           $        4,248          $     4,842
                                                    =============           ==============          ===========

Nonperforming loans to loans receivable, net                 1.79%                    1.84%                2.12%
Nonperforming assets as a percentage
 of loans and other real estate owned                        1.91%                    1.88%                2.20%
Nonperforming assets to total assets                         1.19%                    1.17%                1.40%
</TABLE>

                                       14
<PAGE>

     Regulations  require that we classify our assets on a regular basis.  There
are three classifications for problem assets: substandard, doubtful and loss. We
regularly   review  our  assets  to   determine   whether  any  assets   require
classification or  re-classification.  At December 31, 2003, we had $4.9 million
in  classified  assets  consisting  of $4.6  million  in  substandard  loans and
$273,000 in real estate  owned.  At September  30, 2003,  we had $4.9 million in
substandard  assets  consisting  of $4.8  million  in loans and  $95,000 in real
estate owned.  At December 31, 2002, we had $5.4 million in  substandard  assets
consisting of $5.2 million in loans and $183,000 in real estate owned.

     In addition to  regulatory  classifications,  we also  classify as "special
mention" and "watch"  assets that are currently  performing  in accordance  with
their contractual terms but may become classified or nonperforming assets in the
future.  At December  31, 2003,  we have  identified  approximately  $935,000 in
assets classified as special mention and $34.7 million as watch. At December 31,
2002,  we had  identified  approximately  $1.2 million in assets  classified  as
special mention and $30.6 million as watch.

     Included in the total of watch list assets are five loans with an aggregate
outstanding balance of $4.3 million at December 31, 2003 to a company affiliated
with one of our directors.  In addition,  the director has the ability to borrow
an additional  $392,000  from us under a line of credit.  At September 30, 2003,
the aggregate outstanding balance was $4.5 million with additional  availability
of $172,000. All the loans are secured by a first lien on all assets,  including
accounts receivable,  inventory, equipment, furniture and real property occupied
by the  borrower.  In  addition,  the  director  and his spouse have  personally
guaranteed repayment of the loans. At December 31, 2003, such loans were current
with respect to their payment  terms and,  except for the waiver of certain debt
covenants  by the Bank,  were  performing  in  accordance  with the related loan
agreements.  Based on an analysis of the borrower's current financial statements
received in December  2003,  management  has concerns that the borrower may have
difficulty  in  complying  with the present loan  repayment  terms on an ongoing
basis.  Accordingly,  this loan may become an impaired  loan in future  periods.
Management  will continue to closely  monitor the  performance of these loans in
future periods.

LIQUIDITY AND CAPITAL RESOURCES

     The Bank must meet certain liquidity requirements  established by the State
of North Carolina Office of the Commissioner of Banks (the  "Commissioner").  At
December  31, 2003,  the Bank's  liquidity  ratio  exceeded  such  requirements.
Liquidity generally refers to the Bank's ability to generate adequate amounts of
funds to meet its cash needs.  Adequate  liquidity  guarantees  that  sufficient
funds are available to meet deposit withdrawals, fund loan commitments, maintain
adequate reserve  requirements,  pay operating expenses,  provide funds for debt
service, pay dividends to stockholders and meet other general commitments.

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

     Our most liquid assets are cash and cash  equivalents.  The levels of these
assets  are  dependent  on  our  operating,  financing,  lending  and  investing
activities  during  any  given  period.  At  December  31,  2003,  cash and cash
equivalents  totaled $9.8 million.  We have other sources of liquidity should we
need additional funds.  During the three months ended December 31, 2003, we sold
loans totaling $6.8 million. Additional sources of funds include FHLB of Atlanta
advances.  Other sources of liquidity  include loans and  investment  securities
designated  as available  for sale,  which totaled $88.0 million at December 31,
2003.

     We  anticipate  that we will have  sufficient  funds  available to meet our
current commitments. At December 31, 2003, we had $5.1 million in commitments to
originate  new loans,  $59.1  million in unfunded  commitments  to extend credit
under existing  equity lines and commercial  lines of credit and $1.6 million in
standby letters of credit. At December 31, 2003,  certificates of deposit, which
are scheduled to mature within one year, totaled $125.0 million. We believe that
a significant portion of such deposits will remain with us.

     The Federal Deposit  Insurance  Corporation  ("FDIC")  requires the Bank to
meet a minimum leverage capital requirement of Tier I capital to assets ratio of
4%.  The  FDIC  also  requires  the Bank to meet a ratio  of  total  capital  to
risk-weighted  assets of 8%, of which 4% must be in the form of Tier I  capital.
The  Commissioner  requires  the Bank at

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<PAGE>

all times to maintain certain minimum capital levels. The Bank was in compliance
with all capital  requirements of the FDIC and the  Commissioner at December 31,
2003 and is deemed to be "well capitalized."

     The Federal Reserve also mandates capital  requirements on all bank holding
companies,  including 1st State  Bancorp,  Inc. These capital  requirements  are
similar to those  imposed by the FDIC on the Bank.  At December  31,  2003,  the
Company was in compliance with the capital requirements of the Federal Reserve.

     On October 2, 2000, the Company paid a one-time  special cash  distribution
of $5.17 per share to its stockholders.  The distribution was made to manage the
Company's  capital  and  enhance  shareholder  value.  Returning  capital to the
stockholders  reduced the  Company's  equity to asset ratio from 21.2% to 17.2%.
The  Company's  equity  to asset  ratio at  December  31,  2003 was  17.5%.  The
Company's capital level is sufficient to support future growth.

     The Company has declared cash  dividends  per common share of $0.10,  $0.10
and $0.08 for each of the three months ended  December 31, 2003,  September  30,
2003 and December 31, 2002, respectively. The Company's ability to pay dividends
is dependent upon earnings.  The Company's  dividend  payout ratio for the three
months ended  December 31,  2003,  September  30, 2003 and December 31, 2003 was
38.5%, 31.2% and 24.2%, respectively.

ACCOUNTING MATTERS

     In  November  2002,  the  FASB  issued  Interpretation  No.  45  (FIN  45),
"Guarantor's  Accounting and Disclosure  Requirements for Guarantees,  Including
Indirect  Guarantees of Indebtedness of Others",  which addresses the disclosure
to be made by a guarantor in its interim and annual  financial  statements about
its obligations under  guarantees.  FIN 45 requires the guarantor to recognize a
liability  for  the  non-contingent  component  of the  guarantee,  such  as the
obligation  to stand  ready to perform in the event  that  specified  triggering
events or conditions  occur.  The initial  measurement  of this liability is the
fair value of the guarantee at inception.  The  recognition  of the liability is
required even if it is not probable  that  payments  will be required  under the
guarantee or if the guarantee was issued with a premium  payment or as part of a
transaction with multiple events. The disclosure  requirements are effective for
interim and annual  financial  statements  ending after  December 15, 2002.  The
initial recognition and measurement  provisions are effective for all guarantees
within the scope of FIN 45 issued or  modified  after  December  31,  2002.  The
Company  issues  standby  letters  of  credit  whereby  the  Company  guarantees
performance  if a specified  triggering  event or  condition  occurs  (primarily
nonperformance  under  construction   contracts  entered  into  by  construction
customers.)  The  guarantees  generally  expire  within  one  year  and  may  be
automatically  renewed  depending  on the terms of the  guarantee.  The  maximum
potential  amount of undiscounted  future payments related to standby letters of
credit at December 31, 2003 is $1.6 million.  At September 30, 2003, the Company
has recorded no liability for the current  carrying  amount of the obligation to
perform as a guarantor and no contingent liability is considered  necessary,  as
such amounts are deemed immaterial.  Substantially all standby letters of credit
are secured by real estate  and/or  guaranteed by third parties in the event the
Company had to advance funds to fulfill the guarantee.


     In a recent speech regarding loan commitments related to the origination of
mortgage  loans that will be held for sale, the SEC staff has indicated that the
practice of recognizing assets, and no liabilities,  should be discontinued.  In
view of the ongoing discussions and the nature of this particular issue, the SEC
staff would not object if registrants  discontinue this practice  beginning with
commitments entered into in the first reporting period beginning after March 31,
2004. Any previously  recognized loan commitments should be taken care of in the
normal  course  of  closing  loans in the  mortgage  pipeline.  The  Company  is
evaluating the impact of this accounting  change on the  consolidated  financial
statements.

     In January 2003, FASB  Interpretation  No. 46,  "Consolidation  of Variable
Interest  Entities,  an interpretation of ARB No. 51",  (Interpretation  46) was
issued. Interpretation 46 addresses the consolidation by business enterprises of
variable interest entities as defined in the  Interpretation.  Interpretation 46
applies  immediately to variable interests in variable interest entities created
after January 31, 2003, and to variable  interests in variable interest entities
obtained after January 31, 2003.

     In  December  2003,  the FASB issued  FASB  Interpretation  No. 46 (revised
December 2003),  "Consolidation of Variable Interest Entities",  which addresses
how a business enterprise should evaluate whether it has a controlling financial
interest in an entity  through  means other than voting  rights and  accordingly
should  consolidate  the entity.  FIN 46R replaces FASB  Interpretation  No. 46,
"Consolidation of Variable Interest Entities", which was issued in January 2003.
The Company  will be required  to apply FIN 46R to  variable  interests  in VIEs

                                       16
<PAGE>

created after December 31, 2003. The application of this revised  interpretation
is not  expected  to  have a  material  effect  on  the  consolidated  financial
statements.

ITEM 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

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

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

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

ITEM 4.  CONTROLS AND PROCEDURES

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

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


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<PAGE>

                           PART II. OTHER INFORMATION

     ITEM 1. LEGAL PROCEEDINGS

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

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

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

     None.

     ITEM 3. DEFAULTS UPON SENIOR SECURITIES

     None.

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

     None.

     ITEM 5. OTHER INFORMATION

     None.

     ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

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

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

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

          32   Certification  Pursuant to 18  U.S.C.  Section  1350  as  Adopted
               Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

     (b) REPORTS ON FORM 8-K.
         --------------------
          The Registrant filed the following  Current Reports on Form 8-K during
          the quarter ended December 31, 2003:

          Date of Report       Item(s) Reported       Financial Statements Filed
          --------------       ----------------       --------------------------
          October 27, 2003          7, 12                        N/A

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<PAGE>

                                   SIGNATURES


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

                                       1st STATE BANCORP, INC.


                                       /s/ James C. McGill
Date:  February 13, 2004               ----------------------------------------
                                       James C. McGill
                                       President and Chief Executive Officer
                                       (Principal Executive Officer)



                                       /s/ A. Christine Baker
Date:  February 13, 2004               ----------------------------------------
                                       A. Christine Baker
                                       Executive Vice President
                                       Treasurer and Secretary
                                       (Principal Financial and Accounting
                                       Officer)


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