UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                              Washington, DC 20549


                                    FORM 10-Q

(Mark One)

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

      For the quarterly period ended June 30, 2005

                                       OR

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

      For the transition period from              to
                                     ------------    -----------

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

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


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

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

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

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

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

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

      As of August 1,  2005,  the issuer had  2,898,637  shares of common  stock
issued and outstanding.

<PAGE>
<TABLE>
<CAPTION>
                                                    CONTENTS

                                                                                                        PAGE
                                                                                                        ----
<S>                                                                                                      <C>

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

Item 1.  Financial Statements

         Consolidated Balance Sheets as of June 30, 2005 (unaudited) and September 30, 2004................1

         Consolidated Statements of Income for the Three Months Ended June 30, 2005 and
                  2004 (unaudited).........................................................................2

         Consolidated Statements of Income for the Nine Months Ended June 30, 2005 and
                  2004 (unaudited).........................................................................3

         Consolidated Statements of Stockholders' Equity and Comprehensive Income for the Nine
                  Months Ended June 30, 2005 and 2004 (unaudited)..........................................4

         Consolidated Statements of Cash Flows for the Nine Months Ended June 30, 2005 and
                  2004 (unaudited).........................................................................5

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

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

Item 3.  Quantitative and Qualitative Disclosures About Market Risk.......................................19

Item 4.  Controls and Procedures..........................................................................19


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

Item 1.  Legal Proceedings................................................................................20

Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds......................................20

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

Item 4.  Submission of Matters to a Vote of Security Holders..............................................21

Item 5.  Other Information................................................................................21

Item 6.  Exhibits.........................................................................................21


SIGNATURES

</TABLE>
<PAGE>

                     1st State Bancorp, Inc. and Subsidiary
                           Consolidated Balance Sheets
                      June 30, 2005 and September 30, 2004
                        (In Thousands, except share data)
<TABLE>
<CAPTION>
                                                                       At            At
                                                                    June 30,    September 30,
                                                                      2005          2004
                                                                    ---------    ---------
                                                                    (Unaudited)
                                      ASSETS
<S>                                                                 <C>          <C>
Cash and cash equivalents                                           $   8,949    $   9,854
Investment securities:
     Held to maturity (fair value of $24,130 and $22,884
         at June 30, 2005 and September 30, 2004, respectively)        24,251       22,919
     Available for sale (cost of $88,445 and $97,386
         at June 30, 2005 and September 30, 2004, respectively)        87,540       96,693
Loans held for sale, at lower of cost or fair value                     1,390          930
Loans receivable (net of allowance for loan losses of $4,191
    and $3,956 at June 30, 2005 and September 30, 2004,
    respectively)                                                     234,396      231,763
Real estate owned                                                         301           17
Federal Home Loan Bank stock, at cost                                   2,000        2,325
Premises and equipment                                                  7,567        7,884
Accrued interest receivable                                             2,452        2,124
Other assets                                                            4,241        3,205
                                                                    ---------    ---------

             Total assets                                           $ 373,087    $ 377,714
                                                                    =========    =========
                LIABILITIES AND STOCKHOLDERS' EQUITY

Liabilities:
  Deposit accounts                                                    274,367      262,734
  Advances from Federal Home Loan Bank                                 28,000       44,000
  Advance payments by borrowers for property taxes and insurance          273           39
  Dividend payable                                                        287          296
  Other liabilities                                                     4,040        4,731
                                                                    ---------    ---------
          Total liabilities                                           306,967      311,800
                                                                    ---------    ---------

Stockholders' Equity:
   Preferred stock, $0.01 par value, 1,000,000 shares authorized;
         none issued                                                       --           --
   Common stock, $0.01 par value, 7,000,000 shares authorized;
   2,898,637 and 2,962,323 shares issued and outstanding
         at June 30, 2005 and September 30, 2004, respectively             33           33
   Additional paid-in capital                                          36,316       36,038
   Unallocated ESOP shares                                             (2,154)      (2,571)
   Deferred compensation payable in treasury stock                      6,700        6,440
   Treasury stock                                                     (16,324)     (14,086)
   Retained income - substantially restricted                          42,100       40,462
   Accumulated other comprehensive loss - net unrealized
        loss on investment securities available for sale                 (551)        (402)
                                                                    ---------    ---------
Total stockholders' equity                                             66,120       65,914
                                                                    ---------    ---------
        Total liabilities and stockholders' equity                  $ 373,087    $ 377,714
                                                                    =========    =========
</TABLE>

See accompanying notes to the consolidated financial statements.


                                       1
<PAGE>

                     1st State Bancorp, Inc. and Subsidiary
                        Consolidated Statements of Income
                For the Three Months Ended June 30, 2005 and 2004
                      (In Thousands, Except per Share Data)

                                   (Unaudited)
<TABLE>
<CAPTION>
                                                            For the Three Months Ended
                                                                    June 30,
                                                               -----------------
                                                                 2005      2004
                                                               -------   -------
<S>                                                            <C>       <C>
Interest income:
   Interest and fees on loans                                  $ 3,605   $ 2,812
   Interest and dividends on investments                         1,151     1,288
   Overnight deposits                                               29         6
                                                               -------   -------
     Total interest income                                       4,785     4,106
                                                               -------   -------

Interest expense:
    Deposit accounts                                             1,311       824
    Borrowings                                                     298       346
                                                               -------   -------
     Total interest expense                                      1,609     1,170
                                                               -------   -------
         Net interest income                                     3,176     2,936

Provision for loan losses                                          500        60
                                                               -------   -------
         Net interest income after provision for loan losses     2,676     2,876
                                                               -------   -------

Other income:
   Customer service fees                                           245       253
   Commissions from sales of annuities and mutual funds            105        99
   Mortgage banking income, net                                    102       126
   Other                                                            72       208
                                                               -------   -------
     Total other income                                            524       686
                                                               -------   -------

Operating expenses:
   Compensation and related benefits                             1,290     1,351
   Occupancy and equipment                                         364       351
   Real estate operations, net                                       7        (4)
   Other expenses                                                  398       375
                                                               -------   -------

     Total operating expenses                                    2,059     2,073
                                                               -------   -------

         Income before income taxes                              1,141     1,489

Income taxes                                                       403       516
                                                               -------   -------

         Net income                                            $   738   $   973
                                                               =======   =======

         Net income per share:

         Basic                                                 $  0.27   $  0.35
         Diluted                                               $  0.25   $  0.33
</TABLE>

See accompanying notes to the consolidated financial statements.


                                       2
<PAGE>

                     1st State Bancorp, Inc. and Subsidiary
                        Consolidated Statements of Income
                For the Nine Months Ended June 30, 2005 and 2004
                      (In Thousands, Except per Share Data)

                                   (Unaudited)
<TABLE>
<CAPTION>
                                                             For the Nine Months Ended
                                                                     June 30,
                                                               --------------------
                                                                 2005        2004
                                                               --------    --------
<S>                                                            <C>         <C>
Interest income:
   Interest and fees on loans                                  $ 10,066    $  8,495
   Interest and dividends on investments                          3,500       3,588
   Overnight deposits                                                68          24
                                                               --------    --------
     Total interest income                                       13,634      12,107
                                                               --------    --------

Interest expense:
    Deposit accounts                                              3,380       2,629
    Borrowings                                                      957         965
                                                               --------    --------
     Total interest expense                                       4,337       3,594
                                                               --------    --------
         Net interest income                                      9,297       8,513

Provision for loan losses                                           890         180
                                                               --------    --------
         Net interest income after provision for loan losses      8,407       8,333
                                                               --------    --------

Other income:
   Customer service fees                                            788         699
   Commissions from sales of annuities and mutual funds             229         263
   Mortgage banking income, net                                     314         337
   Securities (losses) gains, net                                    (2)        185
   Other                                                            304         318
                                                               --------    --------
     Total other income                                           1,633       1,802
                                                               --------    --------

Operating expenses:
   Compensation and related benefits                              3,828       3,999
   Occupancy and equipment                                        1,074       1,034
   Real estate operations, net                                       (1)         (9)
   Other expenses                                                 1,302       1,208
                                                               --------    --------
     Total operating expenses                                     6,203       6,232
                                                               --------    --------
         Income before income taxes                               3,837       3,903
Income taxes                                                      1,363       1,393
                                                               --------    --------

Net income                                                     $  2,474    $  2,510
                                                               ========    ========

Net income per share:

         Basic                                                 $   0.88    $   0.89
         Diluted                                               $   0.84    $   0.85
</TABLE>

See accompanying notes to the consolidated financial statements.


                                       3
<PAGE>
<TABLE>
<CAPTION>
                                                1st State Bancorp, Inc. and Subsidiary
                                Consolidated Statements of Stockholders' Equity and Comprehensive Income
                                           For the Six Months Ended June 30, 2005 and 2004 (Unaudited)
                                                            (In Thousands)

                                                                           Deferred
                                                                          compensation                    Accumulated
                                                   Additional Unallocated  payable in                         other       Total
                                            Common   paid-in     ESOP      treasury  Treasury  Retained  comprehensive stockholders'
                                             stock   capital    Shares      stock      stock    income   income (loss)    equity
                                             -----   -------    ------      -----      -----    ------   -------------    ------
<S>                                         <C>       <C>        <C>         <C>      <C>        <C>           <C>       <C>
Balance at September 30, 2003               $    33   35,778     (3,141)     5,466    (12,785)   38,118        (768)     62,701

Comprehensive income:
     Net income                                  --       --         --         --         --     2,510          --       2,510
     Other comprehensive loss-unrealized
       loss on securities
       available-for-sale, net
       of income tax benefit of $587             --       --         --         --         --        --        (912)       (912)
                                                                                                                        -------
           Total comprehensive income                                                                                     1,598
Allocation of ESOP shares                        --      190        429         --         --        --          --         619
Acquisition of treasury stock                    --       --         --         --     (1,112)       --          --      (1,112)
Deferred compensation                            --       --         --        786         --        --          --         786
Exercise of stock options                        --       19         --         --         --        --          --          19
Cash dividends declared  ($0.30 per share)       --       --         --         --         --      (889)         --        (889)
Cash dividends on unallocated ESOP shares        --       --         --         --         --        48          --          48
                                            -------  -------    -------    -------    -------   -------     -------     -------
Balance at June 30, 2004                    $    33   35,987     (2,712)     6,252    (13,897)   39,787      (1,680)     63,770
                                            =======  =======    =======    =======    =======   =======     =======     =======

Balance at September 30, 2004               $    33   36,038     (2,571)     6,440    (14,086)   40,462        (402)     65,914

Comprehensive income:
     Net income                                  --       --         --         --         --     2,474          --       2,474

     Other comprehensive loss-unrealized
       loss on securities
       available-for-sale, net
       of income tax benefit of $63,000          --       --         --         --         --        --        (149)       (149)
                                                                                                                        -------
           Total comprehensive income                                                                                     2,325
Allocation of ESOP shares                        --      198        417         --         --        --          --         615
Acquisition of treasury stock                    --       --         --         --     (2,238)       --          --      (2,238)
Deferred compensation                            --       --         --        260         --        --          --         260
Exercise of stock options                        --       80         --         --         --        --          --          80
Cash dividends declared  ($0.30 per share)       --       --         --         --         --      (875)         --        (875)
Cash dividends on unallocated ESOP shares        --       --         --         --         --        39          --          39
                                            -------  -------    -------    -------    -------   -------     -------     -------
Balance at June 30, 2005                    $    33   36,316     (2,154)     6,700    (16,324)   42,100        (551)     66,120
                                            =======  =======    =======    =======    =======   =======     =======     =======
</TABLE>

See accompanying notes to the consolidated financial statements


                                                                   4
<PAGE>

                              1st State Bancorp, Inc. and Subsidiary
                              Consolidated Statements of Cash Flows
                         For the Nine Months Ended June 30, 2005 and 2004
                                            (Unaudited)
                                          (In Thousands)

<TABLE>
<CAPTION>
                                                                               For the Nine Months Ended
                                                                                      June 30,
                                                                                --------------------
                                                                                  2005        2004
                                                                                --------    --------
<S>                                                                             <C>         <C>
Cash flows from operating activities:
   Net income                                                                   $  2,474    $  2,510
   Adjustment to reconcile net income to net cash provided by
       operating activities:
           Provision for loan losses                                                 890         180
           Depreciation                                                              485         514
           Deferred tax benefit                                                     (247)       (135)
           Amortization of premiums and discounts, net                               (24)          8
           Deferred compensation                                                     180         180
           Release of ESOP shares                                                    615         619
           Loan origination fees and unearned discounts
               deferred, net of current amortization                                 (45)        (49)
           Gain on sale of other real estate                                         (10)        (22)
           Loss (gain) on sale of investment securities available for sale             2        (185)
           Net loss on sale of loans                                                  26          39
           Proceeds from loans held for sale                                      17,470      21,072
           Originations of loans held for sale                                   (17,956)    (21,688)
           Increase in other assets                                                 (726)       (190)
           Increase in accrued interest receivable                                  (328)       (262)
           Decrease in other liabilities                                            (610)        (74)
                                                                                --------    --------

                Net cash provided by operating activities                          2,196       2,517
                                                                                --------    --------


Cash flows from investing activities:
           Proceeds from redemption of FHLB stock                                  5,463       2,500
           Purchases of FHLB stock                                                (5,138)     (3,250)
           Purchases of investment securities held to maturity                    (4,564)     (9,776)
           Purchases of investment securities available for sale                      --     (48,504)
           Proceeds from sales of investment securities available for sale         1,944      10,993
           Proceeds from maturities and issuer calls of investment securities
               available for sale                                                  7,000      30,302
           Proceeds from maturities and issuer calls of investment securities
               held to maturity                                                    3,251       6,002
           Net increase in loans receivable                                       (3,767)     (4,965)
           Purchase of and improvements to
               real estate acquired in settlement of loans                           (12)       (255)
           Purchases of premises and equipment net of disposals                     (168)       (139)
           Proceeds from disposal of real estate acquired in
               settlement of loans                                                    17         528
                                                                                --------    --------

          Net cash provided by (used in) investing activities                      4,026     (16,564)
                                                                                --------    --------

                                                                                          (Continued)
</TABLE>

                                                       5
<PAGE>

                     1st State Bancorp, Inc. and Subsidiary
                Consolidated Statements of Cash Flows - Continued
                For the Nine Months Ended June 30, 2005 and 2004
                                   (Unaudited)
                                 (In Thousands)
<TABLE>
<CAPTION>
                                                                         For the Nine Months Ended
                                                                                 June 30,
                                                                          ----------------------
                                                                             2005        2004
                                                                          ---------    ---------
<S>                                                                       <C>          <C>
Cash flows from financing activities:
   Net increase in deposits                                               $  11,633    $   1,126
   Advances from the Federal Home Loan Bank                                 119,500       90,000
   Repayments of advances from the Federal Home Loan Bank                  (135,500)     (74,000)
   Purchase of treasury stock                                                (2,238)      (1,112)
   Exercise of stock options                                                     80           19
   Dividends paid on common stock                                              (836)        (841)
   Increase in advance payments by borrowers for
     property taxes and insurance                                               234          231
                                                                          ---------    ---------

   Net cash used in financing activities                                     (7,127)     (15,423)
                                                                          ---------    ---------

        Net decrease in cash and cash equivalents                              (905)      (1,376)

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

Cash and cash equivalents at end of period                                $   8,949    $  10,735
                                                                          =========    =========

Payments are shown below for the following:
       Interest                                                           $   4,299    $   3,566
                                                                          =========    =========

       Income taxes                                                       $   1,811    $   1,397
                                                                          =========    =========

Noncash investing and financing activities:

     Unrealized losses on investment securities
          available for sale                                              $     212    $   1,499
                                                                          =========    =========

     Cash dividends declared but not paid                                 $     274    $     280
                                                                          =========    =========

     Cash dividends on unallocated ESOP shares                            $      39    $      48
                                                                          =========    =========

     Transfer from loans to real estate acquired in settlement of loans   $     289    $     182
                                                                          =========    =========
</TABLE>

See accompanying notes to the consolidated financial statements.


                                       6
<PAGE>

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

Note 1. Nature of Business

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

Note 2. Basis of Presentation

      The accompanying  consolidated  financial statements (which are unaudited,
except for the  consolidated  balance  sheet at  September  30,  2004,  which is
derived from the September 30, 2004 audited consolidated  financial  statements)
have been prepared in accordance with accounting  principles  generally accepted
in the  United  States of  America  and with the rules  and  regulations  of the
Securities and Exchange Commission.  Accordingly, they do not include all of the
information and footnotes required by accounting  principles  generally accepted
in the United  States of  America  for  complete  financial  statements.  In the
opinion of  management,  all  adjustments  (none of which were other than normal
recurring  accruals) necessary for a fair presentation of the financial position
and results of operations for the periods presented have been included.

      The results of operations  for the three and nine month periods ended June
30, 2005 are not necessarily indicative of the results of operations that may be
expected for the year ending September 30, 2005. The preparation of consolidated
financial statements in accordance with accounting principles generally accepted
in the United States of America requires  management to make certain  estimates.
These amounts may be revised in future  periods  because of changes in the facts
and circumstances underlying their estimation.

Note 3. Earnings Per Share

      For purposes of computing basic and diluted  earnings per share,  weighted
average shares outstanding  excludes  unallocated ESOP shares that have not been
committed to be released. The deferred compensation obligation discussed in Note
5 that is funded with shares of the Company's  common stock has no net impact on
the  Company's  earnings  per share  computations.  Diluted  earnings  per share
include the potentially  dilutive effects of the Company's  stock-based  benefit
plans.  There were no anti-dilutive  stock options for the three and nine months
ended June 30, 2005 and 2004. A reconciliation  of the denominators of the basic
and diluted earnings per share computations is as follows:

<TABLE>
<CAPTION>
                                                               Three Months Ended
                                                                    June 30,
                                                               2005          2004
                                                            ----------    ----------
<S>                                                          <C>           <C>
Average shares issued and outstanding                        2,898,955     2,962,323
Less: Unallocated ESOP shares                                 (113,607)     (142,207)
                                                            ----------    ----------
Average basic shares for earnings per share                  2,785,348     2,820,116
Add: Potential common stock pursuant to stock option plan      158,593       145,534
                                                            ----------    ----------
Average dilutive shares for earnings per share               2,943,941     2,965,560
                                                            ==========    ==========
</TABLE>


                                       7
<PAGE>
<TABLE>
<CAPTION>
                                                               Nine Months Ended
                                                                    June 30,
                                                               2005          2004
                                                            ----------    ----------
<S>                                                          <C>           <C>
Average shares issued and outstanding                        2,930,589     2,965,045
Less: Unallocated ESOP shares                                 (120,705)     (149,527)
                                                            ----------    ----------
Average basic shares for earnings per share                  2,809,884     2,815,518
Add: Potential common stock pursuant to stock option plan      151,573       150,436
                                                            ----------    ----------
Average dilutive shares for earnings per share               2,961,457     2,965,954
                                                            ==========    ==========
</TABLE>

Note 4. Employee Stock Ownership Plan ("ESOP")

      The Company sponsors an employee stock ownership plan (the "ESOP") whereby
an aggregate  number of shares amounting to 253,050 or 8% of the stock issued in
the  conversion was purchased for future  allocation to employees.  The ESOP was
funded by an 11-year term loan from the Company in the amount of $4,899,000. The
loan is secured by the shares of stock  purchased by the ESOP.  During the three
and nine  months  ended June 30,  2005 and 2004,  7,098 and 7,280 and 21,294 and
21,920 shares of stock were committed to be released and approximately  $215,000
and $199,000 and $615,000 and $619,000,  respectively,  of compensation  expense
was recognized.

Note 5. Deferred Compensation

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

      Prior  to the  Stock  Conversion,  amounts  deferred  by each  participant
accumulated interest at a rate equal to the highest rate of interest paid on the
Bank's  one-year   certificates  of  deposit.   In  connection  with  the  Stock
Conversion, participants in the plan were given the opportunity to prospectively
elect to have their deferred compensation balance earn a rate of return equal to
the total return of the Company's stock.  All  participants  elected this option
concurrent with the Stock Conversion,  so the Company purchases its common stock
to fund this obligation.  Refer to the Company's notes to consolidated financial
statements,  incorporated  by reference in the  Company's  2004 Annual Report on
Form 10-K for a discussion  of the Company's  accounting  policy with respect to
this deferred  compensation plan and the related treasury stock purchased by the
Company to fund this obligation.

      The expense  related to this plan were $60,000 in each of the three months
ended June 30, 2005 and 2004 and  $180,000 in each of the nine months ended June
30, 2005 and 2004. This expense is included in compensation expense.

Note 6. Stock Option and Incentive Plan

      On June  6,  2000,  the  Company's  stockholders  approved  the 1st  State
Bancorp,  Inc. 2000 Stock Option and Incentive Plan (the "Plan"). The purpose of
this plan is to advance the interests of the Company  through  providing  select
key employees and directors of the Bank with the  opportunity to acquire shares.
By encouraging  such stock ownership,  the Company seeks to attract,  retain and
motivate  the  best   available   personnel   for   positions   of   substantial
responsibility  and to provide  incentives to the key  employees and  directors.
Under the Plan, the Company  granted  316,312  options to purchase its $0.01 par
value common  stock.  The  exercise  price per share is equal to the fair market
value per share on the date of the grant. Options granted under the Stock Option
Plan are 100% vested on the date of the grant,  and all options  expire 10 years
from the date of the grant.  As a result of the one-time  cash dividend of $5.17
paid on October 2, 2000, the exercise price for the options repriced from $18.44
to $14.71.  There were 5,423 options exercised during each of the three and nine
months ended June 30,  2005,  respectively.  No options were granted  during the
three and nine months ended June 30, 2005 and 2004.  At June 30,  2005,  308,812
options are outstanding, all of which are exercisable.

Note 7. Mortgage Servicing Rights

      The rights to service  mortgage  loans for  others are  included  in other
assets on the consolidated balance sheet. Mortgage servicing rights ("MSRs") are
capitalized  based on the allocated cost that is determined  when the underlying
loans are sold. MSRs are amortized over a period that  approximates  the life of
the underlying loan as an adjustment of servicing income.  Impairment reviews of
MSRs are performed on a quarterly  basis.  As of June 30, 2005 and September 30,
2004,  MSRs  totaled  $464.000  and  $493,000,  respectively,  and no  valuation
allowance was required.

      Amortization expense totaled $75,000 and $85,000 for the nine months ended
June 30, 2005 and 2004, respectively.

                                       8
<PAGE>

Note 8. Standby Letters of Credit and Loan Commitments

      In  November  2002,  the  FASB  issued  Interpretation  No.  45 (FIN  45),
"Guarantor's  Accounting and Disclosure  Requirements for Guarantees,  Including
Indirect  Guarantees of Indebtedness of Others",  which addressed the disclosure
to be made by a guarantor in its interim and annual  financial  statements about
its obligations under  guarantees.  FIN 45 requires the guarantor to recognize a
liability  for  the  non-contingent  component  of the  guarantee,  such  as the
obligation  to stand  ready to perform in the event  that  specified  triggering
events or conditions  occur.  The initial  measurement  of this liability is the
fair value of the guarantee at inception.  The  recognition  of the liability is
required even if it is not probable  that  payments  will be required  under the
guarantee or if the guarantee was issued with a premium  payment or as part of a
transaction  with  multiple  events.  The initial  recognition  and  measurement
provisions are effective for all guarantees within the scope of FIN 45 issued or
modified  after June 30,  2003.  The Company  issues  standby  letters of credit
whereby the Company  guarantees  performance if a specified  triggering event or
condition occurs (primarily  nonperformance under construction contracts entered
into by construction customers). The guarantees generally expire within one year
and may be automatically  renewed  depending on the terms of the guarantee.  The
maximum  potential  amount of undiscounted  future  payments  related to standby
letters  of credit  at June 30,  2005 is $2.1  million.  At June 30,  2005,  the
Company has recorded no liability for the  obligation to perform as a guarantor.
In addition, no contingent liability is considered necessary as such amounts are
not deemed probable.  Substantially all standby letters of credit are secured by
real estate  and/or  guaranteed by third parties in the event the Company had to
advance funds to fulfill the guarantee.

      The Company originates certain fixed rate residential  mortgage loans with
the  intention  of selling  these loans.  At the time the Company  enters into a
commitment to originate a fixed rate residential  mortgage loan with a potential
borrower, we concurrently "lock in" the sale of the loan with a secondary market
investor under a best efforts delivery  mechanism.  Between the time the Company
commits to originate the loan and the time the closed loan is sold,  the Company
is  subject  to  changes in market  prices  related  to these  commitments.  The
commitments to originate fixed rate  residential  mortgage loans and the forward
sales commitments are freestanding derivative  instruments.  They do not qualify
for hedge  accounting  treatment  so their fair value  adjustments  are recorded
through the income statement.

Note 9. Investments

      The following table provides additional  information  regarding unrealized
losses as of June 30, 2005,  none of which relate to securities  that are deemed
to be other than temporarily impaired.  The table is segregated into investments
that have been in a continuous  unrealized loss position for less than 12 months
and those that have been in a continuous  unrealized loss position for more than
12 months.

<TABLE>
<CAPTION>
                                   Less than 12 months             12 months or more                   Total
                               ---------------------------    ---------------------------    ---------------------------
                                  Fair         Unrealized        Fair        Unrealized         Fair        Unrealized
                                  Value          Losses          Value         Losses           Value         Losses
                               ------------   ------------    ------------   ------------    ------------   ------------
                                                                      (In thousands)
<S>                            <C>                     <C>          <C>               <C>           <C>             <C>
Held to maturity:
     U.S. Government and
           agency securities   $      4,555            (44)         10,896            (95)          6,451           (139)
     Municipal bonds                  1,599            (24)            613            (20)          2,212             44)
     Collateralized mortgage
           obligations                   --             --              --             --              --             --
                               ------------   ------------    ------------   ------------    ------------   ------------
              Total            $      6,154            (68)         11,509           (115)          8,663           (183)
                               ============   ============    ============   ============    ============   ============

Available for sale:
     U.S. Government and
           agency securities   $     13,689            (59)         60,115           (875)         73,804           (904)
                               ============   ============    ============   ============    ============   ============
</TABLE>

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

Note 10. Recent Developments

      On June 29,  2005,  the  Board of  Directors  of 1st State  Bancorp,  Inc.
executed  a   definitive   agreement  to  merge  the  company  to  Capital  Bank
Corporation,  headquartered  in Raleigh,  N.C. This  transaction  is expected to
close in January 2006, subject to approval of shareholders of both companies and
regulators and other normal and customary closing conditions.


                                       9
<PAGE>

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

Forward-Looking Statements

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

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

General

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

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

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

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

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

      Due to a general  slowdown in the economy  beginning in 2000,  the Federal
Reserve acted to provide a stimulus through a series of interest rate reductions
that  lowered  the prime rate from 9.50% in January  2001 to 4.00% in June 2003.
These reductions in prime tended to negatively impact the Company's net interest
margin and net interest  spread which resulted in lower net interest  income for
the  Company.  Beginning  June 29,  2004,  the  Federal  Reserve  implemented  a
tightening policy that has resulted in nine one-quarter percent increases in the
prime rate  bringing  it to 6.25% at July 1, 2005.  These  rate  increases  have
helped to improve  the yield on earning  assets  although  the cost of funds has
also increased  primarily as a result of increase in short-term  interest rates.
The  Company's  balance  sheet is  currently  asset  sensitive,  that  is,  rate
sensitive assets


                                       10
<PAGE>

exceed rate sensitive liabilities.  We expect an increase in net interest income
during periods of rising interest rates and decreased net interest income during
periods of falling interest rates.

Merger Agreement

      On June 29, 2005, the Company entered into a definitive  merger  agreement
with Capital  Bank  Corporation  ("Capital")  whereby the Company will be merged
with and into Capital, with Capital being the surviving corporation.  Capital is
headquartered  in Raleigh,  N.C. and  operates 21 branches  with total assets of
$917 million.  Upon consummation of the transaction,  which is expected to occur
in  January  2006,  each  share  of the  Company's  common  stock  will  receive
approximately  $37.15 (in cash  and/or  stock)  subject to  adjustment  based on
changes in the value of Capital Bank stock above or below  certain  levels . The
merger is subject to approval of  shareholders  of both companies and regulators
and other normal and customary closing conditions.

Critical Accounting Policies

      The Company's  significant  accounting policies are set forth in Note 1 of
the consolidated  financial statements as of September 30, 2004, which was filed
on the Company's  Annual Report on Form 10-K for the fiscal year ended September
30, 2004. Of these significant  accounting  policies,  the Company considers its
policy  regarding  the  allowance  for  loan  losses  to be  its  most  critical
accounting policy,  because it requires management's most subjective and complex
judgments.  In addition,  changes in economic  conditions can have a significant
impact on the  allowance  for loan losses and  therefore  the provision for loan
losses and results of operations. The Company has developed appropriate policies
and  procedures  for  assessing  the adequacy of the  allowance for loan losses,
recognizing  that this process  requires a number of  assumptions  and estimates
with respect to its loan portfolio. The Company's assessments may be impacted in
future  periods by  changes in  economic  conditions,  the impact of  regulatory
examinations, and the discovery of information with respect to borrowers that is
not  known  to  management  at the  time  of the  issuance  of the  consolidated
financial statements.

Comparison of Financial Condition at June 30, 2005 and September 30, 2004

      Total assets  decreased  $4.6 million from $377.7 million at September 30,
2004 to $373.1  million at June 30, 2005.  During the nine months ended June 30,
2005,  the  Company's  loan  growth  was  more  than  offset  by a  decrease  in
investments.  The Company shrank its investment  portfolio by applying  proceeds
from investment calls to reduce overnight borrowings.  The Company grew deposits
by $11.7  million  during the nine months ended June 30,  2005,  the proceeds of
which  were also  applied  to  reduce  overnight  borrowings.  The  Company  was
successful in attracting  retail  certificates  of deposit as an  alternative to
short term  borrowings  from the FHLB of Atlanta as part of its asset  liability
strategy.

      Investment securities available for sale decreased $9.2 million from $96.7
million at September 30, 2004 to $87.5 million at June 30, 2005. During the nine
months  ended  June  30,  2005,  we  received  $8.9  million  in  proceeds  from
maturities,  sales and issuer calls of investment  securities available for sale
and  did not  purchase  any  investments  available  for  sale.  Interest  rates
increased  during the nine months ended June 30, 2005 which caused the Company's
gross  unrealized loss on investment  securities  available for sale to increase
from  $693,000 at September  30, 2004 to $905,000 at June 30,  2005.  Investment
securities  held to  maturity  increased  $1.4  million  from  $22.9  million at
September  30, 2004 to $24.3  million at June 30,  2005.  During the nine months
ended June 30, 2005, we purchased  $4.6 million of securities  and received $3.3
million in proceeds from  maturities  and issuer calls of investment  securities
held to maturity.  As interest rates have  increased,  the Company has purchased
fewer fixed-rate securities.

      Loans  held for sale  increased  to $1.4  million  at June 30,  2005  from
$930,000 at  September  30, 2004.  The increase in loans held for sale  resulted
from timing  differences  in the funding of loan sales.  Loans  receivable,  net
increased  from $231.8  million at September 30, 2004 to $234.4  million at June
30, 2005.  The  Company's  mortgage  originations  have been slower this year as
refinance  activity slowed down in response to higher  mortgage  interest rates.
During this same period,  the Company saw growth in commercial  loans and equity
lines.

      Deposits  increased  $11.7 million to $274.4 million at June 30, 2005 from
$262.7  million at September 30, 2004.  The increase  resulted  from  successful
certificate of deposit campaigns.

      Advances  from the  Federal  Home Loan  Bank of  Atlanta  decreased  $16.0
million from $44.0  million at September  30, 2004 to $28.0 million at June 300,
2005. The Company used deposit proceeds and proceeds from investments  calls and
maturities to repay these borrowings.

      Stockholders' equity increased by $200,000 from $65.9 million at September
30,  2004 to $66.1  million  at June 30,  2005 as a result of net income of $2.5
million and the release of ESOP shares of $615,000 and $80,000 from the exercise
of stock options.  These  increases  were partially  offset by cash dividends to
stockholders declared of $836,000,  purchases of treasury stock of $2.0 million,
and an increase in the net unrealized  loss on available for sale  securities of
$149,000.  The  increase  in the net  unrealized  loss  on  available  for  sale
securities  was a result of increases in interest rates which caused bond prices
to decrease.


                                       11
<PAGE>

Comparison  of  Operating  Results for the Three  Months Ended June 30, 2005 and
2004

      Net Income.  We recorded net income of $738,000 for the quarter ended June
30,  2005,  as  compared  to  $973,000  for the  quarter  ended  June 30,  2004,
representing a decrease of $235,000,  or 24.2%.  For the three months ended June
30,  2005,   basic  and  diluted  earnings  per  share  were  $0.27  and  $0.25,
respectively,  compared  to the basic  and  diluted  earnings  per share for the
quarter  ended June 30, 2004 of $0.35 and $0.33,  respectively.  The decrease in
net income  resulted  primarily  from  increased  provision  for loan losses and
decreased  other  income which was offset  partially  by increased  net interest
income and  decreased  income tax expense.  The increase in net interest  income
resulted  from  growth in net  interest-earning  assets and higher net  interest
margins. The average prime interest rate for the quarter ended June 30, 2005 was
5.91%,  an increase of 191 basis points from 4.00%,  which was the average prime
for the quarter  ended June 30, 2004.  The  repricing  of loans and  investments
increased  the  Company's  average  asset yield by 84 basis  points  whereas the
average cost of funds  increased 70 basis points  during the quarter  ended June
30, 2005.

      Net Interest Income.  Net interest income, the difference between interest
earned  on  loans  and  investments   and  interest  paid  on   interest-bearing
liabilities,  increased by $300,000 or 10.3% for the three months ended June 30,
2005, compared to the same quarter in the prior year. This increase results from
a $700,000 increase in interest income that was partially offset by the $400,000
increase  in total  interest  expense.  The  average  net  interest  rate spread
increased 14 basis points from 3.01% for the three months ended June 30, 2004 to
3.15% for the quarter ended June 30, 2005.

      Interest  Income.  The  increase in interest  income for the three  months
ended June 30, 2005 was the result of an  increase in yield on  interest-earning
assets of 84 basis points from 4.61% for the three months ended June 30, 2004 to
5.45% for the three months ended June 30, 2005 which was offset partially by the
decrease of $5.4 million in average interest-earning assets compared to the same
quarter in the prior year.  Average  loans  receivable  increased  $3.1 million,
average   investment    securities   decreased   $9.7   million,   and   average
interest-bearing  overnight  funds  increased $1.2 million.  The increase in the
average asset yield increased  interest income by  approximately  $740,000 while
the decrease in average  interest-earning  assets  decreased  interest income by
approximately $62,000.

      Interest  Expense.  Interest  expense  increased in the three months ended
June 30, 2005 due to an increase in the cost of interest-bearing  liabilities of
70 basis points from 1.60% for the three months ended June 30, 2004 to 2.30% for
the three months ended June 30, 2005 which was offset  partially by the decrease
in   average   interest-bearing    liabilities   of   $12.2   million.   Average
interest-bearing  deposits increased by $8.6 million while average FHLB advances
decreased $20.9 million for the three months ended June 30, 2005 compared to the
same quarter in the prior year. The average cost of the FHLB advances  increased
202 basis  points to 5.16% for the three  months  ended  June 30,  2005 from the
3.14% for the three  months  ended June 30,  2004.  This  increase  reflects the
increase in short term interest rates as well and the impact of lower volumes of
short-term  borrowings  during the quarter  ended June 30, 2005  compared to the
same quarter in the prior year.  Short-term borrowings averaged $3.1 million for
the quarter  ended June 30, 2005 compared to an average of $24.0 million for the
quarter ended June 30, 2004. The cost of the short-term  borrowings is less than
the average cost of the $20 million  long-term  advance which was outstanding in
both  periods.  The  increase in average  cost of  interest-bearing  liabilities
increased  interest expense by approximately  $488,000 while the decrease in the
average interest-bearing liabilities decreased interest expense by approximately
$49,000.

      The  following   table  presents   average   balances  and  average  rates
earned/paid  by the Company for the quarter  ended June 30, 2005 compared to the
quarter ended June 30, 2004.

<TABLE>
<CAPTION>
                                                    Three Months Ended               Three Months Ended
                                                      June 30, 2005                    June 30, 2004
                                            --------------------------------  -------------------------------
                                                                 (Dollars in Thousands)
                                             Average               Average    Average               Average
                                             Balance    Interest  Yield/Cost  Balance    Interest  Yield/Cost
                                             -------    --------  ----------  -------    --------  ----------
<S>                                         <C>            <C>        <C>     <C>        <C>          <C>
Assets:
Loans receivable (1) ....................   $234,199       3,605      6.16%   $231,111   $  2,812     4.87%
Investment securities(2) ................    113,011       1,151      4.07     122,717      1,288     4.20
Interest-bearing overnight deposits .....      3,983          29      2.88       2,796          6     0.93
                                            --------    --------    ------   ---------   --------   ------
     Total interest-earning assets (3) ..    351,193       4,785      5.45     356,624      4,106     4.61
Non interest-earning assets .............     20,494                            20,466
                                            --------                          --------
     Total assets .......................   $371,687                          $377,090
                                            ========                          ========

Liabilities and stockholders' equity
Interest-bearing
checking ................................     35,073          26      0.29      36,805         19     0.21
Money market investment accounts ........     16,818          42      0.99      19,884         33     0.67
Passbook and statement savings ..........     29,375          54      0.73      30,943         47     0.61
Certificates of deposit .................    175,835       1,189      2.71     160,827        725     1.80
FHLB advances ...........................     23,088         298      5.16      43,967        346     3.14
                                            --------    --------    ------    --------   --------   ------
     Total interest-bearing liabilities..    280,189       1,609      2.30     292,426      1,170     1.60


                                       12
<PAGE>

Noninterest-bearing liabilities .........     25,729                           21,411
                                            --------                         --------
     Total liabilities ..................    305,918                          313,837
Stockholders' equity ....................     65,769                           63,253
                                            --------                         --------
     Total liabilities and stockholders'
       equity ...........................    371,687                         $377,090
                                            ========                         ========
Net interest income .....................               $  3,176                         $  2,936
                                                        ========                         ========
Interest rate spread ....................                             3.15%                           3.01%
                                                                    ======                          ======
Net interest margin (4) .................                             3.62%                           3.29%
                                                                    ======                          ======
Ratio of average interest-earning assets
to average interest-bearing liabilities..                           125.34%                         121.95%
                                                                    ======                          ======
</TABLE>

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

      Provision  for Loan  Losses.  We  charge  provisions  for loan  losses  to
earnings to maintain the total  allowance for loan losses at a level we consider
adequate to provide for probable loan losses,  based on existing loan levels and
types of loans outstanding,  nonperforming loans, prior loss experience, general
economic  conditions  and other  factors.  We estimate  the  allowance  using an
allowance  for loan losses  model which  takes into  consideration  all of these
factors.  Our policies  require the review of assets on a regular basis,  and we
assign  risk  grades  to  loans  based  on the  relative  risk  of  the  credit,
considering  such  factors  as  repayment   experience,   value  of  collateral,
guarantors,  etc.  Our  credit  management  systems  have  resulted  in low loss
experience;  however,  there  can be no  assurances  that such  experience  will
continue.   We  believe  we  use  the  best  information  available  to  make  a
determination  with respect to the allowance for loan losses,  recognizing  that
future  adjustments  may be  necessary  depending  upon  a  change  in  economic
conditions.

      The provision for loan losses was $60,000 and net charge-offs were $42,000
for the three months ended June 30, 2004  compared with a provision of $500,000,
and net  charge-offs of $4,000 for the three months ended June 30, 2005. At June
30, 2005, the Company  established a specific loan valuation reserve of $794,000
on a $3.5 million  credit that has been  identified as a potential loan problem.
This  specific  reserve  increased  the provision for the quarter ended June 30,
2005.  Nonperforming  loans at June 30,  2005 and  September  30, 2004 were $2.8
million  and  $4.0  million,   respectively.   Approximately   $2.2  million  of
nonperforming  loans at June 30,  2005  consist of one  commercial  relationship
which  is  not  necessarily  indicative  of the  credit  quality  of the  entire
portfolio. See "-- Asset Quality" for further information.

      Other Income.  Other income decreased $162,000 from $686,000 for the three
months ended June 30, 2004 to $524,000 for the three months ended June 30, 2005.
Mortgage  banking  income,  net  decreased  $25,000 from  $126,000 for the three
months ended June 30, 2004 to $101,000 for the three months ended June 30, 2005.
The lower fee income  reflects lower volumes of mortgage loan  originations  and
sales.  We sold loans  totaling  $6.0 million in the three months ended June 30,
2005 compared with sales of $7.5 million in the previous year for the comparable
period. Given the current level of mortgage interest rates, the Company believes
that mortgage banking income will continue to decrease in future quarters due to
lower refinancing activity.  The Company recorded a gain of $143,000 on the sale
of real  estate  that  had  previously  served  as one of the  Company's  branch
offices.  This gain was included in other income for the quarter  ended June 30,
2004.  There was no such gain  reported in the  quarter  ended June 30, 2005 and
other income  decreased  to $72,000 from the $208,000  which was reported in the
three months ended June 30, 2004.

      Operating Expenses. Total operating expenses were $2.1 million for each of
the three  months  ended June 30,  2005 and 2004.  The  Company has been able to
control  expenses  during this period of slower asset  growth and lower  lending
volumes.

      Income Tax Expense. Income tax expense decreased $113,000 from tax expense
of $516,000  for the three  months ended June 30, 2004 to $403,000 for the three
months ended June 30, 2005. The effective tax rates were 35.3% and 34.7% for the
three  months  ended June 30, 2005 and 2004,  respectively.  The increase in the
effective tax rate was primarily due to a relative decrease in tax-exempt income
compared to the prior year.

Comparison of Operating Results for the Nine Months Ended June 30, 2005 and 2004

      Net Income.  We recorded  net income of $2.5  million for each of the nine
months  ended June 30, 2005 and 2004.  For the nine months  ended June 30, 2005,
basic and diluted  earnings  per share were $0.88 and $0.84,  respectively.  The
Company  reported basic and diluted earnings per share for the nine months ended
June 30, 2004 of $0.89 and $0.85,  respectively.  Comparing  the results for the
nine  months  ended June 30,  2005 to the  previous  year,  the  Company  had an
increase in net interest income which was offset by increased provision for loan
losses and a decrease in non-in other  income.  The increase in the net interest
income  resulted from  improved net interest  margins and increased net interest
earning  assets.  The average prime interest rate for the nine months ended June
30, 2005 was 5.45%,  an increase of 145 basis  points from 4.00%,  which was the
average prime for the nine months ended June 30, 2004. The rate increase  caused
a greater  increase in the average yield on earning assets than the average rate
paid on interest-bearing liabilities.


                                       13
<PAGE>

      Net Interest Income.  Net interest income, the difference between interest
earned  on  loans  and  investments   and  interest  paid  on   interest-bearing
liabilities,  increased  by $784,000 or 9.2% for the nine months  ended June 30,
2005, compared to the same nine months in the prior year. This increase reflects
a $1.5  million  increase in interest  income that was  partially  offset by the
$743,000  increase in total  interest  expense.  The average net  interest  rate
spread  increased  14 basis points from 2.97% for the nine months ended June 30,
2004 to 3.11% for the nine months ended June 30, 2005.

      Interest Income. The increase in interest income for the nine months ended
June 30,  2005 was due to a increase in yield on  interest-earning  assets of 49
basis points from 4.67% for the nine months ended June 30, 2004 to 5.16% for the
nine months  ended June 30, 2005  combined  with an increase of $5.6  million in
average  interest-earning  assets compared to the same period in the prior year.
The  increased  volume of average  interest-earning  assets  increased  interest
income by  approximately  $200,000 and the increased  yield  increased  interest
income by approximately  $1.3 million.  Average loans receivable  increased $4.9
million,   average  investment   securities  increased  $576,000,   and  average
interest-bearing  overnight  funds  increased  $196,000  compared with the prior
year.

      Interest Expense. Interest expense increased in the nine months ended June
30, 2005 due to an increase in the cost of  interest-bearing  liabilities  of 35
basis points from 1.70% for the nine months ended June 30, 2004 to 2.05% for the
nine months ended June 30, 2005.  This was  partially  offset by the decrease in
average  interest-bearing  liabilities  of $342,000  compared to the prior year.
Average deposits  increased by $8.0 million and average FHLB advances  decreased
$8.3 million for the nine months  ended June 30, 2005  compared to the same nine
months in the prior year.  The increase in the average cost of  interest-bearing
liabilities increased interest expense by approximately  $882,000.  The decrease
in  average   interest-bearing   liabilities   decreased   interest  expense  by
approximately $138,000.

      The  following   table  presents   average   balances  and  average  rates
earned/paid  by the Company for the nine months ended June 30, 2005  compared to
the nine months ended June 30, 2004.

<TABLE>
<CAPTION>
                                                  Nine Months Ended                Nine Months Ended
                                                    June 30, 2005                    June 30, 2004
                                            --------------------------------  ------------------------------
                                                                (Dollars in Thousands)
                                            Average                Average    Average              Average
                                            Balance    Interest   Yield/Cost  Balance   Interest  Yield/Cost
                                            -------    --------   ----------  -------   --------  ----------
<S>                                        <C>        <C>           <C>     <C>        <C>          <C>
Assets:
Loans receivable (1) ...................    233,687    $ 10,066      5.74%   $228,827   $  8,495     4.95%
Investment securities (2) ..............    114,056       3,500      4.09     113,480      3,588     4.22
Interest-bearing overnight deposits ....      3,752          68      1.23       3,556         24     0.89
                                           --------    --------    ------    --------   --------   ------
     Total interest-earning assets (3) .    351,495      13,634      5.16     345,863     12,107     4.67
Non interest-earning assets ............     20,527                            20,896
                                           --------                          --------
     Total assets ......................   $372,022                          $366,759
                                           ========                          ========

Liabilities and stockholders' equity:
Interest-bearing checking ..............     35,498          72      0.27      36,148         57     0.21
Money market investment accounts .......     16,800         125      0.99      19,565         98     0.67
Passbook and statement savings .........     29,701         156      0.70      30,377        139     0.61
Certificates of deposit ................    172,537       3,027      2.34     160,476      2,335     1.94
FHLB advances ..........................     27,571         957      4.63      35,883        965     3.58
                                           --------    --------    ------    --------   --------   ------
     Total interest-bearing liabilities     282,107       4,337      2.05     282,449      3,594     1.70
Noninterest-bearing liabilities ........     23,985                            21,060
                                           --------                          --------
     Total liabilities .................    306,092                           303,509
Stockholders' equity ...................     65,930                            63,250
                                           --------                          --------
     Total liabilities and stockholders'
       equity ..........................   $372,022                          $366,759
                                           ========                          ========

Net interest income ....................               $  9,297                         $  8,513
                                                       ========                         ========
Interest rate spread ...................                             3.11%                           2.97%
                                                                  =======                          ======
Net interest margin (4) ................                             3.51%                           3.28%
                                                                  =======                          ======
Ratio of average interest-earning assets
 to average interest-bearing liabilities                           124.60%                         122.45%
                                                                  =======                          ======
</TABLE>

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


                                       14
<PAGE>

(4)   Represents  net  interest   income  divided  by  the  average  balance  of
      interest-earning assets.

      Provision  For Loan Losses.  The  provision  for loan losses is charged to
earnings to maintain the total  allowance for loan losses at a level  considered
adequate to absorb  estimated  probable  losses  inherent in the loan  portfolio
based on  existing  loan levels and types of loans  outstanding,  non-performing
loans,  prior  loan  loss  experience,  general  economic  conditions  and other
factors.  Provisions for loan losses totaled  $890,000 and $180,000 for the nine
months ended June 30, 2005 and 2004, respectively. The provision for loan losses
was impacted by the increase  the loan  charge-offs  and an increase in specific
reserves for impaired loans. Net loan charge-offs for the nine months ended June
30, 2005 and 2004 were $655,000 and $126,000, respectively. The most significant
chargeoff during the nine months ended June 30, 2005 totaled $620,000 related to
one credit.

      Other Income.  Other income was $1.6 million and $1.8 million for the nine
months  ended June 30,  2005 and 2004,  respectively.  Customer  fees  increased
$89,000 to $788,000  for the nine months ended June 30, 2005  compared  with the
$699,000  reported in the prior year.  This increase was the result of increased
deposit  service  charges and loan late  charges  compared  with the prior year.
Commissions  from sales of  annuities  and mutual funds  decreased  $34,000 from
$263,000 for the nine months ended June 30, 2004 to $229,000 for the nine months
ended June 30, 2005.  This  decrease  results from lower sales of annuities  and
mutual funds.  The Company recorded gains on sales of investments of $185,000 in
the nine  months  ended June 30,  2004  compared to a loss of $2,000 in the nine
months ended June 30, 2005.  Mortgage banking income, net decreased $23,000 from
$337,000 for the nine months ended June 30, 2004 to $314,000 for the nine months
ended June 30, 2005.  The lower fee income  reflects  lower  volumes of mortgage
loan  originations  and sales.  We sold loans totaling $18.0 million in the nine
months ended June 30, 2005  compared with sales of $21.1 million in the previous
year for the comparable period.

      Operating Expenses. Total operating expenses were $6.2 million for each of
the nine months ended June 30, 2005 and 2004, respectively. The Company has been
able to control expenses during this period of slower asset growth.

      Income Tax  Expense.  Income tax expense was $1.4  million for each of the
nine months ended June 30, 2005 and 2004. The effective tax rates were 35.5% and
35.7% for the nine months ended June 30, 2005 and 2004, respectively.

Commitments, Contingencies and Off-Balance Sheet Risk

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

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

<TABLE>
<CAPTION>
                                                         June 30, 2005      September 30, 2004
                                                         -------------      ------------------
                                                                     (In thousands)
<S>                                                          <C>                  <C>
Commitments to originate new loans                           $ 4,052              $ 2,177
Commitments to originate new loans held for sale                 117                   --
Unfunded commitments to extend credit under existing
     equity line and commercial lines of credit               65,554               55,357
Commercial letters of credit                                   2,150                2,055
Commitments to sell loans held for sale                        1,344                2,174

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

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

      Commitments  to sell loans held for sale are agreements to sell loans to a
third party at an agreed upon price.  At June 30, 2005, the aggregate fair value
of these commitments exceeded the book value of the loans to be sold.

                                       15
<PAGE>

Contractual Obligations

As of June 30, 2005:

                                          Payments Due by Period
                                          ----------------------
                                          (Dollars in thousands)

                           Less than
                             1 year   1-3 years  4-5 years Over 5 years   Total
                            --------   --------   --------   --------   --------

Deposits                    $238,425   $ 25,966   $  9,976   $     --   $274,367

Advances from
   Federal Home Loan Bank      8,000     20,000         --         --     28,000
Lease obligations                 20         42         42          5        109
                            --------   --------   --------   --------   --------
Total contractual cash
    obligations             $246,445   $ 46,008   $ 10,018   $      5   $302,476
                            ========   ========   ========   ========   ========

Asset Quality

      At  June  30,  2005,  the  Company  had  approximately   $3.1  million  in
nonperforming  assets (nonaccrual loans and real estate owned) or 0.83% of total
assets. At September 30, 2004,  nonperforming  assets were $4.0 million or 1.05%
of total assets. At June 30, 2005 and September 30, 2004, impaired loans totaled
$5.9 million (of which $2.4 were on nonaccrual  status) and $3.8 million (all of
which were on  nonaccrual  status),  respectively,  as defined by  Statement  of
Financial  Accounting Standards No. 114, "Accounting by Creditors for Impairment
of a Loan." The most significant impaired loans at June 30, 2005 result from two
unrelated commercial loans secured by commercial real estate and business assets
in Alamance  County.  At June 30, 2005,  the combined loan balances of these two
relationships totaled $5.7 million. The average carrying value of impaired loans
was $3.2 million during the nine months ended June 30, 2005.  Interest income of
$97,000 has been  recorded on impaired  loans in the nine months  ended June 30,
2005.  The Bank's net  charge-offs  for the nine months ended June 30, 2005 were
$655,000. The Bank's allowance for loan losses was $4.2 million and $4.0 million
at June 30, 2005 and  September  30,  2004,  respectively,  and the ratio of the
allowance  for loan losses to total loans,  net of loans in process and deferred
loan  fees was  1.76%  and  1.68%  at June 30,  2005  and  September  30,  2004,
respectively.

      At June 30, 2005, the Company had one $3.5 million loan relationship which
is not currently classified as nonaccrual, 90 days past due or restructured, but
where  known  financial   information  about  possible  credit  problems  causes
management to have serious concerns as to the ability of the borrowers to comply
with present loan repayment terms and may result in disclosure as nonaccrual, 90
days past due or restructured. See "--Provision For Loan Losses" for information
concerning the specific reserve on this loan.

      The following table presents an analysis of our nonperforming assets:

<TABLE>
<CAPTION>
                                                     At           At           At
                                                  June 30,   September 30,   June 30,
                                                    2005         2004         2004
                                                  ---------    ---------    ---------
Non-performing loans:                                   (Dollars in thousands)
<S>                                               <C>          <C>          <C>
Nonaccrual loans                                  $   2,370    $   3,962    $   4,007
Loans 90 days past due and accruing                     430           --           --
Restructured loans                                       --           --           --
                                                  ---------    ---------    ---------
    Total non-performing loans                        2,800        3,962        4,007
Other real estate                                       301           26           17
                                                  ---------    ---------    ---------
    Total non-performing assets                   $   3,101    $   3,979    $   4,033
                                                  =========    =========    =========

Non-performing loans to loans receivable, net          1.17%        1.72%        1.74%
Non-performing assets as a percentage
 of loans and other real estate owned                  1.30%        1.72%        1.75%
Non-performing assets to total assets                  0.83%        1.05%        1.06%

</TABLE>


                                       16
<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 June 30, 2005, we had $6.9 million in
classified  assets  consisting of $6.6 million in substandard  loans,  $4,000 in
loans  classified  as loss and $301,000 in real estate  owned.  At September 30,
2004,  we had $4.7 million in  classified  assets  consisting of $4.7 million in
substandard  loans and $17,000 in real estate  owned.  At June 30, 2004,  we had
$4.8 million in  classified  assets  consisting  of $4.8 million in  substandard
loans, $7,000 in loss loans and $26,000 in real estate owned.

      In addition to  regulatory  classifications,  we also classify as "special
mention" and "watch"  assets that are currently  performing  in accordance  with
their contractual terms but may become classified or nonperforming assets in the
future.  At June 30, 2005, we have identified  approximately  $923,000 in assets
classified as special  mention and $25.4 million as watch.  At June 30, 2004, we
had  identified  approximately  $4.8  million  in assets  classified  as special
mention and $28.0 million as watch.

      The  following  table sets forth an  analysis  of our  allowance  for loan
losses for the periods indicated.
<TABLE>
<CAPTION>
                                          Three Months Ended June 30,  Nine Months Ended June 30,
                                            -----------------------     -----------------------
                                              2005          2004          2005          2004
                                            ---------     ---------     ---------     ---------
                                                           (Dollars in thousands)
<S>                                         <C>           <C>           <C>           <C>
Balance at beginning period                 $   3,695     $   3,892     $   3,956     $   3,856
                                            ---------     ---------     ---------     ---------

Loans charged off                                  (5)          (42)         (657)         (126)
                                            ---------     ---------     ---------     ---------

Recoveries                                          1            --             2            --
                                            ---------     ---------     ---------     ---------

Net loans charged off                              (4)          (42)         (655)         (126)
                                            ---------     ---------     ---------     ---------

Provisions for losses                             500            60           890           180
                                            ---------     ---------     ---------     ---------
Balance at end of period                    $   4,191     $   3,910     $   4,191     $   3,910
                                            =========     =========     =========     =========

Average loans outstanding                   $ 234,199     $ 231,111     $ 233,687     $ 228,827
                                            =========     =========     =========     =========

Ratio of net loans charged off to average
   loans outstanding during the period          .0017%        .0182%        .2803%        .0551%
                                            =========     =========     =========     =========
</TABLE>
Liquidity and Capital Resources

      The Bank must meet certain liquidity requirements established by the State
of North Carolina Office of the Commissioner of Banks (the  "Commissioner").  At
June 30, 2005, the Bank's liquidity ratio exceeded such requirements.  Liquidity
generally refers to the Bank's ability to generate  adequate amounts of funds to
meet its cash needs.  Adequate  liquidity  guarantees that sufficient  funds are
available to meet deposit withdrawals, fund loan commitments,  maintain adequate
reserve  requirements,  pay operating expenses,  provide funds for debt service,
pay dividends to stockholders and meet other general commitments.

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

      Our most liquid assets are cash and cash equivalents.  The levels of these
assets  are  dependent  on  our  operating,  financing,  lending  and  investing
activities  during any given period. At June 30, 2005, cash and cash equivalents
totaled  $8.9  million.  We have  other  sources  of  liquidity  should  we need
additional funds.  During the three and nine months ended June 30, 2005, we sold
loans totaling $6.0 million and $17.9 million, respectively.  Additional sources
of funds include FHLB of Atlanta  advances.  Other sources of liquidity  include
loans and investment  securities designated as available for sale, which totaled
$88.9 million at June 30, 2005.

      We anticipate  that we will have  sufficient  funds  available to meet our
current  commitments.  At June 30, 2005, we had $4.2 million in  commitments  to
originate  new loans,  $65.6  million in unfunded  commitments  to extend credit
under existing  equity lines and commercial  lines of credit and $2.2 million in
standby letters of credit. At June 30, 2005,  certificates of deposit, which are
scheduled to mature within one year,  totaled $142.4 million.  We believe that a
significant portion of such deposits will remain with us.

                                       17
<PAGE>

      The Federal Deposit  Insurance  Corporation  ("FDIC") requires the Bank to
meet a minimum leverage capital requirement of Tier I capital to assets ratio of
4%.  The  FDIC  also  requires  the Bank to meet a ratio  of  total  capital  to
risk-weighted  assets of 8%, of which 4% must be in the form of Tier I  capital.
The  Commissioner  requires  the Bank at all times to maintain  certain  minimum
capital levels. The Bank was in compliance with all capital  requirements of the
FDIC  and  the  Commissioner  at  June  30,  2005  and  is  deemed  to be  "well
capitalized."

      The Federal Reserve also mandates capital requirements on all bank holding
companies,  including 1st State  Bancorp,  Inc. These capital  requirements  are
similar to those imposed by the FDIC on the Bank. At June 30, 2005,  the Company
was in compliance with the capital requirements of the Federal Reserve.

      The  Company's  equity  to asset  ratio at June 30,  2005 was  17.7%.  The
Company's capital level is sufficient to support future growth.

      The Company has declared cash dividends per common share of $0.10 for each
of the three months ended June 30, 2005,  September  30, 2004 and June 30, 2004.
The Company's ability to pay dividends is dependent upon earnings. The Company's
dividend  payout ratio for the three months ended June 30, 2005,  September  30,
2004 and June 30, 2004 was 40.0%, 31.3% and 30.3%, respectively.

Accounting Matters

      In March  2004,  the SEC  released  Staff  Accounting  Bulletin  No. 105 -
Application of Accounting Principles to Loan Commitments. This bulletin requires
all registrants to begin accounting for their issued loan commitments (including
interest rate lock  commitments)  subject to Statement  133 as written  options.
Treatment  as a written  option  would  require  those  loan  commitments  to be
reported as liabilities  until either they are exercised (and a loan is made) or
they expire  unexercised.  Staff Accounting  Bulletin No. 105 must be applied to
loan  commitments  that are issued  after June 30,  2004.  The adoption of Staff
Accounting  Bulletin No. 105 did not have a material impact on the  consolidated
financial statements.

      In January 2003, FASB  Interpretation  No. 46,  "Consolidation of Variable
Interest  Entities,  an interpretation of ARB No. 51",  (Interpretation  46) was
issued. Interpretation 46 addresses the consolidation by business enterprises of
variable interest entities as defined in the  Interpretation.  Interpretation 46
applies  immediately to variable interests in variable interest entities created
after January 31, 2003, and to variable  interests in variable interest entities
obtained  after  January  31,  2003.  In  December  2003,  the FASB  issued FASB
Interpretation  No. 46  (revised  December  2003),  "Consolidation  of  Variable
Interest  Entities",  which addresses how a business  enterprise should evaluate
whether it has a controlling financial interest in an entity through means other
than voting  rights and  accordingly  should  consolidate  the  entity.  FIN 46R
replaces  FASB  Interpretation  No.  46,  "Consolidation  of  Variable  Interest
Entities",  which was issued in January  2003.  The Company  will be required to
apply FIN 46R to variable  interests  in VIEs created  after  December 31, 2003.
FASB deferred the effective date of FIN 46 to no later than the end of the first
reporting period that ends after March 15, 2004. The application of this revised
interpretation  is not  expected to have a material  effect on the  consolidated
financial statements.

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

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

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


                                       18
<PAGE>

Item 3. Quantitative and Qualitative Disclosures About Market Risk

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

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

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

Item 4. Controls and Procedures

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

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


                                       19
<PAGE>

                           PART II. OTHER INFORMATION

Item 1. Legal Proceedings

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

      A civil action was filed against 1st State Bank and Brokers,  Incorporated
by Michael  Locklar in Davidson  County  Superior  Court,  in the State of North
Carolina on May 16, 2003.  Mr.  Locklar has alleged in the action that 1st State
Bank granted him an option to purchase certain real property located in Davidson
County,  North  Carolina,  which  1st State  Bank  wrongfully  sold to  Brokers,
Incorporated  for $150,000 in breach of the option granted to Mr.  Locklar.  Mr.
Locklar  is  seeking  to set  aside  the  conveyance  of  property  to  Brokers,
Incorporated  and to purchase  the  property  from 1st State Bank for the option
price.  Brokers,  Incorporated  has filed a  cross-claim  against 1st State Bank
seeking  indemnification  in the form of return of the purchase  price they paid
for the  property,  damages and attorneys  fees should  Locklar be successful in
setting aside the real estate  conveyance.  1st State Bank intends to vigorously
contest Mr.  Locklar's  allegations.  Management  does not anticipate  that this
lawsuit will have a material adverse impact on the Company's financial condition
or results of operations.

      The Bank had been named as a co-defendant in a lawsuit brought by minority
stockholders  of  a  corporation  against  the  majority   stockholders  of  the
corporation.  A director of the Company and the Bank, along with family members,
is the majority  stockholder of the corporation,  which had previously had loans
outstanding  from the Bank.  During the quarter ended  December 31, 2004,  these
loans were paid off in full.  The Bank  settled this lawsuit in July 2005 for an
immaterial amount.

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

      (a)   Not applicable.

      (b)   Not applicable.

      (c)   The following table sets forth  information  regarding the Company's
            repurchases  of its common stock  during the quarter  ended June 30,
            2005.

<TABLE>
<CAPTION>
                                                                        (c)              (d)
                                                                 Total Number of       Maximum
                                     (a)                       Shares Purchased    Number of Shares
                                    Total           (b)            as Part of      that May Yet Be
                                  Number of        Average          Publicly       Purchased Under
                                    Shares       Price Paid     Announced Plans      the Plans or
      Period                     Purchased        per Share        or Programs         Programs
      ------                     ---------        ---------        -----------         --------

<S>                               <C>            <C>                 <C>              <C>
April 2005
Beginning date: April 1             4,880          $29.10              4,880            227,123 (1)
Ending date:  April 30

May 2005
Beginning date: May 1
Ending date:  May 31

June 2005
Beginning date: June 1
Ending date: June 30

Total                               4,880          $29.10              4,880

</TABLE>

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

Item 3. Defaults Upon Senior Securities

        None.


                                       20
<PAGE>

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

        Not applicable.

Item 5. Other Information

        None.

Item 6. Exhibits

        The following exhibits are filed herewith:

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

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

        32      Section 1350 Certifications


                                       21
<PAGE>

                                   SIGNATURES

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

                               1st STATE BANCORP, INC.


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


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


                                       22