##### Table of Contents

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U.S. SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20429



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FORM 10-QSB



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|x | QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ---------------------------------------------------------------------------------



For the Quarterly Period Ended June 30, 2004



| ̈ | TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ----------------------------------------------------------------------------------



FOR THE TRANSITION PERIOD FROM  TO



Commission File Number 000-32951



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CRESCENT FINANCIAL CORPORATION

(Exact name of small business issuer as specified in its charter)



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|                         |  |                                     
|------------------------ |  | ------------------------------------
|NORTH CAROLINA           |  | 56-2259050                          
|(State of Incorporation) |  | (IRS Employer Identification Number)



1005 HIGH HOUSE
ROAD, CARY, NORTH CAROLINA 27513

(Address of principal executive offices)



(919) 460-7770

(Issuers Telephone Number)



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Check whether the issuer (1) has filed all reports required to be filed by Section 13 or
15(d) of the Securities Exchange Act of 1934 during the past 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 ̈



The number of shares of the registrants
common stock outstanding as of July 23, 2004 was 3,549,952.



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##### Table of Contents

|         |  |                                                                                       |  |                                                                                                |  |      
|-------- |  | ------------------------------------------------------------------------------------- |  | ---------------------------------------------------------------------------------------------- |  | -----
|         |  |                                                                                       |  | Page No.                                                                                      
|Part I.  |  | FINANCIAL INFORMATION                                                                
|         | 
|Item 1 - |  | Financial Statements (Unaudited)                                                     
|         |  |                                                                                       | 
|         |  |                                                                                       |  | Consolidated Balance Sheets June 30, 2004 and December 31, 2003                                |  | 3    
|         |  |                                                                                       | 
|         |  |                                                                                       |  | Consolidated Statements of Operations Three and Six Month Periods Ended June 30, 2004 and 2003 |  | 4    
|         |  |                                                                                       | 
|         |  |                                                                                       |  | Consolidated Statements of Cash Flows Six Months Ended June 30, 2004 and 2003                  |  | 5    
|         |  |                                                                                       | 
|         |  |                                                                                       |  | Notes to Consolidated Financial Statements                                                     |  | 6 - 8
|         |  |                                                                                      
|Item 2 - |  | Managements Discussion and Analysis of Financial Condition and Results of Operations |  | 9 -26                                                                                         
|         |  |                                                                                      
|Item 3 - |  | Controls and Procedures                                                               |  | 27                                                                                            
|         | 
|Part II. |  | Other Information                                                                    
|         |  |                                                                                       | 
|         |  |                                                                                       |  | Item 4. Submission of Matters to a Vote of Security Holders                                    |  | 28   
|         |  |                                                                                       | 
|         |  |                                                                                       |  | Item 6. Exhibits and Reports on Form 8-K                                                       |  | 29   



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##### Table of Contents

Part I. FINANCIAL INFORMATION

Item 1 - Financial Statements



CRESCENT FINANCIAL CORPORATION AND SUBSIDIARY

CONSOLIDATED BALANCE SHEETS



|                                                                                                                                                     |  |                        |         |   |              |   |         |  
|---------------------------------------------------------------------------------------------------------------------------------------------------- |  | ---------------------- | ------- | - | ------------ | - | ------- | -
|                                                                                                                                                     |  | June 30, 2004          |         |   | December 31, |  
|                                                                                                                                                     |  | (Unaudited)            |         |   | 2003*        |  
|                                                                                                                                                     |  | (dollars in thousands) |        
|ASSETS                                                                                                                                               |  |                        |         |   |              |   |         |  
|Cash and due from banks                                                                                                                              |  | $                      | 8,665   |   |              | $ | 6,613   |  
|Interest-earning deposits with banks                                                                                                                 |  |                        | 463     |   |              |   | 438     |  
|Federal funds sold                                                                                                                                   |  |                        | 783     |   |              |   |        |  
|Investment securities available for sale at fair value                                                                                               |  |                        | 41,487  |   |              |   | 36,995  |  
|Loans                                                                                                                                                |  |                        | 244,199 |   |              |   | 216,746 |  
|Allowance for loan losses                                                                                                                            |  |                        | (3,556  | ) |              |   | (3,304  | )
|                                                                                                                                                     |  |                        |         |   |              |   |         |  
|NET LOANS                                                                                                                                            |  |                        | 240,643 |   |              |   | 213,442 |  
|Accrued interest receivable                                                                                                                          |  |                        | 976     |   |              |   | 964     |  
|Federal Home Loan Bank stock                                                                                                                         |  |                        | 825     |   |              |   | 950     |  
|Bank premises and equipment                                                                                                                          |  |                        | 2,986   |   |              |   | 2,699   |  
|Investment in life insurance                                                                                                                         |  |                        | 5,180   |   |              |   | 5,073   |  
|Goodwill                                                                                                                                             |  |                        | 3,600   |   |              |   | 3,600   |  
|Other assets                                                                                                                                         |  |                        | 3,775   |   |              |   | 2,940   |  
|                                                                                                                                                     |  |                        |         |   |              |   |         |  
|TOTAL ASSETS                                                                                                                                         |  | $                      | 309,383 |   |              | $ | 273,714 |  
|                                                                                                                                                     |  |                        |         |   |              |   |         |  
|LIABILITIES AND STOCKHOLDERS EQUITY                                                                                                                 |  |                        |         |   |              |   |         |  
|LIABILITIES                                                                                                                                          |  |                        |         |   |              |   |         |  
|Deposits                                                                                                                                             |  |                        |         |   |              |   |         |  
|Demand                                                                                                                                               |  | $                      | 41,453  |   |              | $ | 37,942  |  
|Savings                                                                                                                                              |  |                        | 2,837   |   |              |   | 2,193   |  
|Money market and NOW                                                                                                                                 |  |                        | 73,765  |   |              |   | 65,962  |  
|Time                                                                                                                                                 |  |                        | 144,585 |   |              |   | 112,518 |  
|                                                                                                                                                     |  |                        |         |   |              |   |         |  
|TOTAL DEPOSITS                                                                                                                                       |  |                        | 262,640 |   |              |   | 218,615 |  
|                                                                                                                                                     |  |                       
|Short-term borrowings                                                                                                                                |  |                        | 443     |   |              |   | 9,002   |  
|Long-term borrowings                                                                                                                                 |  |                        | 12,000  |   |              |   | 12,000  |  
|Trust preferred securities                                                                                                                           |  |                        | 8,000   |   |              |   | 8,000   |  
|Accrued expenses and other liabilities                                                                                                               |  |                        | 1,642   |   |              |   | 1,947   |  
|                                                                                                                                                     |  |                        |         |   |              |   |         |  
|TOTAL LIABILITIES                                                                                                                                    |  |                        | 284,725 |   |              |   | 249,564 |  
|                                                                                                                                                     |  |                        |         |   |              |   |         |  
|STOCKHOLDERS EQUITY                                                                                                                                 |  |                        |         |   |              |   |         |  
|Preferred stock, no par value, 5,000,000 shares authorized, none outstanding;                                                                        |  |                        |        |   |              |   |        |  
|Common stock, $1 par value, 20,000,000 shares authorized; 3,539,409 shares outstanding June 30, 2004; 2,924,429 shares outstanding December
31, 2003 |  |                        | 3,539   |   |              |   | 2,924   |  
|Additional paid-in capital                                                                                                                           |  |                        | 18,482  |   |              |   | 18,885  |  
|Retained earnings                                                                                                                                    |  |                        | 3,212   |   |              |   | 2,230   |  
|Accumulated other comprehensive income (loss) (Note D)                                                                                               |  |                        | (575    | ) |              |   | 111     |  
|                                                                                                                                                     |  |                        |         |   |              |   |         |  
|TOTAL STOCKHOLDERS EQUITY                                                                                                                           |  |                        | 24,658  |   |              |   | 24,150  |  
|                                                                                                                                                     |  |                        |         |   |              |   |         |  
|COMMITMENTS (Note B)                                                                                                                                 |  |                        |         |   |              |   |         |  
|TOTAL LIABILITIES AND STOCKHOLDERS EQUITY                                                                                                           |  | $                      | 309,383 |   |              | $ | 273,714 |  
|                                                                                                                                                     |  |                        |         |   |              |   |         |  

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|* | Derived from audited consolidated financial statements.
|- | -------------------------------------------------------



See accompanying notes.



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##### Table of Contents

CRESCENT FINANCIAL CORPORATION AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited)

Three and Six Month Periods Ended June 30, 2004 and 2003



|                                                    |  |                                                 |           |                                  |   |           |  |      |           |  |   |          
|--------------------------------------------------- |  | ----------------------------------------------- | --------- | -------------------------------- | - | --------- |  | ---- | --------- |  | - | ---------
|                                                    |  | Three-month Periods Ended June 30,              |           | Six-month Periods Ended June 30,
|                                                    |  | 2004                                            |           | 2003                             |   | 2004      |  | 2003
|                                                    |  | (In Thousands, except share and per share data)
|INTEREST INCOME                                     |  |                                                 |           |                                  |   |           |  |      |           |  |   |          
|Loans                                               |  | $                                               | 3,295     |                                  | $ | 2,068     |  | $    | 6,498     |  | $ | 4,022    
|Investment securities available for sale            |  |                                                 | 428       |                                  |   | 321       |  |      | 830       |  |   | 684      
|Federal funds sold and interest-bearing deposits    |  |                                                 | 7         |                                  |   | 29        |  |      | 18        |  |   | 48       
|                                                    |  |                                                 |           |                                  |   |           |  |      |           |  |   |          
|TOTAL INTEREST INCOME                               |  |                                                 | 3,730     |                                  |   | 2,418     |  |      | 7,346     |  |   | 4,754    
|                                                    |  |                                                 |           |                                  |   |           |  |      |           |  |   |          
|INTEREST EXPENSE                                    |  |                                                 |           |                                  |   |           |  |      |           |  |   |          
|Deposits                                            |  |                                                 | 1,046     |                                  |   | 690       |  |      | 2,044     |  |   | 1,375    
|Borrowings                                          |  |                                                 | 231       |                                  |   | 107       |  |      | 464       |  |   | 212      
|                                                    |  |                                                 |           |                                  |   |           |  |      |           |  |   |          
|TOTAL INTEREST EXPENSE                              |  |                                                 | 1,277     |                                  |   | 797       |  |      | 2,508     |  |   | 1,587    
|                                                    |  |                                                 |           |                                  |   |           |  |      |           |  |   |          
|NET INTEREST INCOME                                 |  |                                                 | 2,453     |                                  |   | 1,621     |  |      | 4,838     |  |   | 3,167    
|                                                    |  |                                                 |           |                                 
|PROVISION FOR LOAN LOSSES                           |  |                                                 | 129       |                                  |   | 120       |  |      | 384       |  |   | 228      
|                                                    |  |                                                 |           |                                  |   |           |  |      |           |  |   |          
|NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES |  |                                                 | 2,324     |                                  |   | 1,501     |  |      | 4,454     |  |   | 2,939    
|                                                    |  |                                                 |           |                                  |   |           |  |      |           |  |   |          
|NON-INTEREST INCOME                                 |  |                                                 | 585       |                                  |   | 342       |  |      | 1,076     |  |   | 646      
|                                                    |  |                                                 |           |                                  |   |           |  |      |           |  |   |          
|NON-INTEREST EXPENSE                                |  |                                                 |           |                                  |   |           |  |      |           |  |   |          
|Salaries and employee benefits                      |  |                                                 | 1,099     |                                  |   | 675       |  |      | 2,109     |  |   | 1,315    
|Occupancy and equipment                             |  |                                                 | 366       |                                  |   | 232       |  |      | 710       |  |   | 455      
|Data processing                                     |  |                                                 | 135       |                                  |   | 78        |  |      | 259       |  |   | 152      
|Other                                               |  |                                                 | 539       |                                  |   | 277       |  |      | 993       |  |   | 517      
|                                                    |  |                                                 |           |                                  |   |           |  |      |           |  |   |          
|TOTAL NON-INTEREST EXPENSE                          |  |                                                 | 2,139     |                                  |   | 1,262     |  |      | 4,071     |  |   | 2,439    
|                                                    |  |                                                 |           |                                  |   |           |  |      |           |  |   |          
|INCOME BEFORE INCOME TAXES                          |  |                                                 | 770       |                                  |   | 581       |  |      | 1,459     |  |   | 1,146    
|                                                    |  |                                                 |           |                                 
|INCOME TAXES                                        |  |                                                 | 251       |                                  |   | 207       |  |      | 477       |  |   | 409      
|                                                    |  |                                                 |           |                                  |   |           |  |      |           |  |   |          
|NET INCOME                                          |  | $                                               | 519       |                                  | $ | 374       |  | $    | 982       |  | $ | 737      
|                                                    |  |                                                 |           |                                  |   |           |  |      |           |  |   |          
|NET INCOME PER COMMON SHARE                         |  |                                                 |           |                                  |   |           |  |      |           |  |   |          
|Basic                                               |  | $                                               | .15       |                                  | $ | .13       |  | $    | .28       |  | $ | .25      
|                                                    |  |                                                 |           |                                  |   |           |  |      |           |  |   |          
|Diluted                                             |  | $                                               | .14       |                                  | $ | .12       |  | $    | .26       |  | $ | .24      
|                                                    |  |                                                 |           |                                  |   |           |  |      |           |  |   |          
|WEIGHTED AVERAGE COMMON SHARES OUTSTANDING (Note C) |  |                                                 |           |                                  |   |           |  |      |           |  |   |          
|Basic                                               |  |                                                 | 3,520,859 |                                  |   | 2,958,092 |  |      | 3,515,469 |  |   | 2,957,889
|                                                    |  |                                                 |           |                                  |   |           |  |      |           |  |   |          
|Diluted                                             |  |                                                 | 3,710,948 |                                  |   | 3,084,429 |  |      | 3,708,439 |  |   | 3,072,704
|                                                    |  |                                                 |           |                                  |   |           |  |      |           |  |   |          



See accompanying notes.



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CRESCENT FINANCIAL CORPORATION AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)

Six Months Ended June 30, 2004 and 2003



|                                                                             |  |                |         |   |      |   |         |  
|---------------------------------------------------------------------------- |  | -------------- | ------- | - | ---- | - | ------- | -
|                                                                             |  | 2004           |         |   | 2003 |  
|                                                                             |  | (In Thousands) |        
|CASH FLOWS FROM OPERATING ACTIVITIES                                         |  |                |         |   |      |   |         |  
|Net income                                                                   |  | $              | 982     |   |      | $ | 737     |  
|                                                                             |  |                |         |   |      |   |         |  
|Adjustments to reconcile net income to net cash used by operating activities |  |                |         |   |      |   |         |  
|Depreciation                                                                 |  |                | 269     |   |      |   | 133     |  
|Provision for loan losses                                                    |  |                | 384     |   |      |   | 228     |  
|Deferred income taxes                                                        |  |                |        |   |      |   | 28      |  
|(Gain) loss on sale of assets                                                |  |                | (8      | ) |      |   | 4       |  
|Net amortization of premiums on securities                                   |  |                | 56      |   |      |   | 23      |  
|Increase in cash value of life insurance                                     |  |                | (107    | ) |      |   |        |  
|Change in assets and liabilities                                             |  |                |         |   |      |   |         |  
|(Increase) in accrued interest receivable                                    |  |                | (12     | ) |      |   | (56     | )
|(Increase) in other assets                                                   |  |                | (404    | ) |      |   | (223    | )
|(Decrease) in accrued interest payable                                       |  |                | (64     | ) |      |   | (10     | )
|(Decrease) in other liabilities                                              |  |                | (241    | ) |      |   | (651    | )
|                                                                             |  |                |         |   |      |   |         |  
|TOTAL ADJUSTMENTS                                                            |  |                | (127    | ) |      |   | (524    | )
|                                                                             |  |                |         |   |      |   |         |  
|NET CASH PROVIDED BY OPERATING ACTIVITIES                                    |  |                | 855     |   |      |   | 213     |  
|                                                                             |  |                |         |   |      |   |         |  
|CASH FLOWS FROM INVESTING ACTIVITIES                                         |  |                |         |   |      |   |         |  
|Purchases of securities available for sale                                   |  |                | (14,216 | ) |      |   | (8,041  | )
|Maturities of securities available for sale                                  |  |                | 770     |   |      |   | 1,200   |  
|Proceeds from disposals of securities available for sale                     |  |                | 4,312   |   |      |   |        |  
|Principal repayments of securities available for sale                        |  |                | 3,594   |   |      |   | 8,359   |  
|Net increase in loans                                                        |  |                | (27,585 | ) |      |   | (15,633 | )
|Purchases of bank premises and equipment                                     |  |                | (548    | ) |      |   | (323    | )
|                                                                             |  |                |         |   |      |   |         |  
|NET CASH USED BY INVESTING ACTIVITIES                                        |  |                | (33,673 | ) |      |   | (14,438 | )
|                                                                             |  |                |         |   |      |   |         |  
|CASH FLOWS FROM FINANCING ACTIVITIES                                         |  |                |         |   |      |   |         |  
|Net increase in deposits:                                                    |  |                |         |   |      |   |         |  
|Non-interest bearing demand                                                  |  |                | 3,512   |   |      |   | 32,397  |  
|Savings                                                                      |  |                | 644     |   |      |   | (181    | )
|Money market and NOW                                                         |  |                | 7,803   |   |      |   | 9,504   |  
|Time deposits                                                                |  |                | 32,067  |   |      |   | 3,067   |  
|Net decrease in short-term borrowings                                        |  |                | (8,560  | ) |      |   |        |  
|Proceeds from the issuance of stock                                          |  |                | 2       |   |      |   |        |  
|Proceeds from exercise of stock options                                      |  |                | 210     |   |      |   | 7       |  
|                                                                             |  |                |         |   |      |   |         |  
|NET CASH PROVIDED BY FINANCING ACTIVITIES                                    |  |                | 35,678  |   |      |   | 44,794  |  
|                                                                             |  |                |         |   |      |   |         |  
|NET INCREASE IN CASH AND CASH EQUIVALENTS                                    |  |                | 2,860   |   |      |   | 30,569  |  
|                                                                             |  |               
|CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD                               |  |                | 7,051   |   |      |   | 26,232  |  
|                                                                             |  |                |         |   |      |   |         |  
|CASH AND CASH EQUIVALENTS, END OF PERIOD                                     |  | $              | 9,911   |   |      | $ | 56,801  |  
|                                                                             |  |                |         |   |      |   |         |  



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##### Table of Contents

CRESCENT FINANCIAL CORPORATION AND SUBSIDIARY

Notes to Consolidated Financial Statements



NOTE A - BASIS OF PRESENTATION



In managements opinion, the financial information, which is unaudited, reflects all
adjustments (consisting solely of normal recurring adjustments) necessary for a fair presentation of the financial information as of and for the three and six-month periods ended June 30, 2004 and 2003, in conformity with accounting principles
generally accepted in the United States of America. The financial statements include the accounts of Crescent Financial Corporation (the Company) and its wholly owned subsidiaries, Crescent State Bank (the Bank) and Crescent
Financial Capital Trust I (Capital Trust I). All significant inter-company transactions and balances are eliminated in consolidation. Operating results for the three-month and six-month periods ended June 30, 2004 are not necessarily
indicative of the results that may be expected for the fiscal year ending December 31, 2004.



The organization and business of Crescent Financial Corporation and subsidiaries (the Company), accounting policies followed by the Company and other information are contained in the notes to the
consolidated financial statements filed as part of the Companys 2003 annual report on Form 10-KSB. This quarterly report should be read in conjunction with such annual report.



NOTE B  COMMITMENTS



At June 30, 2004, loan and other commitments are as follows



|                                                     |  |   |           
|---------------------------------------------------- |  | - | ----------
|Undisbursed lines of credit                          |  | $ | 56,295,000
|Stand-by letters of credit                           |  |   | 1,557,000 
|Investment in Small Business Investment Corporations |  |   | 288,000   



NOTE C  PER SHARE RESULTS



The Company effected a stock split in the form of a 20% stock dividend
paid on April 16, 2004 to stockholders of record March 12, 2004. Share and per share data for the periods presented have been adjusted to reflect the effects of the stock split. Basic and diluted net income per common share have been computed by
dividing net income for each period by the weighted average number of shares of common stock outstanding during each period after retroactively adjusting for the stock split.



Basic earnings per share represents income available to common stockholders divided by the weighted-average number of common shares
outstanding during the period. Diluted earnings per share reflect additional common shares that would have been outstanding if dilutive potential common shares had been issued, as well as any adjustment to income that would result from the assumed
issuance. Potential common shares that may be issued by the company relate solely to outstanding stock options and are determined using the treasury stock method.



For the three months ended June 30, 2004, the weighted-average number of common shares used in computing basic earnings per share, adjusted
for the stock split effected as a 20% stock dividend, was 3,520,859. The dilutive effect of stock options was 190,089 shares. The weighted-average number of common shares and dilutive potential common shares used in computing diluted earnings per
share was 3,710,948. For the three months ended June 30, 2003, the weighted-average number of common shares used in computing basic earnings per share, adjusted for the stock split effected as a 20% stock dividend, was 2,958,092. The dilutive effect
of stock options was 126,337 shares. The weighted-average number of common shares and dilutive potential common shares used in computing diluted earnings per share was 3,084,429.



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For the six months ended June 30, 2004, the weighted-average number of common shares used in computing basic earnings per
share, adjusted for the stock split effected as a 20% stock dividend, was 3,515,469. The dilutive effect of stock options was 192,970 shares. The weighted-average number of common shares and dilutive potential common shares used in computing diluted
earnings per share was 3,708,439. For the six months ended June 30, 2003, the weighted-average number of common shares used in computing basic earnings per share, adjusted for the stock split effected as a 20% stock dividend, was 2,957,889. The
dilutive effect of stock options was 114,815 shares. The weighted-average number of common shares and dilutive potential common shares used in computing diluted earnings per share was 3,072,704.



NOTE D - COMPREHENSIVE INCOME



For the three months ended June 30, 2004 and 2003, total comprehensive income or (loss),
consisting of net income or (loss) and unrealized securities gains and losses, net of taxes, was ($494,000) and $475,000, respectively.



For the six months ended June 30, 2004 and 2003, total comprehensive income, consisting of net income and unrealized securities gains and losses, net of taxes, was
$296,000 and $664,000, respectively.



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CRESCENT FINANCIAL CORPORATION AND SUBSIDIARY

Notes to Consolidated Financial Statements



NOTE F  STOCK COMPENSATION PLANS



Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for Stock-Based Compensation, encourages all entities to adopt a fair value based
method of accounting for employee stock compensation plans, whereby compensation cost is measured at the grant date based on the value of the award and is recognized over the service period, which is usually the vesting period. However, it also
allows an entity to continue to measure compensation cost for those plans using the intrinsic value based method of accounting prescribed by Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, whereby compensation
cost is the excess, if any, of the quoted market price of the stock at the grant date (or other measurement date) over the amount an employee must pay to acquire the stock. Stock options issued under the companys stock option plans have no
intrinsic value at the grant date and, under Opinion No. 25, no compensation cost is recognized for them. The company has elected to continue with the accounting methodology in Opinion No. 25. Presented below are the pro forma disclosures of net
income and earnings per share and other disclosures as if the fair value based method of accounting had been applied.



|                                                                                                                                      |  |                                               |     |                           |   |      |  |      |     |  |   |    
|------------------------------------------------------------------------------------------------------------------------------------- |  | --------------------------------------------- | --- | ------------------------- | - | ---- |  | ---- | --- |  | - | ---
|                                                                                                                                      |  | Three Months Ended June 30,                   |     | Six Months Ended June 30,
|                                                                                                                                      |  | 2004                                          |     | 2003                      |   | 2004 |  | 2003
|                                                                                                                                      |  | (Amounts in thousands, except per share data)
|Net income:                                                                                                                           |  |                                               |     |                           |   |      |  |      |     |  |   |    
|As reported                                                                                                                           |  | $                                             | 519 |                           | $ | 374  |  | $    | 982 |  | $ | 737
|Deduct: Total stock-based employee compensation expense determined under fair value method for all awards, net of related tax
effects |  |                                               | 11  |                           |   | 10   |  |      | 28  |  |   | 21 
|                                                                                                                                      |  |                                               |     |                           |   |      |  |      |     |  |   |    
|Pro forma                                                                                                                             |  | $                                             | 508 |                           | $ | 364  |  | $    | 954 |  | $ | 716
|                                                                                                                                      |  |                                               |     |                           |   |      |  |      |     |  |   |    
|Basic earnings per share:                                                                                                             |  |                                               |     |                           |   |      |  |      |     |  |   |    
|As reported                                                                                                                           |  | $                                             | .15 |                           | $ | .13  |  | $    | .28 |  | $ | .25
|Pro forma                                                                                                                             |  |                                               | .14 |                           |   | .12  |  |      | .27 |  |   | .24
|                                                                                                                                      |  |                                               |     |                          
|Diluted earnings per share:                                                                                                           |  |                                               |     |                           |   |      |  |      |     |  |   |    
|As reported                                                                                                                           |  | $                                             | .14 |                           | $ | .12  |  | $    | .26 |  | $ | .24
|Pro forma                                                                                                                             |  |                                               | .14 |                           |   | .12  |  |      | .26 |  |   | .23



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



Managements discussion and analysis is intended to assist readers in the understanding and evaluation of the financial condition and consolidated results of
operations of Crescent Financial Corporation (the Company). The analysis includes detailed discussions for each of the factors affecting Crescent Financial Corporations operating results and financial condition for the three and
six-month periods ended June 30, 2004 and 2003. It should be read in conjunction with the consolidated financial statements and accompanying notes included in this report and the supplemental financial data appearing throughout this discussion and
analysis. Because the Company has no operations and conducts no business on its own other than owning Crescent State Bank, the discussion contained in this Managements Discussion and Analysis concerns primarily the business of the Bank.
However, for ease of reading and because the financial statements are presented on a consolidated basis, the Company and the Bank are collectively referred to herein as the Company unless otherwise noted. All significant intercompany transactions
and balances are eliminated in consolidation.



COMPARISON OF
FINANCIAL CONDITION AT JUNE 30, 2004 AND DECEMBER 31, 2003



Total assets at
June 30, 2004 are $309.4 million compared with $273.7 million at December 31, 2003. Earning assets totaled $287.8 million or 93% of total assets at June 30, 2004 compared with $255.1 million or 93% of total assets as of December 31, 2003. Components
of earning assets at June 30, 2004 are $244.2 million in loans, $42.3 million in investment securities and FHLB stock, $783,000 in overnight investments and $463,000 in interest bearing deposits with correspondent banks. Total deposits and
stockholders equity at June 30, 2004 were $262.6 million and $24.7 million, respectively, compared to $218.6 million and $24.1 million at December 31, 2003.



Gross loans outstanding at June 30, 2004 increased by $27.5 million or 13% to $244.2 million compared to $216.7 million reported at December
31, 2003. The composition of the loan portfolio, by category, as of June 30, 2004 is 47% commercial mortgage loans, 20% commercial loans, 14% construction loans, 12% home equity loans and lines, 5% residential mortgage loans and 2% consumer loans.
The commercial mortgage category showed the most growth increasing $14.4 million from $101.3 million at December 31, 2003 to $115.7 million at June 30, 2004. The commercial loan portfolio increased by $10.9 million from $38.2 million at December 31,
2003 to $49.1 million at June 30, 2004. Home equity loans and lines increased by $5.5 million during the first six months of 2004 from $23.0 million at December 31, 2003 to $28.5 million at June 30, 2004. Construction and development loans
experienced a net increase of $1.3 million, growing from $31.6 million at year end to $32.9 million at June 30, 2004. The consumer loan and residential mortgage loan portfolios experienced net declines during the first half of 2004 of $3.0 million
and $1.7 million, respectively. The composition of the loan portfolio, by category, as of December 31, 2003 was 47% commercial mortgage loans, 18% commercial loans, 14% construction loans, 10% home equity loans and lines, 7% residential real estate
mortgage loans and 4% consumer loans.



The Company had an allowance for loan
losses at June 30, 2004 of $3.6 million or 1.46% of total outstanding loans compared to $3.3 million or 1.52% of total outstanding loans at December 31, 2003. At June 30, 2004, there were four loans totaling $302,000 in non-accrual status and no
loans 90 days or more past due and still accruing interest. Non-performing assets, which consist of loans in nonaccrual status, other real estate owned and repossessed vehicles, totaled $337,000 or 0.11% of total outstanding assets at June 30, 2004.



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The Company has investment securities with an amortized cost of $42.4 million at June 30, 2004. All investments are
accounted for as available for sale under Financial Accounting Standards Board (FASB) No. 115 and are presented at their fair market value of $41.5 million. The Companys investment in debt securities at June 30, 2004, consists of U.S.
Government agency securities, collateralized mortgage obligations, mortgage-backed securities, municipal bonds and corporate bonds. The portfolio increased by $4.5 million or 12% compared with $37.0 million at December 31, 2003. During the first six
months of 2004, the Company purchased $14.2 million in new securities. Activities resulting in decreases to the portfolio include sales of $4.3 million in available for sale securities, $3.6 million of principal re-payments, a $1.0 million decline
in the fair market value of securities available for sale, $770,000 in bond maturities or redemptions, and $56,000 in net premium amortization. During the period, the Company repositioned a portion of the portfolio by selling several small remaining
blocks of mortgage-related securities and other bonds that had not performed as expected. The transaction resulted in a net gain on the sale of less than $1,000. The Company also owned $825,000 of Federal Home Loan Bank stock at June 30, 2004
compared to $950,000 at December 31, 2003. The volume of Federal Home Loan Bank stock required is dictated by a variety of factors including the Companys level of outstanding Federal Home Loan Bank borrowings and the volume mortgage-related
assets on the Companys balance sheet.



Federal funds sold at June 30,
2004 are $783,000 compared with no Federal funds sold at December 31, 2003. Excess funds created due to fluctuations in deposit levels are invested overnight in Federal funds through our correspondent banks. Overnight funds tend to increase at
month-end due to increased deposit volumes from several real estate settlement accounts maintained by attorney customers. At June 30, 2004, the entire Federal funds sold balance outstanding was due to the fluctuation in the real estate settlement
accounts. The daily average balances for Federal funds sold for the six-month period ended June 30, 2004 was $4.1 million.



Interest-earning deposits held at correspondent banks increased by approximately $25,000 from $438,000 at December 31, 2003 to $463,000 at June 30, 2004. Balances held at
correspondent banks represent principal and interest payments from the investment portfolio waiting to be re-invested.



Non-earning and other assets increased by approximately $3.3 million between December 31, 2003 and June 30, 2004. Non-interest bearing cash due from banks increased by
$2.0 million during the six months ended June 30, 2004. Cash due from banks includes amounts represented by checks in the process of being collected through the Federal Reserve payment system. Funds represented by these checks were not yet collected
and therefore could not be invested overnight. For more details regarding the increase in cash and cash equivalents, see the Consolidated Statement of Cash Flows. Categories of other assets experiencing increases between December 31, 2003 and June
30, 2004 include interest receivable, bank premises and equipment, deferred tax asset and cash surrender value on bank owned life insurance. The Company has an outstanding commitment to invest in two Small Business Investment Corporations
(SBICs) and at June 30, 2004, the amount of commitment still due is $288,000.



Total deposits increased by $44.0 million between December 31, 2003 and June 30, 2004 from $218.6 million to $262.6 million. The largest increase occurred in the time deposit category, which increased by $32.1 million from $112.5 million on
December 31, 2003 to $144.6 million on June 30, 2004. Other deposit categories increased between December 31, 2003 and June 30, 2004 as follows: money market deposits increased by $4.9 million from $24.8 million to



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$29.7 million, non-interest bearing demand deposits increased by $3.5 million from $37.9 million to $41.4 million,
interest-bearing demand deposits increased by $2.9 million from $41.1 million to $44.0 million and savings deposits increased by $644,000 from $2.2 million to $2.8 million.



As previously mentioned in the discussion of Federal funds sold, the Company maintains a number of deposit relationships with real estate
settlement attorneys. The nature of the settlement attorneys business dictates that cash flows into their deposit accounts prior to settling a real estate transaction and flows out following the transaction. The majority of real estate
transactions tend to occur toward the end of each month. At June 30, 2004, aggregate balances in the real estate settlement deposit accounts are $17.4 million compared with $35.7 million at March 31, 2004 and $15.7 million at December 31, 2003. Of
the $17.4 million in real estate settlement deposits on June 30, 2004, $10.8 million is in the non-interest bearing demand deposit category and $6.6 million is in the interest bearing demand category. At December 31, 2003, $12.3 million of the $15.7
million was in the non-interest bearing demand deposit category and the remaining $3.4 million was in the interest bearing category. The average aggregate quarterly balances in these real estate settlement accounts were approximately $11.4 million
and $11.8 million on June 30, 2004 and December 31, 2003, respectively. Excluding the temporary, month-end effect of the real estate settlement deposit accounts, total deposits at June 30, 2004 and December 31, 2003 would have been approximately
$256.6 million and $214.7 million, respectively.



The composition of the
deposit base, by category, at June 30, 2004 is as follows: 55% time deposits, 17% interest-bearing demand deposits, 16% non-interest-bearing demand deposits, 11% money market and 1% statement savings. The composition of the deposit base, by
category, at December 31, 2003 was 52% time deposits, 19% interest-bearing demand deposits, 17% non-interest-bearing demand deposits, 11% money market and 1% statement savings. Time deposits of $100,000 or more totaled $90.3 million at June 30, 2004
compared to $53.4 million at December 31, 2003. The Company uses brokered certificates of deposit as an alternative funding source. Brokered deposits represent a source of fixed rate funds priced competitively with Federal Home Loan Bank borrowing,
but do not require collateralization like Federal Home Loan Bank borrowings. Brokered deposits were $42.8 million at June 30, 2004 compared with $11.0 million at December 31, 2003.



The Company had $12.0 million of Federal Home Loan Bank borrowings outstanding at June 30, 2004 compared with $19.0 million at December 31,
2003. Long-term borrowings outstanding at the end of both periods are comprised of two $5.0 million advances and one $2.0 million advance. At December 31, 2003, an additional $7.0 million of overnight Federal Home Loan Bank borrowings were
outstanding. These were replaced in early 2004 with brokered certificates of deposit.



On August 27, 2003, Crescent Capital Trust I issued Trust Preferred securities in the amount of $8.0 million at a variable interest rate equal to three-month LIBOR plus 310 basis points. The Trust Preferred securities have a thirty year
maturity with a continuous five year call provision and are eligible for inclusion as Tier 1 capital. The $8.0 million in Trust Preferred securities were outstanding at both June 30, 2004 and December 31, 2003.



At December 31, 2003, the Company had $1.4 million in overnight borrowings in the form of
Federal funds purchased. These borrowing generally mature within one to four days from the transaction date. There were no Federal funds purchased as of June 30, 2004.



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On June 30, 2004, the Company had securities sold under repurchase agreements in the amount of $443,000 compared to
$633,000 at December 31, 2003. Securities sold under repurchase agreements generally mature within one to four days from the transaction date.



Accrued interest payable and other liabilities decreased by $305,000 to $1.6 million at June 30, 2004 compared with $1.9 million at December 31, 2003. The decrease is
primarily the result of the payment of merger consideration to former Centennial Bank shareholders as they present their share certificates for exchange.



Between December 31, 2003 and June 30, 2004, total stockholders equity rose by $508,000. The increase was the net result of net income for the six month period of
$982,000, plus $212,000 in new stock issuance and the exercise of stock options, less $686,000 net unrealized loss on available for sale securities.



COMPARISON OF RESULTS OF OPERATIONS FOR THE THREE MONTH PERIODS ENDED JUNE 30, 2004 AND 2003



Net Income.Net income for the three-month period ending June 30, 2004 was $519,000 or
$.15 per basic ($.14 diluted) share compared with $374,000 or $.13 per basic ($.12 diluted) share for the three-month period ended June 30, 2003. Annualized return on average assets was .69% and .83% for the two periods ended June 30, 2004 and 2003,
respectively. The decline in return on average assets is the result of additional expenses incurred due to franchise expansion and pressure on net interest margin due to the extended period of low interest rates. Return on average equity for the
current period was 8.33% compared to 8.19% for the prior period. Return on average equity for the current period increased as the Company leveraged capital more efficiently.



Results of operations for the three-month period ended June 30, 2004 were positively impacted by strong earning asset growth over the past
twelve months resulting in improved net interest income. The Company also experienced increases in non-interest income, non-interest expenses and loan loss provision.



Net Interest Income. Net interest income increased by $833,000 or 51% from $1.6 million for the three-month period ended June 30,
2003 to $2.5 million for the three-month period ended June 30, 2004. Net interest income increased significantly due to strong growth in earning assets. The growth in earning assets more than offset the unfavorable impact from a continued decline in
the yield on those assets. Total interest expense from deposits and other borrowings increased due to growth in interest-bearing liabilities needed to fund the higher volume of assets. The Companys net interest margin declined due to the
combination of the low interest rate environment and the increased dependence on interest-bearing liabilities to fund asset growth.



Total average earning assets increased $107.2 million or 62% from an average of $173.2 million for the prior year three-month period to an average of $280.4 million for
the three-month period ended June 30, 2004. The average balance of loans outstanding during the quarter ended June 30, 2004 was $234.9 million or 73% higher than the $136.0 million of average outstanding loans for the prior year period. The average
balance of the investment securities portfolio for the three-month period ended June 30, 2004 was $42.6 million increasing by $15.3 million or 56% compared to an average of $27.3 million at June 30, 2003. The average balance of federal funds sold
and other earning assets decreased to $3.0 million for the current three-month period compared to $10.0 million for the prior period. Average interest-bearing liabilities increased by $108.8 million or 85% from $127.6 million for the quarter ended
June 30, 2003 to $236.4 million for the current quarter.



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Total interest income increased by $1.3 million for the current three-month period compared to the same period from the
prior year. The increase was the net result of an additional $1.6 million due to the growth in total average earning assets less a $287,000 decrease due to lower yields realized on earning assets. Total interest expense experienced a net increase of
$480,000. Interest expense increased during the current three-month period by $782,000 due to growth in interest-bearing funds and declined by $302,000 due to the lower interest rate environment.



Net interest margin is interest income earned on loans, securities and other earning assets,
less interest expense paid on deposits and borrowings, expressed as a percentage of total average earning assets. The net interest margin for the three-month period ended June 30, 2004 was 3.52% compared to 3.75% for the three-month period ended
June 30, 2003. The average yield on earning assets for the current three-month period declined 25 basis points to 5.35% compared with 5.60% for the prior year period, while the average cost of interest-bearing funds decreased by 34 basis points to
2.17% from 2.51%. The interest rate spread, which is the difference between the average yield on earning assets and the cost of interest-bearing funds, increased by 9 basis points from 3.09% for the quarter ended June 30, 2003 to 3.18% for the
quarter ended June 30, 2004. Despite the increase in spread, the net interest margin tightened due to the increased dependence on interest-bearing liabilities to fund earning assets. The percentage of interest earning assets to average
interest-bearing liabilities declined from 135.81% during the quarter ended June 30, 2003 to 118.63% for the current quarter.



Between January 1, 2001 and June 29, 2004, the Federal Reserve cut short-term interest rates 550 basis points in an effort to stimulate an ailing economy. During this
time, the Company has tried to position its balance sheet to take advantage of the next interest rate cycle in which rates increase. Therefore, approximately 70% to 75% of new loan volume has been priced at a variable interest rate. The rate on a
typical variable loan might adjust based on the Prime lending rate (currently at 4.25%) plus 1% to 2%. Overall, 68% of outstanding loans are tied to a variable rate index. On June 30, 2004, the Federal Reserve began the next interest rate cycle when
it increased rates by 25 basis points. We anticipate this to be the first of several increases, although the timing and magnitude of those increases are not known. This should have a favorable impact on the yield on the loan portfolio, which
constitutes the largest component of the Companys earning assets.



Since
January 2001 and continuing until June 2004, interest rates on the one-year certificates of deposit declined by approximately 500 basis points. As shorter-term time deposits have matured and renewed, there has been some tendency for customers to
extend the term of their deposits into the two, three, four and five year time horizons to earn additional income. As rates begin to rise, the customers will begin to shorten their time horizons in an attempt to improve yield over time. We believe
that as short-term rates begin to increase, the cost of funds will increase, albeit at a slower pace than the yield on earning assets, creating larger spreads and improving margins.



Provision for Loan Losses.The Companys provision for loan losses for the three-month period ended June 30, 2004 was $129,000
compared to $120,000 recorded for the same period in 2003. Provision for loan losses is charged to income to bring the allowance for loan losses to a level deemed appropriate by management based on factors discussed under Analysis of Allowance
for Loan Losses. The increase in the loan loss provision is primarily due to loan



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growth in the second quarter of 2004, although the analysis discussion outlines additional factors impacting the
provision. The allowance for loan losses was $3.6 million at June 30, 2004, representing 1.46% of total outstanding loans.



Non-Interest Income.For the three-month period ended June 30, 2004, non-interest income increase by $243,000 or 71% to $585,000 compared to $342,000 for the same
period in 2003. Total mortgage origination and other loan related fees increased by $43,000 to $212,000 for the current period from $169,000 for the prior period. Customer service fees on deposit accounts increased by $83,000 from $96,000 to
$179,000. The Company recorded $60,000 in earnings from increases in cash value of life insurance. No such investment in life insurance existed in the prior year period. Revenue earned from service charges on deposit accounts increased by $10,000
from $38,000 to $48,000. Other non-interest income, which includes investment referral fees, dividends from the Companys investment in a mortgage company and gains on sales of assets, increased by $47,000 from $38,000 to $85,000.



In the prior year period, a significant percentage of non-interest income was derived from
mortgage loan origination fees. The volume of these fees was driven, to a large extent, by refinancing due to the favorable interest rate environment. The Company has committed additional resources to the mortgage production area by adding staff and
more emphasis has been placed on purchase money activity. While we anticipate that mortgage loan origination fees will continue to be an important source of non-interest revenue, it may be difficult to maintain current levels through the end of the
year. Mortgage loan origination fees were $188,000 in the current year compared with $152,000 for the prior year.



Non-Interest Expenses.Non-interest expenses were $2.1 million for the three-month period ended June 30, 2004 compared with $1.3 million for the same period ended
June 30, 2003. The largest component of non-interest expense for the current period was personnel expense. Salaries and benefits expense was $1.1 million for the three-month period ended June 30, 2004, compared to $675,000 for the same period in the
prior year. The Company has expanded into four new markets since May 2003 and the number of employees has increased significantly. Management anticipates personnel expense to continue to increase through 2004 as we prepare to convert an existing
loan production office into a full-service branch. The expansion of the branch network will also require additional administrative and support personnel.



Occupancy and equipment expenses increased by $134,000 or 58% from $232,000 for the three-month period ended June 30, 2003 to $366,000 for the current year period.
Through the acquisition of two offices in Pinehurst and Southern Pines and the expansion in Holly Springs and Sanford, the Company has almost doubled its presence in central North Carolina over the past year. Data processing costs increased from
$78,000 for the three-months ended June 30, 2003 to $135,000 for the current three-month period. The Company outsources its data processing and expenses are closely tied to transaction and account volumes. The added costs of installing and
maintaining data communications lines to the new branch facilities are also considered data processing expenses. As the Company continues to grow in accordance with its strategic plan, management expects both occupancy and data processing costs to
increase.



Other non-interest expenses increased by $262,000 to $539,000 for
the second quarter of 2004 compared with $277,000 for the second quarter in the prior year. The increase was primarily a result of the Companys continued growth. The largest components of other non-interest expenses include professional fees
and services, office supplies and printing, advertising, and loan related fees. Management expects that as the complexity and size of the Company increases, expenses associated with these categories will continue to increase.



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Provision for Income Taxes.The Company recorded income tax expense of $251,000 for the three-months ended June
30, 2004 compared with $207,000 for the prior year period. The effective tax rate for the three-month period ended June 30, 2004 was 32.6% compared with 35.6% for the prior year period. The improvement in the effective tax rate is attributable to a
substantial increase in tax exempt investments.



COMPARISON
OF RESULTS OF OPERATIONS FOR THE SIX MONTH PERIODS ENDED JUNE 30, 2004 AND 2003



Net Income.Net income for the six-month period ending June 30, 2004 was $982,000 compared to $737,000 for the period ended June 30, 2003. For the current six-month period, basic earnings per share were $.28 ($.26 diluted) compared
with basic earnings per share of $.25 ($.24 diluted) for the prior period. Annualized return on average assets was .67% and .84% for the six-month periods ended June 30, 2004 and 2003, respectively. Return on average equity for the current period
was 7.92% compared to 8.18% for the prior period. Despite higher earnings during the six-months ended June 30, 2004, return on average assets and return on average equity declined in comparison to the prior year period. Over the past thirteen
months, the Company has expanded its franchise by doubling the number of locations. While management believes the expansion into new markets adds shareholder value, it does have a negative impact on short-term earnings.



Results of operations for the six-month period ended June 30, 2004 were positively impacted
by strong earning asset growth over the past twelve months resulting in improved net interest income. The franchise expansion efforts resulted in increases in both non-interest income and non-interest expenses. The strong loan growth experienced
during the first six months of 2004 resulted in an increase in the provision for loan losses.



Net Interest Income.Net interest income for the six-month period ended June 30, 2004 was approximately $4.8 million, representing a $1.6 million or 53% increase over the $3.2 million reported for the prior
year period. The increase in net interest income was due to growth in the average volume of interest-earning assets. The impact on net interest income from the growth in earning assets more than offset the unfavorable impact from the decline in the
yield on those assets. Total interest expense from deposits and borrowings also increased due to growth in interest-bearing liabilities needed to fund the higher volume of assets. Although the interest rate spread increased during the current
period, net interest margin declined due to the Companys increased reliance on interest-bearing liabilities to fund the asset growth.



Total average earning assets increased $105.9 million or 63% from an average of $168.2 million for the six-months ended June 30, 2003 to an average of $274.1 million for
the six-months ended June 30, 2004. The average balance of loans outstanding during the six-months ended June 30, 2004 was $229.4 million, increasing by $96.8 million or 73% compared to $132.6 million of average outstanding loans for the prior year
period. The average balance of the investment securities portfolio for the current six-month period was $40.7 million compared to an average of $27.4 million for the six-months ended June 30, 2003. The average balance of federal funds sold and other
earning assets declined to $4.1 million for the current period compared to $8.2 million for the prior period. Average interest-bearing liabilities increased by $105.4 million or 85% from $124.5 million for the period ended June 30, 2003 to $229.9
million for the current period.



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Total interest income increased by $2.6 million for the six-months ended June 30, 2004 to $7.3 million compared to $4.7
million the prior year. The net growth in volume of total average earning assets accounted for a $3.0 million increase in interest income, which was partially offset by a $437,000 decrease in interest income due to lower yields realized on earning
assets. Total interest expense experienced a net increase of $921,000 increasing from $1.6 million at June 30, 2003 to $2.5 million for the current period. Interest expense increased by $1.2 million due to growth in interest-bearing funds and
declined by $322,000 due to the lower interest rate environment.



Net interest
margin is interest income earned on loans, securities and other earning assets, less interest expense paid on deposits and borrowings, expressed as a percentage of total average earning assets. The net interest margin for the six-month period ended
June 30, 2004 was 3.55% compared to 3.80% for the six-month period ended June 30, 2003. The average yield on earning assets for the current six-month period declined 31 basis points to 5.39% compared with 5.70% for the prior year period, while the
average cost of interest-bearing funds decreased by 38 basis points to 2.19% from 2.57%. The interest rate spread, which is the difference between the average yield on earning assets and the cost of interest-bearing funds, increased by 7 basis
points from 3.13% for the period ended June 30, 2003 to 3.20% for the period ended June 30, 2004.



Between January 1, 2001 and June 29, 2004, the Federal Reserve cut short-term interest rates 550 basis points in an effort to stimulate an ailing economy. During this time, the Company has tried to position its
balance sheet to take advantage of the next interest rate cycle in which rates increase. Therefore, approximately 70% to 75% of new loan volume has been priced at a variable interest rate. The rate on a typical variable loan might adjust based on
the Prime lending rate (currently at 4.25%) plus 1% to 2%. Overall, 68% of outstanding loans are tied to a variable rate index. On June 30, 2004, the Federal Reserve began the next interest rate cycle when it increased rates by 25 basis points. We
anticipate this to be the first of several increases, although the timing and magnitude of those increases are not known. This should have a favorable impact on the yield on the loan portfolio, which constitutes the largest component of the
Companys earning assets.



Since January 2001 and continuing until June
2004, interest rates on the one-year certificates of deposit declined by approximately 500 basis points. As shorter-term time deposits have matured and renewed, there has been some tendency for customers to extend the term of their deposits into the
two, three, four and five year time horizons to earn additional income. As rates begin to rise, the customers will begin to shorten their time horizons in an attempt to improve yield over time. We believe that as short-term rates begin to increase,
the cost of funds will increase, albeit at a slower pace than the yield on earning assets, creating larger spreads and improving margins.



Provision for Loan Losses.The Companys provision for loan losses for the six-month period ended June 30, 2004 was $384,000 compared to $228,000 for the
six-month period from a year ago. Provisions for loan losses are charged to income to bring the allowance for loan losses to a level deemed appropriate by management based on factors discussed under Analysis of Allowance for Loan Losses.
The increase in the loan loss provision during the first six months of 2004 is principally due to the net growth of the loan portfolio. The allowance for loan losses is $3.6 million at June 30, 2004, representing 1.46% of total outstanding loans.



Non-Interest Income.For the six-month period ended June 30, 2004,
non-interest income increase by $430,000 or 66% to $1,076,000 compared to $646,000 for the same period in



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2003. Total mortgage origination and other loan related fees increased by $35,000 to $347,000 for the current period from
$312,000 for the prior period. Customer service fees on deposit accounts increased by $153,000 from $192,000 to $345,000. The Company recorded $120,000 in earnings from increases in cash value of life insurance. No such investment in life insurance
existed in the prior year period. Revenue earned from service charges on deposit accounts increased by $19,000 from $76,000 to $95,000. Other non-interest income, which includes investment referral fees, dividends from the Companys investment
in a mortgage company and gains on sales of assets, increased by $103,000 from $66,000 to $169,000.



In the prior year period, a significant percentage of non-interest income was derived from mortgage loan origination fees. The volume of these fees was driven, to a large extent, by refinancing due to the favorable
interest rate environment. The Company has committed additional resources to the mortgage production area and more emphasis has been placed on purchase money activity. While we anticipate that mortgage loan origination fees will continue to be an
important source of revenue, it may be difficult to maintain current levels through the end of the year. Mortgage loan origination fees were $310,000 in the current year compared with $284,000 for the prior year.



Non-Interest Expenses.Non-interest expenses were $4.1 million for the six-month
period ended June 30, 2004 compared with $2.5 million for the same period ended June 30, 2003. The largest component of non-interest expense for the current period was personnel expense. Salaries and benefits expense was $2.1 million for the
six-month period ended June 30, 2004, compared with $1.3 million recorded for the same period in the prior year. The Company has expanded into four new markets since May 2003 and the number of employees has increased significantly. Management
anticipates personnel expense to continue to increase through 2004 as we prepare to convert an existing loan production office into a full-service branch. The expansion of the branch network will also require additional administrative and support
personnel.



Occupancy expenses increased by $254,000 from $455,000 for the
six-month period ended June 30, 2003 to $710,000 for the current year period. Through the acquisition of two offices in Pinehurst and Southern Pines and the expansion into Holly Springs and Sanford, the Company has almost doubled its presence in
Central North Carolina over the past year. Data processing costs increased from $152,000 for the six-months ended June 30, 2003 to $259,000 for the current six-month period. The Company outsources its data processing and expenses are closely tied to
transaction and account volumes. The added costs of installing and maintaining data communications lines to the new branch facilities are also considered data processing expenses. As the Company continues to grow in accordance with its strategic
plan, management expects both occupancy and data processing costs to increase.



Other non-interest expenses increased by $476,000 to $993,000 for the first half of 2004 compared with $517,000 for the comparative prior period. The increase was primarily as a result of the Companys continued growth. The largest
components of other non-interest expenses include professional fees and services, office supplies and printing, advertising and loan related fees. Management expects that as the complexity and size of the Company increases, expenses associated with
these categories will continue to increase.



Provision for Income Taxes.
The Company recorded income tax expense of $477,000 during the six-months ended June 30, 2004 compared with $409,000 for the prior year period. The effective tax rate for the six-month period ended June 30, 2004 was 32.7% compared with 35.7% for the
prior year period. The improvement in the effective tax rate is attributable to a substantial increase in tax exempt investments.



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##### Table of Contents

NET INTEREST INCOME



Net interest income represents the difference between income derived from interest-earning assets and interest expense incurred on
interest-bearing liabilities. Net interest income is affected by both (1) the difference between the rates of interest earned on interest-earning assets and the rates paid on interest-bearing liabilities (interest rate spread) and (2)
the relative amounts of interest-earning assets and interest-bearing liabilities (net interest-earning balance). The following tables set forth information relating to average balances of the Companys assets and liabilities for the
three and six-month periods ended June 30, 2004 and 2003. The tables reflect the average yield on interest-earning assets and the average cost of interest-bearing liabilities (derived by dividing income or expense by the daily average balance of
interest-earning assets or interest-bearing liabilities, respectively) as well as the net interest margin. In preparing the table, non-accrual loans are included, when applicable, in the average loan balance.



Average Balances, Interest and Average Yields/Cost

(Dollars in Thousands)



|                                                                                      |  |                                     |         |          |      |                   |  |        |                |  |          |         |                   |   |       |  |        |  
|------------------------------------------------------------------------------------- |  | ----------------------------------- | ------- | -------- | ---- | ----------------- |  | ------ | -------------- |  | -------- | ------- | ----------------- | - | ----- |  | ------ | -
|                                                                                      |  | For the Three Months Ended June 30, |        
|                                                                                      |  | 2004                                |         |          | 2003 |                  
|                                                                                      |  | AverageBalance                      |         | Interest |      | AverageYield/Cost |  |        | AverageBalance |  | Interest |         | AverageYield/Cost |  
|                                                                                      |  | (Dollars in thousands)              |        
|Interest-earnings assets                                                              |  |                                     |         |          |      |                   |  |        |                |  |          |         |                   |   |       |  |        |  
|Loan portfolio                                                                        |  | $                                   | 234,887 |          | $    | 3,295             |  | 5.64   | %              |  | $        | 135,980 |                   | $ | 2,068 |  | 6.10   | %
|Investment securities                                                                 |  |                                     | 42,569  |          |      | 428               |  | 4.02   | %              |  |          | 27,312  |                   |   | 321   |  | 4.70   | %
|Fed funds and other interest-earning assets                                           |  |                                     | 2,955   |          |      | 7                 |  | 0.95   | %              |  |          | 9,952   |                   |   | 29    |  | 1.17   | %
|                                                                                      |  |                                     |         |          |      |                   |  |        |                |  |          |         |                   |   |       |  |        |  
|Total interest-earning assets                                                         |  |                                     | 280,411 |          |      | 3,730             |  | 5.35   | %              |  |          | 173,244 |                   |   | 2,418 |  | 5.60   | %
|Noninterest-bearing assets                                                            |  |                                     | 20,020  |          |      |                   |  |        |                |  |          | 7,857   |                   |   |       |  |        |  
|                                                                                      |  |                                     |         |          |      |                   |  |        |                |  |          |         |                   |   |       |  |        |  
|Total Assets                                                                          |  | $                                   | 300,431 |          |      |                   |  |        |                |  | $        | 181,101 |                   |   |       |  |        |  
|                                                                                      |  |                                     |         |          |      |                   |  |        |                |  |          |         |                   |   |       |  |        |  
|Interest-bearing liabilities                                                          |  |                                     |         |          |      |                   |  |        |                |  |          |         |                   |   |       |  |        |  
|Interest-bearing NOW                                                                  |  | $                                   | 40,404  |          |      | 77                |  | 0.77   | %              |  | $        | 26,858  |                   |   | 65    |  | 0.97   | %
|Money market and savings                                                              |  |                                     | 33,321  |          |      | 95                |  | 1.15   | %              |  |          | 22,354  |                   |   | 80    |  | 1.44   | %
|Time deposits                                                                         |  |                                     | 139,815 |          |      | 874               |  | 2.51   | %              |  |          | 67,889  |                   |   | 545   |  | 3.22   | %
|Borrowings                                                                            |  |                                     | 22,828  |          |      | 231               |  | 4.00   | %              |  |          | 10,458  |                   |   | 107   |  | 4.05   | %
|                                                                                      |  |                                     |         |          |      |                   |  |        |                |  |          |         |                   |   |       |  |        |  
|Total interest-bearing liabilities                                                    |  |                                     | 236,368 |          |      | 1,277             |  | 2.17   | %              |  |          | 127,559 |                   |   | 797   |  | 2.51   | %
|Non-interest bearing deposits                                                         |  |                                     | 37,699  |          |      |                   |  |        |                |  |          | 34,800  |                   |   |       |  |        |  
|Other liabilities                                                                     |  |                                     | 1,383   |          |      |                   |  |        |                |  |          | 436     |                   |   |       |  |        |  
|                                                                                      |  |                                     |         |          |      |                   |  |        |                |  |          |         |                   |   |       |  |        |  
|Total Liabilities                                                                     |  |                                     | 275,450 |          |      |                   |  |        |                |  |          | 162,795 |                   |   |       |  |        |  
|Stockholders Equity                                                                  |  |                                     | 24,981  |          |      |                   |  |        |                |  |          | 18,306  |                   |   |       |  |        |  
|                                                                                      |  |                                     |         |          |      |                   |  |        |                |  |          |         |                   |   |       |  |        |  
|Total Liabilities & Stockholders Equity                                              |  | $                                   | 300,431 |          |      |                   |  |        |                |  | $        | 181,101 |                   |   |       |  |        |  
|                                                                                      |  |                                     |         |          |      |                   |  |        |                |  |          |         |                   |   |       |  |        |  
|                                                                                      |  |                                     |         |          |      |                   |  |        |                |  |          |         |                   |   |       |  |        |  
|Net interest income                                                                   |  |                                     |         |          | $    | 2,453             |  |        |                |  |          |         |                   | $ | 1,621 |  |        |  
|                                                                                      |  |                                     |         |          |      |                   |  |        |                |  |          |         |                   |   |       |  |        |  
|Interest rate spread                                                                  |  |                                     |         |          |      |                   |  | 3.18   | %              |  |          |         |                   |   |       |  | 3.09   | %
|                                                                                      |  |                                     |         |          |      |                   |  |        |                |  |          |         |                   |   |       |  |        |  
|Net interest-margin                                                                   |  |                                     |         |          |      |                   |  | 3.52   | %              |  |          |         |                   |   |       |  | 3.75   | %
|                                                                                      |  |                                     |         |          |      |                   |  |        |                |  |          |         |                   |   |       |  |        |  
|Percentage of average interest-earning assets to average interest-bearing liabilities |  |                                     |         |          |      |                   |  | 118.63 | %              |  |          |         |                   |   |       |  | 135.81 | %
|                                                                                      |  |                                     |         |          |      |                   |  |        |                |  |          |         |                   |   |       |  |        |  



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##### Table of Contents

Average Balances, Interest and Average Yields/Cost

(Dollars in Thousands)



|                                                                                      |  |                                   |         |          |      |                   |  |        |                |  |          |         |                   |   |       |  |        |  
|------------------------------------------------------------------------------------- |  | --------------------------------- | ------- | -------- | ---- | ----------------- |  | ------ | -------------- |  | -------- | ------- | ----------------- | - | ----- |  | ------ | -
|                                                                                      |  | For the Six Months Ended June 30, |        
|                                                                                      |  | 2004                              |         |          | 2003 |                  
|                                                                                      |  | AverageBalance                    |         | Interest |      | AverageYield/Cost |  |        | AverageBalance |  | Interest |         | AverageYield/Cost |  
|Interest-earnings assets                                                              |  |                                   |         |          |      |                   |  |        |                |  |          |         |                   |   |       |  |        |  
|Loan portfolio                                                                        |  | $                                 | 229,357 |          | $    | 6,498             |  | 5.70   | %              |  | $        | 132,557 |                   | $ | 4,022 |  | 6.12   | %
|Investment securities                                                                 |  |                                   | 40,687  |          |      | 830               |  | 4.08   | %              |  |          | 27,434  |                   |   | 684   |  | 4.99   | %
|Fed funds and other interest-earning assets                                           |  |                                   | 4,066   |          |      | 18                |  | 0.89   | %              |  |          | 8,208   |                   |   | 48    |  | 1.18   | %
|                                                                                      |  |                                   |         |          |      |                   |  |        |                |  |          |         |                   |   |       |  |        |  
|Total earning assets                                                                  |  |                                   | 274,110 |          |      | 7,346             |  | 5.39   | %              |  |          | 168,199 |                   |   | 4,754 |  | 5.70   | %
|Noninterest-bearing assets                                                            |  |                                   | 19,417  |          |      |                   |  |        |                |  |          | 7,717   |                   |   |       |  |        |  
|                                                                                      |  |                                   |         |          |      |                   |  |        |                |  |          |         |                   |   |       |  |        |  
|Total Assets                                                                          |  | $                                 | 293,527 |          |      |                   |  |        |                |  | $        | 175,916 |                   |   |       |  |        |  
|                                                                                      |  |                                   |         |          |      |                   |  |        |                |  |          |         |                   |   |       |  |        |  
|Interest-bearing liabilities                                                          |  |                                   |         |          |      |                   |  |        |                |  |          |         |                   |   |       |  |        |  
|Interest-bearing NOW                                                                  |  | $                                 | 40,390  |          |      | 159               |  | 0.79   | %              |  | $        | 25,487  |                   |   | 128   |  | 1.01   | %
|Money market and savings                                                              |  |                                   | 31,976  |          |      | 181               |  | 1.14   | %              |  |          | 20,977  |                   |   | 143   |  | 1.37   | %
|Time deposits                                                                         |  |                                   | 134,289 |          |      | 1,704             |  | 2.55   | %              |  |          | 67,564  |                   |   | 1,104 |  | 3.30   | %
|Borrowings                                                                            |  |                                   | 23,257  |          |      | 464               |  | 3.95   | %              |  |          | 10,500  |                   |   | 212   |  | 4.07   | %
|                                                                                      |  |                                   |         |          |      |                   |  |        |                |  |          |         |                   |   |       |  |        |  
|Total interest-bearing liabilities                                                    |  |                                   | 229,912 |          |      | 2,508             |  | 2.19   | %              |  |          | 124,528 |                   |   | 1,587 |  | 2.57   | %
|Non interest-bearing deposits                                                         |  |                                   | 37,315  |          |      |                   |  |        |                |  |          | 32,569  |                   |   |       |  |        |  
|Other liabilities                                                                     |  |                                   | 1,432   |          |      |                   |  |        |                |  |          | 670     |                   |   |       |  |        |  
|Total Liabilities                                                                     |  |                                   | 268,659 |          |      |                   |  |        |                |  |          | 157,767 |                   |   |       |  |        |  
|Stockholders Equity                                                                  |  |                                   | 24,868  |          |      |                   |  |        |                |  |          | 18,149  |                   |   |       |  |        |  
|                                                                                      |  |                                   |         |          |      |                   |  |        |                |  |          |         |                   |   |       |  |        |  
|Total Liabilities & Stockholders Equity                                              |  | $                                 | 293,527 |          |      |                   |  |        |                |  | $        | 175,916 |                   |   |       |  |        |  
|                                                                                      |  |                                   |         |          |      |                   |  |        |                |  |          |         |                   |   |       |  |        |  
|                                                                                      |  |                                   |         |          |      |                   |  |        |                |  |          |         |                   |   |       |  |        |  
|Net interest income                                                                   |  |                                   |         |          | $    | 4,838             |  |        |                |  |          |         |                   | $ | 3,167 |  |        |  
|                                                                                      |  |                                   |         |          |      |                   |  |        |                |  |          |         |                   |   |       |  |        |  
|Interest rate spread                                                                  |  |                                   |         |          |      |                   |  | 3.20   | %              |  |          |         |                   |   |       |  | 3.13   | %
|                                                                                      |  |                                   |         |          |      |                   |  |        |                |  |          |         |                   |   |       |  |        |  
|Net margin                                                                            |  |                                   |         |          |      |                   |  | 3.55   | %              |  |          |         |                   |   |       |  | 3.80   | %
|                                                                                      |  |                                   |         |          |      |                   |  |        |                |  |          |         |                   |   |       |  |        |  
|Percentage of average interest-earning assets to average interest bearing liabilities |  |                                   |         |          |      |                   |  | 119.22 | %              |  |          |         |                   |   |       |  | 135.07 | %
|                                                                                      |  |                                   |         |          |      |                   |  |        |                |  |          |         |                   |   |       |  |        |  



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##### Table of Contents

VOLUME/RATE VARIANCE ANALYSIS



The following tables analyze the dollar amount of changes in interest income and interest expense for major components of interest-earning
assets and interest-bearing liabilities for the three and six-month periods ended June 30, 2004 and 2003. The table distinguishes between (i) changes attributable to volume (changes in volume multiplied by the prior periods rate), (ii) changes
attributable to rate (changes in rate multiplied by the prior periods volume), and (iii) net change (the sum of the previous columns). The change attributable to both rate and volume (changes in rate multiplied by changes in volume) has been
allocated equally to both the changes attributable to volume and the changes attributable to rate.



Rate/Volume Analysis

|                                            |  |                                                          |   |  |      |   |  |       |  
|------------------------------------------- |  | -------------------------------------------------------- | - |  | ---- | - |  | ----- | -
|                                            |  | Three Months Ended June 30, 2004 vs. 2003 (in
Thousands) |  
|                                            |  | Increase (Decrease) Due to                               |  
|                                            |  | Volume                                                   |   |  | Rate |   |  | Total |  
|Interest Income                             |  |                                                          |   |  |      |   |  |       |  
|Loan portfolio                              |  | 1,451                                                    |   |  | (224 | ) |  | 1,227 |  
|Investment Securities                       |  | 167                                                      |   |  | (60  | ) |  | 107   |  
|Fed funds and other interest-earning assets |  | (19                                                      | ) |  | (3   | ) |  | (22   | )
|                                            |  |                                                          |   |  |      |   |  |       |  
|Total interest-earning assets               |  | 1,599                                                    |   |  | (287 | ) |  | 1,312 |  
|                                            |  |                                                          |  
|Interest Expense                            |  |                                                          |   |  |      |   |  |       |  
|Interest-bearing NOW                        |  | 30                                                       |   |  | (18  | ) |  | 12    |  
|Money market and savings                    |  | 36                                                       |   |  | (21  | ) |  | 15    |  
|Time deposits                               |  | 591                                                      |   |  | (262 | ) |  | 329   |  
|Borrowings                                  |  | 125                                                      |   |  | (1   | ) |  | 124   |  
|                                            |  |                                                          |   |  |      |   |  |       |  
|Total interest-bearing liabilities          |  | 782                                                      |   |  | (302 | ) |  | 480   |  
|                                            |  |                                                          |  
|Net interest income                         |  | 817                                                      |   |  | 15   |   |  | 832   |  
|                                            |  |                                                          |   |  |      |   |  |       |  



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##### Table of Contents

Rate/Volume Analysis



|                                            |  |                                                        |   |  |      |   |  |       |  
|------------------------------------------- |  | ------------------------------------------------------ | - |  | ---- | - |  | ----- | -
|                                            |  | Six Months Ended June 30, 2004 vs. 2003 (in
Thousands) |  
|                                            |  | Increase (Decrease) Due to                             |  
|                                            |  | Volume                                                 |   |  | Rate |   |  | Total |  
|Interest Income                             |  |                                                        |   |  |      |   |  |       |  
|Loan portfolio                              |  | 2,749                                                  |   |  | (273 | ) |  | 2,476 |  
|Investment Securities                       |  | 301                                                    |   |  | (155 | ) |  | 146   |  
|Fed funds and other interest-earning assets |  | (21                                                    | ) |  | (9   | ) |  | (30   | )
|                                            |  |                                                        |   |  |      |   |  |       |  
|Total interest-earning assets               |  | 3,029                                                  |   |  | (437 | ) |  | 2,592 |  
|                                            |  |                                                        |  
|Interest Expense                            |  |                                                        |   |  |      |   |  |       |  
|Interest-bearing NOW                        |  | 67                                                     |   |  | (36  | ) |  | 31    |  
|Money market and savings                    |  | 69                                                     |   |  | (31  | ) |  | 38    |  
|Time deposits                               |  | 849                                                    |   |  | (249 | ) |  | 600   |  
|Borrowings                                  |  | 258                                                    |   |  | (6   | ) |  | 252   |  
|                                            |  |                                                        |   |  |      |   |  |       |  
|Total interest-bearing liabilities          |  | 1,243                                                  |   |  | (322 | ) |  | 921   |  
|                                            |  |                                                        |  
|Net interest income                         |  | 1,786                                                  |   |  | (115 | ) |  | 1,671 |  
|                                            |  |                                                        |   |  |      |   |  |       |  



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##### Table of Contents

NONPERFORMING ASSETS



The table below sets forth, for the period indicated, information about our nonaccrual loans, restructured loans, total nonperforming loans
(nonaccrual loans plus restructured loans), and total nonperforming assets.



|                                                 |  |                        |         |   |                 |   |          |      |  |   |          |   |  |   |       |  
|------------------------------------------------ |  | ---------------------- | ------- | - | --------------- | - | -------- | ---- |  | - | -------- | - |  | - | ----- | -
|                                                 |  | At June 30,            |         |   | At December 31, |  
|                                                 |  | 2004                   |         |   | 2003            |   |          | 2003 |  |   | 2002     |  
|                                                 |  | (Dollars in thousands) |        
|Nonaccrual loans                                 |  | $                      | 302     |   |                 | $ | 6        |      |  | $ | 159      |   |  | $ |      |  
|Restructured loans                               |  |                        |        |   |                 |   |         |      |  |   |         |   |  |   |      |  
|                                                 |  |                        |         |   |                 |   |          |      |  |   |          |   |  |   |       |  
|Total nonperforming loans                        |  |                        | 302     |   |                 |   | 6        |      |  |   | 159      |   |  |   |      |  
|                                                 |  |                        |         |  
|Real estate owned                                |  |                        |        |   |                 |   | 160      |      |  |   |         |   |  |   |      |  
|Repossessed assets                               |  |                        | 35      |   |                 |   |         |      |  |   |         |   |  |   |      |  
|                                                 |  |                        |         |   |                 |   |          |      |  |   |          |   |  |   |       |  
|Total nonperforming assets                       |  | $                      | 337     |   |                 | $ | 166      |      |  | $ | 159      |   |  | $ |      |  
|                                                 |  |                        |         |   |                 |   |          |      |  |   |          |   |  |   |       |  
|Accruing loans past due 90 days or more          |  | $                      |        |   |                 | $ |         |      |  | $ | 647      |   |  | $ |      |  
|Allowance for loan losses                        |  |                        | 3,556   |   |                 |   | 1,902    |      |  |   | 3,304    |   |  |   | 1,711 |  
|Nonperforming loans to period end loans          |  |                        | .12     | % |                 |   | .004     | %    |  |   | 0.07     | % |  |   | 0.00  | %
|Allowance for loan losses to period end loans    |  |                        | 1.46    | % |                 |   | 1.35     | %    |  |   | 1.52     | % |  |   | 1.36  | %
|Allowance for loan losses to nonperforming loans |  |                        | 1177.81 | % |                 |   | 31700.00 | %    |  |   | 2,077.99 | % |  |   | 0.00  | %
|Nonperforming assets to total assets             |  |                        | .11     | % |                 |   | .07      | %    |  |   | 0.06     | % |  |   | 0.00  | %



Our financial statements are prepared
on the accrual basis of accounting, including the recognition of interest income on loans, unless we place a loan on nonaccrual basis. We account for loans on a nonaccrual basis when we have serious doubts about the collectibility of principal or
interest. Generally, our policy is to place a loan on nonaccrual status when the loan becomes past due 90 days. We also place loans on nonaccrual status in cases where we are uncertain whether the borrower can satisfy the contractual terms of the
loan agreement. Amounts received on nonaccrual loans generally are applied first to principal and then to interest only after all principal has been collected. Restructured loans are those for which concessions, including the reduction of interest
rates below a rate otherwise available to that borrower or the deferral of interest or principal have been granted due to the borrowers weakened financial condition. We accrue interest on restructured loans at the restructured rates when we
anticipate that no loss of original principal will occur. Potential problem loans are loans which are currently performing and are not included as nonaccrual or restructured loans above, but about which we have serious doubts as to the
borrowers ability to comply with present repayment terms. These loans are likely to be included later in nonaccrual, past due or restructured loans, so they are considered by our management in assessing the adequacy of our allowance for loan
losses.



The Company did not own any foreclosed real estate at June 30, 2004.
There was one foreclosed real estate asset in the amount of $160,000 at June 30, 2003.



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##### Table of Contents

There were four non-accrual loans at June 30, 2004 in the aggregate amount of $302,000. One loan in the amount of
$271,000 is secured by commercial real estate. The property was foreclosed on in mid July and management anticipates the disposal of the asset by the end of the third quarter. At the time of foreclosure, we charged-off $21,000 on the loan. We do not
anticipate a loss on the disposal of the property. One loan in the amount of $24,000 is secured by residential real estate. The property is in the process of foreclosure. The final two loans in the amounts of $4,000 and $3,000 are secured by
automobiles and the makers are paying an agreed amount monthly. Interest foregone on nonaccrual loans was approximately $12,000 for the six-month period ended June 30, 2004. At June 30, 2003, there was one loan in nonaccrual status totaling $6,000.
Interest foregone on nonaccrual loans was approximately $4,000 for the six-month period ended June 30, 2003.



At June 30, 2004, we had identified four loans totaling $387,000 as potential problem loans. Two loans are cross-collateralized by business assets and a second deed of trust on a personal residence, one loan is
secured by business assets and the final loan is unsecured. Additionally, there is one loan in the amount of $750,000 of which $625,000 is secured by marketable equity securities and $125,000 is unsecured. Although this loan is currently performing,
management continues to monitor the situation carefully for deterioration.



ANALYSIS OF ALLOWANCE FOR LOAN LOSSES



The allowance for loan losses is established through periodic charges to earnings in the form of a provision for loan losses. Increases to the allowance for loan losses occur as a result of provisions charged to operations and recoveries of
amounts previously charged-off, and decreases to the allowance occur when loans are charged-off. Management evaluates the adequacy of our allowance for loan losses on a monthly basis. The evaluation of the adequacy of the allowance for loan losses
involves the consideration of loan growth, loan portfolio composition and industry diversification, historical loan loss experience, current delinquency levels, adverse conditions that might affect a borrowers ability to repay the loan,
estimated value of underlying collateral, prevailing economic conditions and all other relevant factors derived from the Companys limited history of operations. Because of our limited history, we also consider the loss experience history and
allowance ratios of other similar community banks and the knowledge and expertise obtained by management and senior lending officers from prior years experience at former institutions. Additionally, as an important component of their periodic
examination process, regulatory agencies review the allowance for loan losses and may require additional provisions for estimated losses based on judgments that differ from those of management.



The Company uses an internal grading system to assign the degree of inherent risk on each
individual loan. The grade is initially assigned by the lending officer and reviewed by the Loan Administration function. The internal grading system is reviewed and tested periodically by an independent third party credit review firm. The testing
process involves the evaluation of a sample of new loans, loans having been identified as possessing potential weakness in credit quality, past due loans and nonaccrual loans to determine the ongoing effectiveness of the internal grading system. The
loan grading system is used to assess the adequacy of the allowance for loan losses.



Management has developed a model for evaluating the adequacy of the allowance for loan losses. The model distinguishes between loans that will be evaluated as a group by loan category and those loans to be evaluated individually. Using the
various evaluation factors mentioned above, management predetermined allowance percentages for each major loan category. Loans that exhibit an acceptable level of risk per the internal loan grading system are grouped by loan category and multiplied
by the associated allowance percentage to determine an adequate level of allowance for loan losses.



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##### Table of Contents

Based on the loan grading system, management maintains an internally classified watch list. Loans classified as watch
list credits, and those loans that are not watch list credits but possess other characteristics which in the opinion of management suggest a higher degree of inherent risk, are evaluated individually, by loan category, using higher allowance
percentages. Using the data gathered during the monthly evaluation process, the model calculates an acceptable range for allowance for loan losses. Management and the Board of Directors are responsible for determining the appropriate level of the
allowance for loan losses within that range.



The primary reason for increases
to the allowance for loan losses has been growth in total outstanding loans; however, there were other factors influencing the provision. For the six-month period ended June 30, 2004, there were $132,000 in net loan charge-offs and at June 30, 2004
there were $302,000 in non-performing loans. The allowance for loan losses at June 30, 2004 was $3.6 million, which represents 1.46% of total outstanding loans.



The allowance for loan losses represents managements estimate of an amount adequate to provide for known and inherent losses in the loan portfolio in the normal
course of business. While management believes the methodology used to establish the allowance for loan losses incorporates the best information available at the time, future adjustments to the level of the allowance may be necessary and the results
of operations could be adversely affected should circumstances differ substantially from the assumptions initially used. We believe that the allowance for loan losses was established in conformity with generally accepted accounting principles;
however, there can be no assurances that the regulatory agencies, after reviewing the loan portfolio, will not require management to increase the level of the allowance. Likewise, there can be no assurance that the existing allowance for loan losses
is adequate should there be deterioration in the quality of any loans or changes in any of the factors discussed above. Any increases in the provision for loan losses resulting from such deterioration or change in condition could adversely affect
the financial condition of the Company and results of its operations.



The
following table describes the allocation of the allowance for loan losses among various categories of loans for the dates indicated.



Allocation of Allowance for Loan Losses



|                                |  |                        |       |                     |        |   |        |   |                     |  |        |  
|------------------------------- |  | ---------------------- | ----- | ------------------- | ------ | - | ------ | - | ------------------- |  | ------ | -
|                                |  | At June 30,            |      
|                                |  | 2004                   |       |                     | 2003   |  
|                                |  | Amount                 |       | % of TotalLoans (1) |        |   | Amount |   | % of TotalLoans (1) | 
|                                |  | (Dollars in thousands) |      
|Residential real estate loans   |  | $                      | 49    |                     | 5.20   | % |        | $ | 13                  |  | 2.41   | %
|Home equity loans and lines     |  |                        | 154   |                     | 11.67  | % |        |   | 88                  |  | 11.86  | %
|Commercial mortgage loans       |  |                        | 1,264 |                     | 47.45  | % |        |   | 846                 |  | 47.95  | %
|Construction loans              |  |                        | 650   |                     | 13.46  | % |        |   | 323                 |  | 15.55  | %
|Commercial and industrial loans |  |                        | 1,007 |                     | 19.98  | % |        |   | 563                 |  | 20.30  | %
|Loans to individuals            |  |                        | 432   |                     | 2.24   | % |        |   | 69                  |  | 1.93   | %
|                                |  |                        |       |                     |        |   |        |   |                     |  |        |  
|Total allowance for loan losses |  | $                      | 3,556 |                     | 100.00 | % |        | $ | 1,902               |  | 100.00 | %
|                                |  |                        |       |                     |        |   |        |   |                     |  |        |  

---

|(1) | Represents total of all outstanding loans in each category as a percent of total loans outstanding
|--- | --------------------------------------------------------------------------------------------------



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The following table presents information regarding changes in the allowance for loan losses for the periods indicated:



Changes in Allowance for Loan Losses



|                                                      |  |                               |         |   |      |   |         |  
|----------------------------------------------------- |  | ----------------------------- | ------- | - | ---- | - | ------- | -
|                                                      |  | For the Period Ended June 30, |        
|                                                      |  | 2004                          |         |   | 2003 |  
|                                                      |  | (Dollars in thousands)        |        
|Balance at the beginning of the year                  |  | $                             | 3,304   |   |      | $ | 1,711   |  
|Charge-offs:                                          |  |                               |         |   |      |   |         |  
|Commercial and industrial loans                       |  |                               | 95      |   |      |   | 46      |  
|Residential real estate loans                         |  |                               | 34      |   |      |   |        |  
|Loans to individuals                                  |  |                               | 6       |   |      |   | 3       |  
|                                                      |  |                               |         |   |      |   |         |  
|Total charge-offs                                     |  |                               | 135     |   |      |   | 49      |  
|                                                      |  |                               |         |   |      |   |         |  
|Recoveries                                            |  |                               | 3       |   |      |   | 12      |  
|                                                      |  |                               |         |   |      |   |         |  
|Net charge-offs                                       |  |                               | 132     |   |      |   | 37      |  
|                                                      |  |                              
|Provision for loan losses                             |  |                               | 384     |   |      |   | 228     |  
|                                                      |  |                               |         |   |      |   |         |  
|Balance at the end of the year                        |  | $                             | 3,556   |   |      | $ | 1,902   |  
|                                                      |  |                               |         |   |      |   |         |  
|Total loans outstanding at period-end                 |  | $                             | 244,199 |   |      | $ | 141,109 |  
|                                                      |  |                              
|Average loans outstanding for the period              |  | $                             | 229,357 |   |      | $ | 132,557 |  
|                                                      |  |                              
|Allowance for loan losses to total loans outstanding  |  |                               | 1.46    | % |      |   | 1.35    | %
|                                                      |  |                              
|Ratio of net charge-offs to average loans outstanding |  |                               | 0.06    | % |      |   | 0.03    | %



LIQUIDITY AND
CAPITAL RESOURCES



Maintaining adequate liquidity while managing interest
rate risk is the primary goal of the Companys asset and liability management strategy. Liquidity is the ability to fund the needs of the Companys borrowers and depositors, pay operating expenses, and meet regulatory liquidity
requirements. Maturing investments, loan and mortgage-backed security principal repayments, deposit growth, brokered time deposits and borrowings from the Federal Home Loan Bank and other correspondent banks are presently the main sources of the
Companys liquidity. The Companys primary uses of liquidity are to fund loans and to make investments.



As of June 30, 2004, liquid assets (cash and due from banks, interest-earning deposits with banks, Federal funds sold and investment securities available for sale) were
approximately $51.4 million, which represents 17% of total assets and 20% of total deposits. Supplementing this liquidity, the Company has available lines of credit from various correspondent banks of approximately $69.1 million of which $12.0
million is outstanding at June 30, 2004. At June 30, 2004, outstanding commitments for undisbursed lines of credit, letters of credit and future investments amounted to approximately $58.4 million. Management intends to fund anticipated



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##### Table of Contents

loan closings and operational needs through cash and cash equivalents on hand, brokered deposits, scheduled principal
repayments from the loan and securities portfolios and anticipated increases in deposits. Certificates of deposits represented 55% of the Companys total deposits at June 30, 2004 compared with 52% at December 31, 2003. The Companys
growth strategy will include marketing efforts focused at increasing the relative volume of low cost transaction deposit accounts; however, time deposits will continue to play an important role in the Companys funding strategy. Certificates of
deposit of $100,000 or more represented 34% of the Companys total deposits at June 30, 2004 compared to 24% at year-end December 31, 2003. While these deposits are generally considered rate sensitive and the Company will need to pay
competitive rates to retain these deposits at maturity, there are other subjective factors that will determine the Companys continued retention of those deposits.



Under federal capital regulations, Crescent State Bank must satisfy certain minimum leverage ratio requirements and risk-based capital
requirements. At June 30, 2004, the Banks equity to asset ratio was 7.97%. All capital ratios place the Bank in excess of the minimum required to be deemed a well-capitalized bank by regulatory measures. The Banks ratio of Tier I capital
to risk-weighted assets at June 30, 2004 was 11.28%.



IMPACT
OF INFLATION AND CHANGING PRICES



A commercial bank has an asset and
liability composition that is distinctly different from that of a company with substantial investments in plant and inventory because the major portions of its assets are monetary in nature. As a result, a banks performance may be
significantly influenced by changes in interest rates. Although the banking industry is more affected by changes in interest rates than by inflation in the prices of goods and services, inflation is a factor that may influence interest rates.
However, the frequency and magnitude of interest rate fluctuations do not necessarily coincide with changes in the general inflation rate. Inflation does affect operating expenses in that personnel expenses and the cost of supplies and outside
services tend to increase more during periods of high inflation.



FORWARD-LOOKING INFORMATION



This quarterly report contains
certain forward-looking statements consisting of estimates with respect to the financial condition, results of operations and other business of Crescent Financial Corporation that are subject to various factors which could cause actual results to
differ materially from those estimates. Factors that could influence the estimates include changes in national, regional and local market conditions, legislative and regulatory conditions, and the interest rate environment.



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##### Table of Contents

Item 3. Controls and Procedures



As of June
30, 2004, an evaluation was performed under the supervision and with the participation of the Companys management, including the CEO and CFO, of the effectiveness of the design and operation of the Companys disclosure controls and
procedures. Based on that evaluation, the Companys management, including the CEO and CFO, concluded that the Companys disclosure controls and procedures were effective as of June 30, 2004. There have been no significant changes in the
Companys internal controls or in other factors that could significantly affect internal controls during the period covered by this report.



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##### Table of Contents

Part II. OTHER INFORMATION



Item 2. Subsequent
Events



Effective July 21, 2004, a mortgage company in which the Company
has a membership interest entered into an agreement to be merged with the subsidiary of another company. The transaction is expected to close early in the fourth quarter of 2004. Consideration for the sale of the membership interest will consist of
cash and stock of the acquiring company as well as additional payments over the two years following closing of the transaction if certain performance targets are met. Management anticipates that the Company will realize a gain, net of income taxes,
of approximately $34,000 from this transaction.



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



The Annual Meeting of the Stockholders was held on April 27, 2004. Of 3,509,314 shares entitled to vote at the meeting, 2,383,298 shares voted. The following matters were voted on at the meeting:



| | 1. | Election of Directors
| | -- | ---------------------



Brent D. Barringer, Sheila Hale Ogle, Jon S. Rufty and Stephen K. Zaytoun were elected to three-year terms and Francis R. Quis, Jr. was elected to a two
year term as follows:



|                     |  |           |  |         |  |        
|-------------------- |  | --------- |  | ------- |  | -------
|Nominee              |  | For       |  | Against |  | Abstain
|Brent D. Barringer   |  | 2,368,245 |  |        |  | 15,053 
|Sheila Hale Ogle     |  | 2,380,204 |  |        |  | 3,094  
|Jon S. Rufty         |  | 2,379,754 |  |        |  | 3,544  
|Stephen K. Zaytoun   |  | 2,377,615 |  |        |  | 5,683  
|Francis R. Quis, Jr. |  | 2,380,320 |  |        |  | 2,978  



The following
directors continue in office after the meeting: Michael G. Carlton, Joseph S. Colson, Jr., Bruce I. Howell, James A. Lucas, Jr. and Kenneth A. Lucas.



| | 2. | Ratification of Appointment of Independent Public Accountants
| | -- | -------------------------------------------------------------



Managements appointment of Dixon Hughes, PLLC as the Companys independent public accountants for 2004 was approved with 2,374,711 shares
voting for, 3,386 shares voting against, and 5,201 shares abstaining.



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##### Table of Contents

Item 6. Exhibits and Reports on Form 8-K



| | (a) | Exhibits.
| | --- | ---------



| | 31.1 | Certification of Principal Executive Officer pursuant to Rule 13a  14(a)
| | ---- | -------------------------------------------------------------------------



| | 31.2 | Certification of Principal Financial Officer pursuant to Rule 13a  14(a)
| | ---- | -------------------------------------------------------------------------



| | 32.1 | Certification of Chief Executive Officer pursuant to 18 U.S.C. 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
| | ---- | ----------------------------------------------------------------------------------------------------------------------------------------



| | 32.2 | Certification of Principal Financial Officer pursuant to 18 U.S.C. 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
| | ---- | --------------------------------------------------------------------------------------------------------------------------------------------



| | (b) | Reports on Form 8-K.
| | --- | --------------------



During the quarter ended June 30, 2004, the following Current Reports on Form 8-K were filed with the Securities Exchange Commission:



Form 8-K, dated April 19, 2004, included information regarding the April 19,
2004 press release announcing Crescent Financial Corporations first quarter earnings. The Company reported net income of $464,000 for the three-month period ended March 31, 2004.



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##### Table of Contents

SIGNATURES



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



|                      |  |                                |  |                              
|--------------------- |  | ------------------------------ |  | -----------------------------
|                      |  | CRESCENT FINANCIAL CORPORATION
|                      |  |                               
|Date: August 10, 2004 |  | By:                            |  | /s/ Michael G. Carlton       
|                      |  |                                |  | Michael G. Carlton           
|                      |  |                                |  | President and Chief Executive
|                      |  |                               
|Date: August 10, 2004 |  | By:                            |  | /s/ Bruce W. Elder           
|                      |  |                                |  | Bruce W. Elder               
|                      |  |                                |  | Vice President and Secretary 



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