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U. S. Securities and Exchange Commission  Form 10-KSB [ X ] Annual Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934 For the fiscal year ended December 31, 2003 [  ] Transition Report Under Section 13 or 15(d) of the Securities Exchange
Act of 1934 For the transition period from ____________ to ____________ Commission file number 000-33223 Gateway Financial Holdings, Inc. 
  North Carolina

(State of incorporation)

    56-2040581

(IRS Employer Identification No.)1145 North Road Street, Elizabeth City, North Carolina

(Address of principal executive offices)

    27909
(Zip code)
 (252) 334-1511   Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [ X ] No [  ] Indicate by check mark if disclosure of delinquent filers in response to Item
405 of Regulation S-K is not contained herein, and will not be contained, to
the best of registrants knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-KSB or any
amendment to this Form 10-KSB. [  ] State issuers revenues for its most recent fiscal year $18.0 million. The aggregate market value of the registrants Common Stock at March 9, 2004,
held by those persons deemed by the registrant to be non-affiliates, was
approximately $34.7 million. As of March 9, 2004, (the most recent practicable date), the registrant had
outstanding 3,239,555 shares of common stock, no par value per share.  Page 1




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Form 10-KSB Table of Contents Index
    
    
    
    PAGEPART IItem 1.
    
    Description of Business
    
    
    3Item 2.
    
    Properties
    
    
    11Item 3.
    
    Legal Proceedings
    
    
    11Item 4.
    
    Submission of Matters to a Vote of Security Holders
    
    
    11PART IIItem 5.
    
    Market for Common Equity, Related Stockholder Matters and Small Business Issuer Purchases of Equity Securities
    
    
    11Item 6.
    
    Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    12Item 7.
    
    Financial Statements
    
    
    36Item 8.
    
    Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
    
    
    64Item 8A.
    
    Controls and Procedures
    
    
    64PART IIIItem 9.
    
    Directors and Executive Officers of the Registrant; Compliance with Section 16(a)
    
    
    64Item 10.
    
    Executive Compensation
    
    
    64Item 11.
    
    Securities Ownership of Certain Beneficial Owners and Management
    
    
    64Item 12.
    
    Certain Relationships and Related Transactions
    
    
    65Item 13.
    
    Exhibits and Reports on Form 8-K
    
    
    66Item 14.
    
    Principal Accountant Fees and Services
    
    
    66
  Page 2




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PART I 
 ITEM 1.  DESCRIPTION OF BUSINESS General Gateway Financial Holdings, Inc. (the Company) is a one-bank holding company
incorporated under the laws of North Carolina to serve as the holding company
for Gateway Bank & Trust Co. (the Bank). The Company is registered with the
Federal Reserve System as a financial holding company. Gateway Financial
Holdings, Inc. acquired all of the outstanding capital stock of the Bank on
October 1, 2001. Gateway Bank & Trust Co. was incorporated on November 24,
1998, and commenced operations on December 1, 1998, as a North Carolina
chartered commercial bank with its deposits insured up to applicable limits by
the Federal Deposit Insurance Corporation (FDIC). The Bank is a member of the
Federal Reserve System. The primary purpose of the Bank is to serve the banking
needs of individuals and businesses in Northeastern North Carolina and
Tidewater Virginia, with all decisions and product offerings to be in the best
interests of its customers while providing an acceptable return for the
shareholders of the Company. The Companys slogan is High tech . . . High
touch. The Company uses technology combined with personalized attention to
provide customers with better service. The Company offers a wide range of
banking services including checking and savings accounts; commercial,
installment, mortgage, and personal loans; safe deposit boxes; and other
associated services. The Bank serves its customers from ten full service
financial centers located in Elizabeth City (2), Kitty Hawk, Edenton, Plymouth
and Roper, North Carolina, Virginia Beach (2) and Chesapeake (2), Virginia.
The Bank also has two wholly-owned subsidiaries. Gateway Insurance Services,
Inc., an insurance agency with offices in Edenton, Hertford, Elizabeth City,
Plymouth and Kitty Hawk, North Carolina, sells insurance products to businesses
and individuals. Gateway Investment Services, Inc. assists bank customers in
their securities brokerage activities through an unaffiliated broker-dealer.
Through this arrangement Gateway Investment Services earns revenues through
commission sharing from the unaffiliated broker-dealer. Certain Gateway
Investment Services employees are also employees of the unaffiliated
broker-dealer. During 2003, the Company formed another subsidiary, Gateway
Capital Statutory Trust I, in connection with the issuance of $8.0 million of
trust preferred securities in August 2003. Market Area The Companys market area is the northeastern coastal region of North Carolina
and the Hampton Roads metropolitan statistical area (MSA) of Virginia. The
Banks main office is located in Elizabeth City, North Carolina, in Pasquotank
County, the largest municipality in the northeastern coastal region of North
Carolina with a population of over 17,200. Within the ten mile radius of the
main office site of the Bank is a population of over 37,000 with an average
household income of over $41,000. The Bank also has offices in Edenton (Chowan
County), Kitty Hawk (Dare County), Plymouth and Roper (Washington County) in
northeastern North Carolina. The areas served by the North Carolina offices
had a 2000 population of over 129,556. Median family income in 2000 for the
North Carolina counties served by the Bank ranged from $28,800 to $42,400.
Retail sales for these counties were estimated at $768.1 million.
Approximately 97.2% of the work force is employed in nonagricultural wage and
salary positions. Government employed 24% of the labor. The major
non-governmental employment sectors were trade (21%), service (22%),
manufacturing (17%), and construction (5%). The Hampton Roads MSA, which includes Norfolk, Virginia Beach and Chesapeake,
is the second largest urban concentration in the southern United States, and
the 27th largest in the country, with an estimated population of over 1.5
million. The Port of Virginia, actually four general cargo terminals, is the
largest intermodal facility on the East Coast of the United States. The Norfolk
Naval Base is the worlds largest naval base and Hampton Roads is home to seven
of the nations 60 largest stateside military facilities. Hampton Roads total
personal income in 1998 was estimated at $36.9 billion and estimated gross
retail sales in the MSA exceeded $13.3 billion. The MSA had a labor force of
over 721,000. Non-farm payroll jobs were estimated to be 691,000 in 2000. The Bank has two offices in Chesapeake which had a 2000 estimated population of
199,184, and two offices in Virginia Beach, which had a 2000 estimated
population of 425,257. In 2000, the median household income in Chesapeake was
over $50,700 and the median household income in Virginia Beach exceeded
$48,700. The major employment sectors were management and professional (35%),
sales (29%), services (14%), and construction (11%). Page 3




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The Company will continue to solicit retail deposits from consumers,
principally in the form of Certificates of Deposit, Money Market Accounts and
Demand Deposits, and from small businesses, principally in the form of Demand
Deposits and Money Market Accounts. These deposits will be actively sought in
order to provide funding for anticipated loan demand. Bank management is
committed to keeping its focus aggressively on its stated marketing plan of
developing relationships with small businesses, residential builders, and
consumers. Competition The Bank, the operating subsidiary of the Company, faces considerable
competition in its market areas. As of June 2003, there were 12 branches in
Pasquotank County, North Carolina operated by seven commercial banks, including
the Bank, and one savings institution. As of that date, approximately $571
million in deposits were located in Pasquotank County, and deposits of the Bank
on that date totaled $124.9 million. As of June 2003, there were six branches
in Washington County operated by five commercial banks, including the Bank,
with approximately $117 million in deposits. Deposits of the Bank on that date
totaled $17.9 million. As of June 2003, there were seven branches in Chowan
County, including the Bank, operated by five commercial banks with
approximately $146.4 million in deposits. Deposits of the Bank on that date
totaled $9.2 million. As of June 2003, there were 21 branches in Dare County
operated by ten commercial banks, including the Bank, with approximately $732
million in deposits. Deposits of the Bank on that date totaled $13.7 million.
As of June 2003, there were 50 branches in Chesapeake, Virginia operated by 15
commercial banks, including the Bank, with approximately $1.5 billion in
deposits. Deposits of the Bank on that date totaled $8.6 million. As of June
2003, there were 97 branches in Virginia Beach operated by 14 commercial banks,
including the Bank, and two savings institutions with approximately $3.9
billion in deposits. Deposits of the Bank on that date totaled $40.1 million.
Almost 60% of the deposits in the Virginia Beach market were controlled by the
top four bank holding companies. Therefore, in its market area, the Bank has
significant competition for deposits and loans from other depository
institutions. Many of the Banks competitors have substantially greater
resources, broader geographic markets, and higher lending limits than the Bank
and offer certain services which the Bank does not provide. Additionally, with
the elimination of restrictions on interstate banking, the Bank may be required
to compete with out-of-state financial institutions that are not presently in
its market area. The Bank also competes with credit unions, insurance
companies, money market mutual funds, and other financial institutions, some of
which are not subject to the same degree of regulation and restrictions as the
Bank, in attracting deposits and making loans. Other Products and Services Other Banking Products and Services. To enable it to offer more personalized service to its customers, the Company
offers or expects to offer additional products and services for its customers.
Products and services currently offered are a debit card program, automated
teller machines and drive-through facilities at its branches and internet
banking to both business and individual customers. Other Financial Services. The Company, through its subsidiary, Gateway Investment Services, Inc., uses a
networking arrangement to make available securities brokerage products to its
customers. Commercial and personal insurance products are offered through the
Banks insurance subsidiary, Gateway Insurance Services, Inc. Employees The Company had 123 full-time equivalent employees at December 31, 2003. None
of the Companys employees are covered by a collective bargaining agreement.
The Company considers its relations with its employees to be good. Page 4




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SUPERVISION AND REGULATION Banking is a complex, highly regulated industry. The primary goals of the bank
regulatory scheme are to maintain a safe and sound banking system and to
facilitate the conduct of sound monetary policy. In furtherance of these goals,
Congress has created several largely autonomous regulatory agencies and enacted
numerous laws that govern banks, bank holding companies and the banking
industry. The descriptions of and references to the statutes and regulations
below are brief summaries and do not purport to be complete. The descriptions
are qualified in their entirety by reference to the specific statutes and
regulations discussed. Gateway Financial Holdings, Inc. Gateway Financial Holdings, Inc. (the GFH) is a bank holding company that has
elected to be treated as a financial holding company. As a bank holding company
under the Bank Holding Company Act of 1956, as amended, GFH is registered with
and subject to regulation by the Federal Reserve. GFH is required to file
annual and other reports with, and furnish information to, the Federal Reserve.
The Federal Reserve conducts periodic examinations of GFH and may examine any
of its subsidiaries, including the Bank. The Bank Holding Company Act provides that a bank holding company must obtain
the prior approval of the Federal Reserve for the acquisition of more than five
percent of the voting stock or substantially all the assets of any bank or bank
holding company. In addition, the Bank Holding Company Act restricts the
extension of credit to any bank holding company by its subsidiary bank. The
Bank Holding Company Act also provides that, with certain exceptions, a bank
holding company may not engage in any activities other than those of banking or
managing or controlling banks and other authorized subsidiaries or own or
control more than five percent of the voting shares of any company that is not
a bank. The Federal Reserve has deemed limited activities to be closely related
to banking and therefore permissible for a bank holding company. However, with the passage of the Gramm-Leach-Bliley Financial Services
Modernization Act of 1999, which became effective on March 11, 2000, the types
of activities in which a bank holding company may engage were significantly
expanded. Subject to various limitations, the Modernization Act generally
permits a bank holding company to elect to become a financial holding
company. A financial holding company may affiliate with securities firms and
insurance companies and engage in other activities that are financial in
nature. Among the activities that are deemed financial in nature are, in
addition to traditional lending activities, securities underwriting, dealing in
or making a market in securities, sponsoring mutual funds and investment
companies, insurance underwriting and agency activities, certain merchant
banking activities as well as activities that the Federal Reserve considers to
be closely related to banking. A bank holding company may become a financial holding company under the
Modernization Act if each of its subsidiary banks is well-capitalized under
the Federal Deposit Insurance Corporation Improvement Act prompt corrective
action provisions, is well managed and has at least a satisfactory rating under
the Community Reinvestment Act. In addition, the bank holding company must file
a declaration with the Federal Reserve that the bank holding company wishes to
become a financial holding company. A bank holding company that falls out of
compliance with these requirements may be required to cease engaging in some of
its activities. GFH has elected, and been authorized by the Federal Reserve, to
become a financial holding company. Under the Modernization Act, the Federal Reserve serves as the primary
umbrella regulator of financial holding companies, with supervisory authority
over each parent company and limited authority over its subsidiaries. Expanded
financial activities of financial holding companies generally will be regulated
according to the type of such financial activity: banking activities by banking
regulators, securities activities by securities regulators and insurance
activities by insurance regulators. The Modernization Act also imposes
additional restrictions and heightened disclosure requirements regarding
private information collected by financial institutions. Enforcement Authority. GFH will be required to obtain the approval of the
Federal Reserve prior to engaging in or, with certain exceptions, acquiring
control of more than 5% of the voting shares of a company engaged in, any new
activity. Prior to granting such approval, the Federal Reserve must weigh the
expected benefits of any such new activity to the public (such as greater
convenience, increased competition, or gains in efficiency) against the risk of Page 5




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possible adverse effects of such activity (such as undue concentration of
resources, decreased or unfair competition, conflicts of interest, or unsound
banking practices). The Federal Reserve has cease-and-desist powers over bank
holding companies and their nonbanking subsidiaries where their actions would
constitute a serious threat to the safety, soundness or stability of a
subsidiary bank. The Federal Reserve also has authority to regulate debt
obligations (other than commercial paper) issued by bank holding companies.
This authority includes the power to impose interest ceilings and reserve
requirements on such debt obligations. A bank holding company and its
subsidiaries are also prohibited from engaging in certain tie-in arrangements
in connection with any extension of credit, lease or sale of property or
furnishing of services. Interstate Acquisitions. Federal banking law generally provides that a bank
holding company may acquire or establish banks in any state of the United
States, subject to certain aging and deposit concentration limits. In addition,
North Carolina banking laws permit a bank holding company which owns stock of a
bank located outside North Carolina to acquire a bank or bank holding company
located in North Carolina. Federal banking law will not permit a bank holding
company to own or control banks in North Carolina if the acquisition would
exceed 20% of the total deposits of all federally-insured deposits in North
Carolina. Capital Adequacy. The Federal Reserve has promulgated capital adequacy
regulations for all bank holding companies with assets in excess of $150
million. The Federal Reserves capital adequacy regulations are based upon a
risk-based capital determination, whereby a bank holding companys capital
adequacy is determined in light of the risk, both on- and off-balance sheet,
contained in the companys assets. Different categories of assets are assigned
risk weightings and are counted at a percentage of their book value. The regulations divide capital between Tier 1 capital (core capital) and Tier 2
capital. For a bank holding company, Tier 1 capital consists primarily of
common stock, related surplus, noncumulative perpetual preferred stock,
minority interests in consolidated subsidiaries and a limited amount of
qualifying cumulative preferred securities. Goodwill and certain other
intangibles are excluded from Tier 1 capital. Tier 2 capital consists of an
amount equal to the allowance for loan and lease losses up to a maximum of
1.25% of risk-weighted assets, limited other types of preferred stock not
included in Tier 1 capital, hybrid capital instruments and term subordinated
debt. Investments in and loans to unconsolidated banking and finance
subsidiaries that constitute capital of those subsidiaries are excluded from
capital. The sum of Tier 1 and Tier 2 capital constitutes qualifying total
capital. The Tier 1 component must comprise at least 50% of qualifying total
capital. Every bank holding company has to achieve and maintain a minimum Tier 1 capital
ratio of at least 4.0% and a minimum total capital ratio of at least 8.0%. In
addition, banks and bank holding companies are required to maintain a minimum
leverage ratio of Tier 1 capital to average total consolidated assets (leverage
capital ratio) of at least 3.0% for the most highly-rated, financially sound
banks and bank holding companies and a minimum leverage ratio of at least 4.0%
for all other banks. The Federal Deposit Insurance Corporation and the Federal
Reserve define Tier 1 capital for banks in the same manner for both the
leverage ratio and the risk-based capital ratio. However, the Federal Reserve
defines Tier 1 capital for bank holding companies in a slightly different
manner. As of December 31, 2003, GFHs Tier 1 leverage capital ratio and total
capital were 9.33% and 12.68%, respectively. The guidelines also provide that banking organizations experiencing internal
growth or making acquisitions will be expected to maintain strong capital
positions substantially above the minimum supervisory level, without
significant reliance on intangible assets. The guidelines also indicate that
the Federal Reserve will continue to consider a Tangible Tier 1 Leverage
Ratio in evaluating proposals for expansion or new activities. The Tangible
Tier 1 Leverage Ratio is the ratio of Tier 1 capital, less intangibles not
deducted from Tier 1 capital, to quarterly average total assets. As of December
31, 2002, the Federal Reserve had not advised GFH of any specific minimum
Tangible Tier 1 Leverage Ratio applicable to it. Source of Strength for Subsidiaries.Bank holding companies are required to
serve as a source of financial strength for their depository institution
subsidiaries, and, if their depository institution subsidiaries become
undercapitalized, bank holding companies may be required to guarantee the
subsidiaries compliance with capital restoration plans filed with their bank
regulators, subject to certain limits. Page 6




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Dividends. As a bank holding company that does not, as an entity, currently
engage in separate business activities of a material nature, the ability of GFH
to pay cash dividends depends upon the cash dividends received from its
subsidiary bank. The only source of income to GFH is dividends and management
fees paid by the Bank. GFH must pay all of its operating expenses from funds it
receives from the Bank. Therefore, shareholders may receive dividends from GFH
only to the extent that funds are available after payment of operating
expenses. In addition, the Federal Reserve generally prohibits bank holding
companies from paying dividends except out of operating earnings, and the
prospective rate of earnings retention appears consistent with the bank holding
companys capital needs, asset quality and overall financial condition. GFH
expects that, for the foreseeable future, any dividends paid by the Bank to it
will likely be limited to amounts needed to pay any separate expenses of GFH. Change of Control.State and federal banking law restricts the amount of
voting stock of a bank that a person may acquire without the prior approval of
banking regulators. The Bank Holding Company Act requires that a bank holding
company obtain the approval of the Federal Reserve before it may merge with a
bank holding company, acquire a subsidiary bank, acquire substantially all of
the assets of any bank, or before it may acquire ownership or control of any
voting shares of any bank or bank holding company if, after such acquisition,
it would own or control, directly or indirectly, more than 5% of the voting
shares of that bank or bank holding company. The overall effect of such laws is
to make it more difficult to acquire GFH by tender offer or similar means than
it might be to acquire control of another type of corporation. Consequently,
GFH shareholders may be less likely to benefit from rapid increases in stock
prices that often result from tender offers or similar efforts to acquire
control of other types of companies. The Bank Gateway Bank & Trust Co. (the Bank) is subject to various requirements and
restrictions under the laws of the United States and the State of North
Carolina. As a North Carolina bank, the Bank is subject to regulation,
supervision and regular examination by the North Carolina Banking Commission.
As a member of the Federal Reserve, the Bank is subject to regulation,
supervision and regular examination by the Federal Reserve. The North Carolina
Banking Commission and the Federal Reserve have the power to enforce compliance
with applicable banking statutes and regulations. These requirements and
restrictions include requirements to maintain reserves against deposits,
restrictions on the nature and amount of loans that may be made and the
interest that may be charged thereon and restrictions relating to investments
and other activities of the Bank. Transactions with Affiliates. The Bank may not engage in specified
transactions (including, for example, loans) with its affiliates unless the
terms and conditions of those transactions are substantially the same or at
least as favorable to the Bank as those prevailing at the time for comparable
transactions with or involving other nonaffiliated entities. In the absence of
comparable transactions, any transaction between the Bank and its affiliates
must be on terms and under circumstances, including credit standards, which in
good faith would be offered or would apply to nonaffiliated companies. In
addition, transactions referred to as covered transactions between the Bank
and its affiliates may not exceed 10% of the Banks capital and surplus per
affiliate and an aggregate of 20% of its capital and surplus for covered
transactions with all affiliates. Certain transactions with affiliates, such as
loans, also must be secured by collateral of specific types and amounts. The
Bank also is prohibited from purchasing low-quality assets from an affiliate.
Every company under common control with the Bank, including GFH, is deemed to
be an affiliate of the Bank. Loans to Insiders. Federal law also constrains the types and amounts of loans
that the Bank may make to its executive officers, directors and principal
shareholders. Among other things, these loans are limited in amount, must be
approved by the Banks board of directors in advance, and must be on terms and
conditions as favorable to the Bank as those available to an unrelated person. Regulation of Lending Activities. Loans made by the Bank are also subject to
numerous federal and state laws and regulations, including the Truth-In-Lending
Act, Federal Consumer Credit Protection Act, the Equal Credit Opportunity Act,
the Real Estate Settlement Procedures Act and adjustable rate mortgage
disclosure requirements. Remedies to the borrower or consumer and penalties to
the Bank are provided if the Bank fails to comply with these laws and
regulations. The scope and requirements of these laws and regulations have
expanded significantly in recent years. Page 7




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Branch Banking. All banks located in North Carolina are authorized to branch
statewide. Accordingly, a bank located anywhere in North Carolina has the
ability, subject to regulatory approval, to establish branch facilities near
any of our facilities and within our market area. If other banks were to
establish branch facilities near our facilities, it is uncertain whether these
branch facilities would have a material adverse effect on our business. Federal law provides for nationwide interstate banking and branching, subject
to certain aging and deposit concentration limits that may be imposed under
applicable state laws. Applicable North Carolina statutes permit regulatory
authorities to approve de novo branching in North Carolina by institutions
located in states that would permit North Carolina institutions to branch on a
de novo basis into those states. Federal regulations prohibit an out-of-state
bank from using interstate branching authority primarily for the purpose of
deposit production. These regulations include guidelines to insure that
interstate branches operated by an out-of-state bank in a host state are
reasonably helping to meet the credit needs of the host state communities
served by the out-of-state bank. Reserve Requirements.Pursuant to regulations of the Federal Reserve, the bank
must maintain average daily reserves against its transaction accounts. No
reserves are required to be maintained on the first $6.6 million of transaction
accounts, but reserves equal to 3.0% must be maintained on the aggregate
balances of those accounts between $6.6 million and $45.4 million, and reserves
equal to 10.0% plus $1.2 million must be maintained on aggregate balances in
excess of $45.4 million. These percentages are subject to adjustment by the
Federal Reserve. Because required reserves must be maintained in the form of
vault cash or in a non-interest-bearing account at a Federal Reserve Bank, the
effect of the reserve requirement is to reduce the amount of the institutions
interest-earning assets. As of December 31, 2003, the bank met its reserve
requirements. Community Reinvestment.Under the Community Reinvestment Act (CRA), as
implemented by regulations of the federal bank regulatory agencies, an insured
bank has a continuing and affirmative obligation, consistent with its safe and
sound operation, to help meet the credit needs of its entire community,
including low and moderate income neighborhoods. The CRA does not establish
specific lending requirements or programs for banks, nor does it limit a banks
discretion to develop the types of products and services that it believes are
best suited to its particular community, consistent with the CRA. The CRA
requires the federal bank regulatory agencies, in connection with their
examination of insured banks, to assess the banks records of meeting the
credit needs of their communities, using the ratings of outstanding,
satisfactory, needs to improve, or substantial noncompliance, and to take
that record into account in its evaluation of certain applications by those
banks. All banks are required to make public disclosure of their CRA
performance ratings. The Bank received a satisfactory rating in its most
recent CRA examination. Governmental Monetary Policies. The commercial banking business is affected
not only by general economic conditions but also by the monetary policies of
the Federal Reserve. Changes in the discount rate on member bank borrowings,
control of borrowings, open market transactions in United States government
securities, the imposition of and changes in reserve requirements against
member banks and deposits and assets of foreign bank branches, and the
imposition of and changes in reserve requirements against certain borrowings by
banks and their affiliates are some of the monetary policies available to the
Federal Reserve. Those monetary policies influence to a significant extent the
overall growth of all bank loans, investments and deposits and the interest
rates charged on loans or paid on time and savings deposits in order to
mitigate recessionary and inflationary pressures. These techniques are used in
varying combinations to influence overall growth and distribution of bank
loans, investments, and deposits, and their use may also affect interest rates
charged on loans or paid for deposits. The monetary policies of the Federal Reserve Board have had a significant
effect on the operating results of commercial banks in the past and are
expected to continue to do so in the future. In view of changing conditions in
the national economy and money markets, as well as the effect of actions by
monetary and fiscal authorities, no prediction can be made as to possible
future changes in interest rates, deposit levels, loan demand or the business
and earnings of the Bank. Dividends. All dividends paid by the Bank are paid to GFH, the sole
shareholder of the Bank. The general dividend policy of the Bank is to pay
dividends at levels consistent with maintaining liquidity and preserving
applicable capital ratios and servicing obligations. The dividend policy of the
Bank is subject to the discretion of the board of directors of the Bank and
will depend upon such factors as future earnings, financial condition, cash
needs, capital adequacy, compliance with applicable statutory and regulatory
requirements and general business conditions. The ability of the Bank to pay dividends is restricted under applicable law and
regulations. Under North Carolina banking law, dividends must be paid out of
retained earnings and no cash dividends may be paid if the Banks Page 8




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surplus is less than 50% of its paid-in capital. Also, under federal banking
law, no cash dividend may be paid if the Bank is undercapitalized or insolvent
or if payment of the cash dividend would render the Bank undercapitalized or
insolvent, and no cash dividend may be paid by the Bank if it is in default of
any deposit insurance assessment due to the Federal Deposit Insurance
Corporation. The exact amount of future dividends on the stock of the Bank will be a
function of the profitability of the Bank in general and applicable tax rates
in effect from year to year. The Banks ability to pay dividends in the future
will directly depend on its future profitability, which cannot be accurately
estimated or assured. Management expects that, for the foreseeable future,
profits resulting from the Banks operations will be retained by the Bank as
additional capital to support its operations and growth other than dividends
paid by the Bank to GFH as needed to pay any separate expenses of GFH. Capital Adequacy. The capital adequacy regulations which apply to state banks,
such as the Bank, are similar to the Federal Reserve requirements promulgated
with respect to bank holding companies discussed above. Changes in Management. Any depository institution that has been chartered less
than two years, is not in compliance with the minimum capital requirements of
its primary federal banking regulator, or is otherwise in a troubled condition
must notify its primary federal banking regulator of the proposed addition of
any person to the board of directors or the employment of any person as a
senior executive officer of the institution at least 30 days before such
addition or employment becomes effective. During this 30-day period, the
applicable federal banking regulatory agency may disapprove of the addition of
such director or employment of such officer. The Bank is not subject to any
such requirements. Enforcement Authority. The federal banking laws also contain civil and
criminal penalties available for use by the appropriate regulatory agency
against certain institution-affiliated parties primarily including
management, employees and agents of a financial institution, as well as
independent contractors such as attorneys and accountants and others who
participate in the conduct of the financial institutions affairs and who
caused or are likely to cause more than minimum financial loss to or a
significant adverse affect on the institution, who knowingly or recklessly
violate a law or regulation, breach a fiduciary duty or engage in unsafe or
unsound practices. These practices can include the failure of an institution to
timely file required reports or the submission of inaccurate reports. These
laws authorize the appropriate banking agency to issue cease and desist orders
that may, among other things, require affirmative action to correct any harm
resulting from a violation or practice, including restitution, reimbursement,
indemnification or guarantees against loss. A financial institution may also be
ordered to restrict its growth, dispose of certain assets or take other action
as determined by the primary federal banking agency to be appropriate. Prompt Corrective Action. Banks are subject to restrictions on their
activities depending on their level of capital. Federal prompt corrective
action regulations divide banks into five different categories, depending on
their level of capital. Under these regulations, a bank is deemed to be
well-capitalized if it has a total risk-based capital ratio of 10% or more, a
core capital ratio of six percent or more and a leverage ratio of five percent
or more, and if the bank is not subject to an order or capital directive to
meet and maintain a certain capital level. Under these regulations, a bank is
deemed to be adequately capitalized if it has a total risk-based capital
ratio of eight percent or more, a core capital ratio of four percent or more
and a leverage ratio of four percent or more (unless it receives the highest
composite rating at its most recent examination and is not experiencing or
anticipating significant growth, in which instance it must maintain a leverage
ratio of three percent or more). Under these regulations, a bank is deemed to
be undercapitalized if it has a total risk-based capital ratio of less than
eight percent, a core capital ratio of less than four percent or a leverage
ratio of less than three percent. Under these regulations, a bank is deemed to
be significantly undercapitalized if it has a risk-based capital ratio of
less than six percent, a core capital ratio of less than three percent and a
leverage ratio of less than three percent. Under such regulations, a bank is
deemed to be critically undercapitalized if it has a leverage ratio of less
than or equal to two percent. In addition, the applicable federal banking
agency has the ability to downgrade a banks classification (but not to
critically undercapitalized) based on other considerations even if the bank
meets the capital guidelines.
If a state member bank, such as the Bank, is classified as undercapitalized,
the bank is required to submit a capital restoration plan to the Federal
Reserve. An undercapitalized bank is prohibited from increasing its assets,
engaging in a new line of business, acquiring any interest in any company or
insured depository institution, or opening or acquiring a new branch office,
except under certain circumstances, including the acceptance by the Federal
Reserve of a capital restoration plan for that bank. If a state member bank is classified as undercapitalized, the Federal Reserve
may take certain actions to correct the capital position of the bank. If a
state member bank is classified as significantly undercapitalized, the Federal Page 9




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##### 



Reserve would be required to take one or more prompt corrective actions. These
actions would include, among other things, requiring sales of new securities to
bolster capital, changes in management, limits on interest rates paid,
prohibitions on transactions with affiliates, termination of certain risky
activities and restrictions on compensation paid to executive officers. If a
bank is classified as critically undercapitalized, the bank must be placed into
conservatorship or receivership within 90 days, unless the Federal Deposit
Insurance Corporation determines otherwise. The capital classification of a bank affects the frequency of examinations of
the bank and impacts the ability of the bank to engage in certain activities
and affects the deposit insurance premiums paid by the bank. The Federal
Reserve is required to conduct a full-scope, on-site examination of every
member bank at least once every twelve months. Banks also may be restricted in their ability to accept brokered deposits,
depending on their capital classification. Well-capitalized banks are
permitted to accept brokered deposits, but all banks that are not
well-capitalized are not permitted to accept such deposits. The Federal Reserve
may, on a case-by-case basis, permit member banks that are adequately
capitalized to accept brokered deposits if the Federal Reserve determines that
acceptance of such deposits would not constitute an unsafe or unsound banking
practice with respect to the bank. Deposit Insurance.The Banks deposits are insured up to $100,000 per insured
account by the Bank Insurance Fund of the Federal Deposit Insurance
Corporation. The Banks deposit insurance assessments may increase depending
upon the risk category and subcategory, if any, to which the Bank is assigned.
The Federal Deposit Insurance Corporation assesses insurance premiums on a
banks deposits at a variable rate depending on the probability that the
deposit insurance fund will incur a loss with respect to the bank. The Federal
Deposit Insurance Corporation determines the deposit insurance assessment rates
on the basis of the banks capital classification and supervisory evaluations.
Each of these categories has three subcategories, resulting in nine assessment
risk classifications. The three subcategories with respect to capital are
well-capitalized, adequately capitalized and less than adequately
capitalized (that would include undercapitalized, significantly
undercapitalized and critically undercapitalized banks). The three
subcategories with respect to supervisory concerns are healthy, supervisory
concern and substantial supervisory concern. A bank is deemed healthy if
it is financially sound with only a few minor weaknesses. A bank is deemed
subject to supervisory concern if it has weaknesses that, if not corrected,
could result in significant deterioration of the bank and increased risk to the
Bank Insurance Fund of the Federal Deposit Insurance Corporation. A bank is
deemed subject to substantial supervisory concern if it poses a substantial
probability of loss to the Bank Insurance Fund. Any increase in insurance
assessments could have an adverse effect on the Banks earnings. GFHs management and the Banks management cannot predict what other
legislation might be enacted or what other regulations might be adopted or the
effects thereof. Page 10




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##### 



ITEM 2  PROPERTIES The Company currently operates out of ten banking offices as set forth below: Approximate Square
    
    Year Established/Office Location
    
    Footage
    
    AcquiredElizabeth City- 1145 North Road Street
    
    
    9,000
    
    
    
    1999Elizabeth City- 1404 West Ehringhaus Street
    
    
    2,000
    
    
    
    2003Virginia Beach- 4460 Corporation Lane, Suite 100
    
    
    4,000
    
    
    
    2000Virginia Beach- 3001 Shore Drive
    
    
    2,000
    
    
    
    2003Plymouth- 433 U.S. Highway 64 East
    
    
    5,200
    
    
    
    2000Roper- 102 W. Buncomb Street
    
    
    550
    
    
    
    2000Edenton- 344 Virginia Road
    
    
    1,500
    
    
    
    2002Kitty Hawk- 3600 Croatan Highway
    
    
    6,500
    
    
    
    2002Chesapeake- 111 Gainsbourgh Square
    
    
    7,200
    
    
    
    2002Chesapeake- 575 Cedar Road
    
    
    2,000
    
    
    
    2003
 All properties owned by the Company and its subsidiaries, including land,
buildings and improvements, furniture, equipment and vehicles, had a net book
value at December 31, 2003 of $12.0 million. In the opinion of the Companys
management, such properties are adequately covered by insurance. 
 ITEM 3  LEGAL PROCEEDINGS The Company is aware of no material legal proceeding to which the Company or
any of its subsidiaries is a party or of which any of their properties is
subject. 
 ITEM 4  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted for a vote of our shareholders during the fourth
quarter of fiscal 2003. 
 PART II 
 ITEM 5  MARKET FOR COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND SMALL
BUSINESS ISSUER PURCHASES OF EQUITY SECURITIES Our common stock is traded on the NASDAQ under the symbol GBTS. The following
table sets forth the high and low published closing prices for shares of our
common stock for the periods indicated. Where appropriate, prices have been
adjusted for the effects of and an 11-for-10 stock split effected in the form
of a 10% stock dividend in 2002, a 21-for-20 stock split effected in the form
of a 5% stock dividend in 2003, and a 21-for-20 stock split to be effected in
the form of a 5% stock dividend that was announced February 27, 2004 and is to
be distributed April 8, 2004 to shareholders of record on March 15, 2004. The
last reported sales price of the common stock on March 8, 2004 was $13.52 per
share. As of December 31, 2003, Gateway Bank had approximately 2,100
shareholders of record. High
    
    Low2003
    
    First Quarter
    
    $
    8.34
    
    
    $
    6.94Second Quarter
    
    
    10.14
    
    
    
    7.99Third Quarter
    
    
    10.62
    
    
    
    9.52Fourth Quarter
    
    
    11.47
    
    
    
    10.422002
    
    First Quarter
    
    $
    8.04
    
    
    $
    6.93Second Quarter
    
    
    8.76
    
    
    
    7.42Third Quarter
    
    
    8.29
    
    
    
    6.35Fourth Quarter
    
    
    7.65
    
    
    
    6.43
 Page 11




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##### 



We conducted an initial public offering of our common stock that closed in
1998, pursuant to which we sold 1,044,495 shares at $11.00 per share in cash.
During 2000, we sold 515,597 shares of our common stock at $10.00 per share in
a public offering. During 2001, we sold 1,110,973 units at $9.25 per unit in a
public offering, with each such unit consisting of one share of our common
stock and one warrant to purchase 1.213 shares of our common stock. In 2002,
we effected an 11-for-10 stock split in the form of a 10% stock dividend, in
2003 we effected a 21-for-20 stock split in the form of a 5% stock dividend,
and on February 27, 2004 we announced a 21-for-20 stock split to be effected in
the form of a 5% stock dividend in 2004. Our warrants, which are exercisable
at any time until June 30, 2004, are presently exercisable at a price of $9.15 per common share.
Those warrants are traded separately on the NASDAQ under the symbol GBTSW. The following table sets forth the high and low published closing prices for
our warrants for the periods indicated. The last reported sales price of the
warrants on March 8, 2004 was $4.45 per warrant. High
    
    Low2003
    
    First Quarter
    
    $
    1.30
    
    
    $
    .95Second Quarter
    
    
    2.10
    
    
    
    1.15Third Quarter
    
    
    2.65
    
    
    
    1.70Fourth Quarter
    
    
    2.70
    
    
    
    1.572002
    
    First Quarter
    
    $
    1.55
    
    
    $
    .70Second Quarter
    
    
    1.85
    
    
    
    1.05Third Quarter
    
    
    1.75
    
    
    
    1.05Fourth Quarter
    
    
    1.40
    
    
    
    .90
 We have not paid cash dividends, and we anticipate that all or substantially
all of our earnings for the foreseeable future will be required for use in the
development of the Companys business. Consequently, we do not anticipate
paying cash dividends for the foreseeable future. As a holding company, we are
dependent upon our subsidiary, Gateway Bank, to provide funding for our
operating expenses and dividends. North Carolina banking law will permit the
payment of dividends only out of retained earnings and will prohibit the
payment of cash dividends if Gateway Banks surplus is less than 50% of its
paid-in capital. Also, under federal banking law, no cash dividend may be paid
if Gateway Bank is undercapitalized or insolvent or if payment of the cash
dividend would render Gateway Bank undercapitalized or insolvent, and no cash
dividend may be paid by Gateway Bank if it is in default of any deposit
insurance assessment due to the FDIC. Subject to these restrictions, our Board
of Directors will consider the payment of dividends when it is deemed prudent
to do so. 
 ITEM 6  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 results of
operations of Gateway Financial Holdings, Inc. It should be read in conjunction
with the audited consolidated financial statements and accompanying notes
included in this annual report and the supplemental financial data appearing
throughout this discussion and analysis. On February 27, 2004, the Companys
Board of Directors declared a 21-for-20 stock split, to be effected in the form
of a 5% stock dividend, which is to be distributed on April 8, 2004 to
shareholders of record on March 15, 2004. On May 19, 2003, the Companys Board
of Directors declared a 21-for-20 stock split, effected in the form of a 5%
stock dividend, which was distributed June 12, 2003 to shareholders of record
on May 21, 2003. On May 14, 2002, the Companys Board of Directors declared an
11-for-10 stock split, effected in the form of a 10% stock dividend, which was
distributed June 5, 2002 to shareholders of record on May 22, 2002. All
references in this discussion and analysis to per share results and weighted
average shares outstanding have been adjusted to reflect the effects of these
stock splits. Page 12




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##### 



OVERVIEW Gateway Financial Holdings, Inc. is a one-bank holding company incorporated
under the laws of North Carolina to serve as the holding company for Gateway
Bank & Trust Co. (the Bank). Gateway Financial Holdings, Inc. acquired all of
the outstanding capital stock of the Bank on October 1, 2001. Gateway Financial
Holdings, Inc., the Bank and the Banks wholly owned subsidiaries are
collectively referred to as the Company. The Bank began operations on December 1, 1998 in a temporary banking facility
located in Elizabeth City, North Carolina. Soon thereafter, construction
started on the Banks permanent headquarters facility located at 1145 North
Road Street in Elizabeth City. The Bank moved into this attractive and
customer friendly facility in November 1999. Since inception, the Bank has
aggressively pursued its primary objective of building a full service banking
operation with broad customer support in a market area that includes
northeastern North Carolina and the Tidewater area of Virginia, supplementing
the banking enterprise with other financial services intended to generate
significant non-interest income. In addition to completion of its headquarters
facility, the Bank completed, in March of 2000, the successful acquisition of
two branches in Plymouth and Roper, North Carolina, and the de novo opening in
July 2000 of its first Virginia branch in Virginia Beach. In January 2002 the
bank opened one new branch in a leased facility in Edenton, North Carolina. Two
other newly constructed owned facilities were opened, one in Kitty Hawk, North
Carolina during September 2002 and one in Chesapeake, Virginia during November
2002. Kitty Hawk, approximately an hours drive from Elizabeth City, is located
on the Outer Banks of North Carolina, a popular and rapidly growing vacation,
resort and recreational area. Chesapeake offers a strong economy and the
Company has a large shareholder base in the area. In January 2003 and April
2003, respectively, the Bank opened de novo offices in leased facilities on
Cedar Road in Chesapeake and Shore Drive in Virginia Beach. In August 2003, the
Bank opened a second banking office in Elizabeth City by acquiring the former
National Bank of Commerce/CCB Ehringhaus Street branch. The Bank will continue
to consider opportunities such as the acquisition of an additional branch or
branches where an opportunity consistent with the Banks long-range strategic
objectives is presented. The Bank will also continue to explore de novo
branching opportunities in markets it considers attractive. In addition to our banking activities, the Bank has focused on insurance and
brokerage services to develop sustainable and growth-oriented sources of
non-interest income. The Bank acquired the Dowd & Twiddy insurance agencies in
January 2000 and Fidelity Insurance in January 2001. These agencies were
combined to form Gateway Insurance Services, Inc., which sells insurance
products to businesses and individuals. Gateway Insurance Services, Inc.
maintains offices in Elizabeth City, Hertford, Edenton, Plymouth and Kitty
Hawk, North Carolina. In addition, the Bank organized Gateway Investment
Services, Inc. in September 1999 to assist bank customers in their securities
brokerage activities through a networking arrangement with an unaffiliated
broker-dealer. Through this arrangement, Gateway Investment Services earns
revenues through commission sharing from the unaffiliated broker-dealer. The
Bank will continue to look for ways to expand non-traditional banking
activities in its insurance subsidiary and securities networking arrangement,
which create significant sources of non-interest income. During its initial years operations, the Company has concentrated its efforts
on building a franchise and infrastructure that can deliver and sustain
long-term profitability. Toward that objective, and consistent with its
business plans, the Company incurred significant operating losses from its date
of opening through December 31, 2000. These losses totaled approximately $2.5
million. The Company achieved its first profitable quarter during the three
months ended March 31, 2001 and has now achieved profitability in twelve
consecutive quarters, producing net income of $547,000 in 2001, $627,000 in
2002 and $1.2 million in 2003. While management expects the Company to
continue to be profitable, continued expansion activity can be expected to
generate significant additional costs that can negatively impact earnings as
the Company pursues its growth strategies. Page 13




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##### 



SELECTED CONSOLIDATED FINANCIAL INFORMATION AND OTHER DATA The information presented below is derived in part from the audited
consolidated financial statements and notes thereto of the Company. This
information presented below does not purport to be complete and should be read
in conjunction with the Companys consolidated financial statements appearing
elsewhere in this annual report. For the Years Ended December 31,2003
    
    2002
    
    2001
    
    2000
    
    1999(Dollars in thousands, except per share data)Operating Data:Total interest income
    
    $
    13,486
    
    
    $
    10,311
    
    
    $
    9,125
    
    
    $
    6,181
    
    
    $
    1,859Total interest expense
    
    
    5,341
    
    
    
    4,819
    
    
    
    5,059
    
    
    
    3,457
    
    
    
    753Net interest income
    
    
    8,145
    
    
    
    5,492
    
    
    
    4,066
    
    
    
    2,724
    
    
    
    1,106Provision for loan losses
    
    
    1,200
    
    
    
    480
    
    
    
    440
    
    
    
    482
    
    
    
    455Net interest income after
provision for loan losses
    
    
    6,945
    
    
    
    5,012
    
    
    
    3,626
    
    
    
    2,242
    
    
    
    651Total non-interest income
    
    
    4,485
    
    
    
    2,826
    
    
    
    2,420
    
    
    
    1,341
    
    
    
    95Total non-interest expense
    
    
    10,230
    
    
    
    7,211
    
    
    
    5,499
    
    
    
    4,655
    
    
    
    1,758Income (loss) before income taxes
    
    
    1,200
    
    
    
    627
    
    
    
    547
    
    
    
    (1,072
    )
    
    
    (1,012
    )Provision for income taxes
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Net income (loss)
    
    $
    1,200
    
    
    $
    627
    
    
    $
    547
    
    
    $
    (1,072
    )
    
    $
    (1,012
    )Per Share Data: (6)Net income (loss), basic
    
    $
    0.36
    
    
    $
    0.19
    
    
    $
    0.21
    
    
    $
    (0.68
    )
    
    $
    (0.80
    )Net income (loss), diluted
    
    
    0.35
    
    
    
    0.19
    
    
    
    0.21
    
    
    
    (0.68
    )
    
    
    (0.80
    )Dividends
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Book value
    
    
    7.51
    
    
    
    7.23
    
    
    
    6.94
    
    
    
    6.83
    
    
    
    7.44Tangible book value
    
    
    6.41
    
    
    
    6.54
    
    
    
    6.23
    
    
    
    5.86
    
    
    
    7.44Balance Sheet Data:Total assets
    
    $
    314,826
    
    
    $
    231,053
    
    
    $
    160,832
    
    
    $
    110,694
    
    
    $
    44,235Loans receivable
    
    
    231,740
    
    
    
    161,488
    
    
    
    107,240
    
    
    
    75,921
    
    
    
    29,574Allowance for loan losses
    
    
    2,759
    
    
    
    1,721
    
    
    
    1,435
    
    
    
    1,028
    
    
    
    462Deposits
    
    
    238,452
    
    
    
    174,663
    
    
    
    115,717
    
    
    
    90,293
    
    
    
    32,181Borrowings
    
    
    50,000
    
    
    
    31,401
    
    
    
    21,300
    
    
    
    6,500
    
    
    
    2,500Shareholders equity
    
    
    24,971
    
    
    
    23,968
    
    
    
    22,998
    
    
    
    13,441
    
    
    
    9,426Selected Performance Ratios:Return on average assets
    
    
    0.43
    %
    
    
    0.32
    %
    
    
    0.41
    %
    
    
    (1.33
    )%
    
    
    (3.51
    )%Return on average equity
    
    
    4.93
    %
    
    
    2.58
    %
    
    
    2.96
    %
    
    
    (9.76
    )%
    
    
    (10.20
    )%Net interest margin (1)
    
    
    3.24
    %
    
    
    3.09
    %
    
    
    3.32
    %
    
    
    3.78
    %
    
    
    4.18
    %Net interest spread (2)
    
    
    2.98
    %
    
    
    2.68
    %
    
    
    2.66
    %
    
    
    3.07
    %
    
    
    2.25
    %Non-interest income as a percentage of
net interest income and non-interest
income
    
    
    35.51
    %
    
    
    33.97
    %
    
    
    37.31
    %
    
    
    32.99
    %
    
    
    7.91
    %Non-interest income as a percentage of
average assets
    
    
    1.61
    %
    
    
    1.46
    %
    
    
    1.80
    %
    
    
    1.66
    %
    
    
    0.33
    %Non-interest expense to average assets
    
    
    3.67
    %
    
    
    3.71
    %
    
    
    4.10
    %
    
    
    5.78
    %
    
    
    6.09
    %Efficiency ratio (3)
    
    
    81.00
    %
    
    
    86.69
    %
    
    
    84.78
    %
    
    
    114.51
    %
    
    
    146.38
    %
 Page 14




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##### 



For the Years Ended December 31,2003
    
    2002
    
    2001
    
    2000
    
    1999(Dollars in thousands, except per share data)Asset Quality Ratios:Nonperforming loans to period-end loans
    
    
    0.52
    %
    
    
    0.82
    %
    
    
    0.00
    %
    
    
    0.00
    %
    
    
    0.00
    %Allowance for loan losses to period-end
loans
    
    
    1.19
    %
    
    
    1.07
    %
    
    
    1.34
    %
    
    
    1.35
    %
    
    
    1.56
    %Allowance for loan losses to
nonperforming loans
    
    
    228.02
    %
    
    
    129.59
    %
    
    NM
    
    NM
    
    NMNonperforming assets to total assets (4)
    
    
    0.38
    %
    
    
    0.67
    %
    
    
    0.14
    %
    
    
    0.00
    %
    
    
    0.00
    %Net loan charge-offs to average
loans outstanding
    
    
    0.11
    %
    
    
    0.15
    %
    
    
    0.04
    %
    
    
    0.01
    %
    
    
    0.02
    %Capital Ratios:(5)Total risk-based capital
    
    
    12.68
    %
    
    
    12.51
    %
    
    
    17.89
    %
    
    
    15.71
    %
    
    
    53.43
    %Tier 1 risk-based capital
    
    
    11.59
    %
    
    
    11.57
    %
    
    
    16.72
    %
    
    
    14.44
    %
    
    
    50.93
    %Leverage ratio
    
    
    9.33
    %
    
    
    9.71
    %
    
    
    13.74
    %
    
    
    11.31
    %
    
    
    23.65
    %Equity to assets ratio
    
    
    7.93
    %
    
    
    10.37
    %
    
    
    14.30
    %
    
    
    12.14
    %
    
    
    21.31
    %Other Data:Number of banking offices
    
    
    10
    
    
    
    7
    
    
    
    4
    
    
    
    4
    
    
    
    1Number of full time equivalent employees
    
    
    123
    
    
    
    96
    
    
    
    69
    
    
    
    53
    
    
    
    22
  (1)
    
    Net interest margin is net interest income divided by average
interest-earning assets.  (2)
    
    Net interest spread is the difference between the average yield on
interest-earning assets and the average cost of interest-bearing
liabilities.  (3)
    
    Efficiency ratio is non-interest expense divided by the sum of net
interest income and non-interest income.  (4)
    
    Nonperforming assets consists of nonaccrual loans, restructured loans,
and real estate owned, where applicable.  (5)
    
    Capital ratios are for the Company.  (6)
    
    Restated for 21-for-20 stock split to occur in 2004, 21-for-20 stock split
occurring during 2003 and 11-for-10 stock split occurring during 2002. Page 15




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FINANCIAL CONDITION
December 31, 2003 and 2002 The Company continued its pattern of strong growth during 2003, with total
assets increasing by $83.8 million, or 36.3%, to $314.8 million at year end.
This growth was principally reflected in increased loans. Total loans increased
by $70.3 million, or 43.5%, from $161.5 million at the beginning of the year to
$231.7 million at year end. The increase in loans was comprised principally of
increases of $9.8 million, $33.1 million and $19.6 million, respectively, in
commercial loans, construction loans, and commercial mortgage loans  three
areas of lending that the Company targets. The Company maintained liquidity at
what it believes to be an appropriate level, as liquid assets, consisting of
cash and due from banks, interest-earning deposits in other banks and
investment securities available for sale, increased in the aggregate to $56.6
million, or 18.0% of total assets, at December 31, 2003. The cash surrender
value of bank owned life insurance totaled $7.1 million, or 2.3% of total
assets at December 31, 2003. Additionally, the Companys investment in premises
and equipment increased by $1.5 million as a result of growth and expansion and
costs incurred in acquiring the former National Bank of Commerce/CCB Ehringhaus
Street branch in Elizabeth City and the upfit costs associated with opening the
de novo offices on Cedar Road in Chesapeake and Shore Drive in Virginia Beach.
Goodwill and other intangibles increased $1.3 million, primarily due to the
acquisition of the former National Bank of Commerce/CCB Ehringhaus Street
branch. Funding for the growth in assets and loans was provided by increases of $63.8
million and $18.6 million, respectively, in deposit accounts and total
borrowings. Total deposit accounts increased 36.5%, from $174.7 million at
December 31, 2002 to $238.5 million at December 31, 2003. Non-interest-bearing
demand accounts increased by $14.0 million, or 59.5%, from $23.5 million at the
beginning of the period to $37.5 million at the end of the period. Savings,
money market and NOW accounts more than doubled to $74.4 million, representing
a total increase of $40.0 million or 116.1% over the $34.4 million reported at
December 31, 2002. Consistent with the Companys objectives to reduce reliance
on time deposits, demand, savings, money market and NOW accounts of $111.9
million at December 31, 2003 represent 46.9% of total deposits at that date, up
from $57.9 million or 33.2% of total deposits at December 31, 2002. Time
deposits totaled $126.6 million at December 31, 2003 as compared to $116.7
million at December 31, 2002. Large denomination time deposits of more than
$100,000 were $35.7 million, or 15.0% of total deposits at
December 31, 2003 as compared with $44.9 million, or 25.7% of total deposits at
December 31, 2002. The Company continues to use brokered deposits to fund
growth, with such deposits increasing from $29.3 million to $42.1 million
during the year, comprising 33.2% of total time deposits at December 31, 2003.
Advances from the Federal Home Loan Bank of Atlanta increased from $28.4
million to $36.0 million during the twelve months, while federal funds
purchased doubled from $3.0 million at the beginning of the year to $6.0
million at December 31, 2003. In addition, during 2003 the Company issued $8.0
million of trust preferred securities, which provided funding to support growth
while enhancing the regulatory capital position of the Company and its bank
subsidiary. Total stockholders equity increased by $1.0 million, as net income for the
current year of $1.2 million and an increase in of $109,000 in capital from
warrant conversion was reduced by a decrease of $306,000 in accumulated other
comprehensive income resulting from a decrease in unrealized securities gains.
Stockholders equity totaled $25.0 million at December 31, 2003. Its capital
ratios continue to place the Bank in excess of the minimums required to be
deemed well-capitalized by regulatory measures. NET INTEREST INCOME Like most financial institutions, the primary component of earnings for the
Company is net interest income. Net interest income is the difference between
interest income, principally from loan and investment securities portfolios,
and interest expense, principally on customer deposits and borrowings. Changes
in net interest income result from changes in volume, spread and margin. For
this purpose, volume refers to the average dollar level of interest-earning
assets and interest-bearing liabilities, spread refers to the difference
between the average yield on interest-earning assets and the average cost of
interest-bearing liabilities, and margin refers to net interest income divided
by average interest-earning assets and is influenced by the level and relative
mix of interest-earning assets and interest-bearing liabilities, as well as
levels of non-interest-bearing liabilities. During the years ended December 31,
2003, 2002 and 2001, average interest-earning assets were $251.7 million,
$177.5 million, and $122.4 million, respectively. During these same years, the
Companys net interest margins were 3.24%, 3.09%, and 3.32%, respectively. Page 16




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##### 



Average Balances and Average Rates Earned and Paid.The following table sets
forth, for the periods indicated, information with regard to average balances
of assets and liabilities, as well as the total dollar amounts of interest
income from interest-earning assets and interest expense on interest-bearing
liabilities, resultant yields or costs, net interest income, net interest
spread, net interest margin and ratio of average interest-earning assets to
average interest-bearing liabilities. For the Years Ended December 31,2003
    
    2002
    
    2001Average
    
    
    
    
    
    Average
    
    Average
    
    
    
    
    
    Average
    
    Average
    
    
    
    
    
    AverageBalance
    
    Interest
    
    Rate
    
    Balance
    
    Interest
    
    Rate
    
    Balance
    
    Interest
    
    Rate(Dollars in thousands)Interest-earning assets:Loans
    
    $
    197,801
    
    
    $
    11,511
    
    
    
    5.82
    %
    
    $
    130,769
    
    
    $
    8,178
    
    
    
    6.25
    %
    
    $
    92,461
    
    
    $
    7,288
    
    
    
    7.88
    %Interest-earning deposits
    
    
    1,867
    
    
    
    21
    
    
    
    1.12
    %
    
    
    4,055
    
    
    
    67
    
    
    
    1.65
    %
    
    
    3,967
    
    
    
    149
    
    
    
    3.76
    %Investment securities available for sale
    
    
    49,652
    
    
    
    1,851
    
    
    
    3.73
    %
    
    
    40,903
    
    
    
    1,959
    
    
    
    4.79
    %
    
    
    24,970
    
    
    
    1,620
    
    
    
    6.49
    %FHLB/FRB stock
    
    
    2,409
    
    
    
    103
    
    
    
    4.28
    %
    
    
    1,815
    
    
    
    107
    
    
    
    5.90
    %
    
    
    985
    
    
    
    68
    
    
    
    6.90
    %Total interest-earning assets
    
    
    251,729
    
    
    
    13,486
    
    
    
    5.36
    %
    
    
    177,542
    
    
    
    10,311
    
    
    
    5.81
    %
    
    
    122,383
    
    
    
    9,125
    
    
    
    7.46
    %Other assets
    
    
    26,727
    
    
    
    
    
    
    
    
    
    
    
    16,593
    
    
    
    
    
    
    
    
    
    
    
    11,747Total assets
    
    $
    278,456
    
    
    
    
    
    
    
    
    
    
    $
    194,135
    
    
    
    
    
    
    
    
    
    
    $
    134,130Interest-bearing liabilities:Deposits:Savings, NOW and money market
    
    $
    55,852
    
    
    
    557
    
    
    
    1.00
    %
    
    $
    28,131
    
    
    
    284
    
    
    
    1.01
    %
    
    $
    19,534
    
    
    
    400
    
    
    
    2.05
    %Time deposits
    
    
    125,100
    
    
    
    3,555
    
    
    
    2.84
    %
    
    
    98,288
    
    
    
    3,479
    
    
    
    3.54
    %
    
    
    72,753
    
    
    
    3,998
    
    
    
    5.50
    %Federal funds purchased
    
    
    4,099
    
    
    

    64
    
    
    
    1.56
    %
    
    
    779
    
    
    
    17
    
    
    
    2.18
    %
    
    
    1,741
    
    
    
    78
    
    
    
    4.48
    %FHLB advances
    
    
    35,812
    
    
    
    1,022
    
    
    
    2.85
    %
    
    
    26,654
    
    
    
    1,039
    
    
    
    3.90
    %
    
    
    11,462
    
    
    
    583
    
    
    
    5.09
    %Trust preferred securities
    
    
    3,333
    
    
    
    143
    
    
    
    4.29
    %
    
    
    
    
    
    
    
    
    
    
    
    %
    
    
    
    
    
    
    
    
    
    
    
    %Total interest-bearing liabilities
    
    
    224,196
    
    
    
    5,341
    
    
    
    2.38
    %
    
    
    153,852
    
    
    
    4,819
    
    
    
    3.13
    %
    
    
    105,490
    
    
    
    5,059
    
    
    
    4.80
    %Demand deposits
    
    
    27,943
    
    
    
    
    
    
    
    
    
    
    
    15,166
    
    
    
    
    
    
    
    
    
    
    
    9,489Other liabilities
    
    
    1,972
    
    
    
    
    
    
    
    
    
    
    
    798
    
    
    
    
    
    
    
    
    
    
    
    659Stockholders equity
    
    
    24,345
    
    
    
    
    
    
    
    
    
    
    
    24,319
    
    
    
    
    
    
    
    
    
    
    
    18,492Total liabilities and stockholders equity
    
    $
    278,456
    
    
    
    
    
    
    
    
    
    
    $
    194,135
    
    
    
    
    
    
    
    
    
    
    $
    134,130Net interest income and interest rate spread
    
    
    
    
    
    $
    8,145
    
    
    
    2.98
    %
    
    
    
    
    
    $
    5,492
    
    
    
    2.68
    %
    
    
    
    
    
    $
    4,066
    
    
    
    2.66
    %Net interest margin
    
    
    
    
    
    
    
    
    
    
    3.24
    %
    
    
    
    
    
    
    
    
    
    
    3.09
    %
    
    
    
    
    
    
    
    
    
    
    3.32
    %Ratio of average interest-earning assets to
average interest-bearing liabilities
    
    
    112.28
    %
    
    
    
    
    
    
    
    
    
    
    115.40
    %
    
    
    
    
    
    
    
    
    
    
    116.01
    %
 Page 17




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##### 



RATE/VOLUME ANALYSIS The following table analyzes the dollar amount of changes in interest income
and interest expense for major components of interest-earning assets and
interest-bearing liabilities. 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. Year Ended
    
    Year EndedDecember 31, 2003 vs. 2002
    
    December 31, 2002 vs. 2001Increase (Decrease) Due to
    
    Increase (Decrease) Due toVolume
    
    Rate
    
    Total
    
    Volume
    
    Rate
    
    Total(Dollars in thousands)Interest income:Loans
    
    $
    4,046
    
    
    $
    (713
    )
    
    $
    3,333
    
    
    $
    2,708
    
    
    $
    (1,818
    )
    
    $
    890Interest-earning deposits
    
    
    (30
    )
    
    
    (16
    )
    
    
    (46
    )
    
    
    2
    
    
    
    (84
    )
    
    
    (82
    )Investment securities available
for sale
    
    
    373
    
    
    
    (481
    )
    
    
    (108
    )
    
    
    898
    
    
    
    (559
    )
    
    
    339FHLB/FRB stock
    
    
    30
    
    
    
    (34
    )
    
    
    (4
    )
    
    
    53
    
    
    
    (14
    )
    
    
    39Total interest income
    
    
    4,419
    
    
    
    (1,244
    )
    
    
    3,175
    
    
    
    3,661
    
    
    
    (2,475
    )
    
    
    1,186Interest expense:DepositsSavings, NOW and
money market
    
    
    278
    
    
    
    (5
    )
    
    
    273
    
    
    
    131
    
    
    
    (247
    )
    
    
    (116
    )Time deposits
    
    
    855
    
    
    
    (779
    )
    
    
    76
    
    
    
    1,154
    
    
    
    (1,673
    )
    
    
    (519
    )Federal funds purchased
    
    
    62
    
    
    
    (15
    )
    
    
    47
    
    
    
    (32
    )
    
    
    (29
    )
    
    
    (61
    )FHLB advances
    
    
    309
    
    
    
    (326
    )
    
    
    (17
    )
    
    
    682
    
    
    
    (226
    )
    
    
    456Trust preferred securities
    
    
    72
    
    
    
    71
    
    
    
    143
    
    
    
    
    
    
    
    
    
    
    
    Total interest expense
    
    
    1,576
    
    
    
    (1,054
    )
    
    
    522
    
    
    
    1,935
    
    
    
    (2,175
    )
    
    
    (240
    )Net interest income
increase (decrease)
    
    $
    2,843
    
    
    $
    (190
    )
    
    $
    2,653
    
    
    $
    1,726
    
    
    $
    (300
    )
    
    $
    1,426
 RESULTS OF OPERATIONS
Years Ended December 31, 2003 and 2002 Overview.The Company reported net income of $1.2 million or $.35 per diluted
share for the year ended
December 31, 2003, as compared with net income of $627,000 or $.19 per diluted
share for 2002, an increase of $573,000 in net income and an increase of $.16
in net income per diluted share. The Companys primary focus continues to be on
growth and development of its branch network and subsidiary operations,
sacrificing some profitability in the near term. The Bank opened two new
branches in leased facilities; one on Cedar Road in Chesapeake, Virginia in
January 2003, and another on Shore Drive in Virginia Beach, Virginia in April
2003. The Bank also purchased a second Elizabeth City, North Carolina banking
location on Ehringhaus Street in August from National Bank of Commerce/CCB.
These new locations increased the number of full service banking branches to
ten. The Company has incurred additional non-interest expenses both as a result
of growth from period to period, and also as a result of staff additions and
other costs incurred as a result of the branch expansion during 2003. Although
interest rates have remained at or near forty year historical lows, the
Companys interest rate spread has increased primarily due to the Banks growth
of low cost core deposits. Page 18




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##### 



Net Interest Income.Like most financial institutions, the primary component
of earnings for the Company is net interest income. Net interest income is the
difference between interest income, principally from loan and investment
securities portfolios, and interest expense, principally on customer deposits
and borrowings. Changes in net interest income result from changes in volume,
spread and margin. For this purpose, volume refers to the average dollar level
of interest-earning assets and interest-bearing liabilities, spread refers to
the difference between the average yield on interest-earning assets and the
average cost of interest-bearing liabilities, and margin refers to net interest
income divided by average interest-earning assets. Margin is influenced by the
level and relative mix of interest-earning assets and interest-bearing
liabilities, as well as by levels of non-interest-bearing liabilities and
capital. Net interest income increased to $8.1 million for the year ended December 31,
2003, a $2.6 million or 48.3% increase from the $5.5 million earned during
2002. Total interest income benefited from strong growth in the level of
average earning assets during the year. This asset growth offset the lower
asset yields caused by the decline in market interest rates during periods
reported. Average total interest-earning assets increased $74.2 million, or
41.8%, for 2003 as compared to 2002, while the average yield dropped by 45
basis points from 5.81% to 5.36%. Average total interest-bearing liabilities
increased by $70.3 million, or 45.7% for 2003 as compared to 2002, while the
average cost of interest-bearing liabilities decreased by 75 basis points from
3.13% to 2.38%. This resulted in a 30 basis point improvement in interest rate
spread and also resulted in an improvement in interest rate margin. For the
year ended December 31, 2003, the net interest rate spread was 2.98% and the
net interest margin was 3.24%. For the year ended December 31, 2002, the net
interest spread was 2.68% and the net interest margin was 3.09%. Provision for Loan Losses.The Company recorded a $1.2 million provision for
loan losses in 2003, representing an increase of $720,000 from the $480,000
provision made in 2002. Provisions for loan losses are charged to income to
bring the allowance for loan losses to a level deemed appropriate by
Management. In evaluating the allowance for loan losses, Management considers
factors that include growth, composition and industry diversification of the
portfolio, historical loan loss experience, current delinquency levels, adverse
situations that may affect a borrowers ability to repay, estimated value of
any underlying collateral, prevailing economic conditions and other relevant
factors. In both 2003 and 2002 the provision for loan losses was made
principally in response to growth in loans, as total loans outstanding
increased by $70.3 million in 2003 and by $54.2 million in 2002. At December
31, the allowance for loan losses was $2.8 million for 2003 and $1.7 million
for 2002, representing 1.19% and 1.07%, respectively, of loans outstanding. Non-Interest Income.Non-interest income totaled $4.5 million for the year
ended December 31, 2003 as compared with $2.8 million for 2002, an increase of
$1.7 million, or 58.7%. Since inception, the Company has actively pursued
additional non-interest income sources outside of traditional banking
operations, including income from insurance, mortgage banking and brokerage
networking operations. The 2003 increases were broad based and include $316,000
in service charges on deposit accounts, $689,000 in income from mortgage
operations, $215,000 in income from insurance operations, and $47,000 in income
from brokerage operations. The increase in income from mortgage operations
consisted of $226,000 from increased originations of presold mortgages,
$251,000 in income distributed on the Companys investment in Sidus Financial
LLC, and $212,000 representing the Companys equity in the 2003 income of
Gateway First Mortgage, LLC. The Bank owns approximately 8% of Sidus Financial,
LLC (Sidus) and 49% of Gateway First Mortgage, LLC (Gateway First). Both
Sidus and Gateway First are providers of mortgage banking services to the Bank
and to other lenders. The increases in income from insurance and brokerage
operations resulted from growth in those lines of business. The Company also
earned $146,000 in 2003 from bank owned life insurance that was purchased
during the year. Other non-interest income increased by $267,000, from $99,000
for 2002 to $366,000 for 2003, reflecting increases of $76,000 and $35,000,
respectively, in miscellaneous service fee income and gains on sales of loans,
as well as a gain of $119,000 in 2003 from the sale of an undeveloped parcel of
land. Non-Interest Expenses.Non-interest expenses totaled $10.2 million for the
year ended December 31, 2003, an increase of $3.0 million or 41.9% over the
$7.2 million reported for 2002. In comparison, total assets averaged $278.5
million for 2003, an increase of 43.4% over average total assets of $194.1
million for the year ended December 31, 2002. Substantially all of the increase
in non-interest expenses resulted from the Companys growth and development,
and reflects the additional expenses in the current year associated with the
opening of new branches in January, April and August 2003, increasing the
number of full service banking locations to ten. Eight of the ten branches
were fully operational throughout 2003, while only five of the seven branches
existing at the end of 2002 were operational throughout all of that year. As a
result of such expansion, personnel costs increased by $1.6 million, or 40.6%,
the costs of occupancy and equipment increased by $890,000, or 91.4%, and other
non-interest expenses increased by $623,000 Page 19




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##### 



or 34.7%. The Companys item processing, which was previously outsourced, was
brought in-house in 2003, and as a result data processing expenses decreased by
$96,000 or 19.4%. As a percentage of average total assets, total non-interest
expenses were consistent at 3.67% for 2003 and 3.71% for 2002. Income Taxes.Income tax expense was $0 for both 2003 and 2002 as a result of
the recognition of deferred tax assets, generated in prior years, that had
previously been offset by a valuation allowance. For 2004, the Company expects
that the provision for income taxes for the year will be approximately 25% to
27% of total income before income taxes. LIQUIDITY AND CAPITAL RESOURCES The Companys sources of funds are customer deposits, cash and demand balances
due from other banks, interest-earning deposits in other banks and investment
securities available for sale. These funds, together with loan repayments, are
used to make loans and to fund continuing operations. In addition, at December
31, 2003, the Bank had credit availability with the Federal Home Loan Bank of
Atlanta (FHLB) of approximately $78.7 million, with $36.0 million
outstanding, federal funds lines of credit with four other financial
institutions in the aggregate amount of $31.4 million, with $6.0 million
outstanding, and a $7.5 million line of credit with another financial
institution, secured by certain commercial loans, no outstanding balance. Total deposits were $238.5 million and $174.7 million at December 31, 2003 and
2002, respectively. As a result of the Companys loan demand exceeding the rate
at which core deposits have been built, the Company has relied significantly on
time deposits as a source of funds. Certificates of deposit are the only
deposit accounts that have stated maturity dates. Such deposits are generally
considered to be rate sensitive. Consistent with its strategy to develop a
higher concentration in lower-costing demand deposits, the Company successfully
reduced its reliance on certificate of deposits during 2003. At December 31,
2003, time deposits represented 53.1% of the Companys total deposits, down
sharply from 66.8% of total deposits at December 31, 2002. Certificates of
deposit of $100,000 or more also reflected this trend, representing 15.0% and
25.7%, respectively, of the Banks total deposits at December 31, 2003 and
2002. At December 31, 2003, the Company had $42.1 million in brokered time
deposits, representing 17.7% of total deposits at that date, down slightly from
18.1% of total deposits at December 31, 2002. While the Company will need to
pay competitive rates to retain these deposits at their maturities, there are
other subjective factors that will determine their continued retention. Based
upon prior experience, the Company anticipates that a substantial portion of
outstanding certificates of deposit will renew upon maturity. Management anticipates that the Company will rely primarily upon customer
deposits, loan repayments, current earnings and, as necessary, additional
borrowings, to provide liquidity, and will use funds thus generated to make
loans and to purchase securities, primarily securities issued by the federal
government and its agencies, corporate securities and mortgage-backed
securities. At December 31, 2003 and 2002, the Companys tangible equity to asset ratio was
6.8% and 9.4%, respectively. All capital ratios place the Bank in excess of the
minimum required to be deemed a well-capitalized bank by regulatory measures.
The regulatory capital position of both the Company and the Bank was enhanced
during 2003 through the issuance of $8.0 million of trust preferred securities
that qualify, subject to certain limitations, as Tier 1 capital. The Banks
Tier I capital ratio at December 31, 2003 and 2002 was 8.4% and 9.7%,
respectively. CAPITAL RATIOS The Bank is subject to minimum capital requirements. See SUPERVISION AND
REGULATION. As the following table indicates, at December 31, 2003, the Bank
exceeded regulatory capital requirements. At December 31, 2003Actual
    
    Minimum
    
    Well-CapitalizedRatio
    
    Requirement
    
    RequirementTotal risk-based capital ratio
    
    
    11.53
    %
    
    
    8.0
    %
    
    
    10.0
    %Tier 1 risk-based capital ratio
    
    
    10.43
    %
    
    
    4.0
    %
    
    
    6.0
    %Leverage ratio
    
    
    8.38
    %
    
    
    4.0
    %
    
    
    5.0
    %
 Page 20




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##### 



Management expects that the Company will remain well-capitalized for
regulatory purposes, although there can be no assurance that additional capital
will not be required in the near future due to greater-than-expected growth, or
otherwise. CONTRACTUAL OBLIGATIONS AND COMMITMENTS In the normal course of business there are various outstanding contractual
obligations of the Company that will require future cash outflows. In
addition, there are commitments and contingent liabilities, such as commitments
to extend credit, that may or may not require future cash outflows. The
following table reflects contractual obligations of the Company outstanding as
of December 31, 2003. Payments Due by PeriodOn DemandOr Within
    
    
    
    
    
    
    
    
    
    AfterContractual Obligations
    
    Total
    
    1 Year
    
    2-3 Years
    
    4-5 Years
    
    5 Years(In thousands)Federal funds purchased
    
    $
    6,000
    
    
    $
    6,000
    
    
    $
    
    
    
    $
    
    
    
    $
    FHLB advances
    
    
    36,000
    
    
    
    18,000
    
    
    
    6,000
    
    
    
    12,000
    
    
    
    Trust preferred securities
    
    
    8,000
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    8,000Lease obligations
    
    
    3,305
    
    
    
    437
    
    
    
    778
    
    
    
    556
    
    
    
    1,534Deposits
    
    
    237,997
    
    
    
    202,661
    
    
    
    34,295
    
    
    
    1,041
    
    
    
    Total contractual cash obligations
    
    $
    291,302
    
    
    $
    227,098
    
    
    $
    41,073
    
    
    $
    13,597
    
    
    $
    9,534
 The following table reflects other commitments of the company outstanding
as of December 31, 2003. Amount of Commitment Expiration Per PeriodTotalAmounts
    
    Within
    
    
    
    
    
    
    
    
    
    AfterOther Commitments
    
    Committed
    
    1 Year
    
    2-3 Years
    
    4-5 Years
    
    5 Years(In thousands)Undisbursed home equity credit lines
    
    $
    10,187
    
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    10,187Other commitments and credit lines
    
    
    46,520
    
    
    
    46,520
    
    
    
    
    
    
    
    
    
    
    
    Undisbursed portion of construction loans
    
    
    26,523
    
    
    
    26,523
    
    
    
    
    
    
    
    
    
    
    
    Standby letters of credit
    
    
    2,377
    
    
    
    2,377
    
    
    
    
    
    
    
    
    
    
    
    Total other commitments
    
    $
    85,607
    
    
    $
    75,420
    
    
    $
    
    
    
    $
    
    
    
    $
    10,187
 In the normal course of business, the Company may enter into purchase
agreements for goods or services. In managements opinion, the dollar amount
of such agreements at December 31, 2003 is not material and has not been
included in the above table. ASSET/LIABILITY MANAGEMENT The Companys results of operations depend substantially on its net interest
income. Like most financial institutions, the Banks interest income and cost
of funds are affected by general economic conditions and by competition in the
market place. The purpose of asset/liability management is to provide stable
net interest income growth by protecting the Companys earnings from undue
interest rate risk, which arises from volatile interest rates and changes in
the balance sheet mix, and by managing the risk/return relationships between
liquidity, interest rate risk, market risk, and capital adequacy. The Company
maintains, and has complied with, a Board approved asset/liability management
policy that provides guidelines for controlling exposure to interest rate risk
by utilizing the following ratios and trend analysis: liquidity, equity,
volatile liability dependence, portfolio maturities, maturing assets and
maturing liabilities. The Companys policy is to control the exposure of its
earnings to changing interest rates by generally endeavoring to Page 21




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maintain a position within a narrow range around an earnings neutral
position, which is defined as the mix of assets and liabilities that generate
a net interest margin that is least affected by interest rate changes. When suitable lending opportunities are not sufficient to utilize available
funds, the Company has generally invested such funds in securities, primarily
U.S. Treasury securities, securities issued by governmental agencies,
mortgage-backed securities and corporate obligations. The securities portfolio
contributes to the Companys profits and plays an important part in the overall
interest rate management. However, management of the securities portfolio alone
cannot balance overall interest rate risk. The securities portfolio must be
used in combination with other asset/liability techniques to actively manage
the balance sheet. The primary objectives in the overall management of the
securities portfolio are safety, liquidity, yield, asset/liability management
(interest rate risk), and investing in securities that can be pledged for
public deposits. In reviewing the needs of the Company with regard to proper management of its
asset/liability program, the Companys management estimates its future needs,
taking into consideration historical periods of high loan demand and low
deposit balances, estimated loan and deposit increases (due to increased demand
through marketing), and forecasted interest rate changes. A number of measures
are used to monitor and manage interest rate risk, including income simulations
and interest sensitivity (gap) analyses. An income simulation model is the
primary tool used to assess the direction and magnitude of changes in net
interest income resulting from changes in interest rates. Key assumptions in
the model include prepayment speeds on mortgage-related assets, cash flows and
maturities of other investment securities, loan and deposit volumes and
pricing. These assumptions are inherently uncertain and, as a result, the model
cannot precisely estimate net interest income or precisely predict the impact
of higher or lower interest rates on net interest income. Actual results will
differ from simulated results due to timing, magnitude and frequency of
interest rate changes and changes in market conditions and management
strategies, among other factors. Based on the results of the income simulation model as of December 31, 2003,
the Company would expect an increase in net interest income of $245,000 if
interest rates increase from current rates by 100 basis points and a decrease
in net interest income of $444,000 if interest rates decrease from current
rates by 100 basis points. The analysis of an institutions interest rate gap (the difference between the
repricing of interest-earning assets and interest-bearing liabilities during a
given period of time) is another standard tool for the measurement of the
exposure to interest rate risk. The Company believes that because interest rate
gap analysis does not address all factors that can affect earnings performance,
it should be used in conjunction with other methods of evaluating interest rate
risk. The following table sets forth the amounts of interest-earning assets and
interest-bearing liabilities outstanding at December 31, 2003 which are
projected to reprice or mature in each of the future time periods shown. Except
as stated below, the amounts of assets and liabilities shown which reprice or
mature within a particular period were determined in accordance with the
contractual terms of the assets or liabilities. Loans with adjustable rates are
shown as being due at the end of the next upcoming adjustment period. Money
market deposit accounts and negotiable order of withdrawal or other transaction
accounts are assumed to be subject to immediate repricing and depositor
availability and have been placed in the shortest period. In making the gap
computations, none of the assumptions sometimes made regarding prepayment rates
and deposit decay rates have been used for any interest-earning assets or
interest-bearing liabilities. In addition, the table does not reflect scheduled
principal payments which will be received throughout the lives of the loans.
The interest rate sensitivity of the Companys assets and liabilities
illustrated in the following table would vary substantially if different
assumptions were used or if actual experience differs from that indicated by
such assumptions. Page 22




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##### 



Terms to Repricing at December 31, 2003Over 3
    
    Total3 Months
    
    Months to
    
    Within
    
    Over 12or Less
    
    12 Months
    
    12 Months
    
    Months
    
    Total(Dollars in thousands)Interest-earning assets:Loans
    
    $
    115,360
    
    
    $
    28,551
    
    
    $
    143,911
    
    
    $
    87,829
    
    
    $
    231,740Interest-earning deposits
    
    
    5,152
    
    
    
    
    
    
    
    5,152
    
    
    
    
    
    
    
    5,152Investment securities available for sale
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    43,773
    
    
    
    43,773FHLB/FRB stock
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,772
    
    
    
    2,772Total interest-earning assets
    
    $
    120,512
    
    
    $
    28,551
    
    
    $
    149,063
    
    
    $
    134,374
    
    
    $
    283,437Percentage of total interest-earning assets
    
    
    42.52
    %
    
    
    10.07
    %
    
    
    52.59
    %
    
    
    47.41
    %
    
    
    100.00
    %Cumulative percentage to total interest-
earning assets
    
    
    42.52
    %
    
    
    52.59
    %
    
    
    52.59
    %
    
    
    100.00
    %
    
    
    100.00
    %Interest-bearing liabilities:Deposits:Savings, NOW and money market
    
    $
    74,438
    
    
    $
    
    
    
    $
    74,438
    
    
    $
    
    
    
    $
    74,438Time
    
    
    19,751
    
    
    
    74,000
    
    
    
    93,751
    
    
    
    32,809
    
    
    
    126,560Federal funds purchased
    
    
    6,000
    
    
    
    
    
    
    
    6,000
    
    
    
    
    
    
    
    6,000FHLB advances
    
    
    21,000
    
    
    
    5,000
    
    
    
    26,000
    
    
    
    10,000
    
    
    
    36,000Trust preferred securities
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    8,000
    
    
    
    8,000Total interest-bearing liabilities
    
    $
    121,189
    
    
    $
    79,000
    
    
    $
    200,189
    
    
    $
    50,809
    
    
    $
    250,998Percentage of total interest-bearing
liabilities
    
    
    48.28
    %
    
    
    31.47
    %
    
    
    79.76
    %
    
    
    20.24
    %
    
    
    100.00
    %Cumulative percentage of total interest-
bearing liabilities
    
    
    48.28
    %
    
    
    79.76
    %
    
    
    79.76
    %
    
    
    100.00
    %
    
    
    100.00
    %Interest sensitivity gap
    
    $
    (677
    )
    
    $
    (50,449
    )
    
    $
    (51,126
    )
    
    $
    83,565
    
    
    $
    32,439Cumulative interest sensitivity gap
    
    $
    (677
    )
    
    $
    (51,126
    )
    
    $
    (51,126
    )
    
    $
    32,439
    
    
    $
    32,439Cumulative interest sensitivity gap as a
percentage of total interest-earning assets
    
    
    (0.24
    )%
    
    
    (18.04
    )%
    
    
    (18.04
    )%
    
    
    11.44
    %
    
    
    11.44
    %Cumulative ratio of interest-sensitive assets
to interest-sensitive liabilities
    
    
    99.44
    %
    
    
    74.46
    %
    
    
    74.46
    %
    
    
    112.92
    %
    
    
    112.92
    %
 The table illustrates that if assets and liabilities reprice in the time
intervals indicated in the table, the Company is asset sensitive within three
months, liability sensitive within twelve months, and asset sensitive
thereafter. As stated above, certain shortcomings are inherent in the method of
analysis presented in the foregoing table. For example, although certain assets
and liabilities may have similar maturities or periods to repricing, they may
react in different degrees to
changes in market interest rates. Also, the interest rates on certain types of
assets and liabilities may fluctuate in advance of changes in market interest
rates, while interest rates on other types may lag behind changes in market
interest rates. For instance, while the table is based on the assumption that
interest-bearing demand accounts, money market accounts and savings accounts
are immediately sensitive to movements in rates, the Company expects that in a
changing rate environment the amount of the adjustment in interest rates for
such accounts would be less than the adjustment in categories of assets which
are considered to be immediately sensitive. Additionally, certain assets have
features which restrict changes in the interest rates of such assets both on a
short-term basis and over the lives of such assets. Further, in the event of a
change in market interest rates, prepayment and early withdrawal levels could
deviate significantly from those assumed in calculating the tables. Finally,
the ability of many borrowers to service their adjustable-rate debt may
decrease in the event of an increase in market interest rates. Due to these
shortcomings, the Company places primary emphasis on its income simulation
model when managing its exposure to changes in interest rates. Page 23




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CRITICAL ACCOUNTING POLICIES The preparation of the Companys audited consolidated financial statements and
the information included in managements discussion and analysis is governed by
policies that are based on accounting principles generally accepted in the
United States of America and general practices within the banking industry.
Among the more significant policies are those that govern accounting for loans
and allowance for loan losses and goodwill. These policies are discussed in
Note B of the Notes To Consolidated Financial Statements included in this
Annual Report. A critical accounting policy is one that is both very important to the
portrayal of the Companys financial condition and results, and requires a
difficult, subjective or complex judgment by management. What makes these
judgments difficult, subjective and/or complex is the need to make estimates
about the effects of matters that are inherently uncertain. Estimates and
judgments are integral to our accounting for certain items, and those estimates
and judgments affect the reported amounts of assets, liabilities, revenues,
expenses and related disclosure of contingent assets and liabilities. The
Company periodically evaluates its estimates, including those related to the
allowance for loan losses and goodwill. While we base our estimates on
historical experience and on various other assumptions that we believe to be
reasonable under the circumstances, actual results may differ from these
estimates under different assumptions or conditions. Further information
regarding the accounting policies that we consider to be critical is provided
below. Allowance for loan losses. The Companys most significant critical accounting
policy is the determination of its allowance for loan losses. The allowance
for loan losses reflects the estimated losses that will result from the
inability of our customers to make required payments. The allowance for loan
losses results from managements evaluation of the risk characteristics of the
loan portfolio under current economic conditions and considers such factors as
the financial condition of the borrower, fair market value of collateral and
other items that, in our opinion, deserve current recognition in estimating
possible credit losses. Our evaluation process is based on historical evidence
and current trends among delinquencies, defaults and nonperforming assets. Our
estimate of the allowance for loan losses does not include the impact of events
that might occur in the future. Management considers the established allowance adequate to absorb losses that
relate to loans outstanding at December 31, 2003, although future additions to
the allowance may be necessary based on changes in economic conditions and
other factors. In addition, various regulatory agencies, as an integral part
of their examination process, periodically review the allowance for loan
losses. Such agencies may require adjustments to the allowance based on their
judgments of information available to them at the time of their examination.
If the financial condition of our borrowers were to deteriorate, resulting in
an impairment of their ability to make payments, our estimates would be
updated, and additional provisions may be required. For further information on
the allowance for loan losses, see Financial Condition in Managements
Discussion and Analysis and Note 3 of the Notes to Consolidated Financial
Statements included in this Annual Report. Goodwill. Goodwill, which represents the excess of the purchase price over the
fair value of net assets acquired in a business combination, is tested at least
annually for impairment. The impairment test is a two-step process that begins
with an initial impairment evaluation. If the initial evaluation suggests that
an impairment of the asset value exists, the second step would determine the
amount of the impairment, if any. If the tests conclude that goodwill is
impaired, the carrying value would be adjusted, and an impairment loss would be
recorded. FORWARD LOOKING STATEMENTS Statements contained in this annual report, which are not historical facts, are
forward-looking statements, as that term is defined in the Private Securities
Litigation Reform Act of 1995. Amounts herein could vary as a result of market
and other factors. Such forward-looking statements are subject to risks and
uncertainties which could cause actual results to differ materially from those
currently anticipated due to a number of factors, which include, but are not
limited to, factors discussed in documents filed by the Company with the
Securities and Commission and the Bank with the Federal Reserve Bank from time
to time. Such forward-looking statements may be identified by the use of such
words as believe, expect, anticipate, should, planned, estimated,
and potential. Examples of forward-looking statements include, but are not
limited to, estimates with respect to the financial condition, expected or
anticipated revenue, results of operations and business of the Company that are
subject to various Page 24




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##### 



factors which could cause actual results to differ materially from these
estimates. These factors include, but are not limited to, general economic
conditions, changes in interest rates, deposit flows, loan demand, real estate
values, and competition; changes in accounting principles, policies, or
guidelines; changes in legislation or regulations; and other economic,
competitive, governmental, regulatory, and technological factors affecting the
Companys operations, pricing, products and services. OFF-BALANCE SHEET ARRANGEMENTS Information about the Companys off-balance sheet risk exposure is presented in
Note L to the accompanying financial statements. As part of its ongoing
business, the Company does not participate in transactions that generate
relationships with unconsolidated entities or financial partnerships, such as
entities often referred to as special purpose entities (SPEs), which generally
are established for the purpose of facilitating off-balance sheet arrangements
or other contractually narrow or limited purposes. As of December 31, 2003,
the Company is not involved in any unconsolidated SPE transactions. RECENT ACCOUNTING PRONOUNCEMENTS See Note B to the consolidated financial statements for a full description of
recent accounting pronouncements including the respective expected dates of
adoption and effects on results of operations and financial condition. LENDING ACTIVITIES General. The Company provides to its customers a full range of short- to
medium-term commercial, agricultural, Small Business Administration guaranteed,
Farmers Home Administration guaranteed, mortgage, construction and personal
loans, both secured and unsecured. The Bank also makes real estate mortgage and
construction loans. The Companys loan policies and procedures establish the basic guidelines
governing its lending operations. Generally, the guidelines address the types
of loans that the Company seeks, target markets, underwriting and collateral
requirements, terms, interest rate and yield considerations and compliance with
laws and regulations. All loans or credit lines are subject to approval
procedures and amount limitations. These limitations apply to the borrowers
total outstanding indebtedness to the Company, including the indebtedness of
any guarantor. The policies are reviewed and approved at least annually by the
Board of Directors of the Company. The Company supplements its own supervision
of the loan underwriting and approval process with periodic loan audits by
internal loan examiners and outside professionals experienced in loan review
work. The Company has focused its portfolio lending activities on typically
higher yielding commercial, construction and consumer loans rather than lower
yielding 1-4 family mortgages which the Company typically sells in the
secondary market. The following table sets forth at the dates indicated the
Companys loan portfolio composition by type of loan: At December 31,2003
    
    2002Percent
    
    
    
    
    
    PercentAmount
    
    of Total
    
    Amount
    
    of Total(Dollars in thousands)Commercial
    
    $
    52,554
    
    
    
    22.7
    %
    
    $
    42,767
    
    
    
    26.5
    %Real estate  construction
    
    
    55,970
    
    
    
    24.2
    %
    
    
    22,861
    
    
    
    14.2
    %Real estate  commercial mortgage
    
    
    67,952
    
    
    
    29.3
    %
    
    
    48,362
    
    
    
    29.9
    %Real estate  1-4 family mortgage
    
    
    32,191
    
    
    
    13.9
    %
    
    
    31,957
    
    
    
    19.8
    %Consumer
    
    
    10,458
    
    
    
    4.5
    %
    
    
    7,707
    
    
    
    4.7
    %Home equity lines of credit
    
    
    12,615
    
    
    
    5.4
    %
    
    
    7,834
    
    
    
    4.9
    %Subtotal
    
    
    231,740
    
    
    
    100.00
    %
    
    
    161,488
    
    
    
    100.00
    %Less: Allowance for loan losses
    
    
    (2,759
    )
    
    
    
    
    
    
    (1,721
    )Net loans
    
    $
    228,981
    
    
    
    
    
    
    $
    159,767
 Page 25




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At December 31,2001
    
    2000Percent
    
    
    
    
    
    PercentAmount
    
    of Total
    
    Amount
    
    of Total(Dollars in thousands)Commercial
    
    $
    61,364
    
    
    
    57.2
    %
    
    $
    35,656
    
    
    
    47.0
    %Real estate  construction
    
    
    10,050
    
    
    
    9.4
    %
    
    
    6,421
    
    
    
    8.4
    %Real estate  commercial mortgage
    
    
    15,401
    
    
    
    14.3
    %
    
    
    15,746
    
    
    
    20.8
    %Real estate  1-4 family mortgage
    
    
    7,074
    
    
    
    6.6
    %
    
    
    7,241
    
    
    
    9.5
    %Consumer
    
    
    7,692
    
    
    
    7.2
    %
    
    
    6,594
    
    
    
    8.7
    %Home equity lines of credit
    
    
    5,659
    
    
    
    5.3
    %
    
    
    4,264
    
    
    
    5.6
    %Subtotal
    
    
    107,240
    
    
    
    100.0
    %
    
    
    75,922
    
    
    
    100.0
    %Less: Allowance for loan losses
    
    
    (1,435
    )
    
    
    
    
    
    
    (1,028
    )Net loans
    
    $
    105,805
    
    
    
    
    
    
    $
    74,894
 At December 31,1999PercentAmount
    
    of Total(Dollars in thousands)Commercial
    
    $
    13,564
    
    
    
    45.9
    %Real estate  construction
    
    
    2,606
    
    
    
    8.8
    %Real estate  commercial mortgage
    
    
    4,815
    
    
    
    16.3
    %Real estate  1-4 family mortgage
    
    
    3,674
    
    
    
    12.4
    %Consumer
    
    
    3,729
    
    
    
    12.6
    %Home equity lines of credit
    
    
    1,186
    
    
    
    4.0
    %Subtotal
    
    
    29,574
    
    
    
    100.0
    %Less: Allowance for loan losses
    
    
    (462
    )Net loans
    
    $
    29,112
 The following table presents, at December 31, 2003, (i) the aggregate
maturities or repricings of loans in the named categories of the Companys loan
portfolio and (ii) the aggregate amounts of such loans maturing or repricing
after one year by fixed and variable rates: Within 1 Year
    
    1-5 Years
    
    After 5 Years
    
    Total(Dollars in thousands)Commercial
    
    $
    42,159
    
    
    $
    9,598
    
    
    $
    797
    
    
    $
    52,554Real estate  construction
    
    
    44,374
    
    
    
    10,922
    
    
    
    674
    
    
    
    55,970Total
    
    $
    86,533
    
    
    $
    20,520
    
    
    $
    1,471
    
    
    $
    108,524Fixed rate loans
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    21,991Variable rate loans
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    21,991
 Commercial Loans.Commercial business lending is a primary focus of the
Companys lending activities. At December 31, 2003, the Companys commercial
loan portfolio equaled $52.6 million or 22.7% of total loans, as compared with
$42.8 million or 26.5% of total loans at December 31, 2002. Commercial loans
include both secured Page 26




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##### 



and unsecured loans for working capital, expansion, and other business
purposes. Short-term working capital loans generally are secured by accounts
receivable, inventory and/or equipment. The Company also makes term commercial
loans secured by equipment and real estate. Lending decisions are based on an
evaluation of the financial strength, management and credit history of the
borrower, and the quality of the collateral securing the loan. With few
exceptions, the Company requires personal guarantees and secondary sources of
repayment. Commercial loans generally provide greater yields and reprice more frequently
than other types of loans, such as real estate loans. More frequent repricing
means that yields on our commercial loans adjust with changes in interest
rates. Real Estate Loans.Real estate loans are made for purchasing, constructing and
refinancing one to four family, five or more family and commercial properties.
The Company offers fixed and adjustable rate options. The Company provides
customers access to long-term conventional real estate loans through its
mortgage loan department which makes Federal National Mortgage Association
(FNMA)  conforming loans for the account of third parties. At December 31, 2003, the Companys residential one to four family loans
amounted to $32.2 million or 13.9% of total loans as compared with $32.0
million or 19.8% of total loans at December 31, 2002. The Companys residential
mortgage loans are secured by properties located within the Companys market
area. Most of the one to four family residential mortgage loans that the
Company makes are originated for the account of third parties. Such loans are
closed by the third party and therefore are not shown in the Companys
financial statements. The Company receives a fee for each such loan originated,
with such fees aggregating $647,000 for the year ended December 31, 2003 and
$422,000 for the year ended December 31, 2002. The Company anticipates that it
will continue to be an active originator of residential loans for the account
of third parties. The Company has made, and anticipates continuing to make, commercial real
estate loans. Commercial real estate loans equaled $68.0 or 29.3% of total
loans at December 31, 2003 and $48.4 million or 29.9% of total loans at
December 31, 2002. This lending has involved loans secured principally by
commercial buildings for office, storage and warehouse space, and by
agricultural properties. Generally in underwriting commercial real estate
loans, the Company requires the personal guaranty of borrowers and a
demonstrated cash flow capability sufficient to service the debt. Loans secured
by commercial real estate may be in greater amount and involve a greater degree
of risk than one to four family residential mortgage loans. Payments on such
loans are often dependent on successful operation or management of the
properties. The Company originates one to four family residential construction loans for
the construction of custom homes (where the home buyer is the borrower) and
provides financing to builders and consumers for the construction of pre-sold
homes. Real estate construction loans amounted to $56.0 million or 24.2% of
total loans at December 31, 2003 and $22.9 million or 14.2% of total loans at
December 31, 2002. The Company generally receives a pre-arranged permanent
financing commitment from an outside entity prior to financing the construction
of pre-sold homes. The Company lends to builders who have demonstrated a
favorable record of performance and profitable operations and who are building
in markets that management believes it understands and in which it is
comfortable with the economic conditions. The Company also makes commercial
real estate construction loans, generally for owner-occupied properties. The
Company further endeavors to limit its construction lending risk through
adherence to established underwriting procedures. Also, the Company generally
requires documentation of all draw requests and utilizes loan officers to
inspect the project prior to paying any draw requests from the builder. With
few exceptions, the Company requires personal guarantees and secondary sources
of repayment on construction loans. Consumer Loans and Home Equity Lines of Credits.Loans to individuals include
automobile loans, boat and recreational vehicle financing, home equity and home
improvement loans and miscellaneous secured and unsecured personal loans.
Consumer loans generally can carry significantly greater risks than other
loans, even if secured, if the collateral consists of rapidly depreciating
assets such as automobiles and equipment. Repossessed collateral securing a
defaulted consumer loan may not provide an adequate source of repayment of the
loan. Consumer loan collections are sensitive to job loss, illness and other
personal factors. The Company attempts to manage the risks inherent in consumer
lending by following established credit guidelines and underwriting practices
designed to minimize risk of loss. Page 27




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##### 



Loan Approvals.The Companys loan policies and procedures establish the basic
guidelines governing its lending operations. Generally, the guidelines address
the type of loans that the Company seeks, target markets, underwriting and
collateral requirements, terms, interest rate and yield considerations and
compliance with laws and regulations. All loans or credit lines are subject to
approval procedures and amount limitations. These limitations apply to the
borrowers total outstanding indebtedness to the Company, including the
indebtedness of any guarantor. The policies are reviewed and approved at least
annually by the Board of Directors of the Company. The Company supplements its
own supervision of the loan underwriting and approval process with periodic
loan audits by independent, outside professionals experienced in loan review
work. Commitments and Contingent Liabilities In the ordinary course of business, the Company enters into various types of
transactions that include commitments to extend credit that are not included in
loans receivable, net, presented on the Companys consolidated balance sheets.
The Company applies the same credit standards to these commitments as it uses
in all its lending activities and has included these commitments in its lending
risk evaluations. The Companys exposure to credit loss under commitments to
extend credit is represented by the amount of these commitments. See NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS. Asset Quality The Company considers asset quality to be of primary importance, and employs a
formal internal loan review process to ensure adherence to the Lending Policy
as approved by the Board of Directors. It is the responsibility of each lending
officer to assign an appropriate risk grade to every loan originated. Credit
Administration, through the loan review process, validates the accuracy of the
initial risk grade assessment. In addition, as a given loans credit quality
improves or deteriorates, it is Credit Administrations responsibility to
change the borrowers risk grade accordingly. The function of determining the
allowance for loan losses is fundamentally driven by the risk grade system. In
determining the allowance for loan losses and any resulting provision to be
charged against earnings, particular emphasis is placed on the results of the
loan review process. Consideration is also given to historical loan loss
experience, the value and adequacy of collateral, economic conditions in the
Companys market area and other factors. For loans determined to be impaired,
the allowance is based on discounted cash flows using the loans initial
effective interest rate or the fair value of the collateral for certain
collateral dependent loans. This evaluation is inherently subjective as it
requires material estimates, including the amounts and timing of future cash
flows expected to be received on impaired loans that may be susceptible to
significant change. The allowance for loan losses represents managements
estimate of the appropriate level of reserve to provide for probable losses
inherent in the loan portfolio. The Companys policy regarding past due loans normally requires a prompt
charge-off to the allowance for loan losses following timely collection efforts
and a thorough review. Further efforts are then pursued through various means
available. Loans carried in a non-accrual status are generally collateralized
and probable losses are considered in the determination of the allowance for
loan losses. Page 28




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##### 



Nonperforming Assets The table sets forth, for the period indicated, information with respect to the
Companys nonaccrual loans, restructured loans, total nonperforming loans
(nonaccrual loans plus restructured loans), and total nonperforming assets. At December 31,2003
    
    2002
    
    2001
    
    2000
    
    1999(Dollars in thousands)Nonaccrual loans
    
    $
    1,210
    
    
    $
    1,328
    
    
    $
    
    
    
    $
    
    
    
    $
    Restructured loans
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Total nonperforming loans
    
    
    1,210
    
    
    
    1,328
    
    
    
    
    
    
    
    
    
    
    
    Real estate owned
    
    
    
    
    
    
    230
    
    
    
    230
    
    
    
    
    
    
    
    Total nonperforming assets
    
    $
    1,210
    
    
    $
    1,558
    
    
    $
    230
    
    
    $
    
    
    
    $
    Accruing loans past due 90 days or more
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    4
    
    
    $
    Potential problem loans
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Allowance for loan losses
    
    
    2,759
    
    
    
    1,721
    
    
    
    1,435
    
    
    
    1,028
    
    
    
    462Nonperforming loans to period end loans
    
    
    0.52
    %
    
    
    0.82
    %
    
    
    
    
    
    
    
    
    
    
    Allowance for loan losses to
period end loans
    
    
    1.19
    %
    
    
    1.07
    %
    
    
    1.34
    %
    
    
    1.35
    %
    
    
    1.56
    %Allowance for loan losses to
nonperforming loans
    
    
    228.02
    %
    
    
    129.59
    %
    
    
    
    
    
    
    
    
    
    
    Nonperforming assets to total assets
    
    
    0.38
    %
    
    
    0.67
    %
    
    
    0.14
    %
    
    
    
    
    
    
    
 Our consolidated 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 in 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. At
December 31, 2003, we had $1.2 million of nonaccrual loans consisting primarily
of loans outstanding to one borrower. These loans are cross collateralized and
are secured by real estate. The borrower, as a result of cash flow problems,
has filed for protection under Chapter 11 of the bankruptcy code, during which
time the Company is not receiving regular interest payments. Accordingly,
Management has placed these loans in nonaccrual status. Management does not
anticipate that the Company will incur any significant loss on these loans. Real estate owned consists of foreclosed, repossessed and idled properties. At
December 31, 2003 the Company had no real estate owned. Page 29




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##### 



Analysis of Allowance for Loan Losses Our allowance for loan losses is established through charges to earnings in the
form of a provision for loan losses. We increase our allowance for loan losses
by provisions charged to operations and by recoveries of amounts previously
charged off, and we reduce our allowance by loans charged off. We evaluate the
adequacy of the allowance at least quarterly. In addition, on a quarterly basis
our board of directors reviews our loan portfolio, conducts an evaluation of
our credit quality and reviews our computation of the loan loss provision,
recommending changes as may be required. In evaluating the adequacy of the
allowance, we consider the growth, composition and industry diversification of
the portfolio, historical loan loss experience, current delinquency levels,
adverse situations that may affect a borrowers ability to repay, estimated
value of any underlying collateral, prevailing economic conditions and other
relevant factors deriving from our limited history of operations. Because we
have a limited history of our own, we also consider the loss experience and
allowance levels of other similar banks and the historical experience
encountered by our management and senior lending officers prior to joining us.
In addition, regulatory agencies, as an integral part of their examination
process, periodically review our allowance for loan losses and may require us
to make adjustments to the allowance based upon judgments different from those
of our management. We use our risk grading program, as described under Asset Quality, to
facilitate our evaluation of probable inherent loan losses and the adequacy of
the allowance for loan losses. In this program, risk grades are initially
assigned by loan officers and reviewed by Credit Administration, and tested by
our internal auditor. The testing program includes an evaluation of a sample of
new loans, large loans, loans that are identified as having potential credit
weaknesses, loans past due 90 days or more, and nonaccrual loans. We strive to
maintain our loan portfolio in accordance with conservative loan underwriting
policies that result in loans specifically tailored to the needs of our market
area. Every effort is made to identify and minimize the credit risks associated
with such lending strategies. We have no foreign loans and we do not engage in
significant lease financing or highly leveraged transactions. We follow a loan review program designed to evaluate the credit risk in our
loan portfolio. Through this loan review process, we maintain an internally
classified watch list that helps management assess the overall quality of the
loan portfolio and the adequacy of the allowance for loan losses. In
establishing the appropriate classification for specific assets, management
considers, among other factors, the estimated value of the underlying
collateral, the borrowers ability to repay, the borrowers payment history and
the current delinquent status. As a result of this process, certain loans are
categorized as substandard, doubtful or loss and reserves are allocated based
on managements judgment and historical experience. Loans classified as substandard are those loans with clear and defined
weaknesses such as unfavorable financial ratios, uncertain repayment sources or
poor financial condition that may jeopardize the liquidation of the debt. They
are characterized by the distinct possibility that we will sustain some losses
if the deficiencies are not corrected. A reserve of 15% is generally allocated
to these loans. Loans classified as doubtful are those loans that have
characteristics similar to substandard loans but with an increased risk that
collection or liquidation in full is highly questionable and improbable. A
reserve of 50% is generally allocated to loans classified as doubtful. Loans
classified as loss are considered uncollectible and of such little value that
their continuance as bankable assets is not warranted. This classification does
not mean that the loan has absolutely no recovery or salvage value but rather
it is not practical or desirable to defer writing off this asset even though
partial recovery may be achieved in the future. As a practical matter, when
loans are identified as loss they are charged off against the allowance for
loan losses. In addition to the above classification categories, we also
categorize loans based upon risk grade and loan type, assigning an allowance
allocation based upon each category. Growth in loans outstanding has, throughout our history, been the primary
reason for increases in our allowance for loan losses and the resultant
provisions for loan losses necessary to provide for those increases. This
growth has been spread among our major loan categories, with the concentrations
of major loan categories being relatively consistent. Between December 31, 1999
and December 31, 2003, the range of each major category of loans as a
percentage of total loans outstanding is as follows: residential mortgage loans
 6.6% to 19.8%; commercial mortgage loans  14.3% to 29.9%; construction loans
- 8.4% to 24.2%; commercial and industrial loans  22.7% to 57.2%; loans to
individuals  4.5% to 12.6%; and home equity lines of credit  4.0% to 5.6%.
For all fiscal years through 2003, our net loan charge-offs in each year were
no more than .15% of average loans outstanding. Because Page 30




---



##### 



of this sustained trend of low loss experience, and based upon our assessment
of probable loss, we have set our allowance for loan losses at December 31,
2003 at $2.8 million, representing 1.19% of total loans outstanding. 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. We make specific allowances that are allocated to
certain individual loans and pools of loans based on risk characteristics, as
discussed below. In addition to the allocated portion of the allowance for loan
losses, we maintain an unallocated portion that is not assigned to any specific
category of loans. This unallocated portion is intended to reserve for the
inherent risk in the portfolio and the intrinsic inaccuracies associated with
the estimation of the allowance for loan losses and its allocation to specific
loan categories. While management believes that it uses the best information
available to establish the allowance for loan losses, future adjustments to the
allowance may be necessary and results of operations could be adversely
affected if circumstances differ substantially from the assumptions used in
making the determinations. Furthermore, while we believe we have established
the allowance for loan losses in conformity with generally accepted accounting
principles, there can be no assurance that regulators, in reviewing our
portfolio, will not require an increase in our allowance for loan losses. In
addition, because future events affecting borrowers and collateral cannot be
predicted with certainty, there can be no assurance that the existing allowance
for loan losses is adequate or that increases will not be necessary should the
quality of any loans deteriorate as a result of the factors discussed herein.
Any material increase in the allowance for loan losses may adversely affect our
financial condition and results of operations. The following table shows the allocation of the allowance for loan losses at
the dates indicated. The allocation is based on an evaluation of defined loan
problems, historical ratios of loan losses and other factors that may affect
future loan losses in the categories of loans shown. At December 31,2003
    
    2002% of Total
    
    
    
    
    
    % of TotalAmount
    
    Loans(1)
    
    Amount
    
    Loans(1)(Dollars in thousands)Balance applicable to:Commercial
    
    $
    683
    
    
    
    22.7
    %
    
    $
    482
    
    
    
    26.5
    %Real estate  construction
    
    
    672
    
    
    
    24.2
    %
    
    
    229
    
    
    
    14.2
    %Real estate  mortgage
    
    
    1,102
    
    
    
    43.2
    %
    
    
    803
    
    
    
    49.7
    %Consumer
    
    
    125
    
    
    
    4.5
    %
    
    
    77
    
    
    
    4.7
    %Home equity lines of credit
    
    
    139
    
    
    
    5.4
    %
    
    
    78
    
    
    
    4.9
    %Unallocated
    
    
    38
    
    
    
    
    
    
    
    52
    
    
    
    Total
    
    $
    2,759
    
    
    
    100.0
    %
    
    $
    1,721
    
    
    
    100.0
    %
 At December 31,2001
    
    2000% of Total
    
    
    
    
    
    % of TotalAmount
    
    Loans(1)
    
    Amount
    
    Loans(1)(Dollars in thousands)Balance applicable to:Commercial
    
    $
    900
    
    
    
    57.2
    %
    
    $
    581
    
    
    
    47.0
    %Real estate  construction
    
    
    120
    
    
    
    9.4
    %
    
    
    90
    
    
    
    8.4
    %Real estate  mortgage
    
    
    150
    
    
    
    20.9
    %
    
    
    230
    
    
    
    30.3
    %Consumer
    
    
    90
    
    
    
    7.2
    %
    
    
    79
    
    
    
    8.7
    %Home equity lines of credit
    
    
    50
    
    
    
    5.3
    %
    
    
    47
    
    
    
    5.6
    %Unallocated
    
    
    125
    
    
    
    
    
    
    
    1
    
    
    
    Total
    
    $
    1,435
    
    
    
    100.0
    %
    
    $
    1,028
    
    
    
    100.0
    %
 Page 31




---



##### 



At December 31,1999% of TotalAmount
    
    Loans(1)(Dollars in thousands)Balance applicable to:Commercial
    
    $
    203
    
    
    
    45.9
    %Real estate  construction
    
    
    35
    
    
    
    8.8
    %Real estate  mortgage
    
    
    49
    
    
    
    28.7
    %Consumer
    
    
    65
    
    
    
    12.6
    %Home equity lines of credit
    
    
    12
    
    
    
    4.0
    %Unallocated
    
    
    98
    
    
    
    Total
    
    $
    462
    
    
    
    100.0
    %
  (1)
    
    Represents total of all outstanding loans in each category as a percent of
total loans outstanding. The following table sets forth for the periods indicated information regarding
changes in the Companys allowance for loan losses: At or for the Years Ended December 31,2003
    
    2002
    
    2001
    
    2000
    
    1999(Dollars in thousands)Balance at beginning of period
    
    $
    1,721
    
    
    $
    1,435
    
    
    $
    1,028
    
    
    $
    462
    
    
    $
    10Charge-offs:Commercial
    
    
    (195
    )
    
    
    (146
    )
    
    
    (20
    )
    
    
    
    
    
    
    Real estate
    
    
    
    
    
    
    (18
    )
    
    
    
    
    
    
    
    
    
    
    Consumer
    
    
    (20
    )
    
    
    (30
    )
    
    
    (17
    )
    
    
    (7
    )
    
    
    (3
    )Home equity lines of credit
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Total charge-offs
    
    
    (215
    )
    
    
    (194
    )
    
    
    (37
    )
    
    
    (7
    )
    
    
    (3
    )Recoveries:Commercial
    
    
    1
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Real estate
    
    
    
    
    
    
    
    
    
    
    4
    
    
    
    
    
    
    
    Home equity lines of credit
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Total recoveries
    
    
    1
    
    
    
    
    
    
    
    4
    
    
    
    
    
    
    
    Net charge-offs
    
    
    (214
    )
    
    
    (194
    )
    
    
    (33
    )
    
    
    (7
    )
    
    
    (3
    )Allowance for loan losses on
loans purchased
    
    
    52
    
    
    
    
    
    
    
    
    
    
    
    91
    
    
    
    Provision for loan losses charged
to operations
    
    
    1,200
    
    
    
    480
    
    
    
    440
    
    
    
    482
    
    
    
    455Balance at end of period
    
    $
    2,759
    
    
    $
    1,721
    
    
    $
    1,435
    
    
    $
    1,028
    
    
    $
    462Ratio of net loan charge-offs to
average loans outstanding
    
    
    0.11
    %
    
    
    0.15
    %
    
    
    0.04
    %
    
    
    0.01
    %
    
    
    0.02
    %
 INVESTMENT ACTIVITIES The Companys portfolio of investment securities, all of which are available
for sale, consists primarily of U.S. Treasury and government agency securities,
and mortgage-backed securities. Securities to be held for indefinite periods of
time and not intended to be held to maturity are classified as available for
sale and carried at fair value Page 32




---



##### 



with any unrealized gains or losses reflected as an adjustment to stockholders
equity. Securities held for indefinite
periods of time include securities that management intends to use as part of
its asset/liability management strategy and that may be sold in response to
changes in interest rates and/or significant prepayment risks. It is the
Companys policy to classify all investment securities as available for sale.
The following table summarizes the amortized costs, gross unrealized gains and
losses and the resulting market value of securities available for sale: Gross
    
    GrossAmortized
    
    Unrealized
    
    Unrealized
    
    MarketCost
    
    Gains
    
    Losses
    
    Value(Dollars in thousands)December 31, 2003U.S. government agencies
    
    $
    24,678
    
    
    $
    147
    
    
    $
    50
    
    
    $
    24,775Corporate debt securities
    
    
    2,083
    
    
    
    75
    
    
    
    
    
    
    
    2,158Mortgage-backed securities
    
    
    16,725
    
    
    
    160
    
    
    
    45
    
    
    
    16,840$
    43,486
    
    
    $
    382
    
    
    $
    95
    
    
    $
    43,773December 31, 2002U.S. government agencies
    
    $
    24,020
    
    
    $
    293
    
    
    $
    
    
    
    $
    24,313Corporate debt securities
    
    
    1,397
    
    
    
    41
    
    
    
    
    
    
    
    1,438Mortgage-backed securities
    
    
    18,496
    
    
    
    355
    
    
    
    1
    
    
    
    18,850$
    43,913
    
    
    $
    689
    
    
    $
    1
    
    
    $
    44,601December 31, 2001U.S. government agencies
    
    $
    16,807
    
    
    $
    94
    
    
    $
    65
    
    
    $
    16,836Corporate debt securities
    
    
    377
    
    
    
    
    
    
    
    1
    
    
    
    376Mortgage-backed securities
    
    
    13,844
    
    
    
    170
    
    
    
    
    
    
    
    14,014$
    31,028
    
    
    $
    264
    
    
    $
    66
    
    
    $
    31,226
 The following table summarizes the amortized costs, fair values and weighted
average yields of securities available-for-sale at December 31, 2003, by
contractual maturity groups: WeightedAmortized
    
    Fair
    
    AverageCost
    
    Value
    
    Yield(Dollars in thousands)Securities available for sale:U.S. Government agencies:Due after one but within five years
    
    $
    11,024
    
    
    $
    11,086
    
    
    
    3.33
    %Due after five but within ten years
    
    
    13,654
    
    
    
    13,689
    
    
    
    3.38
    %24,678
    
    
    
    24,775
    
    
    
    3.36
    %Corporate debt securities:Due after one but within five years
    
    
    1,032
    
    
    
    1,074
    
    
    
    5.52
    %Due after five but within ten years
    
    
    1,051
    
    
    
    1,084
    
    
    
    5.36
    %2,083
    
    
    
    2,158
    
    
    
    5.27
    %Mortgage-backed securities:Due after one but within five years
    
    
    901
    
    
    
    919
    
    
    
    4.11
    %Due after five but within ten years
    
    
    3,017
    
    
    
    2,978
    
    
    
    2.80
    %Due after ten years
    
    
    12,807
    
    
    
    12,943
    
    
    
    4.27
    %16,725
    
    
    
    16,840
    
    
    
    4.00
    %Total securities available for sale:Due after one but within five years
    
    
    12,956
    
    
    
    13,079
    
    
    
    3.53
    %Due after five but within ten years
    
    
    17,723
    
    
    
    17,752
    
    
    
    3.39
    %Due after ten years
    
    
    12,807
    
    
    
    12,942
    
    
    
    4.27
    %$
    43,486
    
    
    $
    43,773
    
    
    
    3.69
    %
 Page 33




---



##### 



The Company does not engage in, nor does it presently intend to engage in,
securities trading activities and therefore does not maintain a trading
account. At December 31, 2003 there were no securities of any issuer (other
than governmental agencies) that exceeded 10% of the Companys shareholders
equity. SOURCES OF FUNDS Deposit Activities The Company provides a range of deposit services, including
non-interest-bearing checking accounts, interest-bearing checking and savings
accounts, money market accounts and certificates of deposit. These accounts
generally earn interest at rates established by management based on competitive
market factors and managements desire to increase or decrease certain types or
maturities of deposits. The Company has used brokered deposits as a funding
source. However, it strives to establish customer relations to attract core
deposits in non-interest-bearing transactional accounts and thus to reduce its
costs of funds. The following table sets forth for the periods indicated the average balances
outstanding and average interest rates for each major category of deposits. At December 31,2003
    
    2002
    
    2001Average
    
    Average
    
    Average
    
    Average
    
    Average
    
    AverageBalance
    
    Rate
    
    Balance
    
    Rate
    
    Balance
    
    Rate(Dollars in thousands)Interest-bearing NOW, money
market and savings accounts
    
    $
    55,852
    
    
    
    1.00
    %
    
    $
    28,131
    
    
    
    1.01
    %
    
    $
    19,534
    
    
    
    2.05
    %Time deposits
    
    
    125,100
    
    
    
    2.84
    %
    
    
    98,288
    
    
    
    3.54
    %
    
    
    72,753
    
    
    
    5.50
    %Total interest-bearing deposits
    
    
    180,952
    
    
    
    2.27
    %
    
    
    126,419
    
    
    
    2.98
    %
    
    
    92,287
    
    
    
    4.77
    %Demand and other non-interest-bearing
deposits
    
    
    27,943
    
    
    
    
    
    
    
    15,166
    
    
    
    
    
    
    
    9,489Total average deposits
    
    $
    208,895
    
    
    
    1.97
    %
    
    $
    141,585
    
    
    
    2.66
    %
    
    $
    101,776
    
    
    
    4.32
    %
 The following table sets forth at the dates indicated the amounts and
maturities of certificates of deposit with balances of $100,000 or more at
December 31, 2003: At December 31, 2003(Dollars in thousands)Remaining maturity:Less than three months
    
    $
    7,235Over three months through one year
    
    
    19,200Over one year through three years
    
    
    9,130Over three years through five years
    
    
    210Total
    
    $
    35,775
 Page 34




---



##### 



Borrowings As additional sources of funding, the Company uses advances from the Federal
Home Loan Bank of Atlanta under a line of credit equal to 25% of the Banks
total assets ($78.7 million at December 31, 2003). Outstanding advances at
December 31, 2003 were as follows: InterestMaturity
    
    Rate
    
    2003
    
    2002January 2, 2004
    
    
    1.15
    %
    
    $
    13,000,000
    
    
    $
    May 25, 2004
    
    
    1.46
    %
    
    
    5,000,000
    
    
    
    February 4, 2005
    
    
    2.14
    %
    
    
    5,000,000
    
    
    
    February 27, 2006
    
    
    5.45
    %
    
    
    1,000,000
    
    
    
    1,400,000March 17, 2010
    
    
    5.71
    %
    
    
    1,500,000
    
    
    
    1,500,000November 10, 2010
    
    
    5.43
    %
    
    
    5,000,000
    
    
    
    5,000,000January 24, 2012
    
    
    3.88
    %
    
    
    5,500,000
    
    
    
    5,500,000February 20, 2003
    
    
    1.43
    %
    
    
    
    
    
    
    5,000,000May 21, 2003
    
    
    1.51
    %
    
    
    
    
    
    
    5,000,000December 19, 2003
    
    
    1.80
    %
    
    
    
    
    
    
    5,000,000$
    36,000,000
    
    
    $
    28,400,000
 Pursuant to collateral agreements with the Federal Home Loan Bank, at December
31, 2003, advances are secured by investment securities available for sale with
a fair value of $29.0 million and by loans with a carrying amount of $32.1
million. In addition, the Company may purchase federal funds through four unsecured
federal funds lines of credit aggregating $31.4 million. These lines are
intended for short-term borrowings and are subject to restrictions limiting the
frequency and term of advances. These lines of credit are payable on demand and
bear interest based upon the daily federal funds rate (1.33% at December 31,
2003). The Company had $6.0 million and $3.0 million outstanding on these lines
of credit as of December 31, 2003 and 2002, respectively. The maximum amounts
outstanding under these lines of credit at any month-end during 2003 and 2002
were $12.2 million and $4.2 million, respectively. The average amounts
outstanding under these lines of credit were $4.1 million for 2003 and $779,000
for 2002. In August of 2003, $8.0 million of trust preferred securities were placed
through Gateway Capital Statutory Trust I (the Trust). The Trust issuer has
invested the total proceeds from the sale of the Trust Preferred in Junior
Subordinated Deferrable Interest Debentures (the Junior Subordinated
Debentures) issued by the Company. The trust preferred securities pay
cumulative cash distributions quarterly at an annual rate, reset quarterly,
equal to LIBOR plus 3.10%. The dividends paid to holders of the trust
preferred securities, which will be recorded as interest expense, are
deductible for income tax purposes. The trust preferred securities are
redeemable on or after
September 17, 2008, in whole or in part. Redemption is mandatory at September
17, 2033. The Company has fully and unconditionally guaranteed the trust
preferred securities through the combined operation of the debentures and other
related documents. The Companys obligation under the guarantee is unsecured
and subordinate to senior and subordinated indebtedness of the Company. The
principal reason for issuing the trust preferred securities is because they
qualify as Tier I capital for regulatory capital purposes (subject to certain
limitations), thereby enabling the Company to enhance its and the Banks
regulatory capital positions without diluting the ownership of the Companys
shareholders. Page 35




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##### 



ITEM 7  FINANCIAL STATEMENTS GATEWAY FINANCIAL HOLDINGS, INC. & SUBSIDIARIES
INDEX TO THE CONSOLIDATED FINANCIAL STATEMENTS Page No.Independent Auditors Report
    
    
    37Consolidated Balance Sheets as of December 31, 2003 and 2002
    
    
    38Consolidated Statements of Operations
for the years ended December 31, 2003, 2002 and 2001
    
    
    39Consolidated Statements of Comprehensive Income
for the years ended December 31, 2003, 2002 and 2001
    
    
    40Consolidated Statements of Changes in Stockholders Equity
for the years ended December 31, 2003, 2002 and 2001
    
    
    41Consolidated Statements of Cash Flows
for the years ended December 31, 2003, 2002 and 2001
    
    
    42Notes to Consolidated Financial Statements
    
    
    43
 Page 36




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##### 



(DIXON HUGHES LOGO) 
 INDEPENDENT AUDITORS REPORT To the Stockholders and the Board of Directors
Gateway Financial Holdings, Inc.
Elizabeth City, North Carolina We have audited the accompanying consolidated balance sheets of Gateway
Financial Holdings, Inc. and subsidiaries as of December 31, 2003 and 2002, and
the related consolidated statements of operations, comprehensive income,
changes in stockholders equity and cash flows for each of the years in the
three-year period ended December 31, 2003. These consolidated financial
statements are the responsibility of the Companys management. Our
responsibility is to express an opinion on these consolidated financial
statements based on our audits. We conducted our audits in accordance with auditing standards generally
accepted in the United States of America. Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the
financial statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements. An audit also includes assessing the accounting
principles used and significant estimates made by management, as well as
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the financial position of Gateway Financial
Holdings, Inc. and subsidiaries at December 31, 2003 and 2002 and the results
of their operations and their cash flows for each of the years in the
three-year period ended December 31, 2003 in conformity with accounting
principles generally accepted in the United States of America. (-s- Dixon Hughes PLLC)Sanford, North CarolinaMarch 9, 2004 Page 37




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##### 



GATEWAY FINANCIAL HOLDINGS, INC. AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETSDecember 31, 2003 and 2002 2003
    
    2002(In thousands, except share data)ASSETSCash and due from banks
    
    $
    7,676
    
    
    $
    7,639Interest-earning deposits in other banks
    
    
    5,152
    
    
    
    1,869Investment in securities available for sale, at fair value (Note C)
    
    
    43,773
    
    
    
    44,601Loans (Note D)
    
    
    231,740
    
    
    
    161,488Allowance for loan losses (Note D)
    
    
    (2,759
    )
    
    
    (1,721
    )NET LOANS
    
    
    228,981
    
    
    
    159,767Accrued interest receivable
    
    
    1,301
    
    
    
    1,167Stock in Federal Reserve Bank, at cost
    
    
    722
    
    
    
    467Stock in Federal Home Loan Bank of Atlanta, at cost
    
    
    2,050
    
    
    
    1,670Foreclosed real estate
    
    
    
    
    
    
    230Premises and equipment, net (Note E)
    
    
    11,967
    
    
    
    10,465Core deposit intangibles, net (Note R)
    
    
    607
    
    
    
    349Goodwill (Notes O and R)
    
    
    2,975
    
    
    
    1,941Bank-owned life insurance
    
    
    7,106
    
    
    
    Other assets
    
    
    2,516
    
    
    
    888TOTAL ASSETS
    
    $
    314,826
    
    
    $
    231,053LIABILITIES AND STOCKHOLDERS EQUITYDepositsDemand
    
    $
    37,454
    
    
    $
    23,483Savings
    
    
    4,428
    
    
    
    2,406Money market and NOW
    
    
    70,010
    
    
    
    32,035Time (Note F)
    
    
    126,560
    
    
    
    116,739TOTAL DEPOSITS
    
    
    238,452
    
    
    
    174,663Federal funds purchased (Note G)
    
    
    6,000
    
    
    
    3,001Advances from Federal Home Loan Bank (Note G)
    
    
    36,000
    
    
    
    28,400Trust preferred securities (Note G)
    
    
    8,000Accrued expenses and other liabilities
    
    
    1,403
    
    
    
    1,021TOTAL LIABILITIES
    
    
    289,855
    
    
    
    207,085Stockholders Equity (Notes I, K and N)Preferred stock, 1,000,000 shares authorized, none issued
    
    
    
    
    
    
    Common stock, no par value, 10,000,000 shares authorized,
3,167,542 and 3,006,007 shares issued and outstanding
at December 31, 2003 and 2002, respectively
    
    
    24,896
    
    
    
    24,788Accumulated deficit
    
    
    (102
    )
    
    
    (1,302
    )Accumulated other comprehensive income
    
    
    177
    
    
    
    482TOTAL STOCKHOLDERS EQUITY
    
    
    24,971
    
    
    
    23,968Commitments (Notes D and L)TOTAL
LIABILITIES AND
STOCKHOLDERS EQUITY
    
    $
    314,826
    
    
    $
    231,053
 See accompanying notes. Page 38




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##### 



GATEWAY FINANCIAL HOLDINGS, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF OPERATIONSYears Ended December 31, 2003, 2002 and 2001 2003
    
    2002
    
    2001(Amounts in thousands, exceptshare and per share data)INTEREST INCOMEInterest and fees on loans
    
    $
    11,511
    
    
    $
    8,178
    
    
    $
    7,288Interest on investment securities
    
    
    1,851
    
    
    
    1,959
    
    
    
    1,620Interest-earning bank deposits
    
    
    21
    
    
    
    67
    
    
    
    149Other interest and dividends
    
    
    103
    
    
    
    107
    
    
    
    68TOTAL INTEREST INCOME
    
    
    13,486
    
    
    
    10,311
    
    
    
    9,125INTEREST EXPENSEMoney market, NOW and savings deposits
    
    
    557
    
    
    
    285
    
    
    
    401Time deposits (Note F)
    
    
    3,555
    
    
    
    3,479
    
    
    
    3,997Federal funds purchased
    
    
    64
    
    
    
    16
    
    
    
    78Advances from Federal Home Loan Bank
    
    
    1,022
    
    
    
    1,039
    
    
    
    583Trust preferred securities
    
    
    143
    
    
    
    
    
    
    
    TOTAL INTEREST EXPENSE
    
    
    5,341
    
    
    
    4,819
    
    
    
    5,059NET INTEREST INCOME
    
    
    8,145
    
    
    
    5,492
    
    
    
    4,066PROVISION FOR LOAN LOSSES (Note D)
    
    
    1,200
    
    
    
    480
    
    
    
    440NET INTEREST
INCOME AFTER
PROVISION FOR LOAN LOSSES
    
    
    6,945
    
    
    
    5,012
    
    
    
    3,626NON-INTEREST INCOMEService charges on deposit accounts
    
    
    898
    
    
    
    582
    
    
    
    381Mortgage operations
    
    
    1,111
    
    
    
    422
    
    
    
    246Insurance operations
    
    
    1,480
    
    
    
    1,264
    
    
    
    1,212Brokerage operations
    
    
    240
    
    
    
    193
    
    
    
    303Gain on sale of securities
    
    
    244
    
    
    
    266
    
    
    
    180Income from bank-owned life insurance
    
    
    146
    
    
    
    
    
    
    
    Other
    
    
    366
    
    
    
    99
    
    
    
    98TOTAL NON-INTEREST INCOME
    
    
    4,485
    
    
    
    2,826
    
    
    
    2,420NON-INTEREST EXPENSEPersonnel costs
    
    
    5,549
    
    
    
    3,947
    
    
    
    2,956Occupancy and equipment
    
    
    1,864
    
    
    
    974
    
    
    
    768Data processing fees
    
    
    397
    
    
    
    493
    
    
    
    388Other (Note J)
    
    
    2,420
    
    
    
    1,797
    
    
    
    1,387TOTAL NON-INTEREST EXPENSE
    
    
    10,230
    
    
    
    7,211
    
    
    
    5,499INCOME BEFORE INCOME TAXES
    
    
    1,200
    
    
    
    627
    
    
    
    547INCOME TAXES (Note H)
    
    
    
    
    
    
    
    
    
    
    NET INCOME
    
    $
    1,200
    
    
    $
    627
    
    
    $
    547NET INCOME PER COMMON SHAREBasic
    
    $
    .36
    
    
    $
    .19
    
    
    $
    .21Diluted
    
    $
    .35
    
    
    
    .19
    
    
    
    .21
 See accompanying notes. Page 39




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##### 



GATEWAY FINANCIAL HOLDINGS, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOMEYears Ended December 31, 2003, 2002 and 2001 2003
    
    2002
    
    2001(Amounts in thousands)Net income
    
    $
    1,200
    
    
    $
    627
    
    
    $
    547Other comprehensive income:Securities available for sale:Unrealized holding gains (losses) on available-for-sale
securities
    
    
    (157
    )
    
    
    756
    
    
    
    41Tax effect
    
    
    38
    
    
    
    (227
    )
    
    
    (113
    )Reclassification of gains recognized in net income
    
    
    (244
    )
    
    
    (266
    )
    
    
    (181
    )Tax effect
    
    
    58
    
    
    
    80
    
    
    
    54Total other comprehensive income (loss)
    
    
    (305
    )
    
    
    343
    
    
    
    (199
    )Comprehensive income
    
    $
    895
    
    
    $
    970
    
    
    $
    348
 See accompanying notes. Page 40




---



##### 



GATEWAY FINANCIAL HOLDINGS, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS EQUITYYears Ended December 31, 2003, 2002 and 2001 AccumulatedCommon Stock
    
    Additional
    
    
    
    
    
    Other Com-Paid-In
    
    Accumulated
    
    prehensive
    
    TotalShares
    
    Amount
    
    Capital
    
    Deficit
    
    Income
    
    Equity(Amounts in thousands, except share data)Balance at December 31, 2000
    
    
    1,621,792
    
    
    $
    8,109
    
    
    $
    7,470
    
    
    $
    (2,476
    )
    
    $
    338
    
    
    $
    13,441Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    547
    
    
    
    
    
    
    
    547Other comprehensive loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (199
    )
    
    
    (199
    )Issuance of common stock
    
    
    1,110,973
    
    
    
    5,555
    
    
    
    3,654
    
    
    
    
    
    
    
    
    
    
    
    9,209Effect of holding company
reorganization
    
    
    
    
    
    
    11,124
    
    
    
    (11,124
    )
    
    
    
    
    
    
    
    
    
    
    Balance at December 31, 2001
    
    
    2,732,765
    
    
    
    24,788
    
    
    
    
    
    
    
    (1,929
    )
    
    
    139
    
    
    
    22,998Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    627
    
    
    
    
    
    
    
    627Other comprehensive income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    343
    
    
    
    343Shares issued in 11-for-10 stock
split effected as a 10% stock
dividend
    
    
    273,242
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Balance at December 31, 2002
    
    
    3,006,007
    
    
    
    24,788
    
    
    
    
    
    
    
    (1,302
    )
    
    
    482
    
    
    
    23,968Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,200
    
    
    
    
    
    
    
    1,200Other comprehensive loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (305
    )
    
    
    (305
    )Shares issued in exercise of
common stock warrants
    
    
    11,662
    
    
    
    112
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    112Shares issued in 21-for-20 stock
split effected as a 5% stock
dividend
    
    
    149,873
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Cash paid for fractional shares
    
    
    
    
    
    
    (4
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (4
    )Balance at December 31, 2003
    
    
    3,167,542
    
    
    $
    24,896
    
    
    $
    
    
    
    $
    (102
    )
    
    $
    177
    
    
    $
    24,971
 See accompanying notes. Page 41




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##### 



GATEWAY FINANCIAL HOLDINGS, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWSYears Ended December 31, 2003, 2002 and 2001 2003
    
    2002
    
    2001(Amounts in thousands)CASH FLOWS FROM OPERATING ACTIVITIESNet income
    
    $
    1,200
    
    
    $
    627
    
    
    $
    547Adjustments to reconcile net income to net
cash provided by operating activities:Amortization of intangibles
    
    
    59
    
    
    
    49
    
    
    
    254Depreciation and amortization
    
    
    1,286
    
    
    
    555
    
    
    
    238Deferred income taxes
    
    
    (368
    )
    
    
    
    
    
    
    Realized gain on available-for-sale securities
    
    
    (244
    )
    
    
    (267
    )
    
    
    (181
    )Realized gain on sale of loans
    
    
    (98
    )
    
    
    (63
    )
    
    
    Realized loss on sale of foreclosed real estate
    
    
    27
    
    
    
    37
    
    
    
    Realized gain on sale of bank premises and equipment
    
    
    (118
    )
    
    
    
    
    
    
    Provision for loan losses
    
    
    1,200
    
    
    
    480
    
    
    
    440Change in assets and liabilities:(Increase) decrease in accrued interest receivable
    
    
    (117
    )
    
    
    (401
    )
    
    
    68Increase in other assets
    
    
    (1,171
    )
    
    
    (235
    )
    
    
    (252
    )Increase in accrued expenses and other liabilities
    
    
    300
    
    
    
    58
    
    
    
    289NET CASH PROVIDED BY OPERATING ACTIVITIES
    
    
    1,956
    
    
    
    840
    
    
    
    1,403CASH FLOWS FROM INVESTING ACTIVITIESPurchases of available-for-sale securities
    
    
    (31,925
    )
    
    
    (45,289
    )
    
    
    (30,399
    )Maturities, sales and calls of available-for-sale securities
    
    
    32,089
    
    
    
    32,472
    
    
    
    21,294Proceeds from sale of loans
    
    
    1,973
    
    
    
    1,552
    
    
    
    Net increase in loans from originations and repayments
    
    
    (68,809
    )
    
    
    (56,161
    )
    
    
    (31,732
    )Proceeds from sale of foreclosed real estate
    
    
    203
    
    
    
    193
    
    
    
    151Proceeds from sale of bank premises and equipment
    
    
    330
    
    
    
    
    
    
    
    Purchase of premises and equipment
    
    
    (1,971
    )
    
    
    (5,029
    )
    
    
    (2,062
    )Purchase of Federal Reserve Bank stock
    
    
    (255
    )
    
    
    
    
    
    
    (467
    )Purchase of Federal Home Loan Bank stock
    
    
    (380
    )
    
    
    (755
    )
    
    
    (590
    )Purchase of bank owned life insurance
    
    
    (7,106
    )
    
    
    
    
    
    
    Net cash (paid) received in branch and subsidiary acquisitions
    
    
    11,260
    
    
    
    
    
    
    
    (600
    )NET CASH USED BY INVESTING ACTIVITIES
    
    
    (64,591
    )
    
    
    (73,017
    )
    
    
    (44,405
    )CASH FLOWS FROM FINANCING ACTIVITIESIncrease in deposits
    
    
    47,248
    
    
    
    58,945
    
    
    
    25,425Net increase in FHLB advances
    
    
    7,600
    
    
    
    10,100
    
    
    
    11,800Net increase in federal funds purchased
    
    
    2,999
    
    
    
    1
    
    
    
    3,000Proceeds from issuance of trust preferred securities
    
    
    8,000
    
    
    
    
    
    
    
    Net repayments on other borrowings
    
    
    
    
    
    
    
    
    
    
    (93
    )Proceeds from issuance of common stock
    
    
    
    
    
    
    
    
    
    
    9,209Proceeds from the conversion of common stock warrants
    
    
    112
    
    
    
    
    
    
    
    Cash paid for fractional shares
    
    
    (4
    )
    
    
    
    
    
    
    NET CASH PROVIDED BY FINANCING ACTIVITIES
    
    
    65,955
    
    
    
    69,046
    
    
    
    49,341NET INCREASE (DECREASE) IN
CASH AND CASH EQUIVALENTS
    
    
    3,320
    
    
    
    (3,131
    )
    
    
    6,339CASH AND CASH EQUIVALENTS, BEGINNING
    
    
    9,508
    
    
    
    12,639
    
    
    
    6,300CASH AND CASH EQUIVALENTS, ENDING
    
    $
    12,828
    
    
    $
    9,508
    
    
    $
    12,639SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATIONInterest paid
    
    $
    5,290
    
    
    $
    4,772
    
    
    $
    4,707Income taxes paid
    
    $
    162
    
    
    $
    
    
    
    $
    SUPPLEMENTAL DISCLOSURES OF NONCASH INVESTING ACTIVITIESUnrealized holding gains (losses) on available-for-sale securities, net
    
    $
    (305
    )
    
    $
    343
    
    
    $
    (199
    )Transfer from loans to real estate acquired in settlement of loans
    
    $
    
    
    
    $
    230
    
    
    $
    381
 Noncash assets acquired and liabilities assumed in a business combination are presented in Note O. See accompanying notes. Page 42




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##### 



GATEWAY FINANCIAL HOLDINGS, INC. AND SUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTSDecember 31, 2003, 2002 and 2001 NOTE A - ORGANIZATION AND OPERATIONS Gateway Bank & Trust Co. (the Bank) was incorporated November 24, 1998 and
began banking operations on December 1, 1998. Effective October 1, 2001, the
Bank became a wholly-owned subsidiary of Gateway Financial Holdings, Inc., a
financial holding company whose principal business activity consists of the
ownership of the Bank and Gateway Capital Statutory Trust I, a trust formed in
August of 2003 to facilitate the issuance of $8.0 million of trust preferred
securities. Gateway Financial Holdings, Inc., its subsidiaries and the Banks
wholly-owned subsidiaries are collectively referred to herein as the Company. The Bank is engaged in general commercial and retail banking in Northeastern
North Carolina and in the Tidewater area of Southeastern Virginia, operating
under state banking laws and the rules and regulations of the Federal Reserve
System and the North Carolina Commissioner of Banks. The Bank undergoes
periodic examinations by those regulatory authorities. The Bank has two wholly-owned subsidiaries, Gateway Investment Services, Inc.,
whose principal activity is to engage in brokerage services as an agent for
non-bank investment products and services and Gateway Insurance Services, Inc.,
an independent insurance agency with offices in Edenton, Hertford, Elizabeth
City, Plymouth and Kitty Hawk, North Carolina. NOTE
B - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Principles of Consolidation The consolidated financial statements include the accounts of Gateway Financial
Holdings, Inc. and its wholly-owned subsidiaries. All significant intercompany
accounts and transactions have been eliminated in consolidation. Use of Estimates The preparation of financial statements in conformity with accounting
principles generally accepted in the United States of America requires
management to make estimates and assumptions that affect the reported amounts
of assets and liabilities and the disclosure of contingent assets and
liabilities at the date of the financial statements and the reported amounts of
revenues and expenses during the reporting period. Actual results could differ
from those estimates. Material estimates that are particularly susceptible to
significant change relate to the determination of the allowance for loan
losses. Cash and Cash Equivalents For the purpose of presentation in the statement of cash flows, cash and cash
equivalents are defined as those amounts included in the balance sheet captions
Cash and due from banks and Interest-earning deposits in other banks. Investment Securities Held to Maturity Investment securities that management has the positive intent and ability to
hold to maturity are reported at cost, adjusted for premiums and discounts that
are recognized in interest income using the interest method over the period to
maturity. Page 43




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##### 



GATEWAY FINANCIAL HOLDINGS, INC. AND SUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTSDecember 31, 2003, 2002 and 2001 NOTE B - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) Investment Securities Available for Sale Investment securities available for sale are reported at fair value and consist
of debt instruments that are not classified as either trading securities or as
held to maturity securities. Unrealized holding gains and losses, net of
deferred income tax, on available for sale securities are reported as a net
amount in other comprehensive income. Gains and losses on the sale of
investment securities available for sale are determined using the
specific-identification method. Declines in the fair value of individual held
to maturity and investment securities available for sale below their cost that
are other than temporary would result in write-downs of the individual
securities to their fair value. Such write-downs would be included in earnings
as realized losses. Premiums and discounts are recognized in interest income
using the interest method over the period to maturity. Loans Loans that management has the intent and ability to hold for the foreseeable
future or until maturity are reported at their outstanding principal adjusted
for any charge-offs, the allowance for loan losses, and any deferred fees or
costs on originated loans and unamortized premiums or discounts on purchased
loans. Loan origination fees and certain direct origination costs are
capitalized and recognized as an adjustment of the yield of the related loan.
The accrual of interest on impaired loans is discontinued when, in managements
opinion, the borrower may be unable to meet payments as they become due. When
interest accrual is discontinued, all unpaid accrued interest is reversed.
Interest income is subsequently recognized only to the extent cash payments are
received. Allowance for Loan Losses The provision for loan losses is based upon managements estimate of the amount
needed to maintain the allowance for loan losses at an adequate level. In
making the evaluation of the adequacy of the allowance for loan losses,
management gives consideration to current economic conditions, statutory
examinations of the loan portfolio by regulatory agencies, delinquency
information and managements internal review of the loan portfolio. Loans are
considered impaired when it is probable that all amounts due under the
contractual terms of the loan will not be collected. The measurement of
impaired loans is generally based on the present value of expected future cash
flows discounted at the historical effective interest rate, or upon the fair
value of the collateral if collateral dependent. If the recorded investment in
the loan exceeds the measure of fair value, a valuation allowance is
established as a component of the allowance for loan losses. While management
uses the best information available to make evaluations, future adjustments to
the allowance may be necessary if conditions differ substantially from the
assumptions used in making the evaluations. In addition, regulatory examiners
may require the Bank to recognize changes to the allowance for loan losses
based on their judgments about information available to them at the time of
their examination. Foreclosed Real Estate Real estate acquired through, or in lieu of, loan foreclosure is initially
recorded at fair value at the date of foreclosure establishing a new cost
basis. After foreclosure, valuations of the property are periodically performed
by management and the real estate is carried at the lower of cost or fair value
minus estimated cost to sell. Revenue and expenses from operations and changes
in the valuation allowance are included in other non-interest expense. Premises and Equipment Premises and equipment are stated at cost less accumulated depreciation.
Depreciation is calculated on the straight-line method over the estimated
useful asset lives of 3 - 10 years for furniture and equipment, 5 years for
vehicles, and 40 years for bank premises. Leasehold improvements are amortized
over the terms of the respective leases or the estimated useful lives of the
improvements, whichever is shorter. Repairs and maintenance costs are charged
to operations as incurred and additions and improvements to premises and
equipment are capitalized. Upon sale or
retirement, the cost and related accumulated depreciation are removed from the
accounts and any gains or losses are reflected in current operations. Page 44




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##### 



GATEWAY FINANCIAL HOLDINGS, INC. AND SUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTSDecember 31, 2003, 2002 and 2001 NOTE B - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) Federal Home Loan Bank and Federal Reserve Bank Stock As a requirement for membership, the Company invests in stock of the Federal
Home Loan Bank of Atlanta (FHLB) and the Federal Reserve Bank (FRB). These
investments are carried at cost. Intangible Assets Branch and business acquisitions typically result in the Company recording
certain intangible assets, principally deposit base premiums and goodwill. The
Companys policy is to amortize core deposit intangibles on a straight-line
basis over ten years. Other acquisition-related intangible assets, including
goodwill and intangible assets previously subject to Statement of Financial
Accounting Standards No. 72, Accounting for Certain Acquisitions of Banking or
Thrift Institutions, are subject to periodic review and are adjusted for any
impairment in value. Income Taxes Deferred tax assets and liabilities are recognized for the estimated future tax
consequences attributable to differences between the tax bases of assets and
liabilities and their carrying amounts for financial reporting purposes.
Deferred tax assets are also recognized for operating loss carryforwards.
Deferred tax assets and liabilities are measured using enacted tax rates in
effect for the year in which the temporary differences are expected to be
recovered or settled. Deferred tax assets are reduced by a valuation allowance
if it is more likely than not that the tax benefits will not be realized. Comprehensive Income The Company reports as comprehensive income all changes in shareholders equity
during the year from sources other than shareholders. Other comprehensive
income refers to all components (revenues, expenses, gains, and losses) of
comprehensive income that are excluded from net income. The Companys only
component of other comprehensive income is unrealized gains and losses on
investment securities available for sale. Mortgage Operations The Bank originates single family, residential first mortgage loans on a
presold basis. The Bank recognizes certain origination and service release
fees upon the sale, which are included in non-interest income on the statements
of operations under the caption Mortgage operations. Also included under
this caption is income derived from equity investments in certain mortgage
companies. 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 plan 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 and, as a result, has provided 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. Page 45




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##### 



GATEWAY FINANCIAL HOLDINGS, INC. AND SUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTSDecember 31, 2003, 2002 and 2001 NOTE B - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) Stock Compensation Plans (Continued) 2003
    
    2002
    
    2001(Amounts in thousands,except per share data)Net income:As reported
    
    $
    1,200
    
    
    $
    627
    
    
    $
    547Deduct:Total stock-based employee compensation
expense determined under fair value method
for all awards, net of related tax effects
    
    
    203
    
    
    
    210
    
    
    
    534Pro forma
    
    $
    997
    
    
    $
    417
    
    
    $
    13Basic net income per share:As reported
    
    $
    .36
    
    
    $
    .19
    
    
    $
    .21Pro forma
    
    
    .30
    
    
    
    .13
    
    
    
    .00Diluted net income per share:As reported
    
    $
    .35
    
    
    $
    .19
    
    
    $
    .21Pro forma
    
    
    .29
    
    
    
    .13
    
    
    
    .00
 Per Share Results 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 to outstanding
stock options and warrants, and are determined using the treasury stock method. The basic and diluted weighted average shares outstanding are as follows: 2003
    
    2002
    
    2001Weighted average outstanding shares used for
basic EPS
    
    
    3,316,768
    
    
    
    3,314,122
    
    
    
    2,649,358Plus incremental shares from assumed exercise of:Stock options
    
    
    92,674
    
    
    
    7,327
    
    
    
    7,117Warrants
    
    
    48,486
    
    
    
    
    
    
    
    Weighted average outstanding shares
used for diluted EPS
    
    
    3,457,928
    
    
    
    3,321,449
    
    
    
    2,656,475
 On May 14, 2002, the Companys Board of Directors declared an 11-for-10 stock
split, effected in the form of a 10% stock dividend, which was distributed June
5, 2002 to shareholders of record on May 22, 2002. On May 1, 2003, the
Companys Board of Directors declared a 21-for-20 stock split, effected in the
form of a 5% stock dividend, which was distributed June 12, 2003 to
shareholders of record on May 23, 2003. On February 27, 2004, the Companys
Board of Directors declared a 21-for-20 stock split, to be effected in the form
of a 5% stock dividend, which will be distributed April 8, 2004 to shareholders
of record on March 15, 2004. All references to per share results and weighted
average common and common equivalent shares outstanding have been adjusted to
reflect the effects of these stock splits. Page 46




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##### 



GATEWAY FINANCIAL HOLDINGS, INC. AND SUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTSDecember 31, 2003, 2002 and 2001 NOTE B - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) Per Share Results (Continued) There were no adjustments required to be made to net income in the computation
of diluted earnings per share. For the years ended December 31, 2002 and 2001,
there were options of 551,183 and 329,086, respectively, that were antidilutive
since the exercise price exceeded the average market price of the Companys
common stock for the year. In addition, for the years ended December 31, 2002
and 2001 there were warrants to purchase 1.3 million shares of common stock
that were antidilutive since the exercise price exceeded the average market
price of the Companys common stock for the year. These options and warrants
have been omitted from the calculation of diluted earnings per share for those
years. Recent Accounting Pronouncements In October 2002, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standards (SFAS) No. 147, Acquisitions of
Certain Financial Institutions, which addresses the financial accounting and
reporting for the acquisition of all or part of a financial institution. This
standard removes certain acquisitions of financial institutions from the scope
of SFAS No. 72, Accounting for Certain Acquisitions of Bank or Thrift
Institutions. This statement requires financial institutions to reclassify
goodwill arising from a qualified business acquisition from SFAS No. 72
goodwill to goodwill subject to the provisions of SFAS No. 142. The
reclassified goodwill will no longer be amortized but will be subject to an
annual impairment test, pursuant to SFAS No. 142. The Company adopted SFAS No.
147 in the fourth quarter of 2002. The adoption of SFAS No. 147 did not have
a material impact on the consolidated financial statements. In April 2003, the FASB issued SFAS No. 149, Amendment of Statement No. 133 on
Derivative Instruments and Hedging Activities. SFAS No. 149 improves financial
reporting by requiring that contracts with comparable characteristics be
accounted for similarly. In particular, SFAS No. 149 clarifies under what
circumstances a contract with an initial net investment meets the
characteristic of a derivative, clarifies when a derivative contains a
financing component, amends the definition of an underlying to conform it to
language used in FIN 45 and amends certain other existing pronouncements. SFAS
No. 149 is effective for contracts entered into or modified after June 30,
2003, and for hedging relationships designated after June 30, 2003. In
addition, with some exceptions, all provisions of SFAS No. 149 should be
applied prospectively. The adoption of SFAS No. 149 did not have a material
impact on the consolidated financial statements. In May 2003, the FASB issued SFAS No. 150, Accounting for Certain Financial
Instruments with Characteristics of both Liabilities and Equity. This Statement
establishes standards for how an issuer classifies and measures certain
financial instruments with characteristics of both liabilities and equity. It
requires that an issuer classify a financial instrument that is within its
scope as a liability (or an asset in some circumstances). This Statement is
effective for financial instruments entered into or modified by the Company
after May 31, 2003, and is effective at the beginning of the first interim
period beginning after June 15, 2003. However, the FASB has deferred
indefinitely the classification and measurement provisions as they related to
certain mandatorily redeemable noncontrolling interests. The adoption of SFAS
No. 150 did not have a material impact on the consolidated financial
statements. In January 2003, the FASB issued Interpretation No. (FIN) 46, Consolidation of
Variable Interest Entities. This interpretation addresses the consolidation by
business enterprises of variable interest entities as defined in the
interpretation. In December 2003, the FASB issued a revision to FIN 46 (FIN
46R) to clarify some of the provisions of FIN 46 and to exempt certain entities
from its requirements. FIN 46R is effective for public entities that have
interests in structures that are commonly referred to as special-purpose
entities for periods ending after December 15, 2003. Application by public
entities, other than small business issuers, for all other types of variable
interest entities is required in financial statements for periods ending after
March 15, 2004. The Company does not expect that FIN 46 and FIN 46R will have a
material impact on its consolidated financial statements. Page 47




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##### 



GATEWAY FINANCIAL HOLDINGS, INC. AND SUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTSDecember 31, 2003, 2002 and 2001 NOTE B - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) Recent Accounting Pronouncements (Continued) In November 2003, the Emerging Issues Task Force (EITF) reached a partial
consensus on Issue 03-1, The Meaning of Other-Than-Temporary Impairment and Its
Application to Certain Investments. Issue 03-1 requires certain quantitative
and qualitative disclosures for investments subject to SFAS No. 115, Accounting
for Certain Investments in Debt and Equity Securities, that are impaired at the
balance sheet date but for which an other-than-temporary impairment has not
been recognized. The Company adopted the partial consensus on Issue 03-1
during 2003 and has provided the new disclosures in Note C. The EITF is
expected to continue deliberating other aspects of Issue 03-1, including when
to recognize other-than-temporary impairment. Reclassifications Certain amounts for 2002 and 2001 have been reclassified to conform to the
classifications adopted for 2003. These reclassifications had no effect on net
income or stockholders equity as previously reported. NOTE
C - INVESTMENT SECURITIES The following is a summary of the securities portfolio by major classification: December 31, 2003Gross
    
    GrossAmortized
    
    Unrealized
    
    Unrealized
    
    FairCost
    
    Gains
    
    Losses
    
    Value(Amounts in thousands)Securities available-for-sale:U. S. government securities
and obligations of U.S.
government agencies
    
    $
    24,678
    
    
    $
    147
    
    
    $
    50
    
    
    $
    24,775Corporate debt securities
    
    
    2,083
    
    
    
    75
    
    
    
    
    
    
    
    2,158Mortgage-backed securities
    
    
    16,725
    
    
    
    160
    
    
    
    45
    
    
    
    16,840$
    43,486
    
    
    $
    382
    
    
    $
    95
    
    
    $
    43,773
 December 31, 2002Gross
    
    GrossAmortized
    
    Unrealized
    
    Unrealized
    
    FairCost
    
    Gains
    
    Losses
    
    Value(Amounts in thousands)Securities available-for-sale:U. S. government securities
and obligations of U.S.
government agencies
    
    $
    24,020
    
    
    $
    293
    
    
    $
    
    
    
    $
    24,313Corporate debt securities
    
    
    1,397
    
    
    
    42
    
    
    
    
    
    
    
    1,439Mortgage-backed securities
    
    
    18,496
    
    
    
    355
    
    
    
    2
    
    
    
    18,849$
    43,913
    
    
    $
    690
    
    
    $
    2
    
    
    $
    44,601
 48




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##### 



GATEWAY FINANCIAL HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2003, 2002 and 2001 NOTE C - INVESTMENT SECURITIES (Continued) The following table shows investments gross unrealized losses and fair value,
aggregated by investment category and length of time that individual securities
have been in a continuous unrealized loss position, at December 31, 2003.
These unrealized losses on investment securities are a result of volatility in
the market during 2003 and relate to three U.S. government securities and
obligations of U.S. government agencies and two mortgage-backed securities.
All unrealized losses on investment securities are considered by management to
be temporary given the credit ratings on these investment securities and the
short duration of the unrealized loss. Less Than 12 Months
    
    12 Months or More
    
    TotalFair
    
    Unrealized
    
    Fair
    
    Unrealized
    
    Fair
    
    Unrealizedvalue
    
    losses
    
    value
    
    losses
    
    value
    
    lossesSecurities available for sale:U.S. government securities
and obligations of U.S.
government agencies
    
    $
    10,976
    
    
    $
    50
    
    
    $
    
    
    
    $
    
    
    
    $
    10,976
    
    
    $
    50Mortgage-backed securities
    
    
    1,802
    
    
    
    38
    
    
    
    674
    
    
    
    7
    
    
    
    2,476
    
    
    
    45Total temporarily impaired
securities
    
    $
    12,778
    
    
    $
    88
    
    
    $
    674
    
    
    $
    7
    
    
    $
    13,452
    
    
    $
    95
 Proceeds from maturities, sales and calls of investment securities during the
years ended December 31, 2003, 2002 and 2001 were $32.1 million, $32.5 million
and $21.3 million, respectively. From those transactions, the Company realized
gross gains of $246,000, $266,000 and $187,000 and gross losses of $2,000, $0
and $6,000 in 2003, 2002 and 2001, respectively. The amortized cost and fair values of securities available-for-sale at December
31, 2003 by contractual maturity are shown below. Expected maturities will
differ from contractual maturities because borrowers may have the right to call
or prepay obligations with or without call or prepayment penalties. Amortized
    
    FairCost
    
    Value(Dollars in thousands)Due after one year through five years
    
    $
    12,956
    
    
    $
    13,079Due after five years through ten years
    
    
    17,723
    
    
    
    17,752Due after ten years
    
    
    12,807
    
    
    
    12,942$
    43,486
    
    
    $
    43,773
 For purposes of the maturity table, mortgage-backed securities, which are not
due at a single maturity date, have been allocated over maturity groupings
based on the weighted-average contractual maturities of underlying collateral.
The mortgage-backed securities may mature earlier than their weighted-average
contractual maturities because of principal prepayments. Securities with an amortized cost of $35.7 million and a fair value of $35.9
million were pledged to secure FHLB advances and public monies on deposit as
required by law at December 31, 2003. Page 49




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##### 



GATEWAY FINANCIAL HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2003, 2002 and 2001 NOTE D - LOANS A summary of the balances of loans follows: December 31,2003
    
    2002(Dollars in thousands)Commercial
    
    $
    52,554
    
    
    $
    42,767Real estate  construction
    
    
    55,970
    
    
    
    22,861Real estate  commercial mortgage
    
    
    67,952
    
    
    
    48,362Real estate  1-4 family mortgage
    
    
    32,191
    
    
    
    31,957Consumer
    
    
    10,458
    
    
    
    7,707Home equity lines of credit
    
    
    12,615
    
    
    
    7,834Subtotal
    
    
    231,740
    
    
    
    161,488Less: Allowance for loan losses
    
    
    (2,759
    )
    
    
    (1,721
    )Net loans
    
    $
    228,981
    
    
    $
    159,767
 Loans are primarily made in Northeastern North Carolina and the Tidewater area
of Southeastern Virginia. Real estate loans can be affected by the condition of
the local real estate market. Commercial and industrial loans and loans to
individuals can be affected by the local economic conditions. Impaired loans
at December 31, 2003 and 2002 consisted of loans of approximately $1,210,000
and $1,328,000, respectively, that were more than 90 days delinquent and on
which the accrual of interest had ceased. The average recorded investment in
impaired loans was approximately $1,295,000, $1,021,000 and $0 for the years
ended December 31, 2003, 2002 and 2001, respectively. Interest income that
would have been recorded on nonaccrual loans totaled $40,000 and $100,000 for
the years ended December 31, 2003 and 2002. There were no nonaccrual,
restructured or impaired loans at December 31, 2001. The allowance for loan
losses allocated to these impaired loans was $194,000 and $153,000,
respectively. The Company grants loans to directors and executive officers of the Bank and
their related interests. Such loans are made on substantially the same terms,
including interest rates and collateral, as those prevailing at the time for
comparable transactions with other borrowers and, in managements opinion, do
not involve more than the normal risk of collectibility. All loans to directors
and executive officers or their related interests are submitted to the Board of
Directors for approval. A summary of related party loan transactions is as follows (in thousands): 2003Balance at beginning of year
    
    $
    11,542Additions
    
    
    14,746Loans of newly elected directors
    
    
    840Loan repayments
    
    
    (9,631
    )Balance at end of year
    
    $
    17,497
 At December 31, 2003, commitments to extend credit to directors, executive
officers and their related interests consisted of unused lines of credit
totaling $1.7 million. Page 50




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GATEWAY FINANCIAL HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2003, 2002 and 2001 NOTE D - LOANS (Continued) An analysis of the allowance for loan losses follows: 2003
    
    2002
    
    2001(Amounts in thousands)Balance at beginning of year
    
    $
    1,721
    
    
    $
    1,435
    
    
    $
    1,028Provision charged to operations
    
    
    1,200
    
    
    
    480
    
    
    
    440Allowance for loan losses on loans purchased
    
    
    52
    
    
    
    
    
    
    
    Charge-offs
    
    
    (215
    )
    
    
    (194
    )
    
    
    (37
    )Recoveries
    
    
    1
    
    
    
    
    
    
    
    4Net charge-offs
    
    
    (214
    )
    
    
    (194
    )
    
    
    (33
    )Balance at end of year
    
    $
    2,759
    
    
    $
    1,721
    
    
    $
    1,435
 NOTE E - PREMISES AND EQUIPMENT Following is a summary of premises and equipment at December 31, 2003 and 2002: 2003
    
    2002(Amounts in thousands)Land
    
    $
    1,921
    
    
    $
    1,782Furniture and equipment
    
    
    3,783
    
    
    
    2,477Vehicles
    
    
    301
    
    
    
    180Buildings and improvements
    
    
    7,505
    
    
    
    6,443Construction in progress
    
    
    63
    
    
    
    414Accumulated depreciation
    
    
    (1,606
    )
    
    
    (833
    )Total
    
    $
    11,967
    
    
    $
    10,465
 Depreciation and amortization amounting to $779,000, $357,000 and $238,000 for
the years ended December 31, 2003, 2002 and 2001, respectively, is included in
occupancy and equipment expense. The Company leases, under separate agreements, land on which the permanent
headquarters and adjacent parking lot are located. The Company also leases land
on which its Chesapeake, Virginia branch is located, as well as, its operations
facility and branch facilities in Virginia Beach, Virginia and Edenton, North
Carolina. These leases expire at various dates through December 31, 2019.
Future rentals under these leases are as follows (in thousands): 2004
    
    $
    4372005
    
    
    4202006
    
    
    3582007
    
    
    2832008
    
    
    273Thereafter
    
    
    1,534$
    3,305
 Rental expense amounted to $423,000, $256,000 and $204,000 during the years
ended December 31, 2003, 2002 and 2001, respectively. Certain leases contain options to extend for up to three consecutive five-year
terms. The Company has an option to purchase the land on which its permanent
headquarters are affixed at the end of the twenty-year lease term for a cost of
$300,000. Page 51




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##### 



GATEWAY FINANCIAL HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2003, 2002 and 2001 NOTE F - DEPOSITS The weighted average cost of time deposits was 2.47%, 3.17% and 4.20% at
December 31, 2003, 2002 and 2001, respectively. Time deposits in denominations of $100,000 or more were $35.8 million and $44.9
million at December 31, 2003 and 2002, respectively. Interest expense on such
deposits aggregated $2.2 million in 2003 and $2.1 million in 2002. At December
31, 2003, the scheduled maturities of time deposits are as follows: $100,000
    
    Underand Over
    
    $100,000
    
    Total2004
    
    $
    26,435
    
    
    $
    67,317
    
    
    $
    93,7522005
    
    
    7,211
    
    
    
    19,089
    
    
    
    26,3002006
    
    
    1,919
    
    
    
    3,549
    
    
    
    5,4682007
    
    
    
    
    
    
    360
    
    
    
    3602008
    
    
    210
    
    
    
    462
    
    
    
    672Thereafter
    
    
    
    
    
    
    8
    
    
    
    8Total
    
    $
    35,775
    
    
    $
    90,785
    
    
    $
    126,560
 NOTE G - BORROWINGS Advances from the Federal Home Loan Bank of Atlanta consisted of the following
at December 31, 2003 and 2002: InterestMaturity
    
    Rate
    
    2003
    
    2002January 2, 2004
    
    
    1.15
    %
    
    $
    13,000,000
    
    
    $
    May 25, 2004
    
    
    1.46
    %
    
    
    5,000,000
    
    
    
    February 4, 2005
    
    
    2.14
    %
    
    
    5,000,000
    
    
    
    February 27, 2006
    
    
    5.45
    %
    
    
    1,000,000
    
    
    
    1,400,000March 17, 2010
    
    
    5.71
    %
    
    
    1,500,000
    
    
    
    1,500,000November 10, 2010
    
    
    5.43
    %
    
    
    5,000,000
    
    
    
    5,000,000January 24, 2012
    
    
    3.88
    %
    
    
    5,500,000
    
    
    
    5,500,000February 20, 2003
    
    
    1.43
    %
    
    
    
    
    
    
    5,000,000May 21, 2003
    
    
    1.51
    %
    
    
    
    
    
    
    5,000,000December 19, 2003
    
    
    1.80
    %
    
    
    
    
    
    
    5,000,000$
    36,000,000
    
    
    $
    28,400,000
 Pursuant to collateral agreements with the Federal Home Loan Bank, at December
31, 2003 advances are secured by investment securities available for sale with
a fair value of $29.0 million and by loans with a carrying amount of $32.1
million, which approximates market value. The Company has a maximum borrowing
availability from FHLB equal to 25% of total assets. The Company may purchase federal funds through four unsecured federal funds
lines of credit aggregating $31.4 million. These lines are intended for
short-term borrowings and are subject to restrictions limiting the frequency
and term of advances. These lines of credit are payable on demand and bear
interest based upon the daily federal funds rate (1.33% at December 31, 2003).
The Company had $6.0 million and $3.0 million outstanding on these lines of
credit as of December 31, 2003 and 2002, respectively. The maximum amounts
outstanding under these lines of credit at any month-end during 2003 and 2002
were $12.2 million and $4.2 million, respectively. The average amounts
outstanding under these lines of credit were $4.1 million for 2003 and $779,000
for 2002. Page 52




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##### 



GATEWAY FINANCIAL HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2003, 2002 and 2001 NOTE G - BORROWINGS (Continued) In August of 2003, $8.0 million of trust preferred securities were placed
through Gateway Capital Statutory Trust I (the Trust). The Trust issuer has
invested the total proceeds from the sale of the Trust Preferred in Junior
Subordinated Deferrable Interest Debentures (the Junior Subordinated
Debentures) issued by the Company. The trust preferred securities pay
cumulative cash distributions quarterly at an annual rate, reset quarterly,
equal to LIBOR plus 3.10%. The dividends paid to holders of the trust
preferred securities, which will be recorded as interest expense, are
deductible for income tax purposes. The trust preferred securities are
redeemable on or after
September 17, 2008, in whole or in part. Redemption is mandatory at September
17, 2033. The Company has fully and unconditionally guaranteed the trust
preferred securities through the combined operation of the debentures and other
related documents. The Companys obligation under the guarantee is unsecured
and subordinate to senior and subordinated indebtedness of the Company. The
trust preferred securities qualify as Tier I capital, limited to 25% of total
Tier I capital. The full amount of the trust preferred securities qualify as
Tier I capital for regulatory capital purposes. NOTE H - INCOME TAXES The significant components of the provision for income taxes for the years
ended December 31, 2003, 2002 and 2001. 2003
    
    2002
    
    2001(In thousands)Current tax provision:Federal
    
    $
    341
    
    
    $
    
    
    
    $
    State
    
    
    79
    
    
    
    
    
    
    
    420
    
    
    
    
    
    
    
    Deferred tax provision:Federal
    
    
    (43
    )
    
    
    192
    
    
    
    176State
    
    
    (9
    )
    
    
    41
    
    
    
    37(52
    )
    
    
    233
    
    
    
    213Provision for income tax expense before
adjustment to deferred tax asset valuation
allowance
    
    
    368
    
    
    
    233
    
    
    
    213Decrease in valuation allowance
    
    
    (368
    )
    
    
    (233
    )
    
    
    (213
    )Net provision for income taxes
    
    $
    
    
    
    $
    
    
    
    $
    
 The difference between the provision for income taxes and the amounts computed
by applying the statutory federal income tax rate of 34% to income before
income taxes is summarized below: 2003
    
    2002
    
    2001(In thousands)Tax computed at the statutory federal rate
    
    $
    408
    
    
    $
    213
    
    
    $
    186Increase (decrease) resulting from:State income taxes, net of federal benefit
    
    
    46
    
    
    
    20
    
    
    
    16Adjustment to deferred tax asset valuation allowance
    
    
    (368
    )
    
    
    (233
    )
    
    
    (213
    )Non-taxable income from bank owned life insurance
    
    
    (50
    )Other permanent differences
    
    
    (36
    )
    
    
    
    
    
    
    11Provision for income taxes
    
    $
    
    
    
    $
    
    
    
    $
    
 Page 53




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##### 



GATEWAY FINANCIAL HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2003, 2002 and 2001 NOTE H - INCOME TAXES (Continued) Deferred income taxes reflect the net tax effects of temporary differences
between the carrying amounts of assets and liabilities for financial reporting
purposes and the amounts used for income tax purposes. Significant components
of deferred taxes at December 31, 2003 and 2002 are as follows: 2003
    
    2002(In thousands)Deferred tax assets relating to:Allowance for loan losses
    
    $
    963
    
    
    $
    521Pre-opening costs and expenses
    
    
    
    
    
    
    47Net operating loss carryforwards
    
    
    33
    
    
    
    234Equity investment basis difference
    
    
    125
    
    
    
    48Other
    
    
    33
    
    
    
    43Total deferred tax assets
    
    
    1,154
    
    
    
    893Less valuation allowance
    
    
    (227
    )
    
    
    (595
    )Net deferred tax assets
    
    
    927
    
    
    
    298Deferred tax liabilities relating to:Depreciation
    
    
    (276
    )
    
    
    (189
    )Deferred loan costs
    
    
    (173
    )
    
    
    (107
    )Amortization of intangible assets
    
    
    (58
    )
    
    
    (2
    )Unrealized securities gains
    
    
    (110
    )
    
    
    (206
    )Total deferred tax liabilities
    
    
    (617
    )
    
    
    (504
    )Net recorded deferred tax assets (liability)
    
    $
    310
    
    
    $
    (206
    )
 The Company and its subsidiaries have federal and state net operating loss
carryfowards aggregating approximately $82,000 and $104,000, respectively,
expiring at various dates through 2018, which are available to offset future
taxable income. NOTE I - COMMON STOCK WARRANTS In connection with the sale of common stock in a secondary stock offering in
2002, the Company issued 1,110,973 warrants for the purchase of the Companys
common stock. Each warrant enables the holder to purchase 1.213 shares of
common stock at $9.15 per share at any time until June 30, 2004. During the
year ended December 31, 2003, 10,098 warrants were exercised for 11,662 shares
of common stock generating proceeds totaling $112,072. NOTE J - OTHER NON-INTEREST EXPENSE The major components of other non-interest expense for the years ended December
31, 2003, 2002 and 2001 are as follows: 2003
    
    2002
    
    2001(Dollars in thousands)Professional services
    
    $
    433
    
    
    $
    409
    
    
    $
    224Postage, printing and office supplies
    
    
    666
    
    
    
    451
    
    
    
    315Advertising and promotion
    
    
    213
    
    
    
    138
    
    
    
    83Amortization of intangibles
    
    
    59
    
    
    
    49
    
    
    
    254Other
    
    
    1,049
    
    
    
    749
    
    
    
    511Total
    
    $
    2,420
    
    
    $
    1,796
    
    
    $
    1,387
 Page 54




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##### 



GATEWAY FINANCIAL HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2003, 2002 and 2001 NOTE K - REGULATORY MATTERS The Company is subject to various regulatory capital requirements administered
by federal and state banking agencies. Failure to meet minimum capital
requirements can initiate certain mandatory, and possibly additional
discretionary, actions by regulators that, if undertaken, could have a direct
material effect on the Companys consolidated financial statements.
Quantitative measures established by regulation to ensure capital adequacy
require the Company to maintain minimum amounts and ratios, as set forth in the
table below. Management believes, as of December 31, 2003, that the Company
meets all capital adequacy requirements to which it is subject. The Companys
only significant asset is its investment in Gateway Bank & Trust Co.
Consequently, the information concerning capital ratios is essentially the same
for the Company and the Bank. As of December 31, 2003, 2002 and 2001, the most recent notification from the
FDIC categorized the Bank as well capitalized under the regulatory framework
for prompt corrective action. To be categorized as well capitalized the Bank
must maintain minimum amounts and ratios, as set forth in the table below.
There are no conditions or events since that notification that management
believes have changed the Banks category. The Banks actual capital amounts
and ratios are also presented in the table below: Minimum to be WellCapitalized underMinimum for Capital
    
    Prompt CorrectiveActual
    
    Adequacy Purposes
    
    Action ProvisionsAmount
    
    Ratio
    
    Amount
    
    Ratio
    
    Amount
    
    Ratio(Dollars in thousands)As of December 31, 2003:Total Capital (to Risk-Weighted Assets)
    
    $
    28,934
    
    
    
    11.53
    %
    
    $
    20,078
    
    
    
    8.00
    %
    
    $
    25,098
    
    
    
    10.00
    %Tier I Capital (to Risk-Weighted Assets)
    
    
    26,175
    
    
    
    10.43
    %
    
    
    10,039
    
    
    
    4.00
    %
    
    
    15,059
    
    
    
    6.00
    %Tier I Capital (to Average Assets)
    
    
    26,175
    
    
    
    8.38
    %
    
    
    12,501
    
    
    
    4.00
    %
    
    
    15,626
    
    
    
    5.00
    %As of December 31, 2002:Total Capital (to Risk-Weighted Assets)
    
    $
    22,917
    
    
    
    12.51
    %
    
    $
    14,659
    
    
    
    8.00
    %
    
    $
    18,323
    
    
    
    10.00
    %Tier I Capital (to Risk-Weighted Assets)
    
    
    21,196
    
    
    
    11.57
    %
    
    
    7,329
    
    
    
    4.00
    %
    
    
    10,994
    
    
    
    6.00
    %Tier I Capital (to Average Assets)
    
    
    21,196
    
    
    
    9.71
    %
    
    
    8,734
    
    
    
    4.00
    %
    
    
    10,918
    
    
    
    5.00
    %
 The Bank may not declare or pay a cash dividend, or repurchase any of its
capital stock, if the effect would cause the regulatory net worth of the Bank
to fall to an amount which is less than the minimum required by the FDIC and
the North Carolina Office of the Commissioner of Banks. NOTE L - OFF-BALANCE SHEET RISK The Company is a party to financial instruments with off-balance sheet risk in
the normal course of business to meet the financing needs of its customers.
These financial instruments include commitments to extend credit and standby
letters of credit. Those instruments involve, to varying degrees, elements of
credit and interest rate risk in excess of the amount recognized in the balance
sheet. The contract or notional amounts of those instruments reflect the extent
of involvement the Company has in particular classes of financial instruments.
The Company uses the same credit policies in making commitments and conditional
obligations as it does for on-balance sheet instruments. Page 55




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##### 



GATEWAY FINANCIAL HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2003, 2002 and 2001 NOTE L - OFF-BALANCE SHEET RISK (Continued) Commitments to extend credit are agreements to lend to a customer as long as
there is no violation of conditions established in the contract. Commitments
generally have fixed expiration dates or other termination clauses and may
require payment of a fee. Since some of the commitments are expected to expire
without being drawn upon, the total commitment amounts do not necessarily
represent future cash requirements. The Company evaluates each customers
creditworthiness on a case-by-case basis. The amount of collateral obtained, if
deemed necessary by the Bank, upon extension of credit is based on managements
credit evaluation of the borrower. Collateral obtained varies but may include
real estate, stocks, bonds, and certificates of deposit. A summary of the contract amount of the Companys exposure to off-balance sheet
risk as of December 31, 2003 is as follows (in thousands): Financial instruments whose contract
amounts represent credit risk:Commitments to extend credit
    
    $
    23,767Undisbursed lines of credit
    
    
    59,463Standby letters of credit
    
    
    2,377
 NOTE M - DISCLOSURES ABOUT FAIR VALUES OF FINANCIAL INSTRUMENTS Financial instruments include cash and due from banks, interest-earning
deposits with banks, investments, loans, stock in the Federal Reserve Bank and
the Federal Home Loan Bank of Atlanta, deposit accounts and borrowings. Fair
value estimates are made at a specific moment in time, based on relevant market
information and information about the financial instrument. These estimates do
not reflect any premium or discount that could result from offering for sale at
one time the Companys entire holdings of a particular financial instrument.
Because no active market readily exists for a portion of the Companys
financial instruments, fair value estimates are based on judgments regarding
future expected loss experience, current economic conditions, risk
characteristics of various financial instruments, and other factors. These
estimates are subjective in nature and involve uncertainties and matters of
significant judgment and, therefore, cannot be determined with precision.
Changes in assumptions could significantly affect the estimates. The following methods and assumptions were used to estimate the fair value of
each class of financial instruments for which it is practicable to estimate
that value: Cash and Due from Banks and Interest-Earning Deposits With Banks The carrying amounts for cash and due from banks and interest-earning deposits
with banks approximate fair value because of the short maturities of those
instruments. Investment Securities Fair value for investment securities equals quoted market price if such
information is available. If a quoted market price is not available, fair value
is estimated using quoted market prices for similar securities. Loans For certain homogenous categories of loans, such as residential mortgages, fair
value is estimated using the quoted market prices for securities backed by
similar loans, adjusted for differences in loan characteristics. The fair value
of other types of loans is estimated by discounting the future cash flows using
the current rates at which similar loans would be made to borrowers with
similar credit ratings and for the same remaining maturities. Page 56




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##### 



GATEWAY FINANCIAL HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2003, 2002 and 2001 NOTE M - DISCLOSURES ABOUT FAIR VALUES OF FINANCIAL INSTRUMENTS (Continued) Accrued Interest The carrying amounts of accrued interest approximate fair value. Stock in Federal Reserve Bank and Federal Home Loan Bank of Atlanta The fair value for FRB and FHLB stock approximates carrying value, based on the
redemption provisions of the Federal Reserve Bank and Federal Home Loan Bank. Bank Owned Life Insurance The carrying value of life insurance approximates fair value because this
investment is carried at cash surrender value, as determined by the insurer. Deposits The fair value of demand, savings, money market and NOW account deposits is the
amount payable on demand at the reporting date. The fair value of time deposits
is estimated based on discounting expected cash flows using the rates currently
offered for instruments of similar remaining maturities. Borrowings and Trust Preferred Securities The fair values are based on discounting expected cash flows at the interest
rate for debt with the same or similar remaining maturities and collateral
requirements. Financial Instruments with Off-Balance Sheet Risk With regard to financial instruments with off-balance sheet risk discussed in
Note L, it is not practicable to estimate the fair value of future financing
commitments. The carrying amounts and estimated fair values of the Companys financial
instruments, none of which are held for trading purposes, are as follows at
December 31, 2003 and 2002: 2003
    
    2002Carrying
    
    Estimated
    
    Carrying
    
    EstimatedAmount
    
    Fair Value
    
    Amount
    
    Fair Value(In thousands)Financial assets:Cash and due from banks
    
    $
    7,676
    
    
    $
    7,676
    
    
    $
    7,639
    
    
    $
    7,639Interest-earning deposits with banks
    
    
    5,152
    
    
    
    5,152
    
    
    
    1,869
    
    
    
    1,869Investment securities
    
    
    43,486
    
    
    
    43,773
    
    
    
    44,601
    
    
    
    44,601Accrued interest receivable
    
    
    1,301
    
    
    
    1,301
    
    
    
    1,167
    
    
    
    1,167Federal Reserve Bank stock
    
    
    722
    
    
    
    722
    
    
    
    467
    
    
    
    467Federal Home Loan Bank stock
    
    
    2,050
    
    
    
    2,050
    
    
    
    1,670
    
    
    
    1,670Loans
    
    
    228,981
    
    
    
    227,810
    
    
    
    159,767
    
    
    
    159,863Bank owned life insurance
    
    
    7,106
    
    
    
    7,106
    
    
    
    
    
    
    
    Financial liabilities:Deposits
    
    
    238,452
    
    
    
    236,481
    
    
    
    174,663
    
    
    
    175,248Borrowings
    
    
    42,000
    
    
    
    40,399
    
    
    
    31,401
    
    
    
    32,077Trust preferred securities
    
    
    8,000
    
    
    
    8,000
    
    
    
    
    
    
    
    Accrued interest payable
    
    
    537
    
    
    
    537
    
    
    
    472
    
    
    
    472
 Page 57




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##### 



GATEWAY FINANCIAL HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2003, 2002 and 2001 NOTE N - EMPLOYEE AND DIRECTOR BENEFIT PLANS 401(k) Retirement Plan The Company has a 401(k) retirement plan that contains provisions for specified
matching contributions by the Bank. The Company funds contributions as they
accrue. Total 401(k) expense was $186,000, $148,000 and $118,000 during the
years ended December 31, 2003, 2002 and 2001, respectively. Stock Option Plans During 1999 the Bank adopted, with shareholder approval, an Employee Stock
Option Plan (the Employee Plan) and a Director Stock Option Plan (the
Director Plan). During 2001 the Company increased the number of shares
available under its option plans. All options granted to non-employee directors
vest immediately at the time of grant, while all other options vest over a
four-year period with 20% vesting on the grant date and 20% vesting annually
thereafter. All unexercised options expire ten years after the date of grant. A
summary of the Banks option plans as of and for the years ended December 31,
2003, 2002 and 2001 is as follows: Outstanding Options
    
    Exercisable OptionsShares
    
    
    
    
    
    Weighted
    
    
    
    
    
    WeightedAvailable
    
    
    
    
    
    Average
    
    
    
    
    
    AverageShares
    
    for Future
    
    Number
    
    Exercise
    
    Number
    
    Exercisein Plans
    
    Grants
    
    Outstanding
    
    Price
    
    Outstanding
    
    PriceAt December 31, 2000
    
    
    393,374
    
    
    
    17
    
    
    
    393,357
    
    
    $
    8.28
    
    
    
    248,785
    
    
    $
    8.36Options authorized
    
    
    327,443
    
    
    
    327,443
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Options granted/vested
    
    
    
    
    
    
    (286,206
    )
    
    
    286,206
    
    
    
    7.42
    
    
    
    197,500
    
    
    
    7.61Options forfeited
    
    
    
    
    
    
    3,032
    
    
    
    (3,032
    )
    
    
    8.25
    
    
    
    (970
    )
    
    
    8.55At December 31, 2001
    
    
    720,817
    
    
    
    44,286
    
    
    
    676,531
    
    
    
    7.92
    
    
    
    445,315
    
    
    
    8.03Options granted/vested
    
    
    
    
    
    
    (26,571
    )
    
    
    26,571
    
    
    
    7.80
    
    
    
    80,644
    
    
    
    7.90At December 31, 2002
    
    
    720,817
    
    
    
    17,715
    
    
    
    703,102
    
    
    
    7.91
    
    
    
    525,959
    
    
    
    8.01Options granted/vested
    
    
    
    
    
    
    (2,625
    )
    
    
    2,625
    
    
    
    11.70
    
    
    
    79,055
    
    
    
    7.92Options forfeited
    
    
    
    
    
    
    6,055
    
    
    
    (6,055
    )
    
    
    7.42
    
    
    
    (2,426
    )
    
    
    7.42At December 31, 2003
    
    
    720,817
    
    
    
    21,145
    
    
    
    699,672
    
    
    $
    7.93
    
    
    
    602,588
    
    
    $
    8.00
 Outstanding options include 697,047 options with exercise prices ranging from
$6.80 to $9.07 per share, of which 602,063 are exercisable at December 31,
2003, and 2,625 options with an exercise price of $11.70 per share, of which
500 are exercisable at December 31, 2003. The weighted average remaining life
of total options outstanding and options exercisable as of December 31, 2003 is
6.6 years and 6.4 years, respectively. The fair value of each option granted
in 2003, 2002 and 2001 was $3.73, $3.02 and $2.85, respectively, and was
determined as of the date of grant using the Black-Scholes option pricing
model, assuming a risk-free interest rate of 3%, a dividend yield of 0%,
volatility of 24%, and an expected life of seven years. Page 58




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##### 



GATEWAY FINANCIAL HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2003, 2002 and 2001 NOTE N - EMPLOYEE AND DIRECTOR BENEFIT PLANS (Continued) Employment Contracts The Company has entered into employment agreements with its chief executive
officer and five other officers to ensure a stable and competent management
base. The agreements provide for a three-year term, but the agreements may be
extended for an additional year at the end of the first year and annually
thereafter. The agreements provide for benefits as spelled out in the contracts
and cannot be terminated by the Board of Directors, except for cause, without
prejudicing the officers rights to receive certain vested rights, including
compensation. In the event of a change in control of the Bank and in certain
other events, as defined in the agreements, the Bank or any successor to the
Company will be bound to the terms of the contracts. NOTE O - ACQUISITIONS On August 15, 2003, the Bank completed its acquisition from another bank of a
branch office in Elizabeth City, North Carolina, in a business combination
transaction accounted for as a purchase. This acquisition was made to expand
the Companys market share in Elizabeth City and because the branch acquired
fits well within the Companys strategic objectives. A summary of assets acquired, and liabilities assumed, is set forth below (in
thousands): Assets Acquired:Cash and cash equivalents
    
    $
    11,260Loans
    
    
    3,532Allowance for loan losses
    
    
    (52
    )Premises and equipment
    
    
    522Core deposit intangibles
    
    
    317Goodwill
    
    
    1,034Other assets
    
    
    10$
    16,623Liabilities Assumed:Deposits
    
    $
    16,541Other liabilities
    
    
    82$
    16,623
 On January 1, 2001, Gateway Insurance Services, Inc., a subsidiary of the Bank,
acquired Fidelity Insurance (Fidelity), an insurance agency, in a business
combination transaction accounted for as a purchase. The details of this
acquisition, with dollar amounts presented in thousands, are as follows: Assets acquired:Cash and equivalents
    
    $
    11Premises and equipment
    
    
    19Total assets acquired
    
    
    30Liabilities assumed:Accounts payable and accrued expenses
    
    
    109Fair value of identifiable net liabilities acquired
    
    
    (79
    )Goodwill
    
    
    679Cash consideration paid
    
    $
    600
 The goodwill resulting from this acquisition is expected to be tax deductible. The Company did not complete any acquisitions or divestitures during 2002. Page 59




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##### 



GATEWAY FINANCIAL HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2003, 2002 and 2001 NOTE P - PARENT COMPANY FINANCIAL DATA Gateway Financial Holdings, Inc. became the holding company for Gateway Bank &
Trust Co. effective October 1, 2001. Following are condensed financial
statements of Gateway Financial Holdings, Inc. as of December 31, 2003 and 2002
and for the years ended December 31, 2003 and 2002 and for the three months
ended December 31, 2001, presented in thousands. Condensed Balance Sheets
December 31, 2003 and 2002 2003
    
    2002Asset:Cash on deposit in subsidiary
    
    $
    2,771
    
    
    $
    Investment in subsidiaries
    
    
    30,242
    
    
    
    23,968Other assets
    
    
    220
    
    
    
    Total assets
    
    $
    33,233
    
    
    $
    23,968Liabilities:Junior subordinated debentures
    
    $
    8,248
    
    
    $
    Other liabilities
    
    
    14
    
    
    
    Convertible junior subordinated debentures
    
    
    8,262
    
    
    
    Stockholders equity:Common stock
    
    
    24,896
    
    
    
    24,788Retained earnings
    
    
    (102
    )
    
    
    (1,302
    )Accumulated other comprehensive income
    
    
    177
    
    
    
    482Total stockholders equity
    
    
    24,971
    
    
    
    23,968Total liabilities and stockholders equity
    
    $
    33,233
    
    
    $
    23,968
 Condensed Statements of Operations
Years Ended December 31, 2003 and 2002 and
Three Months Ended December 31, 2001 2003
    
    2002
    
    2001Equity in income of subsidiary
    
    $
    1,336
    
    
    $
    627
    
    
    $
    547Interest income
    
    
    27
    
    
    
    
    
    
    
    Interest expense
    
    
    (143
    )
    
    
    
    
    
    
    Other expense
    
    
    (20
    )
    
    
    
    
    
    
    $
    1,200
    
    
    $
    627
    
    
    $
    547
 Page 60




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##### 



GATEWAY FINANCIAL HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2003, 2002 and 2001 NOTE P - PARENT COMPANY FINANCIAL DATA (Continued) Condensed Statements of Operations
Years Ended December 31, 2003 and 2002 and
Three Months Ended December 31, 2001 2003
    
    2002
    
    2001Operating activities:Net income
    
    $
    1,200
    
    
    $
    627
    
    
    $
    547Equity in income of subsidiary
    
    
    (1,336
    )
    
    
    (627
    )
    
    
    (547
    )Amortization of debt issuance costs
    
    
    20
    
    
    
    
    
    
    
    Increase in other assets
    
    
    (240
    )
    
    
    
    
    
    
    Increase in other liabilities
    
    
    14
    
    
    
    
    
    
    
    (342
    )
    
    
    
    
    
    
    Investing activities:Investment in subsidiary
    
    
    (5,243
    )
    
    
    
    
    
    
    Financing activities:Proceeds from junior subordinated
debentures, net of debt issuance costs
    
    
    8,248
    
    
    
    
    
    
    
    Proceeds from the conversion of common
stock warrants
    
    
    112
    
    
    
    
    
    
    
    Cash paid in lieu of fractional shares on
5% stock dividend
    
    
    (4
    )
    
    
    
    
    
    
    8,356
    
    
    
    
    
    
    
    Net increase in cash
    
    
    2,771
    
    
    
    
    
    
    
    Cash, beginning of year
    
    
    
    
    
    
    
    
    
    
    Cash, end of year
    
    $
    2,771
    
    
    $
    
    
    
    $
    
 Page 61




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##### 



GATEWAY FINANCIAL HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2003, 2002 and 2001 NOTE Q - BUSINESS SEGMENT REPORTING In addition to its banking operations, the Bank has two other reportable
segments, Gateway Investment Services, Inc., whose principal activity is to
engage in brokerage services as an agent for non-bank investment products and
services, and Gateway Insurance Services, Inc., an independent insurance
agency. The accounting policies of the segments are the same as those described
in the summary of significant accounting policies. Set forth below is certain
financial information for each segment and in total (in thousands): At or for the Year Ended December 31, 2003Consolidated
    
    Adjustments
    
    Banking
    
    Brokerage
    
    InsuranceTotal interest income
    
    $
    13,486
    
    
    $
    
    
    
    $
    13,486
    
    
    $
    
    
    
    $
    Total interest expense
    
    
    5,341
    
    
    
    
    
    
    
    5,341
    
    
    
    
    
    
    
    Net interest income
    
    
    8,145
    
    
    
    
    
    
    
    8,145
    
    
    
    
    
    
    
    Provision for loan losses
    
    
    1,200
    
    
    
    
    
    
    
    1,200
    
    
    
    
    
    
    
    Net interest income after
provision for loan losses
    
    
    6,945
    
    
    
    
    
    
    
    6,945
    
    
    
    
    
    
    
    Non-interest income
    
    
    4,485
    
    
    
    (215
    )
    
    
    2,874
    
    
    
    240
    
    
    
    1,586Non-interest expense
    
    
    10,230
    
    
    
    (106
    )
    
    
    8,618
    
    
    
    235
    
    
    
    1,483Income before income taxes
    
    
    1,200
    
    
    
    (109
    )
    
    
    1,201
    
    
    
    5
    
    
    
    103Provision for income taxes
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Net income
    
    $
    1,200
    
    
    $
    (109
    )
    
    $
    1,201
    
    
    $
    5
    
    
    $
    103Period end total assets
    
    $
    314,826
    
    
    $
    (1,267
    )
    
    $
    314,786
    
    
    $
    103
    
    
    $
    1,204
 At or for the Year Ended December 31, 2002Consolidated
    
    Adjustments
    
    Banking
    
    Brokerage
    
    InsuranceTotal interest income
    
    $
    10,311
    
    
    $
    (2
    )
    
    $
    10,313
    
    
    $
    
    
    
    $
    Total interest expense
    
    
    4,819
    
    
    
    (2
    )
    
    
    4,819
    
    
    
    
    
    
    
    2Net interest income
    
    
    5,492
    
    
    
    
    
    
    
    5,494
    
    
    
    
    
    
    
    (2
    )Provision for loan losses
    
    
    480
    
    
    
    
    
    
    
    480
    
    
    
    
    
    
    
    Net interest income after
provision for loan losses
    
    
    5,012
    
    
    
    
    
    
    
    5,014
    
    
    
    
    
    
    
    (2
    )Non-interest income
    
    
    2,825
    
    
    
    (111
    )
    
    
    1,364
    
    
    
    193
    
    
    
    1,379Non-interest expense
    
    
    7,210
    
    
    
    (115
    )
    
    
    5,751
    
    
    
    196
    
    
    
    1,378Income before income taxes
    
    
    627
    
    
    
    4
    
    
    
    627
    
    
    
    (3
    )
    
    
    (1
    )Provision for income taxes
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Net income
    
    $
    627
    
    
    $
    4
    
    
    $
    627
    
    
    $
    (3
    )
    
    $
    (1
    )Period end total assets
    
    $
    231,053
    
    
    $
    (893
    )
    
    $
    230,867
    
    
    $
    33
    
    
    $
    1,046
 At or for the Year Ended December 31, 2001Consolidated
    
    Adjustments
    
    Banking
    
    Brokerage
    
    InsuranceTotal interest income
    
    $
    9,126
    
    
    $
    (3
    )
    
    $
    9,129
    
    
    $
    
    
    
    $
    Total interest expense
    
    
    5,059
    
    
    
    (3
    )
    
    
    5,056
    
    
    
    
    
    
    
    6Net interest income
    
    
    4,067
    
    
    
    
    
    
    
    4,073
    
    
    
    
    
    
    
    (6
    )Provision for loan losses
    
    
    440
    
    
    
    
    
    
    
    440
    
    
    
    
    
    
    
    Net interest income after
provision for loan losses
    
    
    3,627
    
    
    
    
    
    
    
    3,633
    
    
    
    
    
    
    
    (6
    )Non-interest income
    
    
    2,420
    
    
    
    (39
    )
    
    
    904
    
    
    
    303
    
    
    
    1,252Non-interest expense
    
    
    5,500
    
    
    
    (40
    )
    
    
    3,990
    
    
    
    304
    
    
    
    1,246Income before income taxes
    
    
    547
    
    
    
    1
    
    
    
    547
    
    
    
    (1
    )
    
    
    Provision for income taxes
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Net income
    
    $
    547
    
    
    $
    1
    
    
    $
    547
    
    
    $
    (1
    )
    
    $
    Period end total assets
    
    $
    160,832
    
    
    $
    (1,099
    )
    
    $
    160,861
    
    
    $
    37
    
    
    $
    1,033
 Page 62




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##### 



GATEWAY FINANCIAL HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2003, 2002 and 2001 NOTE R - INTANGIBLE ASSETS The following is a summary of intangible assets as of December 31, 2003, 2002
and 2001. The increase in goodwill for 2003 resulted from the branch
acquisition discussed in Note O. 2003
    
    2002
    
    2001(In thousands)Intangibles assets subject to future amortization:Core deposit
intangibles - gross
    
    $
    805
    
    
    $
    488
    
    
    $
    488Less accumulated amortization
    
    
    (198
    )
    
    
    (139
    )
    
    
    (89
    )Core deposit
intangibles - net
    
    $
    607
    
    
    $
    349
    
    
    $
    399Intangible assets not subject to future amortization:Goodwill - banking segment
    
    $
    2,341
    
    
    $
    1,307
    
    
    $
    1,307Goodwill - insurance segment
    
    
    634
    
    
    
    634
    
    
    
    634$
    2,975
    
    
    $
    1,941
    
    
    $
    1,941
 The following table presents the estimated amortization expense (in thousands)
for intangible assets for each of the five years ending December 31, 2008 and
the estimated amount amortizable thereafter. These estimates are subject to
change in future periods to the extent management determines it is necessary to
make adjustments to the carrying value or estimated useful life of amortizing
intangible assets.  2004
    
    $
    802005
    
    
    802006
    
    
    802007
    
    
    802008
    
    
    80Thereafter
    
    
    207$
    607
 The following tables present the adjusted effect on net income and on basic and
diluted earnings per share of excluding the amortization of goodwill for the
year ended December 31, 2003, 2002 and 2001: Year Ended December 31,2003
    
    2002
    
    2001(In thousands)Net income
    
    $
    1,200
    
    
    $
    627
    
    
    $
    547Add back goodwill amortization
    
    
    
    
    
    
    
    
    
    
    205Adjusted net income
    
    $
    1,200
    
    
    $
    627
    
    
    $
    752Basic net income per share
    
    $
    .36
    
    
    $
    .19
    
    
    $
    .21Add back goodwill amortization
    
    
    
    
    
    
    
    
    
    
    .07Adjusted basic net income per share
    
    $
    .36
    
    
    $
    .19
    
    
    $
    .28Diluted net income per shares
    
    $
    .35
    
    
    $
    .19
    
    
    $
    .21Add back goodwill amortization
    
    
    
    
    
    
    
    
    
    
    .07Adjusted diluted net income per share
    
    $
    .35
    
    
    $
    .19
    
    
    $
    .28
 Page 63




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##### 



ITEM 8  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE None. 
 ITEM 8A  CONTROLS AND PROCEDURES  The Companys management, with the participation of its Chief Executive Officer
and the Chief Financial Officer has evaluated the effectiveness of the
Companys disclosure controls and procedures as of December 31, 2003. Based
on that evaluation, the Companys Chief Executive Officer and Chief Financial
Officer concluded that the Companys disclosure controls and procedures were
effective as of December 31, 2003. There were no material changes in the
Companys internal controls over financial reporting during the fourth quarter
of 2003. 
 PART III 
 ITEM 9  DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT; COMPLIANCE
WITH SECTION 16(a) Incorporated by reference from the Companys definitive proxy statement, to be
filed with the Securities and Exchange Commission with respect to the Annual
Meeting of Shareholders to be held on May 17, 2004. 
 ITEM 10  EXECUTIVE COMPENSATION Incorporated by reference from the Companys definitive proxy statement, to be
filed with the Securities and Exchange Commission with respect to the Annual
Meeting of Shareholders to be held on May 17, 2004. 
 ITEM 11  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Incorporated by reference from the Companys definitive proxy statement, to be
filed with the Securities and Exchange Commission with respect to the Annual
Meeting of Shareholders to be held on May 17, 2004. Page 64




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##### 



The following table sets forth equity compensation plan information at December
31, 2003, as adjusted for the 21-for-20 stock split, to be effected in the form
of a 5% stock dividend, which was announced on February 27, 2004. Equity Compensation Plan Information Number of securitiesNumber of securities
    
    
    
    
    
    remaining available forto be issued
    
    Weighted-average
    
    future issuance underupon exercise of
    
    exercise price of
    
    equity compensationoutstanding
    
    outstanding
    
    plansoptions, warrants
    
    options, warrants
    
    (excluding securitiesPlan Category
    
    and rights
    
    and rights
    
    reflected in column(a))(a)
    
    (b)
    
    (c)Equity compensation
plans approved by
security holders
    
    
    524,944
    
    
    $
    8.06
    
    
    
    1,833Equity compensation
plans not approved
by security holders
    
    
    174,728
    
    
    $
    7.55
    
    
    
    19,312Total
    
    
    699,672
    
    
    $
    7.93
    
    
    
    21,145
 A description of the Companys equity compensation plans is presented in Note N
to the accompanying consolidated financial statements. The 2001 Nonstatutory Stock Option Plan (NSSO Plan) was not approved by
security holders. Options granted under the NSSO Plan do not qualify as
incentive stock options within the meaning of Section 422A of the Internal
Revenue Code and do not afford favorable tax treatment to recipients. Options
granted under the NSSO Plan do result in tax deductions to the Company. The
NSSO Plan is administered by the Executive Committee. Directors and employees
of the Company are eligible to receive options under the NSSO Plan at no cost
to them other than the option exercise price. The options must be exercised
within ten years from the date of grant. In the event that a participant
ceases to serve as a director or employee of the Company due to disability or
retirement, as defined in the NSSO Plan, an exercisable stock option will
continue to be exercisable upon the terms and conditions contained in the
grant. In the event of the death of a participant during service, an
exercisable stock option will continue to be exercisable for 12 months from the
date of death to the extent it was exercisable by the participant immediately
prior to death. In the event that a participant ceases to serve as a director
or employee of the Company for any other reason, the options will terminate. 
 ITEM 12  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Incorporated by reference from the Companys definitive proxy statement, to be
filed with the Securities and Exchange Commission with respect to the Annual
Meeting of Shareholders to be held on May 17, 2004. Page 65




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##### 



ITEM 13  EXHIBITS AND REPORTS ON FORM 8-K  (a)(3) Exhibits. The exhibits required by Item 601 of Regulation S-K are listed below. Exhibit No.
    
    DescriptionExhibit 3.1:
    
    Articles of Incorporation (incorporated by reference to Exhibit 3(i) to the Current
Report on Form 8K dated October 1, 2001)Exhibit 3.2:
    
    Bylaws (incorporated by reference to Exhibit 3(ii) to the Current Report on Form 8K
dated October 1, 2001)Exhibit 4.1:
    
    Specimen Certificate for Common Stock of Gateway Financial Holdings, Inc.
(incorporated by reference to Exhibit 4.1 of Amendment No. 1 to the Registration
Statement on Form S-3 filed September 20, 2001)Exhibit 4.2:
    
    Warrant Agreement (incorporated by reference to Exhibit 4.2 of Amendment No. 1 to
the Registration Statement on Form S-3 dated September 20, 2001.)Exhibit 4.3:
    
    Specimen of Warrant Certificate (incorporated by reference to Exhibit 4.3 to the
Registration Statement on Form S-3 dated August 13, 2001.)Exhibit 10.1:
    
    1999 Incentive Stock Option Plan of Gateway Financial Holdings, Inc. (incorporated
by reference to Exhibit 10.1 to the Annual Report on Form 10K for the year ended
December 31, 2001 (2001 Annual Report))Exhibit 10.2:
    
    1999 Non-Statutory Stock Option Plan of Gateway Financial Holdings, Inc.
(incorporated by reference to Exhibit 10.2 to the 2001 Annual Report)Exhibit 10.3:
    
    2001 Non-Statutory Stock Option Plan of Gateway Financial Holdings, Inc.
(incorporated by reference to Exhibit 10.3 to the 2001 Annual Report)Exhibit 21:
    
    Subsidiaries of the RegistrantExhibit 23:
    
    Consent of Dixon Hughes PLLCExhibit 31.1:
    
    Rule 13a-14(a)/15d-14(a) Certification by Chief Executive OfficerExhibit 31.2:
    
    Rule 13a-14(a)/15d-14(a) Certification by Chief Financial OfficerExhibit 32:
    
    Section 1350 Certifications
  (b)
    
    Current Reports on Form 8-K filed during the fourth quarter of 2003.  The Company filed a Current Report on Form 8-K dated October 6, 2003 to
report plans to construct a headquarters facility and financial center on
Laskin Road in Virginia Beach, Virginia.The Company filed a Current Report on Form 8-K dated October 24, 2003 to
report financial results for the three months and nine months ended
September 30, 2003. 
 ITEM 14  PRINCIPAL ACCOUNTANT FEES AND SERVICES Incorporated by reference from the Companys definitive proxy statement, to be
filed with the Securities and Exchange Commission with respect to the Annual
Meeting of Shareholders to be held on May 17, 2004. Page 66




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##### 



SIGNATURES Pursuant to the requirements of the Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed
on behalf of the undersigned, thereunto duly authorized. GATEWAY FINANCIAL HOLDINGS, INC.Date: March 15, 2004
    
    By:
    
    /s/ D. Ben BerryD. Ben BerryChairman, President and Chief Executive OfficerDate: March 15, 2004
    
    By:
    
    /s/ Mark A. HolmesMark A. HolmesSenior Executive Vice President andChief Financial Officer
  Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated. NAME
    
    TITLE
    
    DATE/s/ D. Ben BerryD. Ben Berry
    
    Chairman, President and CEO
    
    March 15, 2004/s/ Mark A. HolmesMark A. Holmes
    
    Chief Financial Officer
    
    March 15, 2004/s/ William Brumsey IIIWilliam Brumsey III
    
    Director
    
    March 15, 2004Jimmie Dixon, Jr.
    
    Director
    
    March    , 2004/s/ James H. Ferebee, Jr.James H. Ferebee, Jr.
    
    Director
    
    March 15, 2004/s/ Robert Willard Luther, IIIRobert Willard Luther, III
    
    Director
    
    March 15, 2004/s/ Frances Morrisette NorrellFrances Morrisette Norrell
    
    Director
    
    March 15, 2004/s/ W. C. Owens, Jr.W. C. Owens, Jr.
    
    Director
    
    March 15, 2004Ollin B. Sykes
    
    Director
    
    March    , 2004/s/ Russell E. TwifordRussell E. Twiford
    
    Director
    
    March 15, 2004/s/ Richard W. WhitingRichard W. Whiting
    
    Director
    
    March 15, 2004Frank T. Williams
    
    Director
    
    March    , 2004/s/ Jerry T. WomackJerry T. Womack
    
    Director
    
    March 15, 2004
 Page 67