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U. S. Securities and Exchange Commission Washington, D.C. 20549
 Form 10-KSB þ Annual Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934 For the fiscal year ended December 31, 2004 o 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
    
    
    56-2040581(State of incorporation)
    
    (IRS Employer Identification No.)1145 North Road Street, Elizabeth City, North Carolina
    
    
    27909(Address of principal executive offices)
    
    (Zip code)
 (252) 334-1511(Registrants telephone number, including area code)
 Securities registered under Section 12(b) of the Act: None. Securities registered under Section 12(g) of the Act: Common Stock, no par value. 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 þ No o 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. o State issuers revenues for its most recent fiscal year $25.5 million. The aggregate market value of the registrants Common Stock at March 18, 2005, held by those
persons deemed by the registrant to be non-affiliates, was approximately $103.6 million. As of March 18, 2005, (the most recent practicable date), the registrant had outstanding 6,697,672
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
    
    
    12Item 3. Legal Proceedings
    
    
    12Item 4. Submission of Matters to a Vote of Security Holders
    
    
    12PART IIItem 5. Market for Common Equity, Related Stockholder Matters and Small Business Issuer Purchases of Equity Securities
    
    
    12Item 6. Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    14Item 7. Financial Statements
    
    
    38Item 8. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
    
    
    69Item 8A. Controls and Procedures
    
    
    69Item 8B. Other Information
    
    
    69PART IIIItem 9. Directors and Executive Officers of the Registrant; Compliance with Section 16(a)
    
    
    69Item 10. Executive Compensation
    
    
    69Item 11. Securities Ownership of Certain Beneficial Owners and Management
    
    
    69Item 12. Certain Relationships and Related Transactions
    
    
    70Item 13. Exhibits
    
    
    70Item 14. Principal Accountant Fees and Services
    
    
    70
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PART I ITEM 1.  DESCRIPTION OF BUSINESS General Gateway Financial Holdings, Inc. is a financial holding company incorporated under the laws of
North Carolina to serve as the holding company for Gateway Bank & Trust Co., a North Carolina
chartered commercial bank with banking and insurance agency offices in Northeastern North Carolina,
including the Outer Banks, and the Greater Hampton Roads area of Virginia. The bank began
operations on December 1, 1998 and, effective October 1, 2001, became our wholly owned subsidiary. Since inception, we have aggressively pursued the primary objective of building a full service
commercial banking operation, while effectively supplementing our banking activities with other
financial services intended to generate significant non-interest income. Accordingly, a key
component of our growth strategy has been expanding our franchise through the opening of newly
constructed branches and strategic branch acquisitions. The bank serves its customers from sixteen
full service bank branches located in Elizabeth City (3), Edenton, Kitty Hawk, Moyock, Nags Head,
Plymouth and Roper, North Carolina, and Chesapeake (2), Emporia, Suffolk and Virginia Beach (3),
Virginia. During 2004, we added six additional full service bank branches, purchasing three
branches from another bank in October (located in Elizabeth City, North Carolina and Suffolk and
Emporia, Virginia) and opened three de novo branches with one in Virginia Beach, Virginia, one in
Nags Head and Moyock, North Carolina. During the first half of 2005, we expect to open two newly
constructed bank branches in Virginia Beach, Virginia (Hilltop opened March 1, 2005). Consistent
with our long-range strategic objectives, we will continue to consider acquisition opportunities
including whole bank or branch locations. We will also continue to explore de novo branching
opportunities in markets that we consider attractive. The bank has two wholly-owned operating subsidiaries, each of which has contributed to our
profitability. Gateway Insurance Services, Inc., an insurance agency with offices in Edenton,
Hertford, Elizabeth City, Plymouth, Moyock 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 arrangement with an unaffiliated broker-dealer. As
prescribed by this arrangement, Gateway Investment Services earns revenue through a commission
sharing arrangement with the unaffiliated broker-dealer. In an ongoing effort to create
significant sources of non-interest income, we will continue to look for ways to expand
non-traditional banking activities in our insurance and investment services subsidiaries. Since inception, we have concentrated our efforts on building a franchise and infrastructure that
can deliver and sustain long-term profitability. Toward that objective, and consistent with our
business plans, we incurred significant operating losses from the date of our opening through
December 31, 2000. These losses totaled approximately $2.5 million. We achieved our first
profitable quarter during the three months ended March 31, 2001 and have now remained profitable in
sixteen consecutive quarters, producing net income of $547,000 in 2001, $627,000 in 2002, $1.2
million in 2003 and $2.0 million through the twelve months ended December 31, 2004. While we
anticipate continued profitability, future expansion activity can be expected to generate
significant additional costs that can negatively impact earnings as we pursue our growth
strategies. 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 Page 3




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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%). 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 2004, 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 $702 million in deposits were located in Pasquotank County, and deposits of the Bank
on that date totaled $156.6 million. As of June 2004, there were six branches in Washington County
operated by five commercial banks, including the Bank, with approximately $119 million in deposits.
Deposits of the Bank on that date totaled $17.5 million. As of June 2004, there were eight branches
in Chowan County, including the Bank, operated by six commercial banks with approximately $183.4
million in deposits. Deposits of the Bank on that date totaled $13.1 million. As of June 2003,
there were 22 branches in Dare County operated by ten commercial banks, including the Bank, with
approximately $847 million in deposits. Deposits of the Bank on that date totaled $41.1 million. As
of June 2004, there were 45 branches in Chesapeake, Virginia operated by 15 commercial banks,
including the Bank, with approximately $1.7 billion in deposits. Deposits of the Bank on that date
totaled $23.7 million. As of June 2004, there were 96 branches in Virginia Beach operated by 15
commercial banks, including the Bank, and two savings institutions with approximately $4.2 billion
in deposits. Deposits of the Bank on that date totaled $51.2 million. Over 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. Page 4




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Employees The Company had 191 full-time equivalent employees at December 31, 2004. None of the Companys
employees are covered by a collective bargaining agreement. The Company considers its relations
with its employees to be good. 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,
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. 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. Page 5




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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
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, 2004, GFHs Tier 1 leverage capital ratio and total capital
were 13.89% and 17.40%, 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, 2004, the Federal Reserve had not advised GFH of any specific minimum Tangible Tier
1 Leverage Ratio applicable to it. Source of Strength for Subsidiary.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 holding company that does not, as an entity, currently engage in separate business
activities of a material nature, our ability to pay cash dividends depends upon the cash dividends
received from our subsidiary bank and management fees paid by the bank. We must pay our operating
expenses from funds we receive from the bank. Therefore, shareholders may receive cash dividends
from us 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 cash dividends
except out of operating earnings, provided that the prospective rate of earnings retention appears
consistent with the bank holding companys capital needs, asset quality and overall financial
condition. As a North Carolina corporation, our payment of cash dividends is subject to the
restrictions under North Carolina law on the declaration of cash dividends. Under such provisions,
cash dividends may not be paid if a corporation will not be able to pay its debts as they become
due in the usual course of business after paying such a cash dividend or if the corporations total
assets would be less than the sum of its total liabilities plus the amount that would be needed to
satisfy certain liquidation preferential rights. 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. Pursuant to a regulatory agreement between the state banking regulatory authorities in North
Carolina and Virginia, we are permitted to open and operate bank branches in Virginia. The
Virginia banking regulator has the opportunity to comment on our operations in Virginia, but the
banks Virginia operations are subject to regulation, supervision and regular examination by the
North Carolina Commissioner of Banks. 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, 2004, 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 Page 8




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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 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. 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. Page 9




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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 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. Legislation Sarbanes-Oxley Act.On July 30, 2002, the Sarbanes-Oxley Act, or SOX, was enacted. SOX is not
a banking law, but applies to all public companies, including us. The stated goals of SOX are to
increase corporate responsibility, to provide for enhanced penalties for accounting and auditing
improprieties at publicly traded companies, and to protect investors by improving the accuracy and
reliability of corporate disclosures pursuant to the securities laws. Given the extensive role of
the Securities and Exchange Commission in implementing and interpreting the rules relating to many
of SOXs new requirements, the potential impact on us of these requirements may not be determined
for some time. SOX includes additional disclosure requirements and new corporate governance rules for public
companies, requires the SEC to adopt extensive additional disclosure, corporate governance and
other related rules for public companies, increases criminal penalties for violations of the
securities laws, and mandates further studies of specified issues by the SEC and other federal
government agencies. SOX also provides for the federal regulation of accounting firms that provide
services to public companies and mandates additional listing standards for the securities
exchanges. The SEC has adopted rules implementing the provisions of SOX, but some of these rules do not
presently apply to us yet since certain of the rules have delayed effective dates. The SEC has also
extended the effective dates of certain rules after their adoption. Our management believes it is
in compliance with all presently applicable SOX requirements. As the new SOX requirements become
applicable, we will review those rules and comply as required. Page 10




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USA PATRIOT Act.In October 2001, the President signed into law the USA PATRIOT Act.
This Act was in direct response to the terrorist attacks on September 11, 2001, and strengthens the
anti-money laundering provisions of the Bank Secrecy Act. Most of the new provisions added by this
Act apply to accounts at or held by foreign banks, or accounts of or transactions with foreign
entities. The bank does not have significant foreign business and has not had its operations
materially affected by the Act. This Act does, however, require the federal banking regulators to
consider a banks record of compliance under the Bank Secrecy Act in acting on any application
filed by a bank. As the bank is subject to the provisions of the Bank Secrecy Act (i.e., reporting
of cash transactions in excess of $10,000), the banks record of compliance in this area will be an
additional factor in any applications filed by it in the future. To the banks knowledge, its
record of compliance in this area is satisfactory and its processes and procedures to ensure
compliance with the Bank Secrecy Act are satisfactory. 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 11




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ITEM 2  PROPERTIES The Company currently operates out of the banking and insurance offices as set forth below: Approximate Square
    
    
    Year Established/Office Location
    
    Footage
    
    
    AcquiredEdenton- 344 Virginia Road (4)
    
    
    2,400
    
    
    
    2002Elizabeth City- 1145 North Road Street (1)
    
    
    9,000
    
    
    
    1999Elizabeth City 1141 North Road Street (6)
    
    
    6,000
    
    
    
    2001Elizabeth City- 1404 West Ehringhaus Street (3)
    
    
    2,000
    
    
    
    2003Elizabeth City- 400 West Ehringhaus Street (4)
    
    
    5,000
    
    
    
    2004Elizabeth City- 802 West Ehringhaus Street (2)
    
    
    3,200
    
    
    
    2004Hertford 147 North Church Street (2)
    
    
    2,000
    
    
    
    2002Kitty Hawk- 3600 Croatan Highway (1)
    
    
    6,500
    
    
    
    2002Moyock- 100 Moyock Commons Drive (4)
    
    
    4,000
    
    
    
    2004Nags Head 2808 S. Croatan Highway (5)
    
    
    4,800
    
    
    
    2004Plymouth- 433 U.S. Highway 64 East (4)
    
    
    5,200
    
    
    
    2000Roper- 102 W. Buncomb Street (3)
    
    
    550
    
    
    
    2000Chesapeake- 111 Gainsbourgh Square (5)
    
    
    7,200
    
    
    
    2002Chesapeake- 575 Cedar Road (3)
    
    
    2,400
    
    
    
    2003Emporia 5205 Main Street (3)
    
    
    6,500
    
    
    
    2004Suffolk 2825 Godwin Drive (3)
    
    
    3,200
    
    
    
    2004Virginia Beach- 4460 Corporation Lane, Suite 100(3)
    
    
    4,000
    
    
    
    2000Virginia Beach- 3001 Shore Drive (3)
    
    
    2,000
    
    
    
    2003Virginia Beach 713 Independence Boulevard (3)
    
    
    2,200
    
    
    
    2003
   (1)
    
    Includes banking, investment brokerage and insurance services.(2)
    
    Insurance services only.(3)
    
    Banking services only.(4)
    
    Only banking and insurance services.(5)
    
    Only banking and investment brokerage services.(6)
    
    Operations building. The properties we own, including land, buildings and improvements, furniture, equipment and
vehicles, had a net book value at December 31, 2004 of $18.9 million. In the opinion of the
Companys management, such properties are adequately covered by insurance, are in good operating
condition, ordinary wear and tear excepted, and are adequate and suitable for the ordinary and
regular conduct and operation of our business. 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 2004. 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 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 in the Page 12




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##### 



form of a 5% stock dividend that was announced February 27, 2004 and distributed April 8, 2004 to
shareholders of record on March 15, 2004. The last reported sales price of the common stock on
March 18, 2005 was $18.30 per share. As of December 31, 2004, Gateway Bank had approximately 3,210
shareholders of record. High
    
    
    Low2004
    
    First Quarter
    
    
    
    
    
    $
    15.14
    
    
    $
    11.21Second Quarter
    
    
    
    
    
    
    14.56
    
    
    
    11.63Third Quarter
    
    
    
    
    
    
    15.58
    
    
    
    12.29Fourth Quarter
    
    
    
    
    
    
    16.04
    
    
    
    14.232003
    
    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
 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 in the form of a 5% stock dividend to shareholders of record on March 15,
2004 and distributed on April 8, 2004. Our warrants, were exercisable at any time until June 30,
2004. Those warrants were traded separately on the NASDAQ under the symbol GBTSW. In 2004,
1,320,817 shares of common stock were issued from the exercise of warrants. During October 2004 we
sold 1,932,000 shares of our common stock at $14.10 per share in a public offering. 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 June 30, 2004 was $4.30 per
warrant. High
    
    
    Low2004
    
    First Quarter
    
    $
    7.00
    
    
    $
    2.31Second Quarter
    
    
    6.49
    
    
    
    2.69Third Quarter
    
    
    N/A
    
    
    
    N/AFourth Quarter
    
    
    N/A
    
    
    
    N/A2003
    
    First Quarter
    
    $
    1.30
    
    
    $
    .95Second Quarter
    
    
    2.10
    
    
    
    1.15Third Quarter
    
    
    2.65
    
    
    
    1.70Fourth Quarter
    
    
    2.70
    
    
    
    1.57
 The company paid its first cash dividend to shareholders during the last half of 2004 at $0.02 per
common share. Subsequent to year end the Company paid a cash dividend of $0.02 per common share
during the first quarter of 2005. 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. Page 13




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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, distributed
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. OVERVIEW Gateway Financial Holdings, Inc. is a financial holding company incorporated under the laws of
North Carolina to serve as the holding company for Gateway Bank & Trust Co., a North Carolina
chartered commercial bank with banking and insurance agency offices in Northeastern North Carolina,
including the Outer Banks, and the Greater Hampton Roads area of Virginia. The bank began
operations on December 1, 1998 and, effective October 1, 2001, became our wholly owned subsidiary. Since inception, we have aggressively pursued the primary objective of building a full service
commercial banking operation, while effectively supplementing our banking activities with other
financial services intended to generate significant non-interest income. Accordingly, a key
component of our growth strategy has been expanding our franchise through the opening of newly
constructed branches and strategic branch acquisitions. The bank serves its customers from sixteen
full service bank branches located in Elizabeth City (3), Kitty Hawk, Edenton, Moyock, Nags Head,
Plymouth and Roper, North Carolina, and Virginia Beach (3), Emporia, Suffolk and Chesapeake (2),
Virginia. On October 15, 2004, we acquired three additional full service bank branches (located in
Elizabeth City, North Carolina and Suffolk and Emporia, Virginia) purchased from Provident Bank of
Maryland. In December 2004 we opened a newly constructed full service bank branch in Moyock, North
Carolina. During the first half of 2005, we expect to open two newly constructed bank branches in
Virginia Beach, Virginia. Consistent with our long-range strategic objectives, we will continue to
consider acquisition opportunities including whole bank or branch locations. We will also continue
to explore de novo branching opportunities in markets that we consider attractive. The bank has two wholly-owned operating subsidiaries, each of which have contributed to our
profitability. Gateway Insurance Services, Inc., an insurance agency with offices in Edenton,
Hertford, Elizabeth City, Plymouth, Moyock 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 arrangement with an unaffiliated broker-dealer. As
prescribed by this arrangement, Gateway Investment Services earns revenue through a commission
sharing arrangement with the unaffiliated broker-dealer. In an ongoing effort to create
significant sources of non-interest income, we will continue to look for ways to expand
non-traditional banking activities in our insurance and investment services subsidiaries. Since inception, we have concentrated our efforts on building a franchise and infrastructure that
can deliver and sustain long-term profitability. Toward that objective, and consistent with our
business plans, we incurred significant operating losses from the date of our opening through
December 31, 2000. These losses totaled approximately $2.5 million. We achieved our first
profitable quarter during the three months ended March 31, 2001 and have now remained profitable in
sixteen consecutive quarters, producing net income of $547,000 in 2001, $627,000 in 2002, $1.2
million in 2003 and $2.0 million through the twelve months ended December 31, 2004. While we
anticipate continued profitability, future expansion activity can be expected to generate
significant additional costs that can negatively impact earnings as we pursue our growth
strategies. Page 14




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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,
Edenton, Hertford, Moyock, Plymouth and Kitty Hawk, North Carolina. In May 2004, Gateway Insurance
Services, Inc. purchased Whitehurst Insurance Agency with three branches in Elizabeth City, Edenton
and Moyock, North Carolina. In June 2004, Gateway Insurance Services, Inc purchased Insurance
Express Premium Finance to provide specialized financing of insurance premiums. 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. Page 15




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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 31,2004
    
    
    2003
    
    
    2002
    
    
    2001
    
    
    2000(Dollars in thousands, except per share data)Operating Data:Total interest income
    
    $
    19,632
    
    
    $
    13,486
    
    
    $
    10,311
    
    
    $
    9,125
    
    
    $
    6,181Total interest expense
    
    
    6,691
    
    
    
    5,341
    
    
    
    4,819
    
    
    
    5,059
    
    
    
    3,457Net interest income
    
    
    12,941
    
    
    
    8,145
    
    
    
    5,492
    
    
    
    4,066
    
    
    
    2,724Provision for loan losses
    
    
    1,425
    
    
    
    1,200
    
    
    
    480
    
    
    
    440
    
    
    
    482Net interest income after
provision for loan losses
    
    
    11,516
    
    
    
    6,945
    
    
    
    5,012
    
    
    
    3,626
    
    
    
    2,242Total non-interest income
    
    
    5,857
    
    
    
    4,485
    
    
    
    2,826
    
    
    
    2,420
    
    
    
    1,341Total non-interest expense
    
    
    14,653
    
    
    
    10,230
    
    
    
    7,211
    
    
    
    5,499
    
    
    
    4,655Income (loss) before income taxes
    
    
    2,720
    
    
    
    1,200
    
    
    
    627
    
    
    
    547
    
    
    
    (1,072
    )Provision for income taxes
    
    
    710
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Net income (loss)
    
    $
    2,010
    
    
    $
    1,200
    
    
    $
    627
    
    
    $
    547
    
    
    $
    (1,072
    )Per Share Data: (6)Net income (loss), basic
    
    $
    0.45
    
    
    $
    0.36
    
    
    $
    0.19
    
    
    $
    0.21
    
    
    $
    (0.68
    )Net income (loss), diluted
    
    
    0.41
    
    
    
    0.35
    
    
    
    0.19
    
    
    
    0.21
    
    
    
    (0.68
    )Dividends
    
    
    0.02
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Book value
    
    
    9.66
    
    
    
    7.51
    
    
    
    7.23
    
    
    
    6.94
    
    
    
    6.83Tangible book value
    
    
    8.04
    
    
    
    6.41
    
    
    
    6.54
    
    
    
    6.23
    
    
    
    5.86Balance Sheet Data:Total assets
    
    $
    535,738
    
    
    $
    314,826
    
    
    $
    231,053
    
    
    $
    160,832
    
    
    $
    110,694Loans receivable
    
    
    381,956
    
    
    
    231,740
    
    
    
    161,488
    
    
    
    107,240
    
    
    
    75,921Allowance for loan losses
    
    
    4,163
    
    
    
    2,759
    
    
    
    1,721
    
    
    
    1,435
    
    
    
    1,028Deposits
    
    
    406,259
    
    
    
    238,452
    
    
    
    174,663
    
    
    
    115,717
    
    
    
    90,293Borrowings
    
    
    63,926
    
    
    
    50,000
    
    
    
    31,401
    
    
    
    21,300
    
    
    
    6,500Shareholders equity
    
    
    64,318
    
    
    
    24,971
    
    
    
    23,968
    
    
    
    22,998
    
    
    
    13,441Selected Performance Ratios:Return on average assets
    
    
    0.49
    %
    
    
    0.43
    %
    
    
    0.32
    %
    
    
    0.41
    %
    
    
    (1.33
    )%Return on average equity
    
    
    5.12
    %
    
    
    4.93
    %
    
    
    2.58
    %
    
    
    2.96
    %
    
    
    (9.76
    )%Net interest margin (1)
    
    
    3.59
    %
    
    
    3.24
    %
    
    
    3.09
    %
    
    
    3.32
    %
    
    
    3.78
    %Net interest spread (2)
    
    
    3.33
    %
    
    
    2.98
    %
    
    
    2.68
    %
    
    
    2.66
    %
    
    
    3.07
    %Non-interest income as a percentage of
net interest income and non-interest
income
    
    
    31.16
    %
    
    
    35.51
    %
    
    
    33.97
    %
    
    
    37.31
    %
    
    
    32.99
    %Non-interest income as a percentage of
average assets
    
    
    1.44
    %
    
    
    1.61
    %
    
    
    1.46
    %
    
    
    1.80
    %
    
    
    1.66
    %Non-interest expense to average assets
    
    
    3.59
    %
    
    
    3.67
    %
    
    
    3.71
    %
    
    
    4.10
    %
    
    
    5.78
    %Efficiency ratio (3)
    
    
    77.95
    %
    
    
    81.00
    %
    
    
    86.69
    %
    
    
    84.78
    %
    
    
    114.51
    %
 Page 16




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##### 



For the Years Ended December 31,2004
    
    
    2003
    
    
    2002
    
    
    2001
    
    
    2000(Dollars in thousands, except per share data)Asset Quality Ratios:Nonperforming loans to period-end loans
    
    
    0.13
    %
    
    
    0.52
    %
    
    
    0.82
    %
    
    
    0.00
    %
    
    
    0.00
    %Allowance for loan losses to period-end
loans
    
    
    1.09
    %
    
    
    1.19
    %
    
    
    1.07
    %
    
    
    1.34
    %
    
    
    1.35
    %Allowance for loan losses to
nonperforming loans (7)
    
    
    849.59
    %
    
    
    228.02
    %
    
    
    129.59
    %
    
    NM
    
    
    NMNonperforming assets to total assets (4)
    
    
    0.09
    %
    
    
    0.38
    %
    
    
    0.67
    %
    
    
    0.14
    %
    
    
    0.00
    %Net loan charge-offs to average
loans outstanding
    
    
    0.01
    %
    
    
    0.11
    %
    
    
    0.15
    %
    
    
    0.04
    %
    
    
    0.01
    %Capital Ratios:(5)Total risk-based capital
    
    
    17.40
    %
    
    
    12.68
    %
    
    
    12.51
    %
    
    
    17.89
    %
    
    
    15.71
    %Tier 1 risk-based capital
    
    
    16.41
    %
    
    
    11.59
    %
    
    
    11.57
    %
    
    
    16.72
    %
    
    
    14.44
    %Leverage ratio
    
    
    13.89
    %
    
    
    9.33
    %
    
    
    9.71
    %
    
    
    13.74
    %
    
    
    11.31
    %Equity to assets ratio
    
    
    12.01
    %
    
    
    7.93
    %
    
    
    10.37
    %
    
    
    14.30
    %
    
    
    12.14
    %Other Data:Number of banking offices
    
    
    16
    
    
    
    10
    
    
    
    7
    
    
    
    4
    
    
    
    4Number of full time equivalent employees
    
    
    191
    
    
    
    123
    
    
    
    96
    
    
    
    69
    
    
    
    53
   (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 in 2004, 21-for-20 stock split occurring during 2003 and 11-for-10 stock split occurring during 2002.(7)
    
    Considering that the Company had no nonperforming loans in 2001 and 2000, certain allowance for loan losses to nonperforming loans ratios are not considered meaningful NM. Page 17




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##### 



FINANCIAL CONDITION
December 31, 2004 and 2003 The Company continued its pattern of strong growth during 2004, with total assets increasing by
$220.9 million, or 70.2%, to $535.7 million at year end. This growth was principally reflected in
increased loans. Total loans increased by $150.2 million, or 64.8%, from $231.7 million at the
beginning of the year to $382.0 million at year end. The increase in loans was comprised
principally of increases of $8.1 million, $75.5 million and $28.0 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 $92.6 million, or
17.3% of total assets, at December 31, 2004. The cash surrender value of bank owned life insurance
totaled $16.5 million, or 3.1% of total assets at December 31, 2004. Additionally, the Companys
investment in premises and equipment increased by $6.9 million as a result of growth and expansion
and costs incurred in acquiring three branches from Provident Bank of Maryland located in Emporia
and Suffolk, Virginia and Elizabeth City, North Carolina, the upfit costs incurred with the opening
of a branch located at Independence Blvd in Virginia Beach, Virginia and construction costs related
with the opening of two de novo branches located in Nags Head and Moyock, North Carolina. In 2003
we incurred expansion costs 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
$7.3 million, primarily due to the acquisition of three branches from Provident Bank of Maryland. Funding for the growth in assets and loans was provided by increases of $167.8 million and $13.9
million, respectively, in deposit accounts and total borrowings. Total deposit accounts increased
70.4%, from $238.5 million at December 31, 2003 to $406.3 million at December 31, 2004.
Non-interest-bearing demand accounts increased by $14.9 million, or 39.8%, from $37.4 million at
the beginning of the period to $52.3 million at the end of the period. Savings, money market and
NOW accounts more than doubled to $168.5 million, representing a total increase of $94.1 million or
126.5% over the $74.4 million reported at December 31, 2003. Consistent with the Companys
objectives to reduce reliance on time deposits, demand, savings, money market and NOW accounts of
$220.8 million at December 31, 2004 represent 54.3% of total deposits at that date, up from $111.9
million or 46.9% of total deposits at December 31, 2003. Time deposits totaled $185.4 million at
December 31, 2004 as compared to $126.6 million at December 31, 2003. Large denomination time
deposits of more than $100,000 were $56.1 million, or 13.8% of total deposits at
December 31, 2004 as compared with $35.8 million, or 15.0% of total deposits at December 31, 2003.
The Company continues to use brokered deposits to fund growth, with such deposits decreasing from
$29.3 million to $12.8 million during the year, comprising 6.9% of total time deposits at December
31, 2004. Advances from the Federal Home Loan Bank of Atlanta increased from $36.0 million to
$37.6 million during the twelve months, while federal funds purchased increased from $6.0 million
to $10.9 million at December 31, 2003 and December 31, 2004, respectively. In addition, during 2004
and 2003 the Company issued $7.0 million and $8.0 million, respectively 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 $39.3 million, primarily due to net income for the current
year of $2.0 million, proceeds of $12.1 million from warrant conversions, proceeds of $24.9 million
from a stock offering and a reduction due to a cash dividend payment in the amount of $95,000.
Stockholders equity totaled $64.3 million at December 31, 2004. 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, 2004, 2003 and 2002, average
interest-earning assets were $360.5 million, $251.7 million and $177.5 million, respectively.
During these same years, the Companys net interest margins were 3.59%, 3.24%, and 3.09%,
respectively. Page 18




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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. In preparing the table, nonaccrual loans are included in the average loan balance. For the Years Ended December 31,2004
    
    
    2003
    
    
    2002Average
    
    
    
    
    
    
    Average
    
    
    Average
    
    
    
    
    
    
    Average
    
    
    Average
    
    
    
    
    
    
    AverageBalance
    
    
    Interest
    
    
    Rate
    
    
    Balance
    
    
    Interest
    
    
    Rate
    
    
    Balance
    
    
    Interest
    
    
    Rate(Dollars in thousands)Interest-earning assets:Loans
    
    $
    301,466
    
    
    $
    17,509
    
    
    
    5.81
    %
    
    $
    197,801
    
    
    $
    11,511
    
    
    
    5.82
    %
    
    $
    130,769
    
    
    $
    8,178
    
    
    
    6.25
    %Interest-earning deposits
    
    
    6,515
    
    
    
    102
    
    
    
    1.57
    %
    
    
    1,867
    
    
    
    21
    
    
    
    1.12
    %
    
    
    4,055
    
    
    
    67
    
    
    
    1.65
    %Investment securities available for sale taxable
    
    
    47,630
    
    
    
    1,835
    
    
    
    3.85
    %
    
    
    49,652
    
    
    
    1,851
    
    
    
    3.73
    %
    
    
    40,903
    
    
    
    1,959
    
    
    
    4.79
    %Investment securities available for sale tax exempt
    
    
    1,908
    
    
    
    64
    
    
    
    3.35
    %
    
    
    
    
    
    
    
    
    
    
    
    %
    
    
    
    
    
    
    
    
    
    
    
    %FHLB/FRB stock
    
    
    2,936
    
    
    
    122
    
    
    
    4.16
    %
    
    
    2,409
    
    
    
    103
    
    
    
    4.28
    %
    
    
    1,815
    
    
    
    107
    
    
    
    5.90
    %Total interest-earning assets
    
    
    360,455
    
    
    
    19,632
    
    
    
    5.45
    %
    
    
    251,729
    
    
    
    13,486
    
    
    
    5.36
    %
    
    
    177,542
    
    
    
    10,311
    
    
    
    5.81
    %Other assets
    
    
    47,244
    
    
    
    
    
    
    
    
    
    
    
    26,727
    
    
    
    
    
    
    
    
    
    
    
    16,593Total assets
    
    $
    407,699
    
    
    
    
    
    
    
    
    
    
    $
    278,456
    
    
    
    
    
    
    
    
    
    
    $
    194,135Interest-bearing liabilities:Deposits:Savings, NOW and money market
    
    $
    118,242
    
    
    
    1,553
    
    
    
    1.31
    %
    
    $
    55,852
    
    
    
    557
    
    
    
    1.00
    %
    
    $
    28,131
    
    
    
    284
    
    
    
    1.01
    %Time deposits
    
    
    137,440
    
    
    
    3,430
    
    
    
    2.50
    %
    
    
    125,100
    
    
    
    3,555
    
    
    
    2.84
    %
    
    
    98,288
    
    
    
    3,479
    
    
    
    3.54
    %Borrowings
    
    
    59,758
    
    
    
    1,708
    
    
    
    2.86
    %
    
    
    43,244
    
    
    
    1,229
    
    
    
    2.84
    %
    
    
    27,433
    
    
    
    1,056
    
    
    
    3.85
    %Total interest-bearing liabilities
    
    
    315,440
    
    
    
    6,691
    
    
    
    2.12
    %
    
    
    224,196
    
    
    
    5,341
    
    
    
    2.38
    %
    
    
    153,852
    
    
    
    4,819
    
    
    
    3.13
    %Demand deposits
    
    
    52,218
    
    
    
    
    
    
    
    
    
    
    
    27,943
    
    
    
    
    
    
    
    
    
    
    
    15,166Other liabilities
    
    
    815
    
    
    
    
    
    
    
    
    
    
    
    1,972

    
    
    
    
    
    
    
    
    
    
    
    798Stockholders equity
    
    
    39,226
    
    
    
    
    
    
    
    
    
    
    
    24,345
    
    
    
    
    
    
    
    
    
    
    
    24,319Total liabilities and stockholders equity
    
    $
    407,699
    
    
    
    
    
    
    
    
    
    
    $
    278,456
    
    
    
    
    
    
    
    
    
    
    $
    194,135Net interest income and interest rate spread
    
    
    
    
    
    $
    12,941
    
    
    
    3.33
    %
    
    
    
    
    
    $
    8,145
    
    
    
    2.98
    %
    
    
    
    
    
    $
    5,492
    
    
    
    2.68
    %Net interest margin
    
    
    
    
    
    
    
    
    
    
    3.59
    %
    
    
    
    
    
    
    
    
    
    
    3.24
    %
    
    
    
    
    
    
    
    
    
    
    3.09
    %Ratio of average interest-earning assets to
average interest-bearing liabilities
    
    
    114.27
    %
    
    
    
    
    
    
    
    
    
    
    112.28
    %
    
    
    
    
    
    
    
    
    
    
    115.40
    %
 Page 19




---



##### 



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, 2004 vs. 2003
    
    
    December 31, 2003 vs. 2002Increase (Decrease) Due to
    
    
    Increase (Decrease) Due toVolume
    
    
    Rate
    
    
    Total
    
    
    Volume
    
    
    Rate
    
    
    Total(Dollars in thousands)Interest income:Loans
    
    $
    6,027
    
    
    $
    (29
    )
    
    $
    5,998
    
    
    $
    4,046
    
    
    $
    (713
    )
    
    $
    3,333Interest-earning deposits
    
    
    63
    
    
    
    18
    
    
    
    81
    
    
    
    (30
    )
    
    
    (16
    )
    
    
    (46
    )Investment securities available
for saleTaxable
    
    
    (77
    )
    
    
    61
    
    
    
    (16
    )
    
    
    373
    
    
    
    (481
    )
    
    
    (108
    )Tax-exempt
    
    
    32
    
    
    
    32
    
    
    
    64FHLB/FRB stock
    
    
    22
    
    
    
    (3
    )
    
    
    19
    
    
    
    30
    
    
    
    (34
    )
    
    
    (4
    )Total interest income
    
    
    6,067
    
    
    
    79
    
    
    
    6,146
    
    
    
    4,419
    
    
    
    (1,244
    )
    
    
    3,175Interest expense:DepositsSavings, NOW and
money market
    
    
    721
    
    
    
    275
    
    
    
    996
    
    
    
    278
    
    
    
    (5
    )
    
    
    273Time deposits
    
    
    329
    
    
    
    (454
    )
    
    
    (125
    )
    
    
    855
    
    
    
    (779
    )
    
    
    76Borrowings
    
    
    585
    
    
    
    (106
    )
    
    
    479
    
    
    
    443
    
    
    
    (270
    )
    
    
    173Total interest expense
    
    
    1,635
    
    
    
    (285
    )
    
    
    1,350
    
    
    
    1,576
    
    
    
    (1,054
    )
    
    
    522Net interest income
increase (decrease)
    
    $
    4,432
    
    
    $
    364
    
    
    $
    4,796
    
    
    $
    2,843
    
    
    $
    (190
    )
    
    $
    2,653
 RESULTS OF OPERATIONS
Years Ended December 31, 2004 and 2003 Overview. The Company reported net income of $2.0 million or $.41 per diluted share for
the year ended
December 31, 2004, as compared with net income of $1.2 million or $.35 per diluted share for 2003,
an increase of $810,000 in net income and an increase of $.06 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. During 2004 the Bank opened
two new branches in leased facilities, one located on Independence Blvd in Virginia Beach in
February and one in Nags Head, North Carolina. The Bank also opened a newly constructed branch in
Moyock, North Carolina in December 2004. In October 2004 the Bank purchased three branches in
Emporia and Suffolk, Virginia and Elizabeth City, North Carolina from Provident Bank of Maryland.
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 sixteen. 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 2004. In 2004 interest rates obtained 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. The expected current trend with interest rates is an
increasing rate environment. 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 Page 20




---



##### 



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 $12.9 million for the year ended December 31, 2004, a $4.8 million
or 58.9% increase from the $8.1 million earned during 2003. Total interest income benefited from
strong growth in the level of average earning assets during the year. Asset growth combined with
higher asset yields caused by the increase in market interest rates during periods reported
contributed to this rise in income. Average total interest-earning assets increased $108.7
million, or 43.2%, for 2004 as compared to 2003, while the average yield increased by 9 basis
points from 5.36% to 5.45%. Average total interest-bearing liabilities increased by $91.2 million,
or 40.7% for 2004 as compared to 2003, while the average cost of interest-bearing liabilities
decreased by 26 basis points from 2.38% to 2.12%. This resulted in a 35 basis point improvement in
interest rate spread and also resulted in an improvement in interest rate margin. For the year
ended December 31, 2004, the net interest rate spread was 3.33% and the net interest margin was
3.59%. For the year ended December 31, 2003, the net interest spread was 2.98% and the net interest
margin was 3.24%. Provision for Loan Losses. The Company recorded a $1.4 million provision for loan losses
in 2004, representing an increase of $225,000 from the $1.2 million provision made in 2003.
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 2004 and 2003 the provision for loan losses was made principally in
response to growth in loans, as total loans outstanding increased by $150.2 million in 2004 and by
$70.3 million in 2003. At December 31, the allowance for loan losses was $4.2 million for 2004 and
$2.8 million for 2003, representing 1.09% and 1.19%, respectively, of loans outstanding. Non-Interest Income. Non-interest income totaled $5.9 million for the year ended December
31, 2004 as compared with $4.5 million for 2003, an increase of $1.4 million, or 30.6%. 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 2004 increases were broad based and include $602,000 in service charges
on deposit accounts, $352,000 in income from insurance operations, $223,000 in income from
brokerage operations, $281,000 gain from the sale of the Banks membership interest in Sidus
financial, LLC, a mortgage company and $119,000 in income from other service fee income. The Bank
owns 49% of Gateway First Mortgage, LLC (Gateway First) and owned approximately 8% of Sidus
Financial, LLC (Sidus). During 2004 Sidus and Gateway First were 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 had an increase in income
of $256,000 in 2004 from bank owned life insurance that was purchased during 2004 and 2003. Non-Interest Expenses. Non-interest expenses totaled $14.7 million for the year ended
December 31, 2004, an increase of $4.4 million or 43.1% over the $10.2 million reported for 2003.
In comparison, total assets averaged $407.7 million for 2004, an increase of 46.4% over average
total assets of $278.5 million for the year ended December 31, 2003. 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
February, August and December 2004 and the acquisition of three full service bank branches from
Provident Bank of Maryland, increasing the number of full service banking locations to sixteen.
Ten of the sixteen branches were fully operational throughout 2004, while only eight of ten
branches existing at the end of 2003 were operational throughout all of that year. As a result of
such expansion, personnel costs increased by $2.3 million, or 41.3%, the costs of occupancy and
equipment increased by $1.0 million or 54.7%, and other non-interest expenses increased by $905,000
or 37.4%. The Companys data processing increased by $209,000 or 52.6%. As a percentage of
average total assets, total non-interest expenses were consistent at 3.61% for 2004 and 3.67% for
2003. Income Taxes. Income tax expense was $710,000 for 2004 and $0 for 2003 as a result of the
recognition of deferred tax assets, generated in prior years, that had previously been offset by a
valuation allowance. For 2005, the Company expects that the provision for income taxes for the
year will be approximately 36% to 38% of total income before income taxes. During the years ended
December 31, 2004, the Company utilized all remaining net operating loss carryforwards created
during our first three fiscal years. Page 21




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##### 



RESULTS OF OPERATIONS
Years Ended December 31, 2003 and 2002 Overview. We 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, or 91.4%, in net income and an increase of $.16, or 84.2%, in net income per
diluted share. Our primary focus continues to be on growth and development of our branch network
and subsidiary operations, sacrificing some profitability in the near term. During 2003, 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. We generated significantly higher levels of net interest income and
noninterest income in 2003 as compared to 2002, which increases were partially offset by increases
in non-interest expenses. We 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, our interest rate spread and net interest margins have increased primarily due to
the banks growth of low cost core deposits. Net Interest Income. Net interest income increased to $8.1 million for the year ended
December 31, 2003, a $2.7 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%, to $251.7 million for 2003 as compared to $177.5 million for 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%, to $224.2 million for 2003 as compared to $153.9 million for
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 the interest rate margin of 15 basis points. 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%. Contributing to the improvement in our net interest spread and margin was an improved
mix of interest earning assets and interest bearing liabilities. In 2003, higher yielding loans
equaled 78.6% of interest earning assets as compared to 73.7% in 2002. In 2003, lower cost
savings, NOW and money market deposits equaled 24.9% of interest bearing liabilities as compared to
18.3% in 2002. Also contributing to the increase in the net interest margin was a $12.8 million,
or 84.2%, increase in non-interest bearing demand deposits to $27.9 million in 2003 from $15.2
million in 2002. Provision for Loan Losses. We 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, we consider 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, we have actively pursued additional non-interest income sources outside of traditional
banking operations, including income from insurance, mortgage banking and brokerage operations. The
2003 increases include $316,000, or 54.3%, in service charges on deposit accounts, $689,000, or
163.3%, in income from mortgage operations, $216,000, or 17.1%, in income from insurance
operations, and $47,000, or 24.4%, 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 our investment in Sidus Financial, LLC (Sidus), and $212,000
representing our equity in the 2003 income of Gateway First Mortgage, LLC (Gateway First). The
bank owns approximately 8% of Sidus and 49% of 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. We 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. Page 22




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##### 



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 our 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% to $5.5 million from $3.9 million,
the costs of occupancy and equipment increased by $890,000, or 91.4% to $1.9 million from $974,000,
and other non-interest expenses increased by $623,000, or 34.7% to $2.4 million from $1.8 million.
Our 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% to $397,000 from $493,000. 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 zero 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, we expect 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, 2004, the Bank had credit availability with the Federal Home Loan Bank of
Atlanta (FHLB) of approximately $133.9 million, with $37.6 million outstanding, federal funds
lines of credit with three other financial institutions in the aggregate amount of $28.9 million,
with $10.9 million outstanding, secured by certain commercial loans. Total deposits were $406.3 million and $238.5 million at December 31, 2004 and 2003, 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 2004. At December 31, 2004, time deposits represented 45.6% of the Companys total
deposits, down sharply from 53.1% of total deposits at December 31, 2003. Certificates of deposit
of $100,000 or more also reflected this trend, representing 13.8% and 15.0%, respectively, of the
Banks total deposits at December 31, 2004 and 2003. At December 31, 2004, the Company had $12.8
million in brokered time deposits, representing 2.7% of total deposits at that date, down from
17.7% of total deposits at December 31, 2003. 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, 2004 and 2003, the Companys tangible equity to asset ratio was 10.0% and 6.8%,
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 2004 and 2003 through the issuance of $7.0 million and $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, 2004 and 2003 was 11.9% and 8.4%,
respectively. Page 23




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##### 



CAPITAL RATIOS The Bank is subject to minimum capital requirements. See SUPERVISION AND REGULATION. As the
following table indicates, at December 31, 2004, the Bank exceeded regulatory capital requirements. At December 31, 2004Actual
    
    
    Minimum
    
    
    Well-CapitalizedRatio
    
    
    Requirement
    
    
    RequirementTotal risk-based capital ratio
    
    
    17.40
    %
    
    
    8.0
    %
    
    
    10.0
    %Tier 1 risk-based capital ratio
    
    
    16.41
    %
    
    
    4.0
    %
    
    
    6.0
    %Leverage ratio
    
    
    13.89
    %
    
    
    4.0
    %
    
    
    5.0
    %
 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, 2004. Payments Due by PeriodOn DemandOr Within
    
    
    
    
    
    
    
    
    
    
    AfterContractual Obligations
    
    Total
    
    
    1 Year
    
    
    2-3 Years
    
    
    4-5 Years
    
    
    5 Years(In thousands)Federal funds purchased
    
    $
    10,861
    
    
    $
    10,861
    
    
    $
    
    
    
    $
    
    
    
    $
    FHLB advances
    
    
    37,600
    
    
    
    25,000
    
    
    
    12,600
    
    
    
    
    
    
    
    Junior subordinated debentures
    
    
    15,465
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    15,465Lease obligations
    
    
    9,623
    
    
    
    750
    
    
    
    1,250
    
    
    
    1,101
    
    
    
    6,522Deposits
    
    
    406,259
    
    
    
    319,549
    
    
    
    78,690
    
    
    
    8,020
    
    
    
    Total contractual cash obligations
    
    $
    479,808
    
    
    $
    356,160
    
    
    $
    92,540
    
    
    $
    9,121
    
    
    $
    21,987
 The following table reflects other commitments of the company outstanding as of December 31,
2004. 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
    
    $
    18,291
    
    
    $
    18,291
    
    
    $
    
    
    
    $
    
    
    
    $
    Other commitments and credit lines
    
    
    55,574
    
    
    
    55,574
    
    
    
    
    
    
    
    
    
    
    
    Undisbursed portion of construction loans
    
    
    49,323
    
    
    
    49,323
    
    
    
    
    
    
    
    
    
    
    
    Standby letters of credit
    
    
    461
    
    
    
    461
    
    
    
    
    
    
    
    
    
    
    
    Construction
    
    
    2,650
    
    
    
    2,650
    
    
    
    
    
    
    
    
    
    
    
    Total other commitments
    
    $
    126,299
    
    
    $
    126,299
    
    
    $
    
    
    
    $
    
    
    
    $
    
 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, 2004 is
not material and has not been included in the above table. Page 24




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##### 



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 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, 2004, the Company would
expect an increase in net interest income of $1,250,000 if interest rates increase from current
rates by 100 basis points and a decrease in net interest income of $1,464,000 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, 2004 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 25




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##### 



Terms to Repricing at December 31, 2004Over 3
    
    
    Total3 Months
    
    
    Months to
    
    
    Within
    
    
    Over 12or Less
    
    
    12 Months
    
    
    12 Months
    
    
    Months
    
    
    Total(Dollars in thousands)Interest-earning assets:Loans
    
    $
    273,364
    
    
    $
    9,942
    
    
    $
    283,306
    
    
    $
    98,650
    
    
    $
    381,956Interest-earning deposits
    
    
    1,245
    
    
    
    
    
    
    
    1,245
    
    
    
    
    
    
    
    1,245Investment securities available for sale
    
    
    513
    
    
    
    
    
    
    
    513
    
    
    
    92,095
    
    
    
    92,608FHLB/FRB stock
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    3,043
    
    
    
    3,043Total interest-earning assets
    
    $
    275,122
    
    
    $
    9,942
    
    

    $
    285,064
    
    
    $
    193,788
    
    
    $
    478,852Percentage of total interest-earning assets
    
    
    57.45
    %
    
    
    2.08
    %
    
    
    59.53
    %
    
    
    40.47
    %
    
    
    100.00
    %Cumulative percentage to total interest-
earning assets
    
    
    57.45
    %
    
    
    59.53
    %
    
    
    59.53
    %
    
    
    100.00
    %
    
    
    100.00
    %Interest-bearing liabilities:Deposits:Savings, NOW and money market
    
    $
    168,499
    
    
    $
    
    
    
    $
    168,499
    
    
    $
    
    
    
    $
    168,499Time
    
    
    25,189
    
    
    
    73,513
    
    
    
    98,702
    
    
    
    86,710
    
    
    
    185,412Borrowings
    
    
    31,326
    
    
    
    20,000
    
    
    
    51,326
    
    
    
    12,600
    
    
    
    63,926Total interest-bearing liabilities
    
    $
    225,014
    
    
    $
    93,513
    
    
    $
    318,527
    
    
    $
    99,310
    
    
    $
    417,837Percentage of total interest-bearing liabilities
    
    
    53.85
    %
    
    
    22.38
    %
    
    
    76.23
    %
    
    
    23.77
    %
    
    
    100.00
    %Cumulative percentage of total interest-
bearing liabilities
    
    
    53.85
    %
    
    
    76.23
    %
    
    
    76.23
    %
    
    
    100.00
    %
    
    
    100.00
    %Interest sensitivity gap
    
    $
    50,108
    
    
    $
    (83,571
    )
    
    $
    (33,463
    )
    
    $
    94,478
    
    
    $
    61,015Cumulative interest sensitivity gap
    
    $
    50,108
    
    
    $
    (33,463
    )
    
    $
    (33,463
    )
    
    $
    61,015
    
    
    $
    61,015Cumulative interest sensitivity gap as a
percentage of total interest-earning assets
    
    
    10.46
    %
    
    
    (6.99
    )%
    
    
    (6.99
    )%
    
    
    12.74
    %
    
    
    12.74
    %Cumulative ratio of interest-sensitive assets
to interest-sensitive liabilities
    
    
    122.27
    %
    
    
    89.49
    %
    
    
    89.49
    %
    
    
    114.60
    %
    
    
    114.60
    %
 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. 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 Page 26




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##### 



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, 2004, 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 D 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. OFF-BALANCE SHEET ARRANGEMENTS Information about the Companys off-balance sheet risk exposure is presented in Note L to the
accompanying consolidated 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, 2004, except as otherwise
disclosed in Note G to the accompanying consolidated financial statements, 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. Page 27




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##### 



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 31,2004
    
    
    2003Percent
    
    
    
    
    
    
    PercentAmount
    
    
    of Total
    
    
    Amount
    
    
    of Total(Dollars in thousands)Commercial
    
    $
    69,075
    
    
    
    18.0
    %
    
    $
    52,554
    
    
    
    22.7
    %Real estate  construction
    
    
    131,431
    
    
    
    34.4
    %
    
    
    55,970
    
    
    
    24.2
    %Real estate  commercial mortgage
    
    
    90,197
    
    
    
    23.6
    %
    
    
    68,094
    
    
    
    29.3
    %Real estate  1-4 family mortgage
    
    
    51,768
    
    
    
    13.5
    %
    
    
    32,191
    
    
    
    13.9
    %Consumer
    
    
    10,641
    
    
    
    2.8
    %
    
    
    10,458
    
    
    
    4.5
    %Home equity lines of credit
    
    
    29,351
    
    
    
    7.7
    %
    
    
    12,615
    
    
    
    5.4
    %Subtotal
    
    
    382,462
    
    
    
    100.0
    %
    
    
    231,882
    
    
    
    100.0
    %Less: Allowance for loan losses
    
    
    (4,163
    )
    
    
    
    
    
    
    (2,759
    )Unamortized net deferred (fees) costs
    
    
    (506
    )
    
    
    
    
    
    
    (142
    )Net loans
    
    $
    377,793
    
    
    
    
    
    
    $
    228,981
 At December 31,2002
    
    
    2001Percent
    
    
    
    
    
    
    PercentAmount
    
    
    of Total
    
    
    Amount
    
    
    of Total(Dollars in thousands)Commercial
    
    $
    42,767
    
    
    
    26.5
    %
    
    $
    61,364
    
    
    
    57.2
    %Real estate  construction
    
    
    22,861
    
    
    
    14.2
    %
    
    
    10,050
    
    
    
    9.4
    %Real estate  commercial mortgage
    
    
    48,362
    
    
    
    29.9
    %
    
    
    15,373
    
    
    
    14.3
    %Real estate  1-4 family mortgage
    
    
    31,957
    
    
    
    19.8
    %
    
    
    7,074
    
    
    
    6.6
    %Consumer
    
    
    7,707
    
    
    
    4.7
    %
    
    
    7,692
    
    
    
    7.2
    %Home equity lines of credit
    
    
    7,834
    
    
    
    4.9
    %
    
    
    5,659
    
    
    
    5.3
    %Subtotal
    
    
    161,488
    
    
    
    100.0
    %
    
    
    107,212
    
    
    
    100.0
    %Less: Allowance for loan losses
    
    
    (1,721
    )
    
    
    
    
    
    
    (1,435
    )Unamortized net deferred (fees) costs
    
    
    
    
    
    
    
    
    
    
    28Net loans
    
    $
    159,767
    
    
    
    
    
    
    $
    105,805
 Page 28




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##### 



At December 31,2000PercentAmount
    
    
    of Total(Dollars in thousands)Commercial
    
    $
    35,656
    
    
    
    47.0
    %Real estate  construction
    
    
    6,421
    
    
    
    8.4
    %Real estate  commercial mortgage
    
    
    15,825
    
    
    
    20.8
    %Real estate  1-4 family mortgage
    
    
    7,241
    
    
    
    9.5
    %Consumer
    
    
    6,594
    
    
    
    8.7
    %Home equity lines of credit
    
    
    4,264
    
    
    
    5.6
    %Subtotal
    
    
    76,001
    
    
    
    100.0
    %Less: Allowance for loan losses
    
    
    (1,028
    )Unamortized net deferred (fees) costs
    
    
    (79
    )Net loans
    
    $
    74,894
 The following table presents, at December 31, 2004, (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
    
    $
    41,684
    
    
    $
    25,595
    
    
    $
    1,796
    
    
    $
    69,075Real estate  construction
    
    
    76,578
    
    
    
    43,888
    
    
    
    10,965
    
    
    
    131,431Total
    
    $
    118,262
    
    
    $
    69,483
    
    
    $
    12,761
    
    
    $
    200,506Fixed rate loans
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    82,244Variable rate loans
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    82,244
 Commercial Loans.Commercial business lending is a primary focus of the Companys lending
activities. At December 31, 2004, the Companys commercial loan portfolio equaled $66.4 million or
17.4% of total loans, as compared with $52.6 million or 22.7% of total loans at December 31, 2003.
Commercial loans include both secured 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, 2004, the Companys residential one to four family loans amounted to $51.8 million
or 13.6% of total loans as compared with $32.2 million or 13.9% of total loans at December 31,
2003. 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 $872,000 for the year ended December 31, Page 29




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##### 



2004 and $647,000 for the year ended December 31, 2003. 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 $90.2 or 23.6% of total loans at December 31, 2004 and $68.0 million or
29.3% of total loans at December 31, 2003. 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
$131.4 million or 34.3% of total loans at December 31, 2004 and $56.0 million or 24.2% of total
loans at December 31, 2003. 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. 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 Page 30




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##### 



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. 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 31,2004
    
    
    2003
    
    
    2002
    
    
    2001
    
    
    2000(Dollars in thousands)Nonaccrual loans
    
    $
    490
    
    
    $
    1,210
    
    
    $
    1,328
    
    
    $
    
    
    
    $
    Restructured loans
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Total nonperforming loans
    
    
    490
    
    
    
    1,210
    
    
    
    1,328
    
    
    
    
    
    
    
    Real estate owned
    
    
    
    
    
    
    
    
    
    
    230
    
    
    
    230
    
    
    
    Total nonperforming assets
    
    $
    490
    
    
    $
    1,210
    
    
    $
    1,558
    
    
    $
    230
    
    
    $
    Accruing loans past due 90 days or more
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    4Potential problem loans
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Allowance for loan losses
    
    
    4,163
    
    
    
    2,759
    
    
    
    1,721
    
    
    
    1,435
    
    
    
    1,028Nonperforming loans to period end loans
    
    
    0.13
    %
    
    
    0.52
    %
    
    
    0.82
    %
    
    
    
    
    
    
    Allowance for loan losses to
period end loans
    
    
    1.09
    %
    
    
    1.19
    %
    
    
    1.07
    %
    
    
    1.34
    %
    
    
    1.35
    %Allowance for loan losses to
nonperforming loans
    
    
    849.59
    %
    
    
    228.02
    %
    
    
    129.59
    %
    
    
    
    
    
    
    Nonperforming assets to total assets
    
    
    0.09
    %
    
    
    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, 2004, we
had $490,000 of nonaccrual loans. During the third quarter of 2004 we collected our largest
nonaccrual loan in the amount of $861,000. This loan was cross collateralized and was secured by
real estate. The borrower, as a result of cash flow problems, had filed for Page 31




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##### 



protection under Chapter 11 of the bankruptcy code, during which time the Company was not receiving
regular interest payments. Accordingly, Management placed this loan in nonaccrual status. The
Company did not incur any loss on this loan. Real estate owned consists of foreclosed, repossessed and idled properties. At December 31, 2004
the Company had no real estate owned. 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. Between December 31,
1999 and December 31, 2004, 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 34.4%; commercial and industrial loans 18.0%
to 57.2%; loans to individuals  2.8% to 8.7%; and home equity lines of credit  4.9% to Page 32




---



##### 



7.7%. For all fiscal years through 2004, our net loan charge-offs in each year were no more than
        .15% of average loans outstanding. Because 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, 2004 at $4.2 million, representing 1.09% 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 31,2004
    
    
    2003% of Total
    
    
    
    
    
    
    % of TotalAmount
    
    
    Loans (1)
    
    
    Amount
    
    
    Loans (1)(Dollars in thousands)Balance applicable to:Commercial
    
    $
    667
    
    
    
    18.0
    %
    
    $
    683
    
    
    
    22.7
    %Real estate  construction
    
    
    1,577
    
    
    
    34.4
    %
    
    
    672
    
    
    
    24.2
    %Real estate  mortgage
    
    
    1,477
    
    
    
    37.1
    %
    
    
    1,102
    
    
    
    43.2
    %Consumer
    
    
    128
    
    
    
    2.8
    %
    
    
    125
    
    
    
    4.5
    %Home equity lines of credit
    
    
    294
    
    
    
    7.7
    %
    
    
    139
    
    
    
    5.4
    %Unallocated
    
    
    20
    
    
    
    
    
    
    
    38
    
    
    
    Total
    
    $
    4,163
    
    
    
    100.0
    %
    
    $
    2,759
    
    
    
    100.0
    %
 At December 31,2002
    
    
    2001% of Total
    
    
    
    
    
    
    % of TotalAmount
    
    
    Loans (1)
    
    
    Amount
    
    
    Loans (1)(Dollars in thousands)Balance applicable to:Commercial
    
    $
    482
    
    
    
    26.5
    %
    
    $
    900
    
    
    
    57.2
    %Real estate  construction

    
    
    229
    
    
    
    14.2
    %
    
    
    120
    
    
    
    9.4
    %Real estate  mortgage
    
    
    803
    
    
    
    49.7
    %
    
    
    150
    
    
    
    20.9
    %Consumer
    
    
    77
    
    
    
    4.7
    %
    
    
    90
    
    
    
    7.2
    %Home equity lines of credit
    
    
    78
    
    
    
    4.9
    %
    
    
    50
    
    
    
    5.3
    %Unallocated
    
    
    52
    
    
    
    
    
    
    
    125
    
    
    
    Total
    
    $
    1,721
    
    
    
    100.0
    %
    
    $
    1,435
    
    
    
    100.0
    %
 Page 33




---



##### 



At December 31,2000% of TotalAmount
    
    
    Loans (1)(Dollars in thousands)Balance applicable to:Commercial
    
    $
    581
    
    
    
    47.0
    %Real estate  construction
    
    
    90
    
    
    
    8.4
    %Real estate  mortgage
    
    
    230
    
    
    
    30.3
    %Consumer
    
    
    79
    
    
    
    8.7
    %Home equity lines of credit
    
    
    47
    
    
    
    5.6
    %Unallocated
    
    
    1
    
    
    
    Total
    
    $
    1,028
    
    
    
    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 31,2004
    
    
    2003
    
    
    2002
    
    
    2001
    
    
    2000(Dollars in thousands)Balance at beginning of period
    
    $
    2,759
    
    
    $
    1,721
    
    
    $
    1,435
    
    
    $
    1,028
    
    
    $
    462Charge-offs:Commercial
    
    
    
    
    
    
    (195
    )
    
    
    (146
    )
    
    
    (20
    )
    
    
    Real estate
    
    
    
    
    
    
    
    
    
    
    (18
    )
    
    
    
    
    
    
    Consumer
    
    
    (174
    )
    
    
    (20
    )
    
    
    (30
    )
    
    
    (17
    )
    
    
    (7
    )Home equity lines of credit
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Total charge-offs
    
    
    (174
    )
    
    
    (215
    )
    
    
    (194
    )
    
    
    (37
    )
    
    
    (7
    )Recoveries:Commercial
    
    
    125
    
    
    
    1
    
    
    
    
    
    
    
    
    
    
    
    Real estate
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    4
    
    
    
    Consumer
    
    
    28
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Home equity lines of credit
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Total recoveries
    
    
    153
    
    
    
    1
    
    
    
    
    
    
    
    4
    
    
    
    Net charge-offs
    
    
    (21
    )
    
    
    (214
    )
    
    
    (194
    )
    
    
    (33
    )
    
    
    (7
    )Allowance for loan losses on
loans purchased
    
    
    
    
    
    
    52
    
    
    
    
    
    
    
    
    
    
    
    91Provision for loan losses charged
to operations
    
    
    1,425
    
    
    
    1,200
    
    
    
    480
    
    
    
    440
    
    
    
    482Balance at end of period
    
    $
    4,163
    
    
    $
    2,759
    
    
    $
    1,721
    
    
    $
    1,435
    
    
    $
    1,028Ratio of net loan charge-offs to
average loans outstanding
    
    
    0.01
    %
    
    
    0.11
    %
    
    
    0.15
    %
    
    
    0.04
    %
    
    
    0.01
    %
 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 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: Page 34




---



##### 



Gross
    
    
    GrossAmortized
    
    
    Unrealized
    
    
    Unrealized
    
    
    MarketCost
    
    
    Gains
    
    
    Losses
    
    
    Value(Dollars in thousands)December 31, 2004U.S. government agencies
    
    $
    43,709
    
    
    $
    6
    
    
    $
    471
    
    
    $
    43,244Corporate debt securities
    
    
    2,613
    
    
    
    49
    
    
    
    1
    
    
    
    2,661Mortgage-backed securities
    
    
    40,408
    
    
    
    146
    
    
    
    86
    
    
    
    40,468Municipal securities
    
    
    6,239
    
    
    
    17
    
    
    
    21
    
    
    
    6,235$
    92,969
    
    
    $
    218
    
    
    $
    579
    
    
    $
    92,608December 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
    
    
    $
    44,601
 The following table summarizes the amortized costs, fair values and weighted average yields, based
on amortized cost, of securities available-for-sale at December 31, 2004, 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
    
    $
    38,181
    
    
    $
    37,767
    
    
    
    3.27
    %Due after five but within ten years
    
    
    5,528
    
    
    
    5,477
    
    
    
    3.88
    %43,709
    
    
    
    43,244
    
    
    
    3.35
    %Corporate debt/equity securities:Due within one year
    
    
    513
    
    
    
    513
    
    
    
    0.00
    %Due after one but within five years
    
    
    1,563
    
    
    
    1,612
    
    
    
    5.14
    %Due after five but within ten years
    
    
    537
    
    
    
    536
    
    
    
    6.01
    %2,613
    
    
    
    2,661
    
    
    
    4.23
    %Mortgage-backed securities:Due after one but within five years
    
    
    1,050
    
    
    
    1,060
    
    
    
    4.29
    %Due after five but within ten years
    
    
    318
    
    
    
    327
    
    
    
    4.60
    %Due after ten years
    
    
    39,040
    
    
    
    39,081
    
    
    
    4.50
    %40,408
    
    
    
    40,468
    
    
    
    4.50
    %Municipal securities:Due after one but within five years
    
    
    1,065
    
    
    
    1,065
    
    
    
    3.47
    %Due after five but within ten years
    
    
    2,260
    
    
    
    2,256
    
    
    
    3.94
    %Due after ten years
    
    
    2,914
    
    
    
    2,914
    
    
    
    5.17
    %6,239
    
    
    
    6,235
    
    
    
    4.43
    %Total securities available for sale:Due within one year
    
    
    513
    
    
    
    513
    
    
    
    0.00
    %Due after one but within five years
    
    
    41,859
    
    
    
    41,504
    
    
    
    3.38
    %Due after five but within ten years
    
    
    8,643
    
    
    
    8,596
    
    
    
    4.06
    %Due after ten years
    
    
    41,954
    
    
    
    41,995
    
    
    
    4.55
    %$
    92,969
    
    
    $
    92,608
    
    
    
    3.95
    %
 Page 35




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##### 



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, 2004 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 31,2004
    
    
    2003
    
    
    2002Average
    
    
    Average
    
    
    Average
    
    
    Average
    
    
    Average
    
    
    AverageBalance
    
    
    Rate
    
    
    Balance
    
    
    Rate
    
    
    Balance
    
    
    Rate(Dollars in thousands)Interest-bearing NOW, money
market and savings accounts
    
    $
    118,242
    
    
    
    1.31
    %
    
    $
    55,852
    
    
    
    1.00
    %
    
    $
    28,131
    
    
    
    1.01
    %Time deposits
    
    
    137,440
    
    
    
    2.50
    %
    
    
    125,100
    
    
    
    2.84
    %
    
    
    98,288
    
    
    
    3.54
    %Total interest-bearing deposits
    
    
    255,681
    
    
    
    1.95
    %
    
    
    180,952
    
    
    
    2.27
    %
    
    
    126,419
    
    
    
    2.98
    %Demand and other non-interest-bearing
deposits
    
    
    52,218
    
    
    
    
    
    
    
    27,943
    
    
    
    
    
    
    
    15,166Total average deposits
    
    $
    307,900
    
    
    
    1.62
    %
    
    $
    208,895
    
    
    
    1.97
    %
    
    $
    141,585
    
    
    
    2.66
    %
 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, 2004: At December 31, 2004(Dollars in thousands)Remaining maturity:Less than three months
    
    $
    6,675Over three months through six months
    
    
    6,110Over six months through one year
    
    
    15,137Over one year through three years
    
    
    26,969Over three years through five years
    
    
    1,218Total
    
    $
    56,109
 Page 36




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##### 



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 ($133.9 million at December
31, 2004). Outstanding advances at December 31, 2004 were as follows: InterestMaturity
    
    Rate
    
    
    2004
    
    
    2003January 2, 2004
    
    
    1.15
    %
    
    $
    
    
    
    $
    13,000,000May 25, 2004
    
    
    1.46
    %
    
    
    
    
    
    
    5,000,000February 4, 2005
    
    
    2.14
    %
    
    
    5,000,000
    
    
    
    5,000,000July 21, 2005
    
    
    2.44
    %
    
    
    20,000,000
    

    
    
    February 27, 2006
    
    
    5.45
    %
    
    
    600,000
    
    
    
    1,000,000March 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$
    37,600,000
    
    
    $
    36,000,000
 Pursuant to collateral agreements with the Federal Home Loan Bank, at December 31, 2004, advances
are secured by investment securities available for sale with a fair value of $19.2 million and by
loans with a carrying amount of $88.2 million. In addition, the Company may purchase federal funds through three unsecured federal funds lines of
credit aggregating $28.9 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 (2.45% at December 31,
2004). The Company had $10.9 million and $6.0 million outstanding on these lines of credit as of
December 31, 2004 and 2003, respectively. The maximum amounts outstanding under these lines of
credit at any month-end during 2004 and 2003 were $10.9 million and $12.2 million, respectively.
The average amounts outstanding under these lines of credit were $4.7 million for 2004 and $4.1
million for 2003. 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. In June of 2004, $7.0 million of trust preferred securities were placed through Gateway Capital
Statutory Trust II (the Trust). The Trust issuer has invested the total proceeds from the sale of
the Trust Preferred Securities 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 the 3 month LIBOR plus 2.65%.
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 June 17, 2009, in whole or in part. Redemption is mandatory at June 17, 2034. 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.
Based on current Federal Reserve Board guidelines, $15.0 million in Trust Preferred Securities
qualifies as Tier 1 capital and if any excess remained it would qualify as Tier 2 supplementary
capital. On December 31, 2004, the Company applied the provisions of FIN 46R to two wholly-owned subsidiary
trusts that Page 37




---



##### 



issued trust preferred securities to third party investors. The application of FIN 46R resulted in
the deconsolidation of the wholly-owned trusts. The assets and liabilities of the subsidiary
trusts that were deconsolidated totaled $15.5 million and $15.0 million, respectively. 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 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. ITEM 7  FINANCIAL STATEMENTS GATEWAY FINANCIAL HOLDINGS, INC. & SUBSIDIARY
INDEX TO THE CONSOLIDATED FINANCIAL STATEMENTS Page No.Report of Independent Registered Public Accounting Firm
    
    
    39Consolidated Balance Sheets as of December 31, 2004 and 2003
    
    
    40Consolidated Statements of Operations
for the years ended December 31, 2004, 2003 and 2002
    
    
    41Consolidated Statements of Comprehensive Income
for the years ended December 31, 2004, 2003 and 2002
    
    
    42Consolidated Statements of Changes in Stockholders Equity
for the years ended December 31, 2004, 2003 and 2002
    
    
    43Consolidated Statements of Cash Flows
for the years ended December 31, 2004, 2003 and 2002
    
    
    44Notes to Consolidated Financial Statements
    
    
    45
 Page 38




---



##### 



(DIXON HUGHES PLLC LOGO) REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM 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 subsidiary as of December 31, 2004 and 2003, 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, 2004. 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 the standards of the Public Company Accounting Oversight
Board (United States). 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 subsidiary at
December 31, 2004 and 2003 and the results of their operations and their cash flows for each of the
years in the three-year period ended December 31, 2004 in conformity with accounting principles
generally accepted in the United States of America. (DIXON HUGHES PLLC) Sanford, North Carolina
February 11, 2005 Page 39




---



##### 



GATEWAY FINANCIAL HOLDINGS, INC. AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS December 31, 2004 and 2003
 2004
    
    
    2003(In thousands, except share data)ASSETSCash and due from banks
    
    $
    9,028
    
    
    $
    7,676Interest-earning deposits in other banks
    
    
    1,245
    
    
    
    5,152Investment in securities available for sale, at fair value (Note C)
    
    
    92,608
    
    
    
    43,773Loans (Note D)
    
    
    381,956
    
    
    
    231,740Allowance for loan losses (Note D)
    
    
    (4,163
    )
    
    
    (2,759
    )NET LOANS
    
    
    377,793
    
    
    
    228,981Accrued interest receivable
    
    
    2,697

    
    
    
    1,301Stock in Federal Reserve Bank, at cost
    
    
    722
    
    
    
    722Stock in Federal Home Loan Bank of Atlanta, at cost
    
    
    2,321
    
    
    
    2,050Premises and equipment, net (Note E)
    
    
    18,895
    
    
    
    11,967Core deposit intangibles, net (Note R)
    
    
    3,169
    
    
    
    607Goodwill (Notes O and R)
    
    
    7,473
    
    
    
    2,975Bank-owned life insurance
    
    
    16,507
    
    
    
    7,106Other assets
    
    
    3,270
    
    
    
    2,516TOTAL ASSETS
    
    $
    535,728
    
    
    $
    314,826LIABILITIES AND STOCKHOLDERS EQUITYDepositsDemand
    
    $
    52,348
    
    
    $
    37,454Savings
    
    
    10,860
    
    
    
    4,428Money market and NOW
    
    
    157,639
    
    
    
    70,010Time (Note F)
    
    
    185,412
    
    
    
    126,560TOTAL DEPOSITS
    
    
    406,259
    
    
    
    238,452Borrowings (Note G)
    
    
    63,926
    
    
    
    50,000Accrued expenses and other liabilities
    
    
    1,225
    
    
    
    1,403TOTAL LIABILITIES
    
    
    471,410
    
    
    
    289,855Commitments (Notes D and L)Stockholders 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,
6,659,073 and 3,167,542 shares issued and outstanding
at December 31, 2004 and 2003, respectively
    
    
    62,631
    
    
    
    24,896Retained earnings (deficit)
    
    
    1,908
    
    
    
    (102
    )Accumulated other comprehensive income (loss)
    
    
    (221
    )
    
    
    177TOTAL STOCKHOLDERS EQUITY
    
    
    64,318
    
    
    
    24,971TOTAL LIABILITIES AND
STOCKHOLDERS EQUITY
    
    $
    535,728
    
    
    $
    314,826
 See accompanying notes. Page 40




---



##### 



GATEWAY FINANCIAL HOLDINGS, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF OPERATIONS Years Ended December 31, 2004, 2003 and 2002
 2004
    
    
    2003
    
    
    2002(Amounts in thousands, exceptshare and per share data)INTEREST INCOMEInterest and fees on loans
    
    $
    17,509
    
    
    $
    11,511
    
    
    $
    8,178Investment securities available for saleTaxable
    
    
    1,835
    
    
    
    1,851
    
    
    
    1,959Tax-exempt
    
    
    64
    
    
    
    
    
    
    
    Interest-earning bank deposits
    
    
    102
    
    
    
    21
    
    
    
    67Other interest and dividends
    
    
    122
    
    
    
    103
    
    
    
    107TOTAL INTEREST INCOME
    
    
    19,632
    
    
    
    13,486
    
    
    
    10,311INTEREST EXPENSEMoney market, NOW and savings deposits
    
    
    1,553
    
    
    
    557
    
    
    
    285Time deposits (Note F)
    
    
    3,430
    
    
    
    3,555
    
    
    
    3,479Borrowings
    
    
    1,708
    
    
    
    1,229
    
    
    
    1,055TOTAL INTEREST EXPENSE
    
    
    6,691
    
    
    
    5,341
    
    
    
    4,819NET INTEREST INCOME
    
    
    12,941
    
    
    
    8,145
    
    
    
    5,492PROVISION FOR LOAN LOSSES (Note D)
    
    
    1,425
    
    
    
    1,200
    
    
    
    480NET INTEREST INCOME AFTER
PROVISION FOR LOAN LOSSES
    
    
    11,516
    
    
    
    6,945
    
    
    
    5,012NON-INTEREST INCOMEService charges on deposit accounts
    
    
    1,500
    
    
    
    898
    
    
    
    582Mortgage operations
    
    
    872
    
    
    
    1,111
    
    
    
    422Insurance operations
    
    
    1,832
    
    
    
    1,480
    
    
    
    1,264Brokerage operations
    
    
    463
    
    
    
    240
    
    
    
    193Gain on sale of securities
    
    
    159
    
    
    
    244
    
    
    
    266Gain on sale of membership interest in mortgage company
    
    
    281
    
    
    
    
    
    
    
    Income from bank-owned life insurance
    
    
    401
    
    
    
    146
    
    
    
    Other
    
    
    349
    
    
    
    366
    
    
    
    99TOTAL NON-INTEREST INCOME
    
    
    5,857
    
    
    
    4,485
    
    
    
    2,826NON-INTEREST EXPENSEPersonnel costs
    
    
    7,838
    
    
    
    5,549
    
    
    
    3,947Occupancy and equipment
    
    
    2,884
    
    
    
    1,864
    
    
    
    974Data processing fees
    
    
    606
    
    
    
    397
    
    
    
    493Other (Note J)
    
    
    3,325
    
    
    
    2,420
    
    
    
    1,797TOTAL NON-INTEREST EXPENSE
    
    
    14,653
    
    
    
    10,230
    
    
    
    7,211INCOME BEFORE INCOME TAXES
    
    
    2,720
    
    
    
    1,200
    
    
    
    627INCOME TAXES (Note H)
    
    
    710
    
    
    
    
    
    
    
    NET INCOME
    
    $
    2,010
    
    
    $
    1,200
    
    
    $
    627NET INCOME PER COMMON SHAREBasic
    
    $
    .45
    
    
    $
    .36
    
    
    $
    .19Diluted
    
    $
    .41
    
    
    $
    .35
    
    
    
    .19
 See accompanying notes. Page 41




---



##### 



GATEWAY FINANCIAL HOLDINGS, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME Years Ended December 31, 2004, 2003 and 2002
 2004
    
    
    2003
    
    
    2002(Amounts in thousands)Net income
    
    $
    2,010
    
    
    $
    1,200
    
    
    $
    627Other comprehensive income:Securities available for sale:Unrealized holding gains (losses) on available-for-sale
securities
    
    
    (489
    )
    
    
    (157
    )
    
    
    756Tax effect
    
    
    188
    
    
    
    38
    
    
    
    (227
    )Reclassification of gains recognized in net income
    
    
    (159
    )
    
    
    (244
    )
    
    
    (266
    )Tax effect
    
    
    62
    
    
    
    58
    
    
    
    80Total other comprehensive income (loss)
    
    
    (398
    )
    
    
    (305
    )
    
    
    343Comprehensive income
    
    $
    1,612
    
    
    $
    895
    
    
    $
    970
 See accompanying notes. Page 42




---



##### 



GATEWAY FINANCIAL HOLDINGS, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS EQUITY Years Ended December 31, 2004, 2003 and 2002
 AccumulatedRetained
    
    
    OtherCommon Stock
    
    
    Earnings
    
    
    Comprehensive
    
    
    TotalShares
    
    
    Amount
    
    
    (Deficit)
    
    
    Income (loss)
    
    
    Equity(Amounts in thousands, except share data)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
    
    
    
    24,971Net income
    
    
    
    
    
    
    
    
    
    
    2,010
    
    
    
    
    
    
    
    2,010Other comprehensive loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (398
    )
    
    
    (398
    )Shares issued in exercise of
common stock warrants
    
    
    1,320,817
    
    
    
    12,111
    
    
    
    
    
    
    
    
    
    
    
    12,111Shares issued in subsidiary acquisition
    
    
    38,013
    
    
    
    503
    
    
    
    
    
    
    
    
    
    
    
    503Shares issued from options exercise
    
    
    39,517
    
    
    
    311
    
    
    
    
    
    
    
    
    
    
    
    311Issuance of common stock
    
    
    1,932,000
    
    
    
    24,915
    
    
    
    
    
    
    
    
    
    
    
    24,915Shares issued in 21-for-20 stock
split effected as a 5% stock
dividend
    
    
    161,184
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Cash dividends ($.02 per share)
    
    
    
    
    
    
    (95
    )
    
    
    
    
    
    
    
    
    
    
    (95
    )Cash paid for fractional shares
    
    
    
    
    
    
    (10
    )
    
    
    
    
    
    
    
    
    
    
    (10
    )Balance at December 31, 2004
    
    
    6,659,073
    
    
    $
    62,631
    
    
    $
    1,908
    
    
    $
    (221
    )
    
    $
    64,318
 See accompanying notes. Page 43




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##### 



GATEWAY FINANCIAL HOLDINGS, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS Years Ended December 31, 2004, 2003 and 2002
 2004
    
    
    2003
    
    
    2002(Amounts in thousands)CASH FLOWS FROM OPERATING ACTIVITIESNet income
    
    $
    2,010
    
    
    $
    1,200
    
    
    $
    627Adjustments to reconcile net income to net
cash provided by operating activities:Amortization of intangibles
    
    
    130
    
    
    
    59
    

    
    
    49Depreciation and amortization
    
    
    1,310
    
    
    
    1,286
    
    
    
    555Deferred income taxes
    
    
    (308
    )
    
    
    (368
    )
    
    
    Realized gain on available-for-sale securities
    
    
    (159
    )
    
    
    (244
    )
    
    
    (267
    )Earnings on bank-owned life insurance
    
    
    (401
    )
    
    
    (146
    )
    
    
    Realized gain on sale of loans
    
    
    
    
    
    
    (98
    )
    
    
    (63
    )Realized loss on sale of foreclosed real estate
    
    
    
    
    
    
    27
    
    
    
    37Realized (gain) loss on sale of bank premises and equipment
    
    
    14
    
    
    
    (118
    )
    
    
    Provision for loan losses
    
    
    1,425
    
    
    
    1,200
    
    
    
    480Change in assets and liabilities:(Increase) decrease in accrued interest receivable
    
    
    (1,396
    )
    
    
    (117
    )
    
    
    (401
    )(Increase) decrease in other assets
    
    
    92
    
    
    
    (1,171
    )
    
    
    (235
    )Increase in accrued expenses and other liabilities
    
    
    (252
    )
    
    
    300
    
    
    
    58NET CASH PROVIDED BY OPERATING ACTIVITIES
    
    
    2,465
    
    
    
    1,810
    
    
    
    840CASH FLOWS FROM INVESTING ACTIVITIESPurchases of available-for-sale securities
    
    
    (87,212
    )
    
    
    (31,925
    )
    
    
    (45,289
    )Maturities, sales and calls of available-for-sale securities
    
    
    37,620
    
    
    
    32,089
    
    
    
    32,472Proceeds from sale of loans
    
    
    
    
    
    
    1,973
    
    
    
    1,552Net increase in loans from originations and repayments
    
    
    (149,605
    )
    
    
    (68,809
    )
    
    
    (56,161
    )Proceeds from sale of foreclosed real estate
    
    
    
    
    
    
    203
    
    
    
    193Proceeds from sale of bank premises and equipment
    
    
    209
    
    
    
    330
    
    
    
    Purchase of premises and equipment
    
    
    (6,033
    )
    
    
    (1,971
    )
    
    
    (5,029
    )Purchase of Federal Reserve Bank stock
    
    
    
    
    
    
    (255
    )
    
    
    Purchase of Federal Home Loan Bank stock
    
    
    (271
    )
    
    
    (380
    )
    
    
    (755
    )Purchase of bank owned life insurance
    
    
    (9,000
    )
    
    
    (6,960
    )
    
    
    Net cash (paid) received in branch and subsidiary acquisitions
    
    
    117,361
    
    
    
    11,260
    
    
    
    NET CASH USED BY INVESTING ACTIVITIES
    
    
    (96,931
    )
    
    
    (64,445
    )
    
    
    (73,017
    )CASH FLOWS FROM FINANCING ACTIVITIESIncrease in deposits
    
    
    41,001
    
    
    
    47,248
    
    
    
    58,945Net increase in FHLB advances
    
    
    1,600
    
    
    
    7,600
    
    
    
    10,100Net increase in federal funds purchased
    
    
    4,861
    
    
    
    2,999
    
    
    
    1Proceeds from issuance of junior subordinated debentures
    
    
    7,217
    
    
    
    8,000
    
    
    
    Proceeds from exercise of stock options
    
    
    311
    
    
    
    
    
    
    
    Proceeds from issuance of common stock
    
    
    24,915
    
    
    
    
    
    
    
    Proceeds from the conversion of common stock warrants
    
    
    12,111
    
    
    
    112
    
    
    
    Cash paid dividends
    
    
    (95
    )
    
    
    
    
    
    
    Cash paid for fractional shares
    
    
    (10
    )
    
    
    (4
    )
    
    
    NET CASH PROVIDED BY FINANCING ACTIVITIES
    
    
    91,911
    
    
    
    65,955
    
    
    
    69,046NET INCREASE (DECREASE) IN
CASH AND CASH EQUIVALENTS
    
    
    (2,555
    )
    
    
    3,320
    
    
    
    (3,131
    )CASH AND CASH EQUIVALENTS, BEGINNING
    
    
    12,828
    
    
    
    9,508
    
    
    
    12,639CASH AND CASH EQUIVALENTS, ENDING
    
    $
    10,273
    
    
    $
    12,828
    
    
    $
    9,508SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATIONInterest paid
    
    $
    6,788
    
    
    $
    5,290
    
    
    $
    4,772Income taxes paid
    
    $
    1,220
    
    
    $
    162
    
    
    $
    SUPPLEMENTAL DISCLOSURES OF NONCASH INVESTING ACTIVITIESUnrealized holding gains (losses) on available-for-sale
securities, net
    
    $
    (398
    )
    
    $
    (305
    )
    
    $
    343Transfer from loans to real estate acquired in settlement
of loans
    
    $
    
    
    
    $
    
    
    
    $
    230Deconsolidation of grantor trust
    
    
    248
    
    
    $
    
    
    
    $
    
 Noncash assets acquired and liabilities assumed in a business combination are presented in
Note O. See accompanying notes. Page 44




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##### 



GATEWAY FINANCIAL HOLDINGS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2004, 2003 and 2002
 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. (the Company), a financial holding company whose
principal business activity consists of the ownership of the Bank, Gateway Capital Statutory Trust
I, and Gateway Capital Statutory Trust II. 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, Moyock, Plymouth and Kitty Hawk, North Carolina. The Company formed Gateway Capital Statutory Trust I in 2003 and Gateway Capital Statutory Trust II
in 2004, both of which are wholly owned by the Company, to facilitate the issuance of trust
preferred securities totaling $8.0 million and $7.0 million, respectively. Adoption of FASB
Interpretation No. (FIN) 46, Consolidation of Variable Interest Entitiesresulted in the
deconsolidation of these trust preferred subsidiaries. Upon deconsolidation, the junior
subordinated debentures issued by the Company to the trusts were included in long-term debt and the
Companys equity interest in the trusts was included in other assets. The deconsolidation of the
trusts did not materially impact net income. The trust preferred securities presently qualify as Tier 1 regulatory capital and are reported in
Federal Reserve regulatory reports as a minority interest in a consolidated subsidiary. The junior
subordinated debentures do not qualify as Tier 1 regulatory capital. On March 1, 2005, the Board
of Governors of the Federal Reserve issued the final rule that would retain the inclusion of trust
preferred securities in Tier 1 capital of bank holding companies, but with stricter quantitative
limits and clearer qualitative standards. Under the new rule, after a three-year transition period,
the aggregate amount of trust preferred securities and certain other capital elements would be
limited to 25 percent of tier 1 capital elements, net of goodwill less any associated deferred tax
liability. The amount of trust preferred securities and certain other elements in excess of the
limit could be included in tier 2 capital, subject to restrictions. The Company believes that the
Bank would remain well capitalized under the new Federal Reserve Board guidelines. NOTE
B -  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Principles of Consolidation The consolidated financial statements include the accounts of Gateway Financial Holdings, Inc. and
Gateway Bank & Trust Co. 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. Page 45




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##### 



GATEWAY FINANCIAL HOLDINGS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2004, 2003 and 2002
 NOTE
B -  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) 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. 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. Page 46




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##### 



GATEWAY FINANCIAL HOLDINGS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2004, 2003 and 2002
 NOTE
B - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) 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. 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. Due
to the redemption provisions of these entities, the Company estimated that fair value equals cost
and that this investment was not impaired at December 31, 2004. 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. Page 47




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##### 



GATEWAY FINANCIAL HOLDINGS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2004, 2003 and 2002
 NOTE
B - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) Mortgage Operations The Bank originates single family, residential first mortgage loans on a presold basis. Such loans
are closed by a third party and therefore are not shown in the Companys consolidated financial
statements. 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. 2004
    
    
    2003
    
    
    2002(Amounts in thousands,except per share data)Net income:As reported
    
    $
    2,010
    
    
    $
    1,200
    
    
    $
    627Deduct:Total stock-based employee compensation
expense determined under fair value method
for all awards, net of related tax effects
    
    
    1,429
    
    
    
    203
    
    
    
    210Pro forma
    
    $
    581
    
    
    $
    997
    
    
    $
    417Basic net income per share:As reported
    
    $
    .45
    
    
    $
    .36
    
    
    $
    .19Pro forma
    
    
    .13
    
    
    
    .30
    
    
    
    .13Diluted net income per share:As reported
    
    $
    .41
    
    
    $
    .35
    
    
    $
    .19Pro forma
    
    
    .12
    
    
    
    .29
    
    
    
    .13
 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. Page 48




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##### 



GATEWAY FINANCIAL HOLDINGS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2004, 2003 and 2002
 NOTE B -  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) Per Share Results (Continued) The basic and diluted weighted average shares outstanding are as follows: 2004
    
    
    2003
    
    
    2002Weighted average outstanding shares used for
basic EPS
    
    
    4,478,760
    
    
    
    3,316,768
    
    
    
    3,314,122Plus incremental shares from assumed exercise of:Stock options
    
    
    225,134
    
    
    
    92,674
    
    
    
    7,327Warrants
    
    
    178,809
    
    
    
    48,486
    
    
    
    Weighted average outstanding shares
used for diluted EPS
    
    
    4,882,703
    
    
    
    3,457,928
    
    
    
    3,321,449
 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 was 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. 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, 2004, 2003 and 2002, there were options of 464,000,
2,625, and 551,183, 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 year ended
December 31, 2002 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 On March 9, 2004, the SEC Staff issued Staff Accounting Bulletin No. 105, Application of Accounting
Principles to Loan Commitments(SAB 105). SAB 105 clarifies existing accounting practices
relating to the valuation of issued loan commitments, including interest rate lock commitments
(IRLC), subject to SFAS No. 149 and Derivative Implementation Group Issue C13, Scope Exceptions:
When a Loan Commitment is included in the Scope of Statement 133. Furthermore, SAB 105 disallows
the inclusion of the values of a servicing component and other internally developed intangible
assets in the initial and subsequent IRLC valuation. The provisions of SAB 105 were effective for
loan commitments entered into after March 31, 2004. The adoption of SAB 105 did not have a material
impact on the consolidated financial statements. In March 2004, the Emerging Issues Task Force (EITF) released EITF Issue 03-01, The Meaning of
Other-Than-Temporary Impairment and its Application to Certain Investments.The Issue provides
guidance for determining whether an investment is other-than-temporarily impaired and requires
certain disclosures with respect to these investments. The recognition and measurement guidance for
other-than-temporary impairment has been delayed by
the issuance of FASB Staff Position EITF 03-1-1 on September 30, 2004. The adoption of Issue 03-1
did not result in any other-than-temporary impairment. Page 49




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##### 



GATEWAY FINANCIAL HOLDINGS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2004, 2003 and 2002
 NOTE B - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) Recent Accounting Pronouncements (Continued) In December 2003, the American Institute of Certified Public Accountants (AICPA) issued Statement
of Position (SOP) 03-3, Accounting for Loans or Certain Debt Securities Acquired in a Transfer.The
SOP addresses accounting for differences between contractual cash flows and cash flows expected to
be collected from an investors initial investment in loans or debt securities acquired in a
transfer if those differences relate to a deterioration of credit quality. The SOP also prohibits
companies from carrying over or creating a valuation allowance in the initial accounting for
loans acquired that meet the scope criteria of the SOP. The SOP is effective for loans acquired in
fiscal years beginning after December 15, 2004. The adoption of this SOP is not expected to have a
material impact on the Companys financial position or results of operations. In December 2004, the FASB issued SFAS No. 123(R), Accounting for Stock-Based Compensation(SFAS
No. 123(R)). SFAS No. 123(R) establishes standards for the accounting for transactions in which an
entity exchanges its equity instruments for goods or services. This Statement focuses primarily on
accounting for transactions in which an entity obtains employee services in share-based payment
transactions. SFAS No. 123(R) requires that the fair value of such equity instruments be
recognized as an expense in the historical financial statements as services are performed. Prior
to SFAS No. 123(R), only certain pro forma disclosures of fair value were required. For the
Company, the provisions of this Statement are effective for the first interim reporting period that
begins after June 15, 2005. Accordingly, we will adopt SFAS No. 123(R) commencing with the quarter
ending September 30, 2005. If we had included the cost of employee stock option compensation in
our consolidated financial statements, our net income for the fiscal years ended December 31, 2004,
2003, and 2002 would have decreased by approximately $1.4 million, $203,000, and $210,000,
respectively. Accordingly, the adoption of SFAS No. 123(R) is expected to have a material effect
on our consolidated financial statements. Reclassifications Certain amounts in the 2003 and 2002 consolidated financial statements have been reclassified to
conform to the 2004 presentation. The 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, 2004Gross
    
    
    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
    
    $
    43,709
    
    
    $
    6
    
    
    $
    471
    
    
    $
    43,244Corporate debt/equity securities
    
    
    2,613
    
    
    
    49
    
    
    
    1
    
    
    
    2,661Mortgage-backed securities
    
    
    40,408
    
    
    
    146
    
    
    
    86
    
    
    
    40,468Municipal securities
    
    
    6,239
    
    
    
    17
    
    
    
    21
    
    
    
    6,235$
    92,969
    
    
    $
    218
    
    
    $
    579
    
    
    $
    92,608
 Page 50




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##### 



GATEWAY FINANCIAL HOLDINGS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2004, 2003 and 2002
 NOTE C  INVESTMENT SECURITIES (Continued) 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
 The following tables show 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, 2004 and 2003. The current year unrealized losses on
investment securities are a result of volatility in the market during 2004 and relate to seventeen
U.S. government securities and obligations of U.S. government agencies, one corporate debt
security, nine municipal securities and five 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. 2004Less 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
    
    $
    42,729
    
    
    $
    471
    
    
    $
    
    
    
    $
    
    
    
    $
    42,729
    
    
    $
    471Corporate
    
    
    536
    
    
    
    1
    
    
    
    
    
    
    
    
    
    
    
    536
    
    
    
    1Mortgage-backed securities
    
    
    18,254
    
    
    
    83
    
    
    
    359
    

    
    
    3
    
    
    
    18,613
    
    
    
    86Municipal securities
    
    
    2,494
    
    
    
    21
    
    
    
    
    
    
    
    
    
    
    
    2,494
    
    
    
    21Total temporarily impaired
securities
    
    $
    64,013
    
    
    $
    576
    
    
    $
    359
    
    
    $
    3
    
    
    $
    64,372
    
    
    $
    579
 2003Less 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
 Page 51




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##### 



GATEWAY FINANCIAL HOLDINGS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2004, 2003 and 2002
 NOTE C -  INVESTMENT SECURITIES (Continued) Proceeds from maturities, sales and calls of investment securities during the years ended December
31, 2004, 2003 and 2002 were $33.2 million, $32.1 million and $32.5 million, respectively. From
those transactions, the Company realized gross gains of $171,000, $246,000 and $266,000 and gross
losses of $12,000, $2,000 and $0 in 2004, 2003 and 2002, respectively. The amortized cost and fair values of securities available-for-sale at December 31, 2004 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 within one year
    
    $
    513
    
    
    $
    513Due after one year through five years
    
    
    41,859
    
    
    
    41,504Due after five years through ten years
    
    
    8,643
    
    
    
    8,596Due after ten years
    
    
    41,954
    
    
    
    41,995$
    92,969
    
    
    $
    92,608
 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 $37.7 million and a fair value of $37.6 million were pledged
to secure FHLB advances and public monies on deposit as required by law at December 31, 2004. NOTE
D -  LOANS A summary of the balances of loans follows: December 31,2004
    
    
    2003(Dollars in thousands)Commercial
    
    $
    69,075
    
    
    $
    52,554Real estate  construction
    
    
    131,431
    
    
    
    55,970Real estate  commercial mortgage
    
    
    90,197
    
    
    
    68,094Real estate  1-4 family mortgage
    
    
    51,768
    
    
    
    32,191Consumer
    
    
    10,641
    
    
    
    10,458Home equity lines of credit
    
    
    29,351
    
    
    
    12,615Subtotal
    
    
    382,462
    
    
    
    231,882Less: Allowance for loan losses
    
    
    (4,163
    )
    
    
    (2,759
    )Unamortized net deferred fees
    
    
    (506
    )
    
    
    (142
    )Net loans
    
    $
    377,793
    
    
    $
    228,981
 Page 52




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##### 



GATEWAY FINANCIAL HOLDINGS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2004, 2003 and 2002
 NOTE D -  LOANS (Continued) 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, 2004 and 2003 consisted of loans of approximately
$490,000 and $1,210,000, 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
$840,000, $1,295,000 and $1,021,000 for the years ended December 31, 2004, 2003 and 2002,
respectively. Interest income that would have been recorded on impaired loans totaled $138,000,
$40,000 and $100,000 for the years ended December 31, 2004, 2003 and 2002. The allowance for loan
losses allocated to these impaired loans was $74,000 and $194,000, 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): 2004Balance at beginning of year
    
    $
    17,497Additions
    
    
    5,030Loans of newly elected directors
    
    
    1,931Loan repayments
    
    
    (10,041
    )Balance at end of year
    
    $
    14,417
 At December 31, 2004, commitments to extend credit to directors, executive officers and their
related interests consisted of unused lines of credit totaling $5.3 million. An analysis of the allowance for loan losses follows: 2004
    
    
    2003
    
    
    2002(Amounts in thousands)Balance at beginning of year
    
    $
    2,759
    
    
    $
    1,721
    
    
    $
    1,435Provision charged to operations
    
    
    1,425
    
    
    
    1,200
    
    
    
    480Allowance for loan losses on loans purchased
    
    
    
    
    
    
    52
    
    
    
    Charge-offs
    
    
    (174
    )
    
    
    (215
    )
    
    
    (194
    )Recoveries
    
    
    153
    
    
    
    1
    
    
    
    Net charge-offs
    
    
    (21
    )
    
    
    (214
    )
    
    
    (194
    )Balance at end of year
    
    $
    4,163
    
    
    $
    2,759
    
    
    $
    1,721
 Page 53




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##### 



GATEWAY FINANCIAL HOLDINGS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2004, 2003 and 2002
 NOTE E - PREMISES AND EQUIPMENT Following is a summary of premises and equipment at December 31, 2004 and 2003: 2004
    
    
    2003(Amounts in thousands)Land
    
    $
    2,443
    
    
    $
    1,921Furniture and equipment
    
    
    5,172
    
    
    
    3,783Vehicles
    
    
    412
    
    
    
    301Buildings and improvements
    
    
    11,350
    
    
    
    7,505Construction in progress
    
    
    2,010
    
    
    
    63Accumulated depreciation
    
    
    (2,492
    )
    
    
    (1,606
    )Total
    
    $
    18,895
    
    
    $
    11,967
 Depreciation and amortization amounting to $970,000, $779,000 and $357,000 for the years ended
December 31, 2004, 2003 and 2002, 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 Cape Charles,
Williamsburg and Virginia Beach, Virginia and Edenton, Elizabeth City and Nags Head, North
Carolina. These leases expire at various dates through January 31, 2034. Future rentals under
these leases are as follows (in thousands): 2005
    
    $
    7502006
    
    
    6872007
    
    
    5632008
    
    
    5502009
    
    
    551Thereafter
    
    
    6,522$
    9,623
 Rental expense amounted to $655,000, $423,000 and $256,000 during the years ended December 31,
2004, 2003 and 2002, 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. NOTE
F - DEPOSITS The weighted average cost of time deposits was 2.69%, 2.47% and 3.17% at December 31, 2004, 2003
and 2002, respectively. Page 54




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##### 



GATEWAY FINANCIAL HOLDINGS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2004, 2003 and 2002
 NOTE F - DEPOSITS (Continued) Time deposits in denominations of $100,000 or more were $56.6 million and $35.8 million at December
31, 2004 and 2003, respectively. Interest expense on such deposits aggregated $3.4 million in 2004
and $2.2 million in 2003. At December 31, 2004, the scheduled maturities of time deposits are as
follows (in thousands): $100,000
    
    
    Underand Over
    
    
    $100,000
    
    
    Total2005
    
    $
    27,922
    
    
    $
    70,780
    
    
    $
    98,7022006
    
    
    18,393
    
    
    
    35,095
    
    
    
    53,4882007
    
    
    8,576
    
    
    
    16,626
    
    
    
    25,2022008
    
    
    1,218
    
    
    
    4,918
    
    
    
    6,1362009
    
    
    
    
    
    
    1,884
    
    
    
    1,884Total
    
    $
    56,109
    
    
    $
    129,303
    
    
    $
    185,412
 NOTE G - BORROWINGS A summary of the balances of borrowings follows: December 31,2004
    
    
    2003(Dollars in thousands)Federal fund purchased
    
    $
    10,861
    
    
    $
    6,000Federal Home Loan Bank
    
    
    37,600
    
    
    
    36,000Trust preferred securities
    
    
    
    
    
    
    8,000Junior Subordinated Debentures
    
    
    15,465
    
    
    
    Total borrowings
    
    $
    63,926
    
    
    $
    50,000
 Advances from the Federal Home Loan Bank of Atlanta consisted of the following at December 31, 2004
and 2003: InterestMaturity
    
    Rate
    
    
    2004
    
    
    2003January 2, 2004
    
    
    1.15
    %
    
    $
    
    
    
    $
    13,000,000May 25, 2004
    
    
    1.46
    %
    
    
    
    
    
    
    5,000,000February 4, 2005
    
    
    2.14
    %
    
    
    5,000,000
    
    
    
    5,000,000July 21, 2005
    
    
    2.44
    %
    
    
    20,000,000
    
    
    
    February 27, 2006
    
    
    5.45
    %
    
    
    600,000
    
    
    
    1,000,000March 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
    
    
    
    5,500,000$
    37,600,000
    
    
    $
    36,000,000
 Pursuant to collateral agreements with the Federal Home Loan Bank, at December 31, 2004 advances
are secured by
investment securities available for sale with a fair value of $19.2 million and by loans with a
carrying amount of $49.8 million, which approximates market value. The Company has a maximum
borrowing availability from FHLB equal to 25% of total assets. Page 55




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##### 



GATEWAY FINANCIAL HOLDINGS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2004, 2003 and 2002
 NOTE
G - BORROWINGS (Continued)

The Company may purchase federal funds through three unsecured federal funds lines of credit
aggregating $28.9 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 (2.45% at December 31, 2004). The
Company had $10.9 million and $6.0 million outstanding on these lines of credit as of December 31,
2004 and 2003, respectively. The maximum amounts outstanding under these lines of credit at any
month-end during 2004, 2003 and 2002 were $10.9 million, $12.2 million and $4.2 million,
respectively. The average amounts outstanding under these lines of credit were $4.7 million for
2004 and $4.1 million for 2003. 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 are 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. In June of 2004, $7.0 million of trust preferred securities were placed through Gateway Capital
Statutory Trust II (the Trust). The Trust issuer has invested the total proceeds from the sale of
the Trust Preferred Securities 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 the 3 month LIBOR plus 2.65%.
The dividends paid to holders of the trust preferred securities, which are recorded as interest
expense, are deductible for income tax purposes. The trust preferred securities are redeemable on
or after June 17, 2009, in whole or in part. Redemption is mandatory at June 17, 2034. 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 presently qualify as Tier 1 regulatory capital and are reported in
Federal Reserve regulatory reports as a minority interest in a consolidated subsidiary. The junior
subordinated debentures do not qualify as Tier 1 regulatory capital. On March 1, 2005, the Board
of Governors of the Federal Reserve issued a final rule stating that trust preferred securities
will continue to be included in Tier 1 capital, subject to stricter quantitative and qualitative
standards. For Bank Holding Companies, trust preferred securities will continue to be included in
Tier 1 capital up to 25% of core capital elements (including trust preferred securities) net of
goodwill less any associate deferred tax liability. On December 31, 2004, the Company applied the provisions of FIN 46R to two wholly-owned subsidiary
trusts that issued trust preferred securities to third party investors. The application of FIN 46R
resulted in the deconsolidation of the wholly-owned trusts. The assets and liabilities of the
subsidiary trusts that were deconsolidated totaled $15.5 million and $15.0 million, respectively. Page 56




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##### 



GATEWAY FINANCIAL HOLDINGS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2004, 2003 and 2002
 NOTE H -  INCOME TAXES The significant components of the provision for income taxes for the years ended December 31, 2004,
2003 and 2002. 2004
    
    
    2003
    
    
    2002(In thousands)Current tax provision:Federal
    
    $
    837
    
    
    $
    341
    
    
    $
    State
    
    
    181
    
    
    
    79
    
    
    
    1,018
    
    
    
    420
    
    
    
    Deferred tax provision:Federal
    
    
    (65
    )
    
    
    (43
    )
    
    
    192State
    
    
    (16
    )
    
    
    (9
    )
    
    
    41(81
    )
    
    
    (52
    )
    
    
    233Provision for income tax expense before
adjustment to deferred tax asset valuation
allowance
    
    
    937
    
    
    
    368
    
    
    
    233Decrease in valuation allowance
    
    
    (227
    )
    
    
    (368
    )
    
    
    (233
    )Net provision for income taxes
    
    $
    710
    
    
    $
    
    
    
    $
    
 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: 2004
    
    
    2003
    
    
    2002(In thousands)Tax computed at the statutory federal rate
    
    $
    925
    
    
    $
    408
    
    
    $
    213Increase (decrease) resulting from:State income taxes, net of federal benefit
    
    
    109
    
    
    
    46
    
    
    
    20Adjustment to deferred tax asset valuation allowance
    
    
    (227
    )
    
    
    (368
    )
    
    
    (233
    )Non-taxable interest income
    
    
    (17
    )
    
    
    
    
    
    
    Non-taxable income from bank owned life insurance
    
    
    (137
    )
    
    
    (50
    )
    
    
    Other permanent differences
    
    
    57
    
    
    
    (36
    )
    
    
    Provision for income taxes
    
    $
    710
    
    
    $
    
    
    
    $
    
 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, 2004 and 2003 are as
follows: Page 57




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##### 



GATEWAY FINANCIAL HOLDINGS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2004, 2003 and 2002
 NOTE H - INCOME TAXES (CONTINUED) 2004
    
    
    2003(In thousands)Deferred tax assets relating to:Allowance for loan losses
    
    $
    1,512
    
    
    $
    963Net operating loss carryforwards
    
    
    
    
    
    
    33Equity investment basis difference
    
    
    122
    
    
    
    125Unrealized gains on securities
available for sale
    
    
    139
    
    
    
    Other
    
    
    22
    
    
    
    33Total deferred tax assets
    
    
    1,795
    
    
    
    1,154Less valuation allowance
    
    
    
    
    
    
    (227
    )Net deferred tax assets
    
    
    1,795
    
    
    
    927Deferred tax liabilities relating to:Depreciation
    
    
    (488
    )
    
    
    (276
    )Deferred loan costs
    
    
    (240
    )
    
    
    (173
    )Amortization of intangible assets
    
    
    (125
    )
    
    
    (58
    )Prepaid expenses
    
    
    (75
    )
    
    
    Unrealized losses on securities
available for sale
    
    
    
    
    
    
    (110
    )Total deferred tax liabilities
    
    
    (928
    )
    
    
    (617
    )Net recorded deferred tax assets
    
    $
    867
    
    
    $
    310
 It is managements opinion that realization of the net deferred tax asset is more than not based on
the Companys history of taxable income and estimates of 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 approximately $112,000. During the year ended December
31, 2004, 1,088,885 warrants were exercised for 1,320,817 shares of common stock generating
proceeds totaling approximately $12,111,000. No warrants remain outstanding at December 31, 2004. NOTE
J - OTHER NON-INTEREST EXPENSE The major components of other non-interest expense for the years ended December 31, 2004, 2003 and
2002 are as follows: 2004
    
    
    2003
    
    
    2002(Dollars in thousands)Professional services
    
    $
    643
    
    
    $
    433
    
    
    $
    409Postage, printing and office supplies
    
    
    847
    
    
    
    666
    
    
    
    451Advertising and promotion
    
    
    478
    
    
    
    213
    
    
    
    138Amortization of intangibles
    
    
    130
    
    
    
    59
    
    
    
    49Other
    
    
    1,227
    
    
    
    1,049
    
    
    
    749Total
    
    $
    3,325
    
    
    $
    2,420
    
    
    $
    1,796
 Page 58




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##### 



GATEWAY FINANCIAL HOLDINGS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2004, 2003 and 2002
 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, 2004,
that the Company meets all capital adequacy requirements to which it is subject. At December 31,
2004, the Companys total risk-based capital, Tier I risk-based capital, and leverage ratios were
17.40%, 16.41% and 13.89%, respectively. As of December 31, 2004, 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, 2004:Total Capital (to Risk-Weighted Assets)
    
    $
    63,295
    
    
    
    15.14
    %
    
    $
    33,443
    
    
    
    8.00
    %
    
    $
    41,803
    
    
    
    10.00
    %Tier I Capital (to Risk-Weighted Assets)
    
    
    59,132
    
    
    
    14.15
    %
    
    
    16,722
    
    
    
    4.00
    %
    
    
    25,082
    
    
    
    6.00
    %Tier I Capital (to Average Assets)
    
    
    59,132
    
    
    
    11.94
    %
    
    
    19,806
    
    
    
    4.00
    %
    
    
    24,757
    
    
    
    5.00
    %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
    %
 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 59




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GATEWAY FINANCIAL HOLDINGS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2004, 2003 and 2002
 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, 2004 is as follows (in thousands): Financial instruments whose contract
amounts represent credit risk:Commitments to extend credit
    
    $
    55,574Undisbursed lines of credit
    
    
    67,614Standby letters of credit
    
    
    461
 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 60




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##### 



GATEWAY FINANCIAL HOLDINGS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004, 2003 and 2002
 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 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, 2004 and 2003: 2004
    
    
    2003Carrying
    
    
    Estimated
    
    
    Carrying
    
    
    EstimatedAmount
    
    
    Fair Value
    
    
    Amount
    
    
    Fair Value(In thousands)Financial assets:Cash and due from banks
    
    $
    9,028
    
    
    $
    9,028
    
    
    $
    7,676
    
    
    $
    7,676Interest-earning deposits with banks
    
    
    1,245
    
    
    
    1,245
    
    
    
    5,152
    
    
    
    5,152Investment securities
    
    
    92,608
    
    
    
    92,608
    
    
    
    43,773
    
    
    
    43,773Accrued interest receivable
    
    
    2,697
    
    
    
    2,697
    
    
    
    1,301
    
    
    
    1,301Federal Reserve Bank stock
    
    
    722
    
    
    
    722
    
    
    
    722
    
    
    
    722Federal Home Loan Bank stock
    
    
    2,321
    
    
    
    2,321
    
    
    
    2,050
    
    
    
    2,050Loans
    
    
    377,793
    
    
    
    381,303
    
    
    
    228,981
    
    
    
    227,810Bank owned life insurance
    
    
    16,507
    
    
    
    16,507
    
    
    
    7,106
    
    
    
    7,106Financial liabilities:Deposits
    
    
    406,259
    
    
    
    408,594
    
    
    
    238,452
    
    
    
    236,481Borrowings
    
    
    63,926
    
    
    
    64,653
    
    
    
    50,000
    
    
    
    50,399Accrued interest payable
    
    
    439
    
    
    
    439
    
    
    
    537
    
    
    
    537
 Page 61




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##### 



GATEWAY FINANCIAL HOLDINGS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004, 2003 and 2002
 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
$240,000, $186,000, and $148,000 during the years ended December 31, 2004, 2003 and 2002,
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. On November 24, 2004, the Company
increased, by 460,000, the number of options that are subject to shareholder approval at the 2005
shareholder meeting, and made certain grants of these options. All options granted prior to
November 2004 to non-employee directors vest immediately at the time of grant, while other options
from this pool vest over a four-year period with 20% vesting on the grant date and 20% vesting
annually thereafter. Options granted from the pool of shares made available on November 24, 2004 to
non-employee directors vest immediately at the time of the grant, while options from this pool
granted to employees vest 50% in at the time of grant and 50% the following year. 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, 2004, 2003 and 2002 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, 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
    
    
    
    8.00Options authorized
    
    
    460,000
    
    
    
    460,000
    
    
    
    Options granted/vested
    
    
    
    
    
    
    (479,250
    )
    
    
    479,250
    
    
    
    15.83
    
    
    
    423,291
    
    
    
    14.83Options exercised
    
    
    (39,517
    )
    
    
    
    
    
    
    (39,517
    )
    
    
    7.98
    
    
    
    (39,517
    )
    
    
    7.98Options forfeited
    
    
    
    
    
    
    4,857
    
    
    
    (4,857
    )
    
    
    7.87
    
    
    
    (4,857
    )
    
    
    7.87At December 31, 2004
    
    
    1,141,300
    
    
    
    6,752
    
    
    
    1,134,548
    
    
    $
    11.26
    
    
    
    981,505
    
    
    $
    10.95
 Outstanding options include 1,134,548 options with exercise prices ranging from $7.01 to
$15.95 per share, of which 981,505 are exercisable at December 31, 2004. The weighted average
remaining life of total options outstanding and options exercisable as of December 31, 2004 is 7.6
years and 7.4 years, respectively. The weighted average fair value of options granted in 2004,
2003 and 2002 was $6.05, $3.73 and $3.02, respectively, and was determined as of the date of grant
using the Black-Scholes option pricing model, assuming a dividend growth rate ranging from 0% to 5%
for each period; expected volatility of 26.4%, 24.0% and 24.0%; risk-free interest rates ranging
from 3.0% to 4.2%; and expected lives of 7 years for new grants during the years ended December 31,
2004, 2003 and 2002, respectively. Page 62




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##### 



GATEWAY FINANCIAL HOLDINGS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004, 2003 and 2002
 NOTE N -  EMPLOYEE AND DIRECTOR BENEFIT PLANS (Continued) Employment Contracts The Company has entered into employment agreements with its chief executive officer and six 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 During May 2004, Gateway Insurance Services, Inc., completed the acquisition of Whitehurst
Insurance Agency, Inc., an independent insurance agency with offices located in Elizabeth City,
Moyock and Edenton, North Carolina. This transaction was accounted for as a purchase. A summary, of
the purchase price and the assets acquired is as follows. (Amounts in Thousands)Purchase price:Portion paid in cash
    
    $
    69Issuance of common stock
    
    
    503Total purchase price
    
    $
    572Assets acquired:Property and equipment
    
    $
    123Goodwill
    
    
    337Other intangibles
    
    
    112Total assets acquired
    
    $
    572
 During June 2004, Gateway Insurance Services, Inc., completed the acquisition of Insurance Express
Premium Finance, an insurance premium finance agency located in Plymouth, North Carolina. This
transaction was accounted for as a purchase. A summary, in thousands, of the purchase price and the
assets acquired is as follows. Purchase price:Portion paid in cash
    
    $
    71Total purchase price
    
    $
    71Assets acquired:Property and equipment
    
    $
    10Goodwill
    
    
    31Loans
    
    
    30Total assets acquired
    
    $
    71
 On October 15, 2004, the Bank completed its acquisition of three branch offices in a business
combination transaction accounted for as a purchase. The branches were located in Emporia and
Suffolk, Virginia and Elizabeth City, North Carolina. This acquisition was made to expand the
Companys market share in Southeastern Virginia and Northeastern North Carolina and because the
branches acquired fit well within the Companys strategic objectives. Page 63




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##### 



GATEWAY FINANCIAL HOLDINGS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004, 2003 and 2002
 NOTE O - ACQUISITIONS (Continued) A summary of assets acquired, and liabilities assumed, is set forth below (in thousands): Assets Acquired:Cash and cash equivalents
    
    $
    117,501Loans
    
    
    602Premises and equipment
    
    
    1,955Core deposit intangibles
    
    
    2,692Goodwill
    
    
    4,130Total assets acquired
    
    $
    126,880Liabilities Assumed:Deposits
    
    $
    126,806Other liabilities
    
    
    74Total liabilities assumed
    
    $
    126,880
 The goodwill resulting from these two acquisitions is expected to be tax deductible. The pro-forma
impact of the acquisitions as though they had been made at the beginning of the periods presented
is not considered material to the Companys consolidated financial statements. 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
 Page 64




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##### 



GATEWAY FINANCIAL HOLDINGS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004, 2003 and 2002
 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, 2004 and 2003 and for the years ended December 31, 2004, 2003 and 2002,
presented in thousands. Condensed Balance Sheets
December 31, 2004 and 2003 2004
    
    
    2003Asset:Cash on deposit in subsidiary
    
    $
    8,952
    
    
    $
    2,771Investment in securities available for sale
    
    
    513
    
    
    
    Investment in subsidiaries
    
    
    70,149
    
    
    
    30,242Other assets
    
    
    203
    
    
    
    220Total assets
    
    $
    79,817
    
    
    $
    33,233Liabilities:Junior subordinated debentures
    
    $
    15,465
    
    
    $
    8,248Other liabilities
    
    
    34
    
    
    
    14Total liabilities
    
    
    15,499
    
    
    
    8,262Stockholders equity:Common stock
    
    
    62,631
    
    
    
    24,896Retained earnings
    
    
    1,908
    
    
    
    (102
    )Accumulated other comprehensive income
    
    
    (221
    )
    
    
    177Total stockholders equity
    
    
    64,318
    
    
    
    24,971Total liabilities and stockholders equity
    
    $
    79,817
    
    
    $
    33,233
 Condensed Statements of Operations
Years Ended December 31, 200, 2003 and 2002 2004
    
    
    2003
    
    
    2002Equity in income of subsidiary
    
    $
    2,584
    
    
    $
    1,336
    
    
    $
    627Interest income
    
    
    19
    
    
    
    27
    
    
    
    Interest expense
    
    
    (541
    )
    
    
    (143
    )
    
    
    Other expense
    
    
    (52
    )
    
    
    (20
    )
    
    
    $
    2,010
    
    
    $
    1,200
    
    
    $
    627
 Page 65




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##### 



GATEWAY FINANCIAL HOLDINGS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004, 2003 and 2002
 NOTE P -  PARENT COMPANY FINANCIAL DATA (Continued) Condensed Statements of Cash Flows
Years Ended December 31, 2004, 2003 and 2002 2004
    
    
    2003
    
    
    2002Operating activities:Net income
    
    $
    2,010
    
    
    $
    1,200
    
    
    $
    627Equity in income of subsidiary
    
    
    (2,584
    )
    
    
    (1,336
    )
    
    
    (627
    )Amortization of debt issuance costs
    
    
    52
    
    
    
    20
    
    
    
    (Increase) decrease in other assets
    
    
    (35
    )
    
    
    (240
    )
    
    
    Increase in other liabilities
    
    
    20
    
    
    
    14
    
    
    
    (537
    )
    
    
    (342
    )
    
    
    Investing activities:Purchases of available for sale securities
    
    
    (513
    )
    
    
    
    
    
    
    Investment in subsidiaries
    
    
    (37,323
    )
    
    
    (5,243
    )
    
    
    Upstream dividend received from the Bank
    
    
    105
    
    
    
    
    
    
    
    (37,731
    )
    
    
    (5,243
    )
    
    
    Financing activities:Proceeds from junior subordinated
debentures, net of debt issuance costs
    
    
    7,217
    
    
    
    8,248
    
    
    
    Proceeds from the conversion of common
stock warrants
    
    
    12,111
    
    
    
    112
    
    
    
    Proceeds from stock offering
    
    
    24,915
    
    
    
    
    
    
    
    Proceeds from options exercise
    
    
    311
    
    
    
    
    
    
    
    Cash dividends paid
    
    
    (95
    )
    
    
    
    
    
    
    Cash paid in lieu of fractional shares on
5% stock dividend
    
    
    (10
    )
    
    
    (4
    )
    
    
    44,449
    
    
    
    8,356
    
    
    
    Net increase in cash
    
    
    6,181
    
    
    
    2,771
    
    
    
    Cash, beginning of year
    
    
    2,771
    
    
    
    
    
    
    
    Cash, end of year
    
    $
    8,952
    
    
    $
    2,771
    
    
    $
    
 Page 66




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##### 



GATEWAY FINANCIAL HOLDINGS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004, 2003 and 2002
 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, 2004Consolidated
    
    
    Adjustments
    
    
    Banking
    
    
    Brokerage
    
    
    InsuranceTotal interest income
    
    $
    19,632
    
    
    $
    
    
    
    $
    19,609
    
    
    $
    
    
    
    $
    23Total interest expense
    
    
    6,691
    
    
    
    
    
    
    
    6,691
    
    
    
    
    
    
    
    Net interest income
    
    
    12,941
    
    
    
    
    
    
    
    12,918
    
    
    
    
    
    
    
    23Provision for loan losses
    
    
    1,425
    
    
    
    
    
    
    
    1,425
    
    
    
    
    
    
    
    Net interest income after
provision for loan losses
    
    
    11,516
    
    
    
    
    
    
    
    11,493
    
    
    
    
    
    
    
    23Non-interest income
    
    
    5,857
    
    
    
    (562
    )
    
    
    3,963
    
    
    
    463
    
    
    
    1,993Non-interest expense
    
    
    14,653
    
    
    
    (161
    )
    
    
    12,736
    
    
    
    400
    
    
    
    1,678Income before income taxes
    
    
    2,720
    
    
    
    (401
    )
    
    
    2,720
    
    
    
    63
    
    
    
    338Provision for income taxes
    
    
    710
    
    
    
    
    
    
    
    710Net income
    
    $
    2,010
    
    
    $
    (401
    )
    
    $
    2,010
    
    
    $
    63
    
    
    $
    338Period end total assets
    
    $
    535,728
    
    
    $
    (2,219
    )
    
    $
    535,751
    
    
    $
    286
    
    
    $
    1,910
 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
 Page 67




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##### 



GATEWAY FINANCIAL HOLDINGS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004, 2003 and 2002
 NOTE R - INTANGIBLE ASSETS The following is a summary of intangible assets as of December 31, 2004, 2003 and 2002. The
increase in goodwill for 2003 resulted from the branch acquisitions discussed in Note O. 2004
    
    
    2003
    
    
    2002(In thousands)Intangibles assets subject to future amortization:Core deposit
intangibles -  gross
    
    $
    3,497
    
    
    $
    805
    
    
    $
    488Less accumulated amortization
    
    
    (328
    )
    
    
    (198
    )
    
    
    (139
    )Core deposit
intangibles  -  net
    
    $
    3,169
    
    
    $
    607
    
    
    $
    349Intangible assets not subject to future amortization:Goodwill  -  banking segment
    
    $
    6,471
    
    
    $
    2,341
    
    
    $
    1,307Goodwill -  insurance segment
    
    
    1,002
    
    
    
    634
    
    
    
    634$
    7,473
    
    
    $
    2,975
    
    
    $
    1,941
 The following table presents the estimated amortization expense (in thousands) for intangible
assets for each of the five years ending December 31, 2009 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. 2005
    
    $
    3792006
    
    
    3792007
    
    
    3792008
    
    
    3792009
    
    
    379Thereafter
    
    
    1,274$
    3,169
 Page 68




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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, 2004. 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, 2004. There were no material changes in the Companys internal
controls over financial reporting during the fourth quarter of 2004. ITEM 8B  OTHER INFORMATION None. 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 16, 2005. 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 16, 2005. 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 16, 2005. The following table sets forth equity compensation plan information at December 31, 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 compensation plansoutstanding options
    
    
    
    outstanding options
    
    
    
    (excluding securitiesPlan Category
    
    
    
    
    
    
    
    
    
    
    
    
    reflected in column(a))(a)
    
    
    
    
    (b)
    
    
    
    
    (c)Equity compensation
plans approved by
security holders
    
    
    
    492,698
    
    
    
    $
    8.06
    
    
    
    
    Equity compensation
plans not approved
by security holders
    
    
    
    641,850
    
    
    
    $
    13.72
    
    
    
    
    6,752Total
    
    
    
    1,134,548
    
    
    
    $
    11.26
    
    
    
    
    6,752
 A description of the Companys equity compensation plans is presented in Note N to the accompanying
consolidated financial statements. Page 69




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##### 



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 16, 2005. ITEM 13  EXHIBITS (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
 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 16, 2005. Page 70




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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 29, 2005
    
    By:
    
    /s/ D. Ben BerryD. Ben BerryChairman, President and Chief Executive OfficerDate: March 29, 2005
    
    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 29, 2005/s/ Mark A. HolmesMark A. Holmes
    
    Chief Financial Officer
    
    March 29, 2005/s/ William Brumsey IIIWilliam Brumsey III
    
    Director
    
    March 29, 2005/s/ Jimmie Dixon, Jr.Jimmie Dixon, Jr.
    
    Director
    
    March 29, 2005/s/ James H. Ferebee, Jr.James H. Ferebee, Jr.
    
    Director
    
    March 29, 2005/s/ Robert Willard Luther, IIIRobert Willard Luther, III
    
    Director
    
    March 29, 2005/s/ Frances Morrisette NorrellFrances Morrisette Norrell
    
    Director
    
    March 29, 2005/s/ W. C. Owens, Jr.W. C. Owens, Jr.
    
    Director
    
    March 29, 2005/s/ Ollin B. SykesOllin B. Sykes
    
    Director
    
    March 29, 2005/s/ Charles R. Franklin, Jr.Charles R. Franklin, Jr.
    
    Director
    
    March 29, 2005/s/ Robert Y. Green, Jr.Robert Y. Green, Jr.
    
    Director
    
    March 29, 2005/s/ Russell E. TwifordRussell E. Twiford
    
    Director
    
    March 29, 2005/s/ Richard W. WhitingRichard W. Whiting
    
    Director
    
    March 29, 2005/s/ Frank T. WilliamsFrank T. Williams
    
    Director
    
    March 29, 2005/s/ Jerry T. WomackJerry T. Womack
    
    Director
    
    March 29, 2005
 Page 71