**Exhibit 13.1**

 

**COASTAL BANKING COMPANY, INC.**

 

**2004 ANNUAL REPORT**

 
| **Contents**                                                                                |   |
|---------------------------------------------------------------------------------------------|--------|
| ** **                                                                                  |   |
| To Our Shareholders                                                                         | 2      |
| Financial  Highlights                                                                       | 3      |
| Selected Financial Data                                                                     | 4      |
| Management’s  Discussion and Analysis of Financial Condition and Results of Operations | 5      |
| Report  of Independent Registered Public Accounting Firm                                    | 19     |
| Consolidated Financial Statements                                                           | 20     |
| Notes to  Consolidated Financial Statements                                                 | 25     |
| Corporate and  Shareholder Information                                                      | 44     |

 

**Aboutthe Company**

 

Coastal Banking Company, Inc.(the “Company”), headquartered in Beaufort, South Carolina, is a bank holdingcompany organized as a South Carolina corporation with a wholly-ownedsubsidiary, Lowcountry National Bank (the “Bank”). Through the Bank, theCompany provides a full range of commercial and consumer banking services todomestic markets, principally in Beaufort County, South Carolina. The Companyalso has an investment in Coastal Banking Company Statutory Trust I (the “Trust”).The Trust is a special purpose non-consolidated subsidiary organized for thesole purpose of issuing trust preferred securities. The Company attributes itssuccess to local decision making and a commitment to deliver superior,personal, friendly, and responsive service to its customers.****The Company and the Bank first commenced operation on May 10,2000**.**The Company opened a branch bankingoffice in the Moss Creek Village of Bluffton, South Carolina during 2003.

 

**OurVision**

 

*“Coastal Banking Company is theleader in the delivery of comprehensive financial services responsive to thecommunities we serve.”*

 

# **Our Values**

#  

*“The values of Coastal BankingCompany shape our relationships with customers, employees, and shareholderswhile capturing the spirit of our business practices and decisions.”*

 

*“Our directors, officers, andstaff will always act with Integrity,guided by what is ethical and right for our customers.”*

 

*“We are Customer-Centered: readilyavailable, responsive to customers’ needs, and accountable for our actions. Wewill provide unparalleled service and support.”*

 

*“As the financial servicesindustry changes, we will be Innovativeto deliver the products and services that exceed our customers’ expectationswhile producing a fair return to our shareholders.”*

 

*“These values will be thefoundation of our operating philosophy in our daily environment.”*

 

**Locations**

 
| **Coastal  Banking Company, Inc.** |       |                                      |
|-----------------------------------------|------------|-------------------------------------------|
| **Lowcountry  National Bank**           | ** ** | **Bluffton  Office**                      |
| 36  Sea Island Parkway                  |       | 1533  Fording Island Road Suite 300  |
| Beaufort,  South Carolina 29902         |       | Hilton  Head Island, South Carolina 29926 |
| (843)  522-1228                         |       | (843)  837-7977                           |
| Website:  coastalbanking.com            |       |                                      |

 

----

 

**Coastal Banking Company, Inc.**

 

DearShareholder:

 

CoastalBanking Company experienced continued growth and success during 2004. TheCompany and our wholly owned subsidiary, Lowcountry National Bank, are wellpositioned to continue the expansion of our franchise in the Beaufort, SouthCarolina area. Our commitment to deliver superior, personal, friendly, andresponsive customer service has been rewarded with solid financial performance.

 

Weexperienced record earnings during 2004. Net income was $1,111,000, compared to$864,000 for the year ended December 31, 2003. Basic earnings per sharewere $1.11 as compared to $0.87 in 2003, while diluted earnings per share were$0.99 in 2004 compared to $0.82 in 2003. The Company also paid its first stockdividend of 5% in 2004.

 

Ourbalance sheet growth was led by a 49% increase in loans to a total of$100,397,000 as of December 31, 2004. We have not compromised ourcommitment to credit quality while experiencing this growth. Our non-performingassets and charge-off history remains low for the year ended December 31,2004. Our allowance for loan losses increased from $866,000 to $1,137,000during the year primarily due to our loan portfolio growth.

 

Depositgrowth during 2004 was very strong. At December 31, 2004, total depositswere $129,432,000 compared to $96,436,000 as of December 31, 2003. This34% increase in deposits was mainly due to an increase in all of our depositproduct lines.

 

OurBluffton office has continued to improve market share since it commencedoperating in 2003. This office contributed $32,682,000 in loans and $13,471,000in deposits to the above totals as of December 31, 2004. We believe thisoffice will be an integral part of our structure and will allow us to maintainand even increase our expected growth level.

 

Wecontinue to work to improve the foundation that we feel is necessary for theCompany to move forward – forward to sound, increased growth, forward tocontinued investments in our community, and most importantly, forward tocontinued shareholders’ investment growth. We thank you for your continuedtrust and support, and we pledge our continued best efforts to be worthy ofboth.

 

 
| Ladson  F. Howell      |   | Randolph  C. Kohn  |
|------------------------|--------|--------------------|
| Chairman  of the Board |   | President  and CEO |

 

2

----

 

 

 

 

 

 

**Financial Highlights**

 
| ** **                                           | ** ** | **2004**    | ** **  | **2003**   | ** ** | **Percent  Change** | ** ** |
|------------------------------------------------------|------------|-------------|-------------|------------|------------|---------------------|------------|
| **Balance  Sheet**                                   |       |        |        |       |       |                |       |
| Total assets                                         |       | $           | 146,071,670 |       | $          | 107,874,055         |       | 35.41 | % |
| Net loans                                            |       | 100,397,246 |        | 67,488,128 |       | 48.76               |       |
| Securities                                           |       | 34,046,381  |        | 35,555,638 |       | (4.24               | )          |
| Deposits                                             |       | 129,431,713 |        | 96,435,587 |       | 34.22               |       |
| Shareholders’  equity                           |       | 10,792,050  |        | 9,753,467  |       | 10.65               |       |
|                                                 |       |        |        |       |       |                |       |
| **For the  Year**                                    |       |        |        |       |       |                |       |
| Net interest  income                                 |       | $           | 4,474,894   |       | $          | 3,328,024           |       | 34.46 | % |
| Provision for  loan losses                           |       | 463,200     |        | 253,500    |       | 82.72               |       |
| Noninterest  income                                  |       | 764,426     |        | 790,667    |       | (3.32               | )          |
| Noninterest  expense                                 |       | 3,269,332   |        | 2,541,808  |       | 28.62               |       |
| Income tax  expense                                  |       | 396,186     |        | 458,933    |       | (13.67              | )          |
| Net income                                           |       | 1,110,602   |        | 864,450    |       | 28.48               |       |
|                                                 |       |        |        |       |       |                |       |
| **Per  Share**                                       |       |        |        |       |       |                |       |
| Net income                                           |       | $           | 1.11        |       | $          | 0.87                |       | 27.59 | % |
| Book value at  year end                              |       | 10.68       |        | 9.80       |       | 8.98                |       |
|                                                 |       |        |        |       |       |                |       |
| **Financial  Performance Ratios**                    |       |        |        |       |       |                |       |
| Return on  average assets                            |       | 0.86        | %           | 0.95       | %          |                |       |
| Return on  average equity                            |       | 10.85       | %           | 9.22       | %          |                |       |
|                                                 |       |        |        |       |       |                |       |
| **Asset  Quality Ratios**                            |       |        |        |       |       |                |       |
| Nonperforming  loans to total loans                  |       | 0.31        | %           | 0.55       | %          |                |       |
| Allowance for  loan losses times nonperforming loans |       | na          |        | na         |       |                |       |
| Net charge-offs to  average total loans              |       | 0.22        | %           | 0.02       | %          |                |       |

 

3

----

 

**COASTALBANKING COMPANY, INC.**

 

**SELECTEDFINANCIAL DATA**

 
| ** **                                   | ** ** | **2004**    | ** **  | **2003**    | ** ** | **2002**   | ** ** | **2001**   | ** ** | **2000**   | ** ** |
|----------------------------------------------|------------|-------------|-------------|-------------|------------|------------|------------|------------|------------|------------|------------|
|                                         |       |        |        |        |       |       |       |       |       |       |       |
| **FOR THE YEAR**                             |       |        |        |        |       |       |       |       |       |       |       |
| Net  interest income                         |       | $           | 4,474,894   |        | 3,328,024  |       | 2,344,944  |       | 1,304,596  |       | 666,283    |   |
| Provision  for loan losses                   |       | 463,200     |        | 253,500     |       | 232,200    |       | 265,800    |       | 165,700    |       |
| Noninterest  income                          |       | 764,426     |        | 790,667     |       | 507,029    |       | 387,928    |       | 96,245     |       |
| Noninterest  expense                         |       | 3,269,332   |        | 2,541,808   |       | 1,835,721  |       | 1,374,986  |       | 969,105    |       |
| Income  taxes (benefit)                      |       | 396,186     |        | 458,933     |       | 268,119    |       | 13,635     |       | (123,094   | )          |
| Net  earnings (loss)                         |       | 1,110,602   |        | 864,450     |       | 515,933    |       | 38,103     |       | (249,183   | )          |
|                                         |       |        |        |        |       |       |       |       |       |       |       |
| **PER COMMON SHARE***                        |       |        |        |        |       |       |       |       |       |       |       |
| Basic  earnings (loss)                       |       | $           | 1.11        |        | 0.87       |       | 0.52       |       | 0.04       |       | (0.25      | ) |
| Diluted  earnings (loss)                     |       | 0.99        |        | 0.82        |       | 0.52       |       | 0.04       |       | (0.25      | )          |
| Cash  dividends declared                     |       | —      |        | —      |       | —     |       | —     |       | —     |       |
| Book  value                                  |       | 10.68       |        | 9.80        |       | 9.08       |       | 8.35       |       | 8.29       |       |
|                                         |       |        |        |        |       |       |       |       |       |       |       |
| **AT YEAR END**                              |       |        |        |        |       |       |       |       |       |       |       |
| Loans,  net                                  |       | $           | 100,397,246 |        | 67,488,128 |       | 49,065,800 |       | 32,566,026 |       | 13,810,463 |   |
| Earning  assets                              |       | 137,904,751 |        | 104,034,196 |       | 70,470,548 |       | 45,288,309 |       | 21,918,374 |       |
| Assets                                       |       | 146,071,670 |        | 107,874,055 |       | 75,696,898 |       | 48,692,697 |       | 24,959,674 |       |
| Deposits                                     |       | 129,431,713 |        | 96,435,587  |       | 65,947,791 |       | 39,478,014 |       | 16,461,767 |       |
| Shareholders’  equity                   |       | 10,792,050  |        | 9,753,467   |       | 9,036,692  |       | 8,314,352  |       | 8,250,618  |       |
|                                         |       |        |        |        |       |       |       |       |       |       |       |
| Common  shares outstanding                   |       | 1,010,379   |        | 995,695     |       | 995,695    |       | 995,695    |       | 995,695    |       |
|                                         |       |        |        |        |       |       |       |       |       |       |       |
| **AVERAGE BALANCES**                         |       |        |        |        |       |       |       |       |       |       |       |
| Loans                                        |       | $           | 86,580,511  |        | 60,860,974 |       | 41,842,080 |       | 24,490,000 |       | 5,725,000  |   |
| Earning  assets                              |       | 124,586,573 |        | 87,772,570  |       | 58,103,534 |       | 32,350,000 |       | 11,816,000 |       |
| Assets                                       |       | 128,884,584 |        | 91,417,046  |       | 61,240,904 |       | 35,489,000 |       | 14,764,000 |       |
| Deposits                                     |       | 116,757,374 |        | 81,427,295  |       | 51,972,457 |       | 26,755,000 |       | 6,337,000  |       |
| Shareholders’  equity                   |       | 10,239,847  |        | 9,375,405   |       | 8,630,130  |       | 8,265,000  |       | 8,302,000  |       |
|                                         |       |        |        |        |       |       |       |       |       |       |       |
| Weighted  average shares outstanding         |       | 1,003,933   |        | 995,695     |       | 995,695    |       | 995,695    |       | 995,695    |       |
|                                         |       |        |        |        |       |       |       |       |       |       |       |
| **KEY PERFORMANCE RATIOS**                   |       |        |        |        |       |       |       |       |       |       |       |
| Return  on average assets                    |       | 0.86        | %           | 0.95        | %          | 0.84       | %          | 0.11       | %          | (1.69      | )%         |
| Return  on average shareholders’ equity |       | 10.85       | %           | 9.22        | %          | 5.98       | %          | 0.46       | %          | (3.00      | )%         |
| Net  interest margin                         |       | 3.59        | %           | 3.79        | %          | 4.04       | %          | 4.03       | %          | 5.64       | %          |
| Dividend  payout ratio                       |       | —      |        | —      |       | —     |       | —     |       | —     |       |
| Average  equity to average assets            |       | 7.94        | %           | 10.26       | %          | 14.09      | %          | 23.29      | %          | 56.23      | %          |

 

----

***** 2003 and prioryears have been restated for a 5% stock dividend.

 

4

----

 

**MANAGEMENT’S DISCUSSION ANDANALYSIS OF FINANCIAL CONDITION**

**AND RESULTS OF OPERATIONS**

 

**General**

 

CoastalBanking Company, Inc. is a bank holding company headquartered in Beaufort,South Carolina organized to own all of the common stock of its subsidiary,Lowcountry National Bank (the “Bank”).  Theprincipal activity of the Bank is to provide banking services to domesticmarkets, principally in Beaufort County, South Carolina. The Bank is primarilyregulated by the Office of the Comptroller of the Currency (“OCC”) andundergoes periodic examinations by this regulatory agency. The holding companyis regulated by the Federal Reserve Bank and also is subject to periodicexaminations. The Bank opened for business on May 10, 2000 at 36 SeaIsland Parkway, Beaufort, South Carolina 29902. The Company also has an investment inCoastal Banking Company Statutory Trust I (the “Trust”). The Trust is a special purposenon-consolidated subsidiary organized for the sole purpose of issuing trustpreferred securities.

 

The following discussiondescribes our results of operations for 2004 as compared to 2003 and alsoanalyzes our financial condition as of December 31, 2004 as compared to December 31,2003. Like most community banks, we derive most of our income from interest wereceive on our loans and investments. Our primary source of funds for makingthese loans and investments is our deposits, on which we pay interest. Consequently,one of the key measures of our success is our amount of net interest income, orthe difference between the income on our interest-earning assets, such as loansand investments, and the expense on our interest-bearing liabilities, such asdeposits. Another key measure is the spread between the yield we earn on theseinterest-earning assets and the rate we pay on our interest-bearingliabilities.

 

We have included a numberof tables to assist in our description of these measures. For example, the “AverageBalances” table shows the average balance during 2004 and 2003 of each categoryof our assets and liabilities, as well as the yield we earned or the rate wepaid with respect to each category. A review of this table shows that our loanstypically provide higher interest yields than do other types of interestearning assets, which is why we intend to continue to direct a substantialpercentage of our earning assets into our loan portfolio. Similarly, the “Rate/VolumeAnalysis” table helps demonstrate the impact of changing interest rates andchanging volume of assets and liabilities during the years shown. We also trackthe sensitivity of our various categories of assets and liabilities to changesin interest rates, and we have included a “Sensitivity Analysis Table” to helpexplain this. Finally, we have included a number of tables that provide detailabout our investment securities, our loans, and our deposits.

 

Of course, there arerisks inherent in all loans, so we maintain an allowance for loan losses toabsorb possible losses on existing loans that may become uncollectible. Weestablish and maintain this allowance by charging a provision for loan lossesagainst our operating earnings. In the following section we have includeda detailed discussion of this process, as well as several tables describing ourallowance for loan losses**.**See commentsin the section entitled “Provision and Allowance for Loan Losses.”

 

In addition to earninginterest on our loans and investments, we earn income through fees and otherexpenses we charge to our customers. We describe the various components of thisnoninterest income, as well as our noninterest expense, in the followingdiscussion.

 

The following discussionand analysis also identifies significant factors that have affected our financialposition and operating results during the periods included in the accompanyingfinancial statements. We encourage you to read this discussion and analysis inconjunction with the financial statements and the related notes and the otherstatistical information also included in this report.

 

5

----

 

**Forward-Looking Statements**

 

This report contains “forward-lookingstatements” relating to, without limitation, future economic performance, plansand objectives of management for future operations, and projections of revenuesand other financial items that are based on the beliefs of management, as wellas assumptions made by and information currently available to management. Thewords “may,” “will,” “anticipate,” “should,” “would,” “believe,” “contemplate,”“expect,” “estimate,” “continue,” “may,” and “intend,” as well as other similarwords and expressions of the future, are intended to identify forward-lookingstatements. Potential risks and uncertainties include, but are not limited tothose described under the heading “Risk Factors” in our Form 10-KSBfor the year ended December 31, 2004.

 

**CriticalAccounting Policies**

 

We have adopted variousaccounting policies, which govern the application of accounting principlesgenerally accepted in the United States of America in the preparation of ourfinancial statements. Our significant accounting policies are described in Note1 in the footnotes to the consolidated financial statements at December 31,2004 included elsewhere in this annual report.

 

We believe that theallowance for loan losses is a critical accounting policy that requires themost significant judgments and estimates used in preparation of ourconsolidated financial statements. Please refer to the portion of management’sdiscussion and analysis of financial condition and results of operations thataddresses the allowance for loan losses for a description of our processes andmethodology for determining the allowance for loan losses.

 

**Results of Operations**

 

**Overview**

 

Netincome for 2004 was $1,111,000, or $1.11 per common share compared to $864,000,or $.87 per common share in 2003. Our operational results depend to a largedegree on net interest income, which is the difference between the interestincome received from our investments (such as loans, investment securities, andfederal funds sold) and interest expense, which is paid on deposit liabilitiesand other borrowings. Net interest income was $4,475,000 for the year ended December 31,2004 compared to net interest income of $3,328,000 for the year ended December 31,2003.

 

Theprovision for loan losses in 2004 was $463,000 compared to $254,000 in 2003. Theincrease in the provision for loan losses was attributable to the increase inour loan growth during 2004. The provision for loan losses continues to reflectour estimate of potential losses inherent in the loan portfolio and thecreation of an allowance for loan losses adequate to absorb such losses.

 

Noninterestincome for the year ended December 31, 2004 totaled $764,000, representinga $26,000 (3%) decrease from December 31, 2003. This decrease wasprimarily associated with the decrease in mortgage origination fees during2004. Noninterest expenses in 2004 were $3,269,000, a $728,000 (29%) increasecompared with the 2003 amount, primarily due to an increase in salaries andemployee benefits paid related to additional employees hired in 2004 and thefull year’s effects of staffing the Bluffton Branch.

 

In2004, we recognized $396,000 of income tax expense compared to an income taxexpense of $459,000 in 2003. Our effective tax rate was 26% in 2004 and 35% in2003. Our income tax expense decreased in 2004 because we concluded that thevaluation allowances were no longer needed after an analysis of certain valuationallowances related to our deferred tax assets. The elimination of these taxvaluation allowances reduced tax expense in 2004 by approximately $115,000.

 

6

----

 

**Net Interest Income**

 

For the yearended December 31, 2004, net interest income totaled $4,475,000, ascompared to $3,328,000 for the same period in 2003. Interest income from loans,including fees, increased $1,333,000, or 32% to $5,565,000 for the year ended December 31,2004. This increase in income was partially offset by increased interestexpense, which totaled $2,482,000 for the year ended December 31, 2004compared to $1,830,000 in 2003. The increase in net interest income is due tothe overall growth in the volume of interest earning assets, partially offsetby decreases in overall weighted average interest rates. The net interestmargin realized on earning assets and the interest rate spread were 3.59% and3.42%, respectively, for the year ended December 31, 2004. For the yearended December 31, 2003, the net interest margin was 3.79% and theinterest rate spread was 3.49%. Maturities of higher yielding loans during 2004lowered overall loan yield even though the general rate environment wastrending upward. As a result the net interest margin as a percentage declinedin 2004 when compared to 2003.

 

**Average Balances and Interest Rates**

 

Thetable below shows the average balance outstanding for each category of interestearning assets and interest-bearing liabilities for 2004 and 2003, and the averagerate of interest earned or paid thereon. Average balances have been derivedfrom the daily balances throughout the period indicated.

 
| ** **                                                           | ** ** | **For  the Years Ended December 31**** ** | ** ** |
|----------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                           | ** ** | **(Amounts  presented in thousands)**               | ** ** |
| ** **                                                           | ** ** | **2004**                                            | ** ** | **2003** | ** ** |
| ** **                                                           | ** ** | **Average  Balance**                                | ** ** | **Interest** | ** ** | **Yield/  Rate** | ** ** | **Average  Balance** | ** ** | **Interest** | ** ** | **Yield/  Rate** | ** ** |
| Assets:                                                              |       |                                                |       |   |   |   |   |   |   |   |   |   |   |
| Interest  earning assets:                                            |       |                                                |       |   |   |   |   |   |   |   |   |   |   |
| Loans  (including loan fees)                                         |       | $                                                   | 86,581     |   | $ | 5,565 |   | 6.43 | % | $ | 60,861 |   | $ | 4,231 |   | 6.95 | % |
| Taxable  investments                                                 |       | 30,561                                              |       | 1,163 |   | 3.81 | % | 21,302 |   | 832 |   | 3.91 | % |
| Tax-free  investments                                                |       | 5,561                                               |       | 271 |   | 4.88 | % | 1,380 |   | 69 |   | 5.00 | % |
| Federal  funds sold                                                  |       | 1,884                                               |       | 28 |   | 1.47 | % | 4,230 |   | 44 |   | 1.04 | % |
| Total  interest earning assets                                       |       | 124,587                                             |       | 7,027 |   | 5.64 | % | 87,773 |   | 5,176 |   | 5.90 | % |
| Other  non-interest earning assets                                   |       | 4,298                                               |       |   |   |   |   | 3,644 |   |   |   |   |   |
| Total  assets                                                        |       | $                                                   | 128,885    |   |   |   |   |   | $ | 91,417 |   |   |   |   |   |
|                                                                 |       |                                                |       |   |   |   |   |   |   |   |   |   |   |
| Liabilities  and shareholders’ equity:                          |       |                                                |       |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing  liabilities:                                       |       |                                                |       |   |   |   |   |   |   |   |   |   |   |
| Deposits:                                                            |       |                                                |       |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing  demand and savings                                 |       | $                                                   | 55,909     |   | $ | 994 |   | 1.78 | % | $ | 40,125 |   | $ | 773 |   | 1.93 | % |
| Time                                                                 |       | 52,088                                              |       | 1,376 |   | 2.64 | % | 36,330 |   | 1,056 |   | 2.91 | % |
| Other                                                                |       | 3,706                                               |       | 112 |   | 3.01 | % | 47 |   | 1 |   | 1.51 | % |
| Total  interest-bearing liabilities                                  |       | 111,703                                             |       | 2,482 |   | 2.22 | % | 76,502 |   | 1,830 |   | 2.39 | % |
| Other  non-interest bearing liabilities                              |       | 6,942                                               |       |   |   |   |   | 5,540 |   |   |   |   |   |
| Shareholders’  equity                                           |       | 10,240                                              |       |   |   |   |   | 9,375 |   |   |   |   |   |
| Total  liabilities and shareholders’ equity                     |       | $                                                   | 128,885    |   |   |   |   |   | $ | 91,417 |   |   |   |   |   |
| Excess  of interest-earning assets over interest bearing liabilities |       | $                                                   | 12,884     |   |   |   |   |   | $ | 11,271 |   |   |   |   |   |
| Ratio  of interest-earning assets to interest-bearing liabilities    |       | 112                                                 | %          |   |   |   |   | 115 | % |   |   |   |   |
| Tax  equivalent adjustment                                           |       |                                                |       | 70 |   |   |   |   |   | 18 |   |   |   |
| Net  interest income                                                 |       |                                                |       | $ | 4,475 |   |   |   |   |   | $ | 3,328 |   |   |   |
| Net  interest spread                                                 |       |                                                |       |   |   | 3.42 | % |   |   |   |   | 3.49 | % |
| Net  interest margin                                                 |       |                                                |       |   |   | 3.59 | % |   |   |   |   | 3.79 | % |

 

Non-accrualloans and the interest income which was recorded on these loans, if any, areincluded in the yield calculation for loans in all periods reported.

 

Amountsare presented on a tax equivalent basis.

 

7

----

 

**Volume/Rate Analysis**

 

Net interest income can also be analyzed in terms ofthe impact of changing rates and changing volume. The following table describesthe extent to which changes in interest rates and changes in the volume ofinterest-earning assets and interest-bearing liabilities have affected ourinterest income and interest expense during the periods indicated. The effectof a change in average balance has been determined by applying the average ratein the earlier year to the change in average balance in the later year, ascompared with the earlier year. The effect of a change in the average rate hasbeen determined by applying the average balance in the earlier year to thechange in the average rate in the later year, as compared with the earlieryear.

 
| ** **                                   | ** ** | **2004 Compared to 2003  Increase (decrease) due to changes in** | ** ** |
|----------------------------------------------|------------|------------------------------------------------------------------|------------|
| ** **                                   | ** ** | **Volume**                                                       | ** ** | **Rate** | ** ** | **Net Change** | ** ** |
| Interest income on:                          | ** ** | ** **                                                       | ** ** | ** ** | ** ** | ** ** | ** ** |
| Loans (including loan fees)                  |       | $                                                                | 1,674      |   | $ | (340 | ) | $ | 1,334 |   |
| Taxable investments                          |       | 353                                                              |       | (22 | ) | 331 |   |
| Non-taxable investments                      |       | 204                                                              |       | (2 | ) | 202 |   |
| Federal funds sold                           |       | (30                                                              | )          | 14 |   | (16 | ) |
| Total interest income (tax equivalent basis) |       | 2,201                                                            |       | (350 | ) | 1,851 |   |
| Interest expense on:                         |       |                                                             |       |   |   |   |   |
| Interest-bearing demand and savings          |       | 285                                                              |       | (64 | ) | 221 |   |
| Time                                         |       | 424                                                              |       | (104 | ) | 320 |   |
| Other                                        |       | 109                                                              |       | 2 |   | 111 |   |
| Total interest expense                       |       | 818                                                              |       | (166 | ) | 652 |   |
| Net interest income (tax equivalent basis)   |       | $                                                                | 1,383      |   | $ | (184 | ) | $ | 1,199 |   |

 

##### **Interest Rate Sensitivity and Asset Liability Management**

#####  

Interest rate sensitivity****measures the timing and magnitude of therepricing of assets compared with the repricing of liabilities and is animportant part of asset/liability management of a financial institution. Theobjective of interest rate sensitivity management is to generate stable growthin net interest income, and to control the risks associated with interest ratemovements. Management constantly reviews interest rate risk exposure and theexpected interest rate environment so that adjustments in interest ratesensitivity can be timely made. Since the assets and liabilities of a bank areprimarily monetary in nature (payable in fixed, determinable amounts), theperformance of a bank is affected more by changes in interest rates than byinflation. Interest rates generally increase as the rate of inflationincreases, but the magnitude of the change in rates may not be the same.

 

Net interest income isthe primary component of net income for financial institutions. Net interestincome is affected by the timing and magnitude of repricing of as well as themix of interest sensitive and noninterest sensitive assets and liabilities. “Gap”is a static measurement of the difference between the contractual maturities orrepricing dates of interest sensitive assets and interest sensitive liabilitieswithin the following twelve months. Gap is an attempt to predict the behaviorof the bank’s net interest income in general terms during periods of movementin interest rates. In general, if the bank is asset sensitive, more of itsinterest sensitive assets are expected to reprice within twelve months than itsinterest sensitive liabilities over the same period. In a rising interest rateenvironment, assets repricing more quickly are expected to enhance net interestincome. Alternatively, decreasing interest rates would be expected to have theopposite effect on net interest income since assets would theoretically berepricing at lower interest rates more quickly than interest sensitiveliabilities. Although it can be used as a general predictor, gap as a predictorof movements in net interest income has limitations due to the static nature ofits definition and due to its inherent assumption that all assets will repriceimmediately and fully at the contractually designated time. At December 31,2004, the bank, as measured by gap, is in a liability sensitive position. Managementhas several tools available to it to evaluate and affect interest rate risk,including deposit pricing policies and changes in the mix of various types ofassets and liabilities.

 

8

----

 

Thefollowing table summarizes the amounts of interest-earning assets andinterest-bearing liabilities outstanding at December 31, 2004, that areexpected to mature, prepay, or reprice in each of the future time periodsshown. Except as stated below, the amount of assets or liabilities that matureor reprice during a particular period was determined in accordance with thecontractual terms of the asset or liability. Adjustable rate loans are includedin the period in which interest rates are next scheduled to adjust rather thanin the period in which they are due, and fixed rate loans and mortgage-backedsecurities are included in the periods in which they are anticipated to berepaid based on scheduled maturities. The bank’s savings accounts andinterest-bearing demand accounts (NOW and money market deposit accounts), whichare generally subject to immediate withdrawal, are included in the “ThreeMonths or Less” category, although historical experience has proven thesedeposits to be more stable over the course of a year.

 

AtDecember 31, 2004Maturing or Repricing in

(dollars inthousands)

 
| ** **                                  | ** ** | **3  Months  or Less** | ** ** | **4  Months to  12 Months** | ** ** | **1  to 5  Years** | ** ** | **Over  5  Years** | ** ** | **Total** | ** ** |
|---------------------------------------------|------------|------------------------|------------|-----------------------------|------------|--------------------|------------|--------------------|------------|-----------|------------|
|                                        |       |                   |       |                        |       |               |       |               |       |      |       |
| Interest-earning  assets:                   |       |                   |       |                        |       |               |       |               |       |      |       |
| Federal  funds sold                         |       | $                      | 2,583      |                        | $          | —             |       | $                  | —     |      | $          | — |   | $ | 2,583 |   |
| Investment  securities                      |       | —                 |       | 674                         |       | 6,815              |       | 26,557             |       | 34,046    |       |
| Loans  held for sale                        |       | 878                    |       | —                      |       | —             |       | —             |       | 878       |       |
| Loans                                       |       | 35,390                 |       | 16,775                      |       | 45,766             |       | 3,603              |       | 101,534   |       |
|                                        |       |                   |       |                        |       |               |       |               |       |      |       |
| Total  interest-earning assets              |       | 38,851                 |       | 17,449                      |       | 52,581             |       | 30,160             |       | 139,041   |       |
|                                        |       |                   |       |                        |       |               |       |               |       |      |       |
| Interest-bearing  liabilities:              |       |                   |       |                        |       |               |       |               |       |      |       |
| Deposits:                                   |       |                   |       |                        |       |               |       |               |       |      |       |
| Savings  and demand                         |       | 58,200                 |       | —                      |       | —             |       | —             |       | 58,200    |       |
| Time  deposits                              |       | 11,761                 |       | 20,230                      |       | 28,006             |       | —             |       | 59,997    |       |
| FHLB  advances                              |       | 2,000                  |       | —                      |       | —             |       | —             |       | 2,000     |       |
| Junior  subordinated debentures             |       | —                 |       | —                      |       | —             |       | 3,093              |       | 3,093     |       |
|                                        |       |                   |       |                        |       |               |       |               |       |      |       |
| Total  interest-bearing liabilities         |       | 71,961                 |       | 20,230                      |       | 28,006             |       | 3,093              |       | 123,290   |       |
|                                        |       |                   |       |                        |       |               |       |               |       |      |       |
| Interest  sensitive difference per period   |       | $                      | (33,110    | )                           | $          | (2,781             | )          | $                  | 24,575     |      | $          | 27,067 |   |   |   |
| Cumulative  interest sensitivity difference |       | $                      | (33,110    | )                           | $          | (35,891            | )          | $                  | (11,316    | )         | $          | 15,751 |   |   |   |
| Cumulative  difference to total assets      |       | (24                    | )%         | (26                         | )%         | (8                 | )%         | 11                 | %          |      |       |
|                                             |            |                        |            |                             |            |                    |            |                    |            |           |            |  |  |  |  |  |

 

AtDecember 31, 2004, the difference between the bank’s liabilities andassets repricing or maturing within one year was $35,891,000. Due to an excessof liabilities repricing or maturing within one year, a rise in interest rateswould cause the bank’s net interest income to decline.

 

Certainshortcomings are inherent in the method of analysis presented in the foregoingtable. For example, although certain assets and liabilities may have similarmaturities or periods of repricing, they may reflect changes in market interestrates differently. Additionally, certain assets, such as adjustable-ratemortgages, have features that restrict changes in interest rates, both on ashort-term basis and over the life of the asset. Other factors which may affectthe assumptions made in the table include changes in interest rates,pre-payment rates, early withdrawal levels, and the ability of borrowers toservice their debt.

 

**ImpairedLoans**

 

A loan will be consideredto be impaired when, in management’s judgment based on current information andevents, it is probable that the loan’s principal or interest will not becollectible in accordance with the terms of the original loan agreement. Impairedloans, when not material, will be carried in the balance sheet at a value notto exceed their observable market price or the fair value of the collateral ifthe repayment of the loan is expected to be provided solely by the underlyingcollateral. The carrying values of any material impaired loans will be measuredbased on the present value of expected future cash flows discounted at the loan’seffective interest rate, which is the contractual interest rate adjusted forany deferred loan fees or costs, premium or discount existing at the inceptionor acquisition of the loan.

 

9

----

 

Loans which managementidentifies as impaired generally will be nonperforming loans. Nonperformingloans include nonaccrual loans or loans which are 90 days or more delinquent asto principal or interest payments. At December 31, 2004 and 2003, the Bankhad $313,000 and $372,000 of loans that were impaired and nonperforming.

 

The accrual of interestwill be discontinued on nonaccrual loans and any previously accrued interest onsuch loans will be reversed against current income. Any subsequent interestincome will be recognized on a cash basis when received unless collectibilityof a significant amount of principal is in serious doubt. In such cases,collections are credited first to the remaining principal balance on a costrecovery basis. An impaired loan will not be returned to accrual status unlessprincipal and interest are current and the borrower has demonstrated theability to continue making payments as agreed.

 

**PotentialProblem Loans**

 

Managementidentifies and maintains a list of potential problem loans. These are loansthat are not included in nonaccrual status, or loans that are past due 90 daysor more and still accruing interest. A loan is added to the potential problemlist when management becomes aware of information about possible creditproblems of borrowers that causes serious doubts as to the ability of suchborrowers to comply with the current loan repayment terms. These loans aredesignated as such in order to be monitored more closely than other credits inthe Bank’s portfolio. There are no potential problem loans not alreadyaddressed.

 

**Provision and Allowance for Loan Losses**

 

Theprovision for loan losses is the charge to operating earnings that managementbelieves is necessary to maintain the allowance for loan losses at an adequatelevel. The provision charged to expense was $463,000 for the year ended December 31,2004 as compared to $254,000 for the year ended December 31, 2003. Thechange in the provision was the result of our loan portfolio growing faster in2004 than in 2003. The loan portfolio increased by approximately $33.2 millionduring the year ended December 31, 2004 as compared to growth of $18.7million in 2003. The allowance for loan losses was 1.11% of gross loans at December 31,2004 as compared to 1.27% at December 31, 2003. There are risks inherentin making all loans, including risks with respect to the period of time overwhich loans may be repaid, risks resulting from changes in economic andindustry conditions, risks inherent in dealing with individual borrowers, and,in the case of a collateralized loan, risks resulting from uncertainties aboutthe future value of the collateral.

 

We have established anallowance for loan losses through a provision for loan losses charged toexpense on our statement of income. Additions to the allowance for loan losses,which are expenses to the provision for loan losses on our income statement,are made periodically to maintain the allowance at an appropriate level basedon management’s analysis of the potential risk in the loan portfolio. Theallowance for loan losses represents an amount which we believe will beadequate to absorb probable losses on existing loans that may becomeuncollectible. Our judgment as to the adequacy of the allowance for loan lossesis based upon anumber of assumptions about future events, which we believe to be reasonable,but which may or may not prove to be accurate. Our losses will undoubtedly vary from our estimates, and there is apossibility that charge-offs              Ourdetermination of the allowance for loan losses is based on evaluations of thecollectibility of loans, including consideration of factors such as the balanceof impaired loans, the quality, mix, and size of our overall loan portfolio,economic conditions that may affect the borrower’s ability to repay, the amountand quality of collateral securing the loans, our historical loan lossexperience, and a review of specific problem loans. We also consider subjectiveissues such as changes in the lending policies and procedures, changes in thelocal/national economy, changes in volume or type of credits, changes involume/severity of problem loans, quality of loan review and board of directoroversight, concentrations of credit, and peer group comparisons.

 

We do not allocate theallowance for loan losses to specific categories of loans but rather evaluatethe adequacy on an overall portfolio basis utilizing a risk grading system. Seethe table below for an indication of our history of charge-offs by loancategory which may or may not be indicative of future charge-offs by category.

 

Due to our limitedoperating history, our policy has been to review the allowance for loan lossesusing a reserve factor based on risk-rated categories of loans since there hasbeen relatively little charge-off activity since the bank’s inception. Theoverall objective is to apply percentages to the loans based on the relativeinherent risk for that loan type and grade. Reserve factors are based on peergroup data, information from regulatory agencies, and on the experience of thebank’s lenders. The reserve factors will change depending on trends in nationaland local economic conditions, the depth of experience of the bank’s lenders, delinquencytrends, and other factors. Our general strategy is to maintain a minimumcoverage of a certain percentage of gross loans until we have sufficienthistorical data and trends available. Periodically, we adjust the amount of

 

10

----

 

the allowance based onchanging circumstances. We charge recognized losses to the allowance and addsubsequent recoveries back to the allowance for loan losses. There can be noassurance that charge-offs of loans in future periods will not exceed theallowance for loan losses as estimated at any point in time or that provisionsfor loan losses will not be significant to a particular accounting period. Thus, there is a risk that substantialadditional increases in the allowance for loan losses could be required.Additions to the allowance for loan losses would result in a decrease of ournet income and, possibly, our capital.

 

Thefollowing table summarizes information concerning the allowance for loanlosses:

 
| ** **                                                                                  | ** ** | **December 31,**                     | ** ** |
|---------------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                                  | ** ** | **2004**                                  | ** ** | **2003** | ** ** |
| ** **                                                                                  | ** ** | **(Amounts  are presented in thousands)** | ** ** |
|                                                                                        |       |                                      |       |   |   |
| Total  loans outstanding, end of year                                                       |       | $                                         | 101,534    |   | $ | 68,354 |   |
| Average  loans outstanding                                                                  |       | $                                         | 86,581     |   | $ | 60,861 |   |
| Allowance,  beginning of year                                                               |       | 866                                       |       | 624 |   |
| Charge-offs:                                                                                |       |                                      |       |   |   |
| Commercial,  financial and industrial                                                       |       | —                                    |       | 17 |   |
| Real  estate – construction                                                            |       | —                                    |       | — |   |
| Real  estate – mortgage                                                                |       | 102                                       |       | — |   |
| Consumer                                                                                    |       | 93                                        |       | — |   |
| Total  charge-offs                                                                          |       | 195                                       |       | 17 |   |
| Recoveries:                                                                                 |       |                                      |       |   |   |
| Commercial,  financial and industrial                                                       |       | 3                                         |       | 5 |   |
| Real  estate – construction                                                            |       | —                                    |       | — |   |
| Real  estate – mortgage                                                                |       | —                                    |       | — |   |
| Consumer                                                                                    |       | —                                    |       | — |   |
| Total  recoveries                                                                           |       | 3                                         |       | 5 |   |
| Net  charge-offs                                                                            |       | 192                                       |       | 12 |   |
| Additions  charged to operations                                                            |       | 463                                       |       | 254 |   |
| Allowance,  end of year                                                                     |       | $                                         | 1,137      |   | $ | 866 |   |
| Ratio  of net charge-offs during the period to average loans outstanding during the  period |       | 0.22                                      | %          | 0.02 | % |
| Allowance  for loan losses to loans, end of year                                            |       | 1.11                                      | %          | 1.27 | % |

 

Thefollowing table summarizes past due and non-accrual loans, other real estateand repossessions, and income that would have been reported on non-accrualloans as of December 31, 2004 and 2003 (amounts are presented inthousands):

 
| ** **                                                    | ** ** | **December 31,** | ** ** |
|---------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                    | ** ** | **2004**              | ** ** | **2003** | ** ** |
|                                                          |       |                  |       |   |   |
| Other  real estate and repossessions                          |       | $                     | 55         |   | $ | — |   |
| Accruing  loans 90 days or more past due                      |       | 313                   |       | 325 |   |
| Non-accrual  loans                                            |       | —                |       | 47 |   |
| Interest  on non-accrual loans which would have been reported |       | —                |       | — |   |
|                                                               |            |                       |            |  |  |  |  |

 

**Noninterest Income and Expense**

 

Noninterestincome for the year ended December 31, 2004 totaled $764,000 as comparedto $791,000 for the year ended December 31, 2003. This decrease innoninterest income was primarily due to a decrease in residential mortgageorigination fees partially offset by an increase in gains on the sale ofsecurities and income from the increase in cash value of life insurancepolicies. Residential mortgage origination fees totaled $391,000 and $542,000in 2004 and 2003, respectively. Lower market interest rates created significantrefinancing volume in the residential mortgage market in 2003. This refinancingvolume slowed in 2004 as interest rates leveled off and started to increase. During2004, we purchased bank owned life insurance policies covering certain of ourexecutives. The cash value of these policies increases over time and,accordingly, we recognized $82,000 in income related to these policies in 2004.We also recognized gains on the sale of certain investment securitiesavailable-for-sale totaling $85,000 during the year ended December 31,2004 as compared to gains of $42,000 in 2003.

 

11

----

 

Totalnoninterest expense for the year ended December 31, 2004 was $3,270,000,as compared to $2,542,000 for the same period in 2003. Salaries and benefits,the largest component of noninterest expense, totaled $1,766,000 for the yearended December 31, 2004, compared to $1,400,000 for the same period a yearago. Other operating expenses were $1,209,000 for the year ended December 31,2004 as compared to $865,000 for the year ended December 31, 2003. Theseother operating expenses included professional fee increases of $87,037 as aresult of higher consulting, internal audit and legal fees, data processingcosts of $119,586 as a result of a full year of transaction volume at ourBluffton branch, and advertising fees of $56,110 as a result of a full year ofoperation at our Bluffton branch.

 

**Financial Condition**

 

Total assetsincreased $38,198,000, or 35%, from December 31, 2003 to December 31,2004. The primary source of growth in assets was net loans, which increased$32,909,000, or 49%. Total deposits increased $32,996,000, or 34%, from the December 31,2003 amount of $96,436,000 to $129,432,000 at December 31, 2004.

 

**Interest-EarningAssets**

 

**Loans**

 

Gross loans totaled$101,534,000 at December 31, 2004, an increase of $33,180,000, or 49%,since December 31, 2003. The largest increase in loans was in Real estate– mortgage loans, which increased $16,677,000, or 39%, to $58,979,000 at December 31,2004. Real estate - construction loans increased $15,752,000, or 88%, during2004. Balances andpercentages within the major loans receivable categories as of December 31, 2004 and December 31, 2003 are asfollows (amounts in thousands):

 
| ** **                           | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------------------|------------|----------|------------|----------|------------|
|                                 |       |     |       |     |       |   |   |   |   |
| Real estate - construction           |       | $        | 33,727     |     | 33         | % | $ | 17,974 |   | 26 | % |
| Real estate - mortgage               |       | 58,979   |       | 58       | %          | 42,303 |   | 62 | % |
| Commercial, financial and industrial |       | 5,561    |       | 6        | %          | 5,354 |   | 8 | % |
| Consumer and other                   |       | 3,267    |       | 3        | %          | 2,723 |   | 4 | % |
|                                 |       |     |       |     |       |   |   |   |   |
|                                 |       | $        | 101,534    |     |       |   | $ | 68,354 |   |   |   |

 

Asof December 31, 2004, maturities of loans in the indicated classificationswere as follows (amounts are presented in thousands):

 
| ** **     | ** ** | **Commercial** | ** ** | **Real  Estate  Construction** | ** ** | **Total** | ** ** |
|----------------|------------|----------------|------------|--------------------------------|------------|-----------|------------|
|           |       |           |       |                           |       |      |       |
| Maturity       |       |           |       |                           |       |      |       |
|           |       |           |       |                           |       |      |       |
| Within  1 year |       | $              | 3,267      |                           | $          | 21,777    |       | $ | 25,024 |   |
| 1  to 5 years  |       | 2,294          |       | 10,635                         |       | 12,929    |       |
| Over  5 years  |       | —         |       | 1,315                          |       | 1,315     |       |
|           |       |           |       |                           |       |      |       |
| Totals         |       | $              | 5,561      |                           | $          | 33,727    |       | $ | 39,268 |   |

 

Asof December 31, 2004, the interest terms of loans in the indicatedclassification for the indicated maturity ranges are as follows (amounts arepresented in thousands):

 
| ** **                       | ** ** | **Fixed  Interest  Rates** | ** ** | **Variable  Interest  Rates** | ** ** | **Total** | ** ** |
|----------------------------------|------------|----------------------------|------------|-------------------------------|------------|-----------|------------|
|                             |       |                       |       |                          |       |      |       |
| Commercial                       |       |                       |       |                          |       |      |       |
| 1  to 5 years                    |       | $                          | 2,294      |                          | $          | —    |       | $ | 2,294 |   |
| Over  5 years                    |       | —                     |       | —                        |       | —    |       |
|                             |       |                       |       |                          |       |      |       |
| Real  estate – construction |       |                       |       |                          |       |      |       |
| 1  to 5 years                    |       | 9,461                      |       | 1,174                         |       | 10,635    |       |
| Over  5 years                    |       | 1,315                      |       | —                        |       | 1,315     |       |
|                             |       |                       |       |                          |       |      |       |
|                             |       | $                          | 13,070     |                          | $          | 1,174     |       | $ | 14,244 |   |

 

12

----

 

**Investment Securities**

 

Investmentsecurities available-for-sale decreased to $27,366,000 at December 31,2004 from $31,274,000 at December 31, 2003. Investment securitiesheld-to-maturity increased from $3,421,000 at December 31, 2003 to$5,643,000 at December 31, 2004. The decrease in investment securitiesavailable-for-sale was due to our increased loan demand in 2004. The increasein investment securities held-to-maturity was due to our increased investmentin tax-free securities.

 

Thefollowing table presents the investments by category at December 31, 2004and 2003:

 
| ** **                    | ** ** | **2004**                                  | ** ** | **2003**                  | ** ** |
|-------------------------------|------------|-------------------------------------------|------------|---------------------------|------------|
| ** **                    | ** ** | **(Amounts  are presented in thousands)** | ** ** |
| ** **                    | ** ** | **Amortized  Cost**                       | ** ** | **Estimated  Fair Value** | ** ** | **Amortized  Cost** | ** ** | **Estimated  Fair Value** | ** ** |
| Available-for-sale            |       |                                      |       |                      |       |   |   |   |   |
| Federal  agencies             |       | $                                         | 15,010     |                      | $          | 14,916 |   | $ | 21,606 |   | $ | 21,694 |   |
| Mortgage-backed               |       | 12,290                                    |       | 12,182                    |       | 9,542 |   | 9,580 |   |
| State,  county and municipals |       | 268                                       |       | 268                       |       | — |   | — |   |
|                          |       |                                      |       |                      |       |   |   |   |   |
| Held-to-maturity              |       | $                                         | 27,568     |                      | $          | 27,366 |   | $ | 31,148 |   | $ | 31,274 |   |
|                          |       |                                      |       |                      |       |   |   |   |   |
| State,  county and municipals |       | $                                         | 5,643      |                      | $          | 5,555 |   | $ | 3,421 |   | $ | 3,353 |   |

 

Thefollowing table presents the maturities of investment securities at carryingvalue and the weighted average yields for each range of maturities presented. Yieldsare based on amortized cost of securities. (Amounts are presented in thousands)

 
| **Maturities  at  December 31, 2004** | ** ** | **State,  County and  Municipals** | ** ** | **Weighted  Average  Yields** | ** ** | **Federal  Agencies** | ** ** | **Weighted  Average  Yields** | ** ** | **Mortgage-  backed** | ** ** | **Weighted  Average  Yields** | ** ** |
|--------------------------------------------|------------|------------------------------------|------------|-------------------------------|------------|-----------------------|------------|-------------------------------|------------|-----------------------|------------|-------------------------------|------------|
|                                       |       |                               |       |                          |       |                  |       |                          |       |                  |       |                          |       |
| Within  1 year                             |       | $                                  | —     |                          | —     | %                     | $          | 668                           |       | 4.43                  | %          | $                             | —     |   | — | % |
| After  1 through 5 years                   |       |                               |       |                          | %          | 6,565                 |       | 3.70                          | %          | 924                   |       | 3.78                          | %          |
| After  5 through 10 years                  |       | 1,166                              |       | 3.16                          | %          | 7,777                 |       | 4.25                          | %          | 5,293                 |       | 3.89                          | %          |
| After  10 years                            |       | 4,745                              |       | 3.60                          | %          | —                |       | —                        | %          | 6,073                 |       | 4.48                          | %          |
|                                       |       |                               |       |                          |       |                  |       |                          |       |                  |       |                          |       |
| Totals                                     |       | $                                  | 5,911      |                          |       |                  | $          | 15,010                        |       |                  |       | $                             | 12,290     |   |   |   |

 

Mortgage-backedsecurities are included in the maturities categories in which they areanticipated to be repaid based on scheduled maturities.

 

**Deposits**

 

At December 31,2004, total deposits increased by $32,996,000, or 34%, to a total of$129,432,000 at December 31, 2004 from $96,436,000 at December 31,2003. Noninterest-bearing demand deposits increased $6,168,000, or 122%, whileinterest-bearing deposits increased $26,828,000, or 29%.

 

Balances andpercentages within the major deposit categories as of December 31, 2004and December 31, 2003 are as follows (amounts in thousands):

 
| ** **                           | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------------------|------------|----------|------------|----------|------------|
|                                 |       |     |       |     |       |   |   |   |   |
| Noninterest-bearing  demand deposits |       | $        | 11,235     |     | 9          | % | $ | 5,067 |   | 5 | % |
| Interest-bearing  demand deposits    |       | 57,239   |       | 44       | %          | 49,686 |   | 52 | % |
| Savings deposits                     |       | 961      |       | 1        | %          | 899 |   | 1 | % |
| Time over  $100,000                  |       | 30,185   |       | 23       | %          | 15,353 |   | 16 | % |
| Time                                 |       | 29,812   |       | 23       | %          | 25,431 |   | 26 | % |
|                                 |       |     |       |     |       |   |   |   |   |
|                                 |       | $        | 129,432    |     |       |   | $ | 96,436 |   |   |   |

 

13

----

 

Theaverage balance of deposits and the average rates paid on such deposits aresummarized for the periods indicated in the following table.

 
| ** **                  | ** ** | **December 31,**                     | ** ** |
|-----------------------------|------------|-------------------------------------------|------------|
| ** **                  | ** ** | **2004**                                  | ** ** | **2003** | ** ** |
| ** **                  | ** ** | **(Amounts  are presented in thousands)** | ** ** |
| ** **                  | ** ** | **Amount**                                | ** ** | **Rate** | ** ** | **Amount** | ** ** | **Rate** | ** ** |
|                        |       |                                      |       |   |   |   |   |   |   |
| Noninterest-bearing  demand |       | $                                         | 8,760      |   | — | % | $ | 4,972 |   | — | % |
| Interest-bearing  demand    |       | 54,931                                    |       | 1.80 | % | 39,352 |   | 1.95 | % |
| Savings                     |       | 978                                       |       | .72 | % | 773 |   | .96 | % |
| Time  deposits              |       | 52,088                                    |       | 2.64 | % | 36,330 |   | 2.91 | % |
|                        |       |                                      |       |   |   |   |   |   |   |
| Totals                      |       | $                                         | 116,757    |   |   |   | $ | 81,427 |   |   |   |

 

Maturitiesof time certificates of deposit of $100,000 or more outstanding at December 31,2004 are summarized as follows (amounts are presented in thousands):

 
| Within  3 months           |   | $      | 6,301  |   |
|----------------------------|--------|--------|--------|--------|
| After  3 through 6 months  |   | 2,812  |   |
| After  6 through 12 months |   | 7,914  |   |
| After  12 months           |   | 13,158 |   |
|                       |   |   |   |
| Total                      |   | $      | 30,185 |   |

 

**Junior Subordinated Debentures**

 

InMay 2004, Coastal Banking Company Statutory Trust I issued $3.0 million oftrust preferred securities with a maturity of May 18, 2034. In accordancewith Financial Interpretation Number (“FIN”) 46, the trust has not beenconsolidated in the Company’s financial statements. The proceeds from theissuance of the trust preferred securities were used by the trust to purchase$3.0 million of the Company’s junior subordinated debentures, which payinterest at a floating rate equal to 3 month LIBOR plus 275 basis points. TheCompany used the proceeds from the sale of the junior subordinated debenturesfor general purposes, primarily to provide capital to the bank. The debenturesrepresent the sole asset of the trust.

 

14

----

 

**Capital Resources**

 

Totalshareholders’ equity increased from $9,753,000 at December 31, 2003 to$10,792,000 at December 31, 2004. This increase was attributable to netearnings for the period partially offset by a decrease of $216,000 in the fairvalue of securities available-for-sale, net of tax.

 

Bank holding companies, such as us, andtheir banking subsidiaries are required by banking regulators to meet certainminimum levels of capital adequacy, which are expressed in the form of certainratios. Capital is separated into Tier 1 capital (essentially common shareholders’equity less intangible assets) and Tier 2 capital (essentially the allowancefor loan losses limited to 1.25% of risk-weighted assets). The first tworatios, which are based on the degree of credit risk in our assets, provide theweighting of assets based on assigned risk factors andinclude off-balance sheet items such as loan commitments and stand-by lettersof credit. The ratio of Tier 1 capital to risk-weighted assets must be at least4.0% and the ratio of total capital (Tier 1 capital plus Tier 2 capital) torisk-weighted assets must be at least 8.0%. The capital leverage ratiosupplements the risk-based capital guidelines.

 

TheFederal Reserve guidelines also contain an exemption from the capitalrequirements for bank holding companies with less than $150 million inconsolidated assets. Because Coastal Banking Company, Inc. had less than$150 million in assets as of December 31, 2004, we were not yet requiredto maintain these minimum capital requirements at the holding company level. However,Lowcountry National Bank falls under these rules as set by bank regulatoryagencies.

 

Banksand bank holding companies are required to maintain a minimum ratio of Tier 1capital to adjusted quarterly average total assets of 3.0%.

 

Thefollowing table summarizes the bank’s risk-based capital ratios at December 31,2004:

 
| Tier 1 capital  (to risk-weighted assets) |   | 10.54 | % |
|-------------------------------------------|--------|-------|---|
| Total capital  (to risk-weighted assets)  |   | 11.53 | % |
| Tier 1 capital  (to total average assets) |   | 8.38  | % |

 

**Liquidity**

 

Thebank must maintain, on a daily basis, sufficient funds to cover the withdrawalsfrom depositors’ accounts and to supply new borrowers with funds. To meet theseobligations, the bank keeps cash on hand, maintains account balances with itscorrespondent banks, and purchases and sells federal funds and other short-terminvestments. Asset and liability maturities are monitored in an attempt tomatch the maturities to meet liquidity needs. It is the policy of the bank tomonitor its liquidity to meet regulatory requirements and their local fundingrequirements.

 

We are a party to financial instrumentswith off-balance-sheet risk in the normal course of business to meet thefinancing needs of our customers. These financial instruments consist ofcommitments to extend credit, standby letters of credit and loans sold withlimited recourse. Commitments to extend credit are agreements to lend to acustomer as long as there is no violation of any condition established in thecontract. Standby lettersof credit are written conditional commitments issued by the Bank to guaranteethe performance of a customer to a third party. Commitmentsgenerally have fixed expiration dates or other termination clauses and mayrequire payment of a fee. A commitment involves, to varying degrees, elementsof credit and interest rate risk in excess of the amount recognized in thebalance sheets. Our exposure to credit loss in the event of non-performance bythe other party to the instrument is represented by the contractual notionalamount of the instrument.

 

Since certain commitmentsare expected to expire without being drawn upon, the total commitment amountsdo not necessarily represent future cash requirements. We use the same creditpolicies in making commitments to extend credit as we do for on-balance-sheetinstruments. Collateral held for commitments to extend credit varies but mayinclude accounts receivable, inventory, property, plant, equipment, andincome-producing commercial properties.

 

Loans sold with limited recourse are 1-4family residential mortgages originated by us and sold to various otherfinancial institutions. These loans are sold with the agreement that a loan maybe returned to us within 90 days of any one of the loan’s first four paymentsbeing missed. Our exposure to credit loss in the event of nonperformance by theother party to the loan is represented by the contractual notional amount ofthe loan. Since none of the loans sold have ever been returned to us, the totalloans sold with limited recourse amount does not necessarily represent futurecash requirements. We use the same credit policies in making loans held forsale as we do for on-balance-sheet instruments.

 

15

----

 

The following tablesummarizes our off-balance-sheet financial instruments whose contract amountsrepresent credit risk as of December 31, 2004:

 
| Commitments to  extend credit     |   | $ | 17,990,000 |   |
|-----------------------------------|--------|---|------------|--------|
| Standby letters  of credit        |   | $ | 552,000    |   |
| Loans sold with  limited recourse |   | $ | 6,157,000  |   |

 

Management is not awareof any significant concentrations of loans to classes of borrowers orindustries that would be affected similarly by economic conditions. Althoughthe bank’s loan portfolio is diversified, a substantial portion of itsborrowers’ ability to honor the terms of their loans is dependent on theeconomic conditions in Beaufort County and surrounding areas. In addition, asubstantial portion of our loan portfolio is collateralized by improved andunimproved real estate and is therefore dependent on the local real estatemarket.

 

Thebank maintains relationships with correspondent banks that can provide funds toit on short notice, if needed. Presently, the bank has arrangements withcommercial banks for short term unsecured advances up to $5,650,000.

 

Cashand cash equivalents as of December 31, 2004 increased $3,892,000 from December 31,2003. Cash provided by operating activities totaled $664,000 in 2004, whileinflows from financing activities totaled $37,634,000, which was attributableto an increase in deposits.

 

During2004, investing activities used $34,406,000. Investing activities included netloans made to customers of approximately $33,427,000 and purchases ofinvestment securities of $16,819,000, partially offset by sales and maturitiesof investment securities of approximately $17,915,000.

 

**Inflation**

 

Inflationimpacts the growth in total assets in the banking industry and causes a need toincrease equity capital at higher than normal rates to meet capital adequacyrequirements. We cope with the effects of inflation through the management ofinterest rate sensitivity gap position, by periodically reviewing and adjustingits pricing of services to consider current costs and through managing ourlevel of net income relative to our dividend payout policy.

 

**Selected Ratios**

 

Thefollowing table sets out certain ratios for the years indicated.

 
| ** **                         | ** ** | **2004** | ** ** | **2003** | ** ** |
|------------------------------------|------------|----------|------------|----------|------------|
| Net  income to:                    |       |     |       |     |       |
| Average  shareholders’ equity |       | 10.85    | %          | 9.22     | %          |
| Average  assets                    |       | 0.86     | %          | 0.95     | %          |
| Dividends  to net income           |       | —   | %          | —   | %          |
| Average  equity to average assets  |       | 7.94     | %          | 10.26    | %          |

 

**Recent Accounting Pronouncements**

 

##### In May 2003, theFinancial Accounting Standards Board (“FASB”) issued SFAS No. 150, *Accounting for Certain Financial Instruments with Characteristics ofboth Liabilities and Equity*, which establishes standards for how anissuer classifies and measures certain financial instruments withcharacteristics of both liabilities and equity. SFAS No. 150 requires anissuer to classify certain financial instruments that include certainobligations, such as mandatory redemption, repurchase of the issuer’s equity,or settlement by issuing equity, previously classified as equity, asliabilities or assets in some circumstances. SFAS No. 150 was generallyeffective forfinancial instruments entered into or modified after May 31, 2003, andotherwise was effective at the beginning of the first interim period beginningafter June 15, 2003, except for mandatorily redeemable financialinstruments of nonpublic entities which are subject to the provisions of SFAS No. 150for the first fiscal period beginning after December 15, 2003. Theadoption of SFAS No. 150 did not have any impact on the financialcondition or operating results of the Company.

 

16

----

 

In December 2004,the FASB issued SFAS No. 153, *Exchange of NonmonetaryAssets, an amendment of APB Opinion No. 29, Accounting for NonmonetaryTransactions.* The amendments made by SFAS No. 153 are based onthe principle that exchanges of nonmonetary assets should be measured on thefair value of the assets exchanged. Further, the amendments eliminate thenarrow exception for nonmonetary exchanges of similar productive assets andreplace it with a broader exception for exchanges of nonmonetary assets that donot have commercial substance. Previously, Accounting Principles Board (“APB”)Opinion No. 29 required that the accounting for an exchange of aproductive asset for a similar productive asset or an equivalent interest inthe same productive asset should be based on the recorded amount of the assetrelinquished. APB Opinion No. 29 provided for an exception to its basicmeasurement principle (fair value) for exchanges of similar productive assets. SFASNo. 153 is effective for nonmonetary asset exchanges occurring in fiscalperiods beginning after June 15, 2005. Earlier application is permittedfor nonmonetary asset exchanges occurring in fiscal periods beginning after thedate of issuance. The provisions of this statement shall be appliedprospectively. The adoption of this statement is not expected to have anyimpact on the financial condition or operating results of the Company.

 

##### In December 2004,the FASB issued SFAS No. 123 (revised 2004), *Share-BasedPayment* (“SFAS No. 123 (R)”). SFAS No. 123(R) will requirecompanies to measure all employee stock-based compensation awards using a fairvalue method and record such expense in its financial statements. In addition,the adoption of SFAS No. 123(R) requires additional accounting anddisclosure related to the income tax and cash flow effects resulting from sharebased payment arrangements. SFAS No. 123(R) is effective beginning as ofthe first interim or annual reporting period beginning after June 15,2005. The Company is currently evaluating the impact that the adoption of SFAS No. 123(R)will have on its financial position, results of operations and cash flows. Thecumulative effect of adoption, if any, will be measured and recognized in thestatement of operations on the date of adoption.

#####  

##### In December 2003,the FASB Issued Fin No. 46 (revised), *Consolidation of VariableInterest Entities* (“FIN No. 46(R)”), which addressesconsolidation by business enterprises of variable interest entities. FIN No. 46(R)requires a variable interest entity to be consolidated by a company if thatcompany is subject to a majority of the risk of loss from the variable interestentity’s activities or entitled to receive a majority of the entity’s residualreturns, or both. FIN No. 46(R) also requires disclosure about variableinterest entities that a company is not required to consolidate, but in whichit has a significant variable interest. FIN No. 46(R) provides guidancefor determining whether an entity qualifies as a variable interest entity byconsidering, among other considerations, whether the entity lacks sufficientequity or its equity holders lack adequate decision-making ability. Theconsolidation requirements of FIN No. 46(R) applied immediately tovariable interest entities created after January 31, 2003. Theconsolidation requirements applied to the Company’s existing variable interestentities in the first reporting period ending March 31, 2004. Certain ofthe disclosure requirements applied to all financial statements issued after December 31,2003, regardless of when the variable interest entity was established. Theadoption of FIN No. 46(R) did not have a material impact on the Company’sfinancial position or results of operations.

 

##### In November 2003,the Emerging Issues Task Force (“EITF”) reached a consensus that certainquantitative and qualitative disclosures should be required for debt andmarketable equity securities classified as available for sale or held tomaturity under SFAS No. 115 and SFAS No. 124 that are impaired at thebalance sheet date but which other-than-temporary impairments has not beenrecognized. Accordingly EITF issued EITF No. 03-1, *The Meaning of Other-Than-Temporary Impairments and Its Application toCertain Investments.* This issue addresses the meaning ofother-than-temporary impairments and its application to investments classifiedas either available for sale or held to maturity under SFAS No. 115 andprovides guidance on quantitative and qualitative disclosures. The disclosurerequirement of EITF No. 03-1 are effective for annual financialstatements for fiscal years ending after June 15, 2004. The effective datefor the measurement and recognition of EITF No. 03-1 had beendelayed. The FASB staff has issued a proposed Board-directed FASB StaffPosition (“FSP”), FSP EITF 03-1-a, *ImplementationGuidance for the Application of Paragraph 16 of Issue No. 03-1*.The proposed FSP would provide implementation guidance with respect to debtsecurities that are impaired solely due to interest rates and/or sector spreadsand analyzed for other-than-temporary impairments under the measurement andrecognition requirements of EITF No. 03-1. The delay of theeffective date for the measurement and recognition requirements of EITF No. 03-1will be superseded with the final issuance of FSP EITF 03-1-a. Adoptingthe disclosure provisions of EITF No. 03-1 did not have any impacton the Company’s financial position or results of operations.

 

17

----

 

##### In March 2004,the Securities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin(“SAB”) No. 105, *Application of AccountingPrinciples to Loan Commitments*, to inform registrants of the Staff’sview that the fair value of the recorded loan commitments should not considerthe expected future cash flows related to the associated servicing of thefuture loan. The provisions of SAB No. 105 must be applied to loancommitments accounted for as derivatives that are entered into after March 31,2004. The Staff will not object to the application of existing accountingpractices to loan commitments accounted for as derivatives that are enteredinto on or before March 31, 2004, with appropriate disclosures. TheCompany adopted the provision of SAB No. 105 on April 1, 2004. Theadoption of SAB No. 105 did not have any impact on the Company’s financialcondition or results of operations.

#####  

Other accounting standards that have been issuedor proposed by the Public Company Accounting Oversight Board (“PCAOB”) or otherstandards-setting bodies that do not require adoption until a future date arenot expected to have a material impact on the consolidated financial statementsupon adoption.

 

18

----

 

**REPORT OF INDEPENDENT REGISTEREDPUBLIC ACCOUNTING FIRM**

 

Board of Directors

***CoastalBanking Company, Inc.***

Beaufort, South Carolina

 

We have audited the accompanying consolidated balancesheets of ***Coastal Banking Company, Inc. andSubsidiary*** (the “Company”) as of December 31, 2004 and 2003and the related consolidated statements of earnings, comprehensive income,changes in shareholders’ equity and cash flows for the years ended December 31,2004 and 2003. These consolidated financial statements are the responsibilityof the Company’s management. Our responsibility is to express an opinion onthese consolidated financial statements based on our audits.

 

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States). Thosestandards require that we plan and perform the audits to obtain reasonableassurance about whether the consolidated financial statements are free ofmaterial misstatement. An audit includes examining, on a test basis, evidencesupporting the amounts and disclosures in the consolidated financialstatements. An audit also includes assessing the accounting principles used andsignificant estimates made by management, as well as evaluating the overallconsolidated financial statement presentation. We believe that our auditsprovide a reasonable basis for our opinion.

 

In our opinion, the consolidated financial statementsreferred to above present fairly, in all material respects, the consolidatedfinancial position of ***Coastal Banking Company, Inc.and Subsidiary***at December 31, 2004 and 2003 and theresults of their operations and cash flows for the years then ended, in conformitywith accounting principles generally accepted in the United States of America.

 

 

Greenville, SouthCarolina

January 28, 2005

 

19

----

 

**COASTAL BANKING COMPANY, INC. ANDSUBSIDIARY**

 

**Consolidated Balance Sheets**

 
| ** **                                                                                                                                       | ** ** | **December 31,** | ** **  |
|--------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|-------------|
| ** **                                                                                                                                       | ** ** | **2004**              | ** **  | **2003** | ** ** |
| Assets                                                                                                                                           |       |                  |        |   |   |
|                                                                                                                                             |       |                  |        |   |   |
| Cash  and due from banks                                                                                                                         |       | $                     | 1,513,726   |   | 205,082 |   |
| Federal  funds sold                                                                                                                              |       | 2,583,000             |        | — |   |
|                                                                                                                                             |       |                  |        |   |   |
| Cash  and cash equivalents                                                                                                                       |       | 4,096,726             |        | 205,082 |   |
|                                                                                                                                             |       |                  |        |   |   |
| Investment  securities available-for-sale                                                                                                        |       | 27,366,390            |        | 31,274,470 |   |
| Investment  securities held-to-maturity (fair value of $5,555,013 in 2004 and $3,352,500  in 2003)                                               |       | 5,642,841             |        | 3,421,218 |   |
| Other  investments, at cost                                                                                                                      |       | 1,037,150             |        | 859,950 |   |
| Loans  held for sale                                                                                                                             |       | 878,124               |        | 124,202 |   |
| Loans,  net                                                                                                                                      |       | 100,397,246           |        | 67,488,128 |   |
| Premises  and equipment, net                                                                                                                     |       | 2,871,908             |        | 2,965,183 |   |
| Cash  value of life insurance                                                                                                                    |       | 2,082,333             |        | — |   |
| Accrued  interest receivable and other assets                                                                                                    |       | 1,698,952             |        | 1,535,822 |   |
|                                                                                                                                             |       |                  |        |   |   |
| Total  assets                                                                                                                                    |       | $                     | 146,071,670 |   | 107,874,055 |   |
|                                                                                                                                             |       |                  |        |   |   |
| Liabilities and Shareholders’ equity                                                                                                        |       |                  |        |   |   |
| Deposits:                                                                                                                                        |       |                  |        |   |   |
| Demand                                                                                                                                           |       | $                     | 11,234,972  |   | 5,066,772 |   |
| Money  market and NOW accounts                                                                                                                   |       | 57,239,217            |        | 49,685,955 |   |
| Savings                                                                                                                                          |       | 960,804               |        | 898,816 |   |
| Time                                                                                                                                             |       | 29,811,472            |        | 25,431,294 |   |
| Time  over $100,000                                                                                                                              |       | 30,185,248            |        | 15,352,750 |   |
|                                                                                                                                             |       |                  |        |   |   |
| Total  deposits                                                                                                                                  |       | 129,431,713           |        | 96,435,587 |   |
|                                                                                                                                             |       |                  |        |   |   |
| Federal  funds purchased                                                                                                                         |       | —                |        | 600,000 |   |
| FHLB  advances                                                                                                                                   |       | 2,000,000             |        | — |   |
| Junior  subordinated debentures                                                                                                                  |       | 3,093,000             |        | — |   |
| Accrued  interest payable and other liabilities                                                                                                  |       | 754,907               |        | 1,085,001 |   |
|                                                                                                                                             |       |                  |        |   |   |
| Total  liabilities                                                                                                                               |       | 135,279,620           |        | 98,120,588 |   |
|                                                                                                                                             |       |                  |        |   |   |
| Commitments  and contingencies – Notes 5, 11 and 13                                                                                         |       |                  |        |   |   |
|                                                                                                                                             |       |                  |        |   |   |
| Shareholders’  equity:                                                                                                                      |       |                  |        |   |   |
| Preferred  stock, $.01 par value; 10,000,000 shares authorized; no shares issued and  outstanding                                                |       | —                |        | — |   |
| Common  stock, par value $.01; 10,000,000 shares authorized; 1,010,379 and 995,695  shares issued and outstanding in 2004 and 2003, respectively |       | 10,104                |        | 9,957 |   |
| Additional  paid-in capital                                                                                                                      |       | 9,626,976             |        | 9,482,517 |   |
| Retained  earnings                                                                                                                               |       | 1,287,727             |        | 177,398 |   |
| Accumulated  other comprehensive income (loss)                                                                                                   |       | (132,757              | )           | 83,595 |   |
|                                                                                                                                             |       |                  |        |   |   |
| Total  shareholders’ equity                                                                                                                 |       | 10,792,050            |        | 9,753,467 |   |
|                                                                                                                                             |       |                  |        |   |   |
| Total  liabilities and shareholders’ equity                                                                                                 |       | $                     | 146,071,670 |   | 107,874,055 |   |
|                                                                                                                                                  |            |                       |             |  |  |  |  |  |

 

See accompanying notes to consolidatedfinancial statements.

 

20

----

 

**COASTAL BANKING COMPANY, INC. ANDSUBSIDIARY**

 

**Consolidated Statements ofEarnings**

 

** **
| ** **                                           | ** ** | **For  the years ended December 31,** | ** ** |
|------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                           | ** ** | **2004**                                   | ** ** | **2003** | ** ** |
| Interest  income:                                    | ** ** | ** **                                 | ** ** | ** ** | ** ** |
| Interest  and fees on loans                          |       | $                                          | 5,564,820  |   | 4,231,576 |   |
| Taxable  investments                                 |       | 1,161,586                                  |       | 831,908 |   |
| Non-taxable  investments                             |       | 200,899                                    |       | 51,112 |   |
| Federal  funds sold                                  |       | 27,767                                     |       | 43,834 |   |
| Other                                                |       | 1,752                                      |       | — |   |
|                                                 |       |                                       |       |   |   |
| Total  interest income                               |       | 6,956,824                                  |       | 5,158,430 |   |
|                                                 |       |                                       |       |   |   |
| Interest  expense:                                   |       |                                       |       |   |   |
| Deposits                                             |       | 2,370,358                                  |       | 1,829,707 |   |
| Junior  subordinated debentures                      |       | 82,882                                     |       | — |   |
| Advances  from FHLB and Federal funds purchased      |       | 28,690                                     |       | 699 |   |
|                                                 |       |                                       |       |   |   |
| Total  interest expense                              |       | 2,481,930                                  |       | 1,830,406 |   |
|                                                 |       |                                       |       |   |   |
| Net  interest income                                 |       | 4,474,894                                  |       | 3,328,024 |   |
|                                                 |       |                                       |       |   |   |
| Provision  for loan losses                           |       | 463,200                                    |       | 253,500 |   |
|                                                 |       |                                       |       |   |   |
| Net  interest income after provision for loan losses |       | 4,011,694                                  |       | 3,074,524 |   |
|                                                 |       |                                       |       |   |   |
| Noninterest  income:                                 | ** ** | ** **                                 | ** ** | ** ** | ** ** |
| Service  charges on deposit accounts                 |       | 188,838                                    |       | 204,481 |   |
| Residential  mortgage origination fees               |       | 390,814                                    |       | 541,854 |   |
| Gain  on sale of securities available-for-sale       |       | 85,181                                     |       | 42,268 |   |
| Income  from investment in life insurance contracts  |       | 82,333                                     |       | — |   |
| Other  income                                        |       | 17,260                                     |       | 2,064 |   |
|                                                 |       |                                       |       |   |   |
| Total  other income                                  |       | 764,426                                    |       | 790,667 |   |
|                                                 |       |                                       |       |   |   |
| Noninterest  expenses:                               | ** ** | ** **                                 | ** ** | ** ** | ** ** |
| Salaries  and employee benefits                      |       | 1,766,124                                  |       | 1,400,186 |   |
| Occupancy  and equipment                             |       | 294,499                                    |       | 276,662 |   |
| Other  operating                                     |       | 1,208,709                                  |       | 864,960 |   |
|                                                 |       |                                       |       |   |   |
| Total  other expenses                                |       | 3,269,332                                  |       | 2,541,808 |   |
|                                                 |       |                                       |       |   |   |
| Earnings  before income taxes                        |       | 1,506,788                                  |       | 1,323,383 |   |
|                                                 |       |                                       |       |   |   |
| Income  tax expense                                  |       | 396,186                                    |       | 458,933 |   |
|                                                 |       |                                       |       |   |   |
| Net  earnings                                        |       | $                                          | 1,110,602  |   | 864,450 |   |
| ** **                                           | ** ** | ** **                                 | ** ** | ** ** | ** ** |
| Basic  earnings per share                            |       | $                                          | 1.11       |   | 0.87 |   |
|                                                 |       |                                       |       |   |   |
| Diluted  earnings per share                          |       | $                                          | 0.99       |   | 0.82 |   |

 

See accompanying notes to consolidatedfinancial statements.

 

21

----

 

**COASTAL BANKING COMPANY, INC. ANDSUBSIDIARY**

 

**Consolidated Statements ofComprehensive Income**

 
| ** **                                                                                                                                           | ** ** | **For  the years ended December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                                                                           | ** ** | **2004**                                   | ** ** | **2003** | ** ** |
|                                                                                                                                                 |       |                                       |       |   |   |
| Net  earnings                                                                                                                                        |       | $                                          | 1,110,602  |   | 864,450 |   |
|                                                                                                                                                 |       |                                       |       |   |   |
| Other  comprehensive income (loss), net of tax:                                                                                                      |       |                                       |       |   |   |
| Unrealized  gains (losses) on investment securities available-for-sale arising during the  period, net of tax of $79,859 in 2004 and $61,704 in 2003 |       | (155,021                                   | )          | (119,778 | ) |
| Reclassification  adjustment for gains included in net earnings, net of tax of $31,595 in 2004  and $14,371 in 2003                                  |       | (61,331                                    | )          | (27,897 | ) |
|                                                                                                                                                 |       |                                       |       |   |   |
| Total  other comprehensive income (loss), net of tax                                                                                                 |       | (216,352                                   | )          | (147,675 | ) |
|                                                                                                                                                 |       |                                       |       |   |   |
| Comprehensive  income                                                                                                                                |       | $                                          | 894,250    |   | 716,775 |   |

 

See accompanying notes to consolidatedfinancial statements.

 

22

----

 

**COASTAL BANKING COMPANY, INC. ANDSUBSIDIARY**

 

**Consolidated Statements ofChanges in Shareholders’ Equity**

 

**For the Years Ended December 31,2004 and 2003**

 
| ** **                                                               | ** ** | **Common  Stock** | ** ** | **Additional  Paid-in** | ** ** | **Retained** | ** ** | **Accumulated  Other  Comprehensive** | ** ** | ** **         | ** ** |
|--------------------------------------------------------------------------|------------|-------------------|------------|-------------------------|------------|--------------|------------|---------------------------------------|------------|--------------------|------------|
| ** **                                                               | ** ** | **Shares**        | ** ** | **Amount**              | ** ** | **Earnings** | ** ** | **Earnings**                          | ** ** | **Income  (Loss)** | ** ** | **Total** | ** ** |
| ** **                                                               | ** ** | ** **        | ** ** | ** **              | ** ** | ** **   | ** ** | ** **                            | ** ** | ** **         | ** ** | ** ** | ** ** |
| Balance,  December 31, 2002                                         |       | 948,281           |       | $                       | 9,483      |         | 8,724,366  |                                  | 71,573     |               | 231,270    |   | 9,036,692 |   |
|                                                                     |       |              |       |                    |       |         |       |                                  |       |               |       |   |   |
| Change  in unrealized gain on securities available-for- sale, net of tax |       | —            |       | —                  |       | —       |       | —                                |       | (147,675           | )          | (147,675 | ) |
| Stock dividend                                                           |       | 47,414            |       | 474                     |       | 758,151      |       | (758,625                              | )          | —             |       | — |   |
| Net  earnings                                                            |       |              |       | —                  |       | —       |       | 864,450                               |       | —             |       | 864,450 |   |
|                                                                     |       |              |       |                    |       |         |       |                                  |       |               |       |   |   |
| Balance,  December 31, 2003                                         |       | 995,695           |       | 9,957                   |       | 9,482,517    |       | 177,398                               |       | 83,595             |       | 9,753,467 |   |
|                                                                     |       |              |       |                    |       |         |       |                                  |       |               |       |   |   |
| Change  in unrealized gain on securities available-for- sale, net of tax |       | —            |       | —                  |       | —       |       | —                                |       | (216,352           | )          | (216,352 | ) |
|                                                                     |       |              |       |                    |       |         |       |                                  |       |               |       |   |   |
| Proceeds from exercise of stock options                                  |       | 14,700            |       | 147                     |       | 144,459      |       | —                                |       | —             |       | 144,606 |   |
|                                                                     |       |              |       |                    |       |         |       |                                  |       |               |       |   |   |
| Cash in lieu of fractional shares                                        |       | (16               | )          | —                  |       | —       |       | (273                                  | )          | (273               | )          |   |   |
|                                                                     |       |              |       |                    |       |         |       |                                  |       |               |       |   |   |
| Net  earnings                                                            |       | —            |       | —                  |       | —       |       | 1,110,602                             |       | —             |       | 1,110,602 |   |
|                                                                     |       |              |       |                    |       |         |       |                                  |       |               |       |   |   |
| Balance,  December 31, 2004                                         |       | 1,010,379         |       | $                       | 10,104     |         | 9,626,976  |                                  | 1,287,727  |               | (132,757   | ) | 10,792,050 |   |

 

Seeaccompanying notes to consolidated financial statements.

 

23

----

 

**COASTAL BANKING COMPANY, INC. ANDSUBSIDIARY**

 

**Consolidated Statements of CashFlows**

 
| ** **                                                                              | ** ** | **For  the years ended December 31,** | ** ** |
|-----------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                              | ** ** | **2004**                                   | ** ** | **2003** | ** ** |
| Cash  flows from operating activities:                                                  |       |                                       |       |   |   |
| Net  earnings                                                                           |       | $                                          | 1,110,602  |   | 864,450 |   |
| Adjustments  to reconcile net earnings to net cash provided by operating activities:    |       |                                       |       |   |   |
| Depreciation,  amortization and accretion                                               |       | 246,113                                    |       | 261,424 |   |
| Provision  for loan losses                                                              |       | 463,200                                    |       | 253,500 |   |
| Provision  for deferred income taxes (benefit)                                          |       | (117,561                                   | )          | (23,700 | ) |
| Gain  on sale of securities available-for-sale                                          |       | (85,181                                    | )          | (42,268 | ) |
| Loss  on sale of premises and equipment                                                 |       | 2,257                                      |       | — |   |
| Increase  in cash value of life insurance                                               |       | (82,333                                    | )          | — |   |
| Origination  of loans held-for-sale                                                     |       | (28,570,922                                | )          | (36,722,469 | ) |
| Proceeds  from sale of loans held-for-sale                                              |       | 27,817,000                                 |       | 40,269,206 |   |
| Change  in other assets and other liabilities                                           |       | (119,002                                   | )          | (636,010 | ) |
|                                                                                    |       |                                       |       |   |   |
| Net  cash provided by operating activities                                              |       | 664,173                                    |       | 4,224,133 |   |
|                                                                                    |       |                                       |       |   |   |
| Cash  flows from investing activities:                                                  |       |                                       |       |   |   |
| Proceeds  from calls and maturities of investment securities available-for-sale         |       | 5,800,837                                  |       | 10,003,255 |   |
| Proceeds  from sales of investment securities available-for-sale                        |       | 11,399,870                                 |       | 2,109,955 |   |
| Purchases  of investment securities available-for-sale                                  |       | (13,603,479                                | )          | (28,991,220 | ) |
| Proceeds  from maturity of securities held-to-maturity                                  |       | 534,612                                    |       | — |   |
| Purchases  of investment securities held-to-maturity                                    |       | (2,765,360                                 | )          | (3,317,054 | ) |
| Proceeds  from sales of other investments                                               |       | 180,000                                    |       | — |   |
| Purchases  of other investments                                                         |       | (357,200                                   | )          | (79,200 | ) |
| Investment  in Coastal Banking Company Statutory Trust I                                |       | (93,000                                    | )          | — |   |
| Net  change in loans                                                                    |       | (33,427,318                                | )          | (18,675,828 | ) |
| Purchase  of life insurance contracts                                                   |       | (2,000,000                                 | )          | — |   |
| Proceeds  from the sale of premises and equipment                                       |       | 10,453                                     |       | — |   |
| Purchase  of premises and equipment                                                     |       | (85,403                                    | )          | (347,669 | ) |
|                                                                                    |       |                                       |       |   |   |
| Net  cash used by investing activities                                                  |       | (34,405,988                                | )          | (39,297,761 | ) |
|                                                                                    |       |                                       |       |   |   |
| Cash  flows from financing activities:                                                  |       |                                       |       |   |   |
| Net  change in deposits                                                                 |       | 32,996,126                                 |       | 30,487,796 |   |
| Net  change in federal funds purchased                                                  |       | (600,000                                   | )          | 600,000 |   |
| Proceeds  from FHLB advances                                                            |       | 17,000,000                                 |       | — |   |
| Repayments  of FHLB advances                                                            |       | (15,000,000                                | )          | — |   |
| Proceeds  from junior subordinated debt                                                 |       | 3,093,000                                  |       | — |   |
| Proceeds  from exercise of stock options                                                |       | 144,606                                    |       | — |   |
| Cash in lieu of fractional shares                                                       |       | (273                                       | )          | — |   |
|                                                                                    |       |                                       |       |   |   |
| Net cash  provided by financing activities                                              |       | 37,633,459                                 |       | 31,087,796 |   |
|                                                                                    |       |                                       |       |   |   |
| Net  change in cash and cash equivalents                                                |       | 3,891,644                                  |       | (3,985,832 | ) |
| Cash  and cash equivalents at beginning of year                                         |       | 205,082                                    |       | 4,190,914 |   |
| Cash  and cash equivalents at end of year                                               |       | $                                          | 4,096,726  |   | 205,082 |   |
|                                                                                    |       |                                       |       |   |   |
| Supplemental  schedule of noncash investing and financing activities:              |       |                                       |       |   |   |
| Change in  unrealized gain/loss on investment securities available-for-sale, net of tax |       | $                                          | (216,352   | ) | (147,675 | ) |
| Loan transferred  to repossessed assets                                                 |       | $                                          | 55,000     |   | — |   |
|                                                                                    |       |                                       |       |   |   |
| Supplemental  disclosures of cash flow information:                                     |       |                                       |       |   |   |
| Cash paid during  the year for interest                                                 |       | $                                          | 2,428,379  |   | 1,963,926 |   |
| Cash paid during  the year for income taxes                                             |       | $                                          | 637,000    |   | 265,685 |   |

 

Seeaccompanying notes to consolidated financial statements.

 

24

----

 

**COASTALBANKING COMPANY, INC. AND SUBSIDIARY**

 

**Notes to Consolidated Financial Statements**

 

**(1)****                                ****Summary of Significant AccountingPolicies**

 

Basis of Presentationand Nature of Operations

CoastalBanking Company, Inc. (the “Company”) is organized under the laws of theState of South Carolina for the purpose of operating as a bank holding companyfor Lowcountry National Bank (the “Bank”). The Bank commenced business on May 10,2000. The Bank provides full commercial banking services to customersthroughout the Beaufort County area of South Carolina and is subject toregulation by the Office of the Comptroller of the Currency (the “OCC”) and theFederal Deposit Insurance Corporation. The Company is subject to regulation bythe Federal Reserve Board. The Company also has aninvestment in Coastal Banking Company Statutory Trust I (the “Trust”) (anon-consolidated subsidiary). The Trust is a special purpose non-consolidatedsubsidiary organized for the sole purpose of issuing trust preferred securities

 

The consolidatedfinancial statements include the accounts of the Company and the Bank. Allsignificant intercompany transactions have been eliminated in consolidation. Theaccounting and reporting policies of the Company conform to accountingprinciples generally accepted in the United States of America and to generalpractices in the banking industry. The Company uses the accrual basis ofaccounting.

 

Estimates

Thepreparation of consolidated financial statements in conformity with accountingprinciples generally accepted in the United States of America requiresmanagement to make estimates and assumptions that affect the reported amountsof assets and liabilities and disclosure of contingent assets and liabilitiesas of the date of the consolidated financial statements and the reported amountof income and expenses during the reporting periods. Actual results coulddiffer from those estimates.

 

Cash and CashEquivalents

Cash equivalents includeamounts due from banks, interest-bearing demand deposits with banks and federalfunds sold. Generally, federal funds are sold for one-day periods.

 

Investment Securities

The Company classifiesits securities in one of three categories: trading, available-for-sale, orheld-to-maturity. Trading securities are bought and held principally for thepurpose of selling them in the near term. Held-to-maturity securities are thosesecurities for which the Company has the ability and intent to hold untilmaturity. All securities not included in trading or held-to-maturity areclassified as available-for-sale. The Company has no trading securities.

 

Trading andavailable-for-sale securities are recorded at fair value. Held-to-maturitysecurities are recorded at cost, adjusted for the amortization or accretion ofpremiums or discounts. Unrealized gains and losses on trading securities arerecognized in earnings. Unrealized holding gains and losses, net of the relatedtax effect, on securities available-for-sale are excluded from earnings and arereported as a separate component of shareholders’ equity until realized. Transfersof securities between categories are recorded at fair value at the date oftransfer.

 

A decline in the marketvalue of any available-for-sale or held-to-maturity security below cost that isdeemed other than temporary is charged to earnings and establishes a new costbasis for the security.

 

Premiums and discountsare amortized or accreted over the life of the related securities asadjustments to the yield. Realized gains and losses for securities classifiedas available-for-sale and held-to-maturity are included in earnings and arederived using the specific identification method for determining the cost ofsecurities sold.

 

Other Investments

Other investmentsinclude equity securities with no readily determinable fair value. Theseinvestments are carried at cost. The Bank, as a member institution, is requiredto own certain stock investments in the Federal Home Loan Bank of Atlanta (“FHLB”)and the Federal Reserve Bank (“FRB”). The stock is generally pledged againstany borrowings from these institutions. No ready market exists for the stockand it has no quoted market price. However, redemption of these stocks hashistorically been at par value.

 

25

----

 

Loans Held for Sale

Loans originated andintended for sale in the secondary market are carried at the lower of aggregatecost or market value. The amount by which cost exceeds market value isaccounted for as a valuation allowance. Changes, if any, in the valuationallowance are included in the determination of net earnings in the period inwhich the change occurs. The Company has recorded no valuation allowancerelated to its loans held for sale as their cost approximates market value.

 

Loans and Allowance forLoan Losses

Loans are stated atprincipal amount outstanding, net of the allowance for loan losses. Interest onloans is calculated by using the interest method based upon the principalamount outstanding. Loan origination and commitment fees and direct loanorigination costs are deferred and amortized over the contractual life of therelated loan or commitments as an adjustment of the related loan yields.

 

A loan is consideredimpaired when, based on current information and events, it is probable that allamounts due according to the contractual terms of the loan agreement will notbe collected. Impaired loans are measured based on the present value ofexpected future cash flows discounted at the loan’s effective interest rate, orat the loan’s observable market price, or at the fair value of the collateralof the loan if the loan is collateral dependent. Accrual of interest isdiscontinued on a loan when management believes, after considering economic andbusiness conditions and collection efforts that the borrower’s financialcondition is such that collection of interest is doubtful. When the ultimatecollectibility of an impaired loan’s principal is in doubt, wholly orpartially, all cash receipts are applied to principal.

 

The allowance for loanlosses is established through a provision for loan losses charged to expense. Loansare charged against the allowance for loan losses when management believes thatthe collectibility of the principal is unlikely. The allowance represents anamount, which, in management’s judgment, will be adequate to absorb probablelosses on existing loans that may become uncollectible.

 

Management’s judgment indetermining the adequacy of the allowance is based on evaluations of thecollectibility of loans. These evaluations take into consideration such factorsas changes in the nature and volume of the loan portfolio, current economicconditions that may affect the borrower’s ability to pay, overall portfolioquality and review of specific problem loans. In determining the adequacy ofthe allowance for loan losses management uses four different methods asindicators of the reasonableness of the allowance. The methods used include arisk method (using internal classifications along with regulatoryclassifications), historical charge-offs, comparison to a peer group, andcurrent classifications based on the loan grading system. The combination ofthese results are compared quarterly to the recorded allowance for loan lossesfor reasonableness and material differences are adjusted by increasing or decreasingthe provision for loan losses. Management uses an external loan review programto challenge and corroborate the internal loan grading system and provideadditional analysis in determining the adequacy of the allowance and the futureprovisions for estimated loan losses.

 

Management believes thatthe allowance for loan losses is adequate. While management uses availableinformation to recognize losses on loans, future additions to the allowance maybe necessary based on changes in economic conditions. In addition, variousregulatory agencies, as an integral part of their examination process,periodically review the Bank’s allowance for loan losses. Such agencies mayrequire the Bank to recognize additions to the allowance based on judgmentsdifferent than those of management.

 

Non-performing Assets

Loans are placed in anon-accrual status when, in the opinion of management, the collection ofadditional interest is questionable. Thereafter, no interest is taken intoincome unless received in cash or until such time as the borrower demonstratesthe ability to pay principal and interest.

 

26

----

 

Premises and Equipment

Premises and equipmentare stated at cost less accumulated depreciation. Costs incurred for maintenanceand repairs that do not extend the useful life of the asset are expensed asincurred.

 

Depreciationexpense is computed using the straight-line method over the following estimateduseful lives:

 

| Building  and improvements |   | 10 - 40 years |   |
|----------------------------|--------|---------------|--------|
| Furniture  and equipment   |   | 3 - 10 years  |   |

 

AdvertisingCosts

TheCompany expenses all advertising costs as incurred. Advertising costs for theCompany were approximately $134,000 and $64,000 for the years ended December 31,2004 and 2003.

 

IncomeTaxes

Deferredtax assets and liabilities are recognized for the future tax consequencesattributable to differences between the financial statement carrying amounts ofexisting assets and liabilities and their respective tax bases. Deferred taxassets and liabilities are measured using enacted tax rates expected to applyto taxable income in the years in which those temporary differences areexpected to be recovered or settled. The effect on deferred tax assets andliabilities of a change in tax rates is recognized in income in the period thatincludes the enactment date.

 

Inthe event the future tax consequences of differences between the financialreporting bases and the tax bases of the assets and liabilities results indeferred tax assets, an evaluation of the probability of being able to realizethe future benefits indicated by such asset is required. A valuation allowanceis provided for the portion of the deferred tax asset when it is more likelythan not that some portion or all of the deferred tax asset will not be realized.In assessing the realizability of the deferred tax assets, management considersthe scheduled reversals of deferred tax liabilities, projected future taxableincome, and tax planning strategies.

 

Stock-BasedCompensation

At December 31,2004, the Company sponsors stock-based compensation plans, which are describedmore fully in Note 14. The Company accounts for these plans under therecognition and measurement principles of Accounting Principles Board (“APB”)Opinion No. 25, *Accounting for StockIssued to Employees,* and related Interpretations. No stock-basedemployee compensation cost is reflected in net earnings, as all options grantedunder those plans had an exercise price equal to the market value of theunderlying common stock on the date of grant. The following table illustratesthe effect on net earnings and earnings per share if the Company had appliedthe fair value recognition provisions of Statement of Financial AccountingStandards (“SFAS”) No. 123, *Accountingfor Stock-Based Compensation,* to stock-based employee compensationfor the years ended December 31, 2004 and 2003.

 
| ** **                                                                                                        | ** ** | **For the  Year Ended****December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                                                                                        | ** ** | **2004**                                     | ** ** | **2003** | ** ** |
| Net earnings as reported                                                                                          |       | $                                            | 1,110,602  |   | 864,450 |   |
| Deduct: Total stock-based  employee compensation expense determined under fair-value based method for  all awards |       | (63,342                                      | )          | (56,092 | ) |
| Pro forma net earnings                                                                                            |       | $                                            | 1,047,260  |   | 808,358 |   |
| Basic earnings per share:                                                                                         |       |                                         |       |   |   |
| As reported                                                                                                       |       | $                                            | 1.11       |   | 0.87 |   |
| Pro forma                                                                                                         |       | $                                            | 1.03       |   | 0.81 |   |
| Diluted earnings per share:                                                                                       |       |                                         |       |   |   |
| As reported                                                                                                       |       | $                                            | 0.99       |   | 0.82 |   |
| Pro forma                                                                                                         |       | $                                            | 0.92       |   | 0.76 |   |

 

27

----

 

Net Earnings Per CommonShare

The Company is requiredto report earnings per common share with and without the dilutive effects ofpotential common stock issuances from instruments such as options, convertiblesecurities and warrants on the face of the statements of earnings. Basicearnings per common share are based on the weighted average number of commonshares outstanding during the period, which was 1,003,933 in 2004 and 995,695in 2003, while the effects of potential common shares outstanding during theperiod are included in diluted earnings per share. Additionally, the Companymust reconcile the amounts used in the computation of both “basic earnings pershare” and “diluted earnings per share”. Antidilutive potential common sharestotaled 10,000 at December 31, 2004 and are excluded from the dilutedearnings per share calculation below. All share amounts have been adjusted forthe five percent stock dividend recorded in 2004. Earnings per common share amounts for theyears ended December 31, 2004 and 2003 are as follows:

 
| **For the year ended December 31,  2004**              | ** ** | **Net Earnings  (Numerator)** | ** ** | **Common  Share  (Denominator)** | ** ** | **Per Share  Amount** | ** ** |
|-------------------------------------------------------------|------------|-------------------------------|------------|----------------------------------|------------|-----------------------|------------|
|                                                        |       |                          |       |                             |       |                  |       |
| Basic earnings per share                                    |       | $                             | 1,110,602  |                             | 1,003,933  |                  | $          | 1.11 |   |
|                                                        |       |                          |       |                             |       |                  |       |
| Effect of dilutive securities - stock options  and warrants |       | —                        |       | 121,472                          |       | (0.12                 | )          |
|                                                        |       |                          |       |                             |       |                  |       |
| Diluted earnings per share                                  |       | $                             | 1,110,602  |                             | 1,125,405  |                  | $          | 0.99 |   |

 
| **For the year ended December 31,  2003**              | ** ** | **Net Earnings  (Numerator****)** | ** ** | **Common  Share  (Denominator****)** | ** ** | **Per Share  Amount** | ** ** |
|-------------------------------------------------------------|------------|-----------------------------------|------------|--------------------------------------|------------|-----------------------|------------|
|                                                        |       |                              |       |                                 |       |                  |       |
| Basic earnings per share                                    |       | $                                 | 864,450    |                                 | 995,695    |                  | $          | 0.87 |   |
|                                                        |       |                              |       |                                 |       |                  |       |
| Effect of dilutive securities - stock options  and warrants |       | —                            |       | 64,914                               |       | (0.05                 | )          |
|                                                        |       |                              |       |                                 |       |                  |       |
| Diluted earnings per share                                  |       | $                                 | 864,450    |                                 | 1,060,609  |                  | $          | 0.82 |   |

 

Recent AccountingPronouncements

##### InMay 2003, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 150,*Accounting for Certain Financial Instruments withCharacteristics of both Liabilities and Equity*, which establishesstandards for how an issuer classifies and measures certain financialinstruments with characteristics of both liabilities and equity. SFAS No. 150requires an issuer to classify certain financial instruments that includecertain obligations, such as mandatory redemption, repurchase of the issuer’sequity, or settlement by issuing equity, previously classified as equity, asliabilities or assets in some circumstances. SFAS No. 150 was generallyeffective forfinancial instruments entered into or modified after May 31, 2003, andotherwise was effective at the beginning of the first interim period beginningafter June 15, 2003, except for mandatorily redeemable financialinstruments of nonpublic entities which are subject to the provisions of SFAS No. 150for the first fiscal period beginning after December 15, 2003. Theadoption of SFAS No. 150 did not have any impact on the financialcondition or operating results of the Company.

#####  

In December 2004,the FASB issued SFAS No. 153, *Exchange of NonmonetaryAssets, an amendment of APB Opinion No. 29, Accounting for NonmonetaryTransactions.* The amendments made by SFAS No. 153 are based onthe principle that exchanges of nonmonetary assets should be measured on thefair value of the assets exchanged. Further, the amendments eliminate thenarrow exception for nonmonetary exchanges of similar productive assets andreplace it with a broader exception for exchanges of nonmonetary assets that donot have commercial substance. Previously, Accounting Principles Board (“APB”)Opinion No. 29 required that the accounting for an exchange of aproductive asset for a similar productive asset or an equivalent interest inthe same productive asset should be based on the recorded amount of the assetrelinquished. APB Opinion No. 29 provided for an exception to its basicmeasurement principle (fair value) for exchanges of similar productive assets. SFASNo. 153 is effective for nonmonetary asset exchanges occurring in fiscalperiods beginning after June 15, 2005. Earlier application is

 

28

----

 

permittedfor nonmonetary asset exchanges occurring in fiscal periods beginning after thedate of issuance. The provisions of this statement shall be applied prospectively.The adoption of this statement is not expected to have any impact on thefinancial condition or operating results of the Company.

 

##### In December 2004, the FASB issued SFAS No. 123(revised 2004), *Share-Based Payment* (“SFAS No. 123(R)”). SFAS No. 123(R) will require companies to measure all employeestock-based compensation awards using a fair value method and record suchexpense in its financial statements. In addition, the adoption of SFAS No. 123(R)requires additional accounting and disclosure related to the income tax andcash flow effects resulting from share based payment arrangements. SFAS No. 123(R)is effective beginning as of the first interim or annual reporting periodbeginning after June 15, 2005. The Company is currently evaluating the impactthat the adoption of SFAS No. 123(R) will have on its financial position,results of operations and cash flows. The cumulative effect of adoption, ifany, will be measured and recognized in the statement of operations on the dateof adoption.

#####  

##### In December 2003, the FASB Issued Fin No. 46(revised), *Consolidation of Variable Interest Entities*(“FIN No. 46(R)”), which addresses consolidation by business enterprisesof variable interest entities. FIN No. 46(R) requires a variable interestentity to be consolidated by a company if that company is subject to a majorityof the risk of loss from the variable interest entity’s activities or entitledto receive a majority of the entity’s residual returns, or both. FIN No. 46(R)also requires disclosure about variable interest entities that a company is notrequired to consolidate, but in which it has a significant variable interest. FINNo. 46(R) provides guidance for determining whether an entity qualifies asa variable interest entity by considering, among other considerations, whetherthe entity lacks sufficient equity or its equity holders lack adequatedecision-making ability. The consolidation requirements of FIN No. 46(R)applied immediately to variable interest entities created after January 31,2003. The consolidation requirements applied to the Company’s existing variableinterest entities in the first reporting period ending March 31, 2004. Certainof the disclosure requirements applied to all financial statements issued afterDecember 31, 2003, regardless of when the variable interest entity wasestablished. The adoption of FIN No. 46(R) did not have a material impacton the Company’s financial position or results of operations.

#####  

##### In November 2003, the Emerging Issues Task Force(“EITF”) reached a consensus that certain quantitative and qualitativedisclosures should be required for debt and marketable equity securitiesclassified as available for sale or held to maturity under SFAS No. 115and SFAS No. 124 that are impaired at the balance sheet date but whichother-than-temporary impairments has not been recognized. Accordingly EITFissued EITF No. 03-1, *The Meaning ofOther-Than-Temporary Impairments and Its Application to Certain Investments*.This issue addresses the meaning of other-than-temporary impairments and itsapplication to investments classified as either available for sale or held tomaturity under SFAS No. 115 and provides guidance on quantitative andqualitative disclosures. The disclosure requirement of EITF No. 03-1are effective for annual financial statements for fiscal years ending after June 15,2004. The effective date for the measurement and recognition of EITF No. 03-1had been delayed. The FASB staff has issued a proposed Board-directed FASBStaff Position (“FSP”), FSP EITF 03-1-a, *ImplementationGuidance for the Application of Paragraph 16 of Issue No. 03-1*.The proposed FSP would provide implementation guidance with respect to debtsecurities that are impaired solely due to interest rates and/or sector spreadsand analyzed for other-than-temporary impairments under the measurement andrecognition requirements of EITF No. 03-1. The delay of theeffective date for the measurement and recognition requirements of EITF No. 03-1will be superseded with the final issuance of FSP EITF 03-1-a. Adoptingthe disclosure provisions of EITF No. 03-1 did not have any impacton the Company’s financial position or results of operations.

 

29

----

 

##### In March 2004, the Securities and ExchangeCommission (“SEC”) issued Staff Accounting Bulletin (“SAB”) No. 105, *Application of Accounting Principles to Loan Commitments*, toinform registrants of the Staff’s view that the fair value of the recorded loancommitments should not consider the expected future cash flows related to theassociated servicing of the future loan. The provisions of SAB No. 105must be applied to loan commitments accounted for as derivatives that areentered into after March 31, 2004. The Staff will not object to theapplication of existing accounting practices to loan commitments accounted foras derivatives that are entered into on or before March 31, 2004, withappropriate disclosures. The Company adopted the provision of SAB No. 105on April 1, 2004. The adoption of SAB No. 105 did not have any impacton the Company’s financial condition or results of operations.

#####  

##### Other accounting standards that have been issued orproposed by the Public Company Accounting Oversight Board (“PCAOB”) or otherstandards-setting bodies that do not require adoption until a future date arenot expected to have a material impact on the consolidated financial statementsupon adoption.

#####  

Risks and Uncertainties

In the normal course of its business, the Companyencounters two significant types of risk: economic and regulatory. There arethree main components of economic risk: interest rate risk, credit risk andmarket risk. The Company is subject to interest rate risk to the degree thatits interest-bearing liabilities mature or reprice at different speeds, or ondifferent bases, than its interest-earning assets. Credit risk is the risk ofdefault on the Company’s loan portfolio that results from borrowers’ inabilityor unwillingness to make contractually required payments. Market risk reflectschanges in the value of collateral underlying loans receivable, the valuationof real estate held by the Company, and the valuation of loans held for saleand mortgage-backed securities available-for-sale.

 

The Company is subject to the regulations of variousgovernment agencies. These regulations can and do change significantly fromperiod to period. The Company also undergoes periodic examinations by theregulatory agencies, which may subject it to further changes with respect toasset valuations, amounts of required loss allowances, and operatingrestrictions, resulting from the regulators’ judgments based on informationavailable to them at the time of their examination.

 

Concentrationsof Credit Risk

TheCompany, through its subsidiary, makes loans to individuals and businesses inand around Beaufort County, South Carolina for various personal and commercialpurposes. The Company has a diversified loan portfolio and the borrowers’ability to repay their loans is not dependent upon any specific economicsector.

 

Reclassifications

Certain reclassifications have been made to the 2003financial statements to conform with classifications used for 2004. All suchreclassifications had no effect on the prior year’s net earnings or retainedearnings as previously reported.

 

**(2)****                                ****Restrictions on Cash andDue From Banks**

TheBank is required to maintain average reserve balances, computed by applyingprescribed percentages to its various types of deposits, either at the Bank oron deposit with the FRB. At December 31, 2004 and 2003, these required reserveswere met by vault cash.

 

30

----

 

**(3)****                                ****Investment Securities**

Investment securities atDecember 31, 2004 and 2003 are as follows:

 
| ** **                   | ** ** | **December 31, 2004** | ** ** |
|------------------------------|------------|----------------------------|------------|
| ** **                   | ** ** | ** **                 | ** ** | **Gross** | ** ** | **Gross** | ** ** | **Estimated** | ** ** |
| ** **                   | ** ** | **Amortized**              | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | **Fair** | ** ** |
| ** **                   | ** ** | **Cost**                   | ** ** | **Gains** | ** ** | **Losses** | ** ** | **Value** | ** ** |
| Available-for-sale           |       |                       |       |   |   |   |   |   |   |
|                         |       |                       |       |   |   |   |   |   |   |
| Federal agencies             |       | $                          | 15,009,737 |   | 38,715 |   | 132,802 |   | 14,915,650 |   |
| Mortgage-backed securities   |       | 12,289,675                 |       | 15,295 |   | 122,355 |   | 12,182,615 |   |
| State, county and municipals |       | 268,125                    |       | — |   | — |   | 268,125 |   |
|                         |       |                       |       |   |   |   |   |   |   |
|                         |       | $                          | 27,567,537 |   | 54,010 |   | 255,157 |   | 27,366,390 |   |
| Held-to-maturity             |       |                       |       |   |   |   |   |   |   |
|                         |       |                       |       |   |   |   |   |   |   |
| State, county and municipals |       | $                          | 5,642,841  |   | 10,983 |   | 98,811 |   | 5,555,013 |   |

 
| ** **                   | ** ** | **December 31, 2003** | ** ** |
|------------------------------|------------|----------------------------|------------|
| ** **                   | ** ** | ** **                 | ** ** | **Gross** | ** ** | **Gross** | ** ** | **Estimated** | ** ** |
| ** **                   | ** ** | **Amortized**              | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | **Fair** | ** ** |
| ** **                   | ** ** | **Cost**                   | ** ** | **Gains** | ** ** | **Losses** | ** ** | **Value** | ** ** |
|                         |       |                       |       |   |   |   |   |   |   |
| Available-for-sale           |       |                       |       |   |   |   |   |   |   |
| Federal agencies             |       | $                          | 21,605,722 |   | 202,780 |   | 113,768 |   | 21,694,734 |   |
| Mortgage-backed securities   |       | 9,542,089                  |       | 54,640 |   | 16,993 |   | 9,579,736 |   |
|                         |       |                       |       |   |   |   |   |   |   |
|                         |       | $                          | 31,147,811 |   | 257,420 |   | 130,761 |   | 31,274,470 |   |
| Held-to-maturity             |       |                       |       |   |   |   |   |   |   |
|                         |       |                       |       |   |   |   |   |   |   |
| State, county and municipals |       | $                          | 3,421,218  |   | 8,408 |   | 77,126 |   | 3,352,500 |   |
|                              |            |                            |            |  |  |  |  |  |  |  |  |

 

Thefollowing table shows gross unrealized losses and fair value, aggregated byinvestment category, and length of time that individual securities have been ina continuous unrealized loss position, at December 31, 2004.

 

Investmentsecurities available-for-sale**:**

 
| ** **                 | ** ** | **Less than  12 Months** | ** ** | **12 Months  or More** | ** ** | **Total**       | ** ** |
|----------------------------|------------|--------------------------|------------|------------------------|------------|-----------------|------------|
| ** **                 | ** ** | **Fair  Value**          | ** ** | **Unrealized  Losses** | ** ** | **Fair  Value** | ** ** | **Unrealized  Losses** | ** ** | **Fair  Value** | ** ** | **Unrealized  Losses** | ** ** |
|                       |       |                     |       |                   |       |            |       |   |   |   |   |   |   |
| Federal agencies           |       | $                        | 11,070,760 |                   | 126,975    |            | 512,228    |   | 5,827 |   | 11,582,988 |   | 132,802 |   |
| Mortgage-backed securities |       | 10,156,259               |       | 114,712                |       | 359,366         |       | 7,643 |   | 10,515,625 |   | 122,355 |   |
|                       |       |                     |       |                   |       |            |       |   |   |   |   |   |   |
| Total                      |       | $                        | 21,227,019 |                   | 241,687    |            | 871,594    |   | 13,470 |   | 22,098,613 |   | 255,157 |   |

 

Twoindividual securities were in a continuous loss position for twelve months ormore. The Company has the ability and intent to hold these securities untilsuch time as the value recovers or the securities mature. The Company believes,based on industry analyst reports and credit ratings, that the deterioration invalue is attributable to changes in market interest rates and not in the creditquality of the issuer and therefore, these losses are not consideredother-than-temporary.

 

Investmentsecurities held-to-maturity**:**

 
| ** **                   | ** ** | **Less than  12 Months** | ** ** | **12 Months  or More** | ** ** | **Total**       | ** ** |
|------------------------------|------------|--------------------------|------------|------------------------|------------|-----------------|------------|
| ** **                   | ** ** | **Fair  Value**          | ** ** | **Unrealized  Losses** | ** ** | **Fair  Value** | ** ** | **Unrealized  Losses** | ** ** | **Fair  Value** | ** ** | **Unrealized  Losses** | ** ** |
|                         |       |                     |       |                   |       |            |       |   |   |   |   |   |   |
| State, county and municipals |       | $                        | 3,295,395  |                   | 43,909     |            | 1,680,965  |   | 54,902 |   | 4,976,360 |   | 98,811 |   |
|                              |            |                          |            |                        |            |                 |            |  |  |  |  |  |  |  |

 

31

----

 

Sevenindividual securities were in a continuous loss position for twelve months ormore. The Company has the ability and intent to hold these securities untilmaturity. The Company believes, based on industry analyst reports and creditratings, that the deterioration in value is attributable to changes in marketinterest rates and not in the credit quality of the issuer and therefore, theselosses are not considered other-than-temporary.

 

The amortized cost andestimated fair value of investment securities at December 31, 2004, bycontractual maturity, are shown below. Expected maturities will differ fromcontractual maturities because borrowers have the right to call or prepayobligations with or without call or prepayment penalties.

 
| ** **                                         | ** ** | **Amortized  Cost** | ** ** | **Estimated  Fair Value** | ** ** |
|----------------------------------------------------|------------|---------------------|------------|---------------------------|------------|
| Available-for-sale                                 |       |                |       |                      |       |
| Federal agencies and state, county and  municipals |       |                |       |                      |       |
| Within 1 year                                      |       | $                   | 668,189    |                      | 674,359    |   |
| 1 to 5 years                                       |       | 6,833,513           |       | 6,815,079                 |       |
| 5 to 10 years                                      |       | 7,776,160           |       | 7,694,337                 |       |
| Mortgage-backed securities                         |       | 12,289,675          |       | 12,182,615                |       |
|                                               |       |                |       |                      |       |
|                                               |       | $                   | 27,567,537 |                      | 27,366,390 |   |
| Held-to-maturity                                   |       |                |       |                      |       |
| State, county and municipals                       |       |                |       |                      |       |
| 5 to 10 years                                      |       | $                   | 1,360,939  |                      | 1,337,664  |   |
| More than 10 years                                 |       | 4,281,902           |       | 4,217,349                 |       |
|                                               |       |                |       |                      |       |
|                                               |       | $                   | 5,642,841  |                      | 5,555,013  |   |

 

Proceeds from sales ofsecurities available-for-sale during 2004 and 2003 totaled approximately$11,400,000 and $2,110,000, respectively. Gross gains of $121,819 were realizedon those sales during 2004 and gross losses of $36,638 were realized on salesduring 2004. Gross gains of $45,232 were realized on those sales during 2003and gross losses of $2,964 were realized on sales during 2003.

 

Securities with anamortized cost and fair value pledged to secure public deposits and for otherpurposes as required by law as of December 31, 2004 and 2003 were$8,766,000 and $8,011,000 and $2,829,000 and $2,863,000, respectively.

 

**(4)****                                ****Loans and allowance for loanlosses**

Major classifications ofloans at December 31, 2004 and 2003 are summarized as follows:

 
| ** **                             | ** ** | **2004**    | ** **  | **2003**   | ** ** |
|----------------------------------------|------------|-------------|-------------|------------|------------|
|                                   |       |        |        |       |       |
| Commercial, financial and agricultural |       | $           | 5,561,639   |       | 5,354,368  |   |
| Real estate – construction        |       | 33,726,328  |        | 17,974,225 |       |
| Real estate – mortgage            |       | 58,979,404  |        | 42,302,684 |       |
| Consumer and other                     |       | 3,266,786   |        | 2,723,079  |       |
|                                   |       |        |        |       |       |
|                                   |       | 101,534,157 |        | 68,354,356 |       |
|                                   |       |        |        |       |       |
| Less:  Allowance  for loan losses |       | 1,136,911   |        | 866,228    |       |
|                                   |       |        |        |       |       |
|                                   |       | $           | 100,397,246 |       | 67,488,128 |   |

 

The Bank grants loansand extensions of credit to individuals and a variety of businesses andcorporations located in its general trade area of the city of Beaufort, BeaufortCounty, South Carolina and adjoining counties. Although the Bank has adiversified loan portfolio, a substantial portion of the loan portfolio iscollateralized by improved and unimproved real estate and is dependent upon thereal estate market.

 

32

----

 

An analysis of theactivity in the allowance for loan losses for the years ended December 31,2004 and 2003 is presented below:

 
| ** **                      | ** ** | **2004** | ** ** | **2003** | ** ** |
|---------------------------------|------------|----------|------------|----------|------------|
|                            |       |     |       |     |       |
| Balance at beginning of year    |       | $        | 866,228    |     | 623,891    |   |
| Provision charged to operations |       | 463,200  |       | 253,500  |       |
| Loans charged off               |       | (194,948 | )          | (16,163  | )          |
| Recoveries                      |       | 2,431    |       | 5,000    |       |
|                            |       |     |       |     |       |
| Balance at end of year          |       | $        | 1,136,911  |     | 866,228    |   |

 

At December 31, 2004 there were no nonaccrual loans. At December 31,2003, nonaccrual loans were approximately $46,600. Foregone interest income onnonaccrual loans in 2004 and 2003 was an insignificant amount. At December 31,2004 and 2003, there were no impaired loans. At December 31, 2004 and 2003, criticized andclassified loans amounted to $1,254,115 and $781,867, respectively.

 

**(5)****                                ****Premises and Equipment**

Major classifications ofpremises and equipment are summarized as follows:

 
| ** **                    | ** ** | **2004**  | ** ** | **2003**  | ** ** |
|-------------------------------|------------|-----------|------------|-----------|------------|
|                          |       |      |       |      |       |
| Land and improvements         |       | $         | 1,514,668  |      | 1,514,668  |   |
| Building and improvements     |       | 1,150,222 |       | 1,133,136 |       |
| Furniture and equipment       |       | 771,996   |       | 739,778   |       |
|                          |       |      |       |      |       |
|                          |       | 3,436,886 |       | 3,387,582 |       |
| Less accumulated depreciation |       | 564,978   |       | 422,399   |       |
|                          |       |      |       |      |       |
|                          |       | $         | 2,871,908  |      | 2,965,183  |   |

 

Depreciation expenseamounted to $158,223 and $135,332 in 2004 and 2003, respectively.

 

The Bank has enteredinto a non-cancelable operating lease related to land and buildings whichexpires in 2008. At December 31, 2004, future minimum lease payments undera non-cancelable operating lease with initial or remaining terms of one year ormore are as follows:

 

| 2005   |   | $      | 34,800  |   |
|--------|--------|--------|---------|--------|
| 2006   |   | 37,800 |    |
| 2007   |   | 37,800 |    |
| 2008   |   | 15,750 |    |
|   |   |   |    |
|   |   | $      | 126,150 |   |

 

Total rental expenseamounted to $30,600 and $28,050 for the years ended December 31, 2004 and2003, respectively, under this operating lease.

 

**(6)****                                ****Deposits**

Maturities of timedeposits at December 31, 2004 are as follows:

 

| Maturing in: |   |       |       |
|--------------|--------|------------|------------|
| 2005         |   | $          | 31,991,654 |   |
| 2006         |   | 10,314,129 |       |
| 2007         |   | 10,323,095 |       |
| 2008         |   | 5,695,281  |       |
| 2009         |   | 1,672,561  |       |
|         |   |       |       |
|         |   | $          | 59,996,720 |   |

 

33

----

 

At December 31,2004 and 2003 $18,612,000 and $26,275,000 of time deposits less than $100,000consisted of brokered deposits. At December 31, 2004 and 2003 $16,963,000and $7,974,233 of time deposits greater than $100,000 consisted of brokereddeposits.

 

Interest expense on timedeposits greater than $100,000 totaled $453,325 and $384,885 in 2004 and 2003,respectively.

 

**(7)****                                ****Federal Home Loan Bank Advances**

At December 31,2004, the Bank has an advance outstanding from the FHLB in the amount of$2,000,000. There were no advances outstanding at December 31, 2003. TheBank has pledged approximately $35,000,000 in qualifying mortgage loans assecurity for this advance and possible future advances. This advance bears interestat a variable rate that was 2.44% at December 31, 2004, requires quarterlyinterest payments and a principal payment at maturity on July 14, 2005. AtDecember 31, 2004, the Bank has approximately $26,000,000 in additionalborrowing capacity under this borrowing arrangement with the FHLB.

 

**(8)****                                ****Junior Subordinated Debentures**

In May 2004, Coastal Banking CompanyStatutory Trust I (the “Trust”) (a non-consolidated subsidiary) issued $3,000,000 of floating rate trustpreferred securities with a maturity of May 18, 2034. In accordance withFIN No. 46(R), the trust has not been consolidated in these financialstatements. The Company received from the Trust the $3,000,000 million proceedsfrom the issuance of securities and the $93,000 initial proceeds from thecapital investment in the Trust, and accordingly has shown the funds due to theTrust as a $3,093,000 junior subordinated debentures..

 

All of the common securities of the Trust are owned bythe Company. The proceeds from the issuance of the trust preferred securitieswere used by the Trust to purchase $3,093,000 of junior subordinated debenturesof the Company, which carry a floating rate equal to the 3-month LIBORplus 2.75%. At December 31, 2004, this rate was 4.85%. The proceedsreceived by the Company from the sale of the junior subordinated debentureswere used to strengthen the capital position of the Bank and to accommodatecurrent and future growth. The current regulatory rules allow certainamounts of junior subordinated debentures to be included in the calculation ofregulatory capital, and have been included in the Tier I calculationaccordingly. The debentures and related accrued interest represent the soleassets of the Trust.

 

Thetrust preferred securities accrue and pay distributions quarterly, equal to 3-monthLIBOR plus 2.75% per annum of the stated liquidation value of $1,000 percapital security. The Company has entered into contractual arrangements which,taken collectively, fully and unconditionally guarantee payment of: (i) accruedand unpaid distributions required to be paid on the trust preferred securities;(ii) the redemption price with respect to any trust preferred securitiescalled for redemption by the Trust, and (iii) payments due upon avoluntary or involuntary dissolution, winding up, or liquidation of the Trust.

 

The Trust Preferred Securities are mandatorilyredeemable upon maturity of the debentures on May 18, 2034, or uponearlier redemption as provided in the indenture. The Company has the right toredeem the debentures purchased by the Trust in whole or in part, on or after May 18,2009. As specified in the indenture, if the debentures are redeemed prior tomaturity, the redemption price will be the unpaid principal amount, plus anyaccrued unpaid interest.

 

**(9)****                                ****Other Noninterest Expenses**

Components of othernoninterest expenses, which are greater than 1% of interest income and otheroperating income for the years ended December 31, 2004 and 2003 are asfollows:

 
| ** **        | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------|------------|----------|------------|----------|------------|
|              |       |     |       |     |       |
| Professional fees |       | $        | 223,487    |     | 136,450    |   |
| Insurance         |       | 84,884   |       | 66,563   |       |
| Data processing   |       | 312,762  |       | 193,196  |       |
| Advertising       |       | 133,955  |       | 77,845   |       |
| Office supplies   |       | 47,982   |       | 64,559   |       |
| Other             |       | 405,639  |       | 326,347  |       |
|              |       | $        | 1,208,709  |     | 864,960    |   |

 

34

----

 

**(10)****                         ****Income Taxes**

The components of incometax expense (benefit) for the years ended December 31, 2004 and 2003 areas follows:

 
| ** **                     | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------------|------------|----------|------------|----------|------------|
|                           |       |     |       |     |       |
| Currently payable              |       | $        | 513,747    |     | 482,633    |   |
| Deferred tax expense (benefit) |       | (117,561 | )          | (23,700  | )          |
|                           |       |     |       |     |       |
|                           |       | $        | 396,186    |     | 458,933    |   |

 

The differences between income tax expense and incometax expense computed by applying the statutory federal income tax rate toearnings before taxes for the years ended December 31, 2004 and 2003 areas follows:

 
| ** **                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
|---------------------------------------------|------------|----------|------------|----------|------------|
|                                        |       |     |       |     |       |
| Tax expense at statutory rate               |       | $        | 512,300    |     | 450,000    |   |
| Add (deduct):                               |       |     |       |     |       |
| State income taxes, net of  federal benefit |       | 35,200   |       | 25,700   |       |
| Non-deductible expenses                     |       | 6,100    |       | 3,300    |       |
| Tax exempt interest                         |       | (68,300  | )          | (18,800  | )          |
| Other                                       |       | (89,114  | )          | (1,267   | )          |
|                                        |       |     |       |     |       |
|                                        |       | $        | 396,186    |     | 458,933    |   |

 

The following summarizesthe components of deferred taxes at December 31, 2004 and 2003.

 
| ** **                                               | ** ** | **2004** | ** ** | **2003** | ** ** |
|----------------------------------------------------------|------------|----------|------------|----------|------------|
| Deferred income tax assets:                              |       |     |       |     |       |
| Allowance for loan losses                                |       | $        | 423,276    |     | 248,713    |   |
| Pre-opening expenses                                     |       | —   |       | 52,548   |       |
| Unrealized loss on securities available for  sale        |       | 68,390   |       | —   |       |
| Other                                                    |       | 13,419   |       | 2,434    |       |
|                                                     |       |     |       |     |       |
| Total deferred tax assets                                |       | 505,085  |       | 303,695  |       |
|                                                     |       |     |       |     |       |
| Deferred income tax liabilities:                         |       |     |       |     |       |
| Premises and equipment                                   |       | 67,987   |       | 52,548   |       |
| Unrealized gain (loss) on securities  available-for-sale |       | —   |       | 43,064   |       |
|                                                     |       |     |       |     |       |
| Total gross deferred tax liabilities                     |       | 67,987   |       | 95,612   |       |
|                                                     |       |     |       |     |       |
| Net deferred tax asset                                   |       | $        | 437,098    |     | 208,083    |   |

 

The net deferred taxasset is included in other assets in the consolidated balance sheets. Thefuture tax consequences of the differences between the financial reporting andtax basis of the Company’s assets and liabilities resulted in a net deferredtax asset for 2004. A portion of the change in the net deferred tax assetrelates to the unrealized gains and losses on investment securities availablefor sale. A current period deferred tax benefit related to the change inunrealized gains and losses on investment securities available for sale of$216,352 has been recorded directly to shareholders’ equity. The rest of thechange in the deferred tax asset results from the current period deferredtax expense of $117,561.

 

**(11)****                         ****Financial Instruments withOff-Balance-Sheet Risk**

The Bank is a party tofinancial instruments with off-balance-sheet risk in the normal course ofbusiness to meet the financing needs of its customers. These financialinstruments include commitments to extend credit, standby letters of credit andloans sold with limited recourse. These instruments involve, to varying degrees,elements of credit risk in excess of the amount recognized in the consolidatedbalance sheet. The contractual amounts of those instruments reflect the extentof involvement the Bank has in particular classes of financial instruments.

 

35

----

 

Commitments to extendcredit are agreements to lend to a customer as long as there is no violation ofany condition established in the contract. Commitments generally have fixedexpiration dates or other termination clauses and may require payment of a fee.Since many of the commitments are expected to expire without being drawn upon,the total commitment amounts do not necessarily represent future cashrequirements. The Bank evaluates each customer’s creditworthiness on acase-by-case basis. The amount of collateral obtained, if deemed necessary bythe Bank upon extension of credit, is based on management’s credit evaluationof the counterparty. The Bank’s loans are primarily collateralized byresidential and other real properties, automobiles, savings deposits, accountsreceivable, inventory and equipment.

 

Standby lettersof credit are written conditional commitments issued by the Bank to guaranteethe performance of a customer to a third party. Those guarantees are primarilyissued to support public and private borrowing arrangements. Most letters ofcredit extend for less than one year. The credit risk involved in issuingletters of credit is essentially the same as that involved in extending loanfacilities to customers.

 

Loanssold with limited recourse are 1-4 family residential mortgagesoriginated by the Bank and sold to various other financial institutions. Theseloans are sold with the agreement that a loan may be returned to the Bankwithin 90 days of any one of the loan’s first four payments being missed. TheBank’s exposure to credit loss in the event of nonperformance by the otherparty to the loan is represented by the contractual notional amount of theloan. The Bank uses the same credit policies in making loans held for sale asit does for on-balance-sheet instruments.

 

The Bank’s exposure tocredit loss in the event of non-performance by the other party to the financialinstrument for commitments to extend credit, standby letters of credit andloans sold with limited recourse is represented by the contractual amount ofthose instruments. The Bank uses the same credit policies in making commitmentsand conditional obligations as it does for on-balance-sheet instruments. Inmost cases, the Bank requires collateral to support financial instruments withcredit risk.

 
| ** **                                                           | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                           | ** ** | **2004**              | ** ** | **2003** | ** ** |
| Financial instruments whose contract amounts  represent credit risk: |       |                  |       |   |   |
| Commitments to extend credit                                         |       |                  |       |   |   |
| Variable rate                                                        |       | $                     | 17,295,000 |   | 17,618,000 |   |
| Fixed rate                                                           |       | 695,000               |       | 1,754,000 |   |
|                                                                 |       | $                     | 17,990,000 |   | 19,372,000 |   |
|                                                                 |       |                  |       |   |   |
| Standby letters of credit                                            |       | $                     | 552,000    |   | 117,000 |   |
| Loans sold with limited recourse                                     |       | $                     | 6,157,000  |   | 6,713,000 |   |

 

**(12)****                         ****UnusedLines of Credit**

At December 31, 2004, the Bank had $5,650,000 of availability onlines of credit to purchase federal funds from unrelated banks. These lines ofcredit are available on a one to seven day basis for general corporate purposesof the Bank. All of the lenders have reserved the right to withdraw these linesat their option.

 

**(13)****                         ****LegalContingencies**

TheCompany has, from time to time, various lawsuits and claims arising from theconduct of its business. Such items are not expected to have any materialadverse effect on the financial position or results of operations of theCompany.

 

36

----

 

**(14)****                         ****Employee and Director BenefitPrograms**

In connection with theCompany’s initial public stock offering, the directors received warrants topurchase 212,100 shares of the Company’s common stock at a price of $9.52 pershare. The warrants vest equally over a three-year period beginning December 2,1999 and expire on December 2, 2010 or 120 days after the warrant holderceased to serve as a member of the board of directors. During 2003, 17,850 ofthese warrants expired due to the fact that the holder ceased to serve as amember of the board of directors, leaving 194,250 warrants outstanding as of December 31,2003. During 2004, a director exercised 4,200 warrants leaving 190,050 warrantsoutstanding at December 31, 2004. As of December 31, 2004 and 2003,all of the warrants are exercisable. Also in connection with the Company’sinitial public stock offering, the Company issued 10,500 options at $9.52 pershare to a consultant. These options vested immediately and expire on December 2,2010.

 

The Company adopted aStock Incentive Plan in 2000 covering up to 149,354 shares of the Company’scommon stock. The Plan is administered by a committee of the Board of Directorsand provides for the granting of options to purchase shares of common stock toofficers, directors, employees or consultants of the Company and Bank. Theexercise price of each option granted under the Plan will not be less than thefair market value of the shares of common stock subject to the option on thedate of grant as determined by the Board of Directors. Options are exercisablein whole or in part upon such terms as may be determined by the committee, andare exercisable no later than ten years after the date of grant. As of December 31,2004, 21,633 shares were available for grant under this plan.

 

A summary status of theCompany’s stock option plan as of December 31, 2004 and 2003, and changesduring the years, are presented below:

 
| ** **                      | ** ** | **2004**   | ** ** | **2003**                             | ** ** |
|---------------------------------|------------|------------|------------|--------------------------------------|------------|
| ** **                      | ** ** | **Shares** | ** ** | **Weighted Average  Exercise Price** | ** ** | **Shares** | ** ** | **Weighted Average  Exercise Price** | ** ** |
|                            |       |       |       |                                 |       |   |   |   |   |
| Outstanding, beginning of year  |       | 128,221    |       | $                                    | 9.85       |   | 86,536 |   | $ | 9.52 |   |
| Granted during the year         |       | 10,000     |       | 16.75                                |       | 41,685 |   | 10.52 |   |
| Exercised during the year       |       | (10,500    | )          | 9.97                                 |       | — |   | — |   |
| Cancelled during the year       |       | (10,500    | )          | 11.30                                |       | — |   | — |   |
|                            |       |       |       |                                 |       |   |   |   |   |
| Outstanding, end of year        |       | 117,221    |       | 10.32                                |       | 128,221 |   | 9.85 |   |
|                            |       |       |       |                                 |       |   |   |   |   |
| Options exercisable at year end |       | 70,961     |       | 9.52                                 |       | 52,971 |   | 9.52 |   |
|                                 |            |            |            |                                      |            |  |  |  |  |  |  |

 

The weighted averageremaining contractual life of these stock options was 6.3 years as of December 31,2004.

 

Thefair value of each option grant is estimated on the date of grant using theBlack-Scholes option pricing model with the following weighted averageassumptions for grants in 2004 and 2003:

 
| ** **                                                                | ** ** | **2004** | ** ** | **2003** | ** ** |
|---------------------------------------------------------------------------|------------|----------|------------|----------|------------|
|                                                                      |       |     |       |     |       |
| Weighted average grant date fair value of options granted during the year |       | $        | 4.99       |     | 5.56       |   |
| Assumptions used to estimate fair value:                                  |       |     |       |     |       |
| Risk-free interest rate                                                   |       | 4.15     | %          | 4.0      |       |
| Dividend yield                                                            |       | 0        | %          | 0        |       |
| Expected volatility                                                       |       | 15       | %          | 25 - 51  | %          |
| Expected life                                                             |       | 7 years  |       | 7 years  |       |
|                                                                           |            |          |            |          |            |  |

 

The Company sponsors theLowcountry National Bank Retirement Savings Plan (the “Plan”) for the benefitof all eligible employees. The Company contributes to the Plan annually uponapproval by the Board of Directors. Contributions made to the Plan in 2004 and2003 amounted to $24,314 and $18,764, respectively.

 

The Company adopted aDirector and Executive Officer Deferred Compensation Plan in 2004 that allowsdirectors and executive officers to defer compensation. Interest accruesquarterly on deferred amounts at a rate which is equal to 75% of the previousquarter’s return on equity, not to exceed 12%.

 

37

----

 

**(15)****                         ****Related Party Transactions**

In the normal course of business, officers and directorsof the Bank, and certain business organizations and individuals associated withthem, maintain a variety of banking relationships with the Bank. Transactionswith officers and directors are made on terms comparable to those available toother Bank customers. At December 31, 2004 and 2003, deposits fromdirectors, executive officers, and their related interests aggregatedapproximately $1,318,000 and $1,348,000, respectively. The following summaryreflects related party loan activity for the years ended December 31, 2004and 2003:

 
| ** **        | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|-------------------|------------|------------|------------|------------|------------|
| Beginning balance |       | $          | 3,347,000  |       | 2,532,000  |   |
| New loans         |       | 2,220,840  |       | 3,327,000  |       |
| Repayments        |       | (1,505,840 | )          | (2,512,000 | )          |
|              |       |       |       |       |       |
| Ending balance    |       | $          | 4,062,000  |       | 3,347,000  |   |

 

**(16)****                         ****Regulatory****Matters**

The Company and the Bankare subject to various regulatory capital requirements administered by thefederal banking agencies. Failure to meet minimum capital requirements caninitiate certain mandatory and possibly additional discretionary actions byregulators that, if undertaken, could have a direct material effect on thefinancial statements. Under certain adequacy guidelines and the regulatoryframework for prompt corrective action, specific capital guidelines thatinvolve quantitative measures of the assets, liabilities, and certainoff-balance sheet items as calculated under regulatory accounting practicesmust be met. The capital amounts and classification are also subject toqualitative judgments by the regulators about components, risk weightings, andother factors.

 

Quantitative measuresestablished by regulation to ensure capital adequacy require the Company andthe Bank to maintain minimum amounts and ratios (set forth in the table below)of Total and Tier 1 Capital (as defined in the regulations) to risk-weightedassets (as defined), and of Tier 1 Capital (as defined) to average assets (asdefined). Management believes, as of December 31, 2004, that the Companyand the Bank meet all capital adequacy requirements to which they are subject.

 

As of December 31,2004, the most recent notification from the Federal Deposit InsuranceCorporation categorized the Bank as well capitalized under the regulatoryframework for prompt corrective action. To be categorized as well capitalized theBank must maintain minimum total risk-based, Tier 1 risk-based and Tier 1leverage ratios as set forth in the table. There are no conditions or eventssince that notification that management believes have changed the Bank’scategory.

 

The actual capitalamounts and ratios are also presented in the table below.

 
| ** **                                    | ** ** | **Actual** | ** ** | **For Capital  Adequacy Purposes** | ** ** | **To Be Well  Capitalized Under  Prompt Corrective  Action Provisions** | ** ** |
|-----------------------------------------------|------------|------------|------------|------------------------------------|------------|-------------------------------------------------------------------------|------------|
| ** **                                    | ** ** | **Amount** | ** ** | **Ratio**                          | ** ** | **Amount**                                                              | ** ** | **Ratio** | ** ** | **Amount** | ** ** | **Ratio** | ** ** |
| **As of December 31, 2004:**             |       |       |       |                               |       |                                                                    |       |   |   |   |   |   |   |
| Total Capital  (to Risk Weighted Assets)      |       | $          | 13,157,000 |                               | 11.53      | %                                                                       | 9,127,000  |   | 8.00 | % | 11,409,000 |   | 10.0 | % |
| Tier 1 Capital  (to Risk Weighted Assets)     |       | 12,020,000 |       | 10.54                              | %          | 4,564,000                                                               |       | 4.00 | % | 6,846,000 |   | 6.00 | % |
| Tier 1 Capital (to Average Assets)       |       | 12,020,000 |       | 8.38                               | %          | 5,734,000                                                               |       | 4.00 | % | 7,168,000 |   | 5.00 | % |
|                                          |       |       |       |                               |       |                                                                    |       |   |   |   |   |   |   |
| **As of December 31, 2003:**             |       |       |       |                               |       |                                                                    |       |   |   |   |   |   |   |
| Total Capital  (to Risk Weighted Assets)      |       | $          | 8,769,000  |                               | 11.65      | %                                                                       | 6,022,000  |   | 8.00 | % | 7,528,000 |   | 10.0 | % |
| Tier 1 Capital (to Risk Weighted Assets) |       | 7,903,000  |       | 10.50                              | %          | 3,011,000                                                               |       | 4.00 | % | 4,517,000 |   | 6.00 | % |
| Tier 1 Capital  (to Average Assets)           |       | 7,903,000  |       | 7.59                               | %          | 4,164,000                                                               |       | 4.00 | % | 5,205,000 |   | 5.00 | % |

 

38

----

 

Cash Dividends – There are not current plans toinitiate payment of cash dividends and future dividend policy will depend onthe Bank’ and the Company’s earnings, capital requirements, financial conditionand other factors considered relevant by the Company’s Board of Directors. TheBank is restricted in its ability to pay dividends under national banking lawsand regulations of the Office of the OCC. Generally, these restrictions requirethe Bank to pay dividends derived solely from net profits. Moreover, the OCC’sprior approval is required if dividends declared in any calendar year exceedthe Bank’s net profit for that year combined with its retained net profits forthe preceding two years.

 

StockDividends – In February 2004,the Company declared a five percent stock dividend to shareholders of record asof March 12, 2004. The dividend was issued on March 26, 2004. Allearnings per share amounts for all periods have been adjusted to reflect thefive percent stock dividend.

 

**(17)****                         ****Shareholders’ Equity**

Shares of preferredstock may be issued from time to time in one or more series as established byresolution of the Board of Directors of the Company, up to a maximum of10,000,000 shares. Each resolution shall include the number of shares issued,preferences, special rights and limitations as determined by the Board.

 

**(18)**                          **FairValue of Financial Instruments**

SFAS No. 107, *Disclosures about Fair Value of Financial Instruments*requires disclosure of fair value information about financial instruments,whether or not recognized on the face of the balance sheet, for which it ispractical to estimate that value. The assumptions used in the estimation of thefair value of your financial instruments are detailed below. Where quotedprices are not available, fair values are based on estimates using discountedcash flows and other valuation techniques. The use of discounted cash flows canbe significantly affected by the assumptions used, including the discount rateand estimates of future cash flows. The following disclosures should not beconsidered as representative of the liquidation value of the bank, but ratherrepresent a good-faith estimate of the increase or decrease in value offinancial instruments held by the bank since purchase, origination, orissuance. This analysis has not undertaken any steps to value any intangibles,which is permitted by the provisions of SFAS No. 107.

 

Certain items arespecifically excluded from the disclosure requirements, including the Company’scommon stock, premises and equipment and other assets and liabilities.

 

The following methodsand assumptions were used in this analysis in estimating the fair value of yourfinancial instruments:

 

•                  ***Cash and due from banks***: Fair value equals the carrying value ofsuch assets.

 

•                  ***Investment securities***:******Fairvalues for investment securities are based on bond accounting reports.

 

•                  ***Federal funds sold and purchased***:******Due to theshort-term nature of these assets, the carrying values of these assetsapproximate their fair value.

 

•                  ***Loans***: For variable rate loans, thoserepricing within six months or less, fair values are based on carrying values. Fixedrate commercial loans, other installment loans, and certain real estatemortgage loans were valued using discounted cash flows. The discount rates usedto determine the present value of these loans were based on interest ratescurrently being charged by your bank on comparable loans as to credit risk andterm.

 

•                  ***Deposit liabilities***: The fair values of demand deposits are,as required by FAS107, equal to the carrying value of such deposits. Demand depositsinclude non-interest-bearing demand deposits, savings accounts, NOW accounts,and money market demand accounts. Discounted cash flows are used to value fixedrate term deposits. The discount rate used is based on interest rates currentlybeing offered by your bank on comparable deposits as to amount and term.

 

•                  ***Short-term borrowings***: The carrying values of federal fundspurchased, securities sold under agreements to repurchase and other short-termborrowings approximate their carrying values.

 

39

----

 

•                  ***FHLB, Junior SubordinatedDebentures and other borrowings***: The carrying amount on variable rateborrowings approximates their fair value.

 

•                  ***Off***-***balance sheet instruments***:Loan commitments are negotiated at current market rates and are relativelyshort-term in nature. Therefore, the estimated value of loan commitmentsapproximates the fees charged.

 

The estimated fairvalues of the Company’s financial instruments are as follows:

 
| ** **                               | ** ** | **December 31,** | ** ** |
|------------------------------------------|------------|-----------------------|------------|
| ** **                               | ** ** | **2004**              | ** ** | **2003** | ** ** |
| ** **                               | ** ** | **Carrying  amount**  | ** ** | **Fair  value** | ** ** | **Carrying  amount** | ** ** | **Fair  Value** | ** ** |
| Financial assets:                        |       |                  |       |   |   |   |   |   |   |
| Cash and due from banks                  |       | $                     | 1,513,726  |   | 1,513,726 |   | 205,082 |   | 205,082 |   |
| Federal funds sold                       |       | 2,583,000             |       | 2,583,000 |   | — |   | — |   |
| Investment securities available-for-sale |       | 27,366,390            |       | 27,366,390 |   | 31,274,470 |   | 31,274,470 |   |
| Investment securities held-to-maturity   |       | 5,642,841             |       | 5,555,013 |   | 3,421,218 |   | 3,352,500 |   |
| Loans held for sale                      |       | 878,124               |       | 878,124 |   | 124,202 |   | 124,202 |   |
| Loans, net                               |       | 100,397,246           |       | 99.569,246 |   | 67,488,128 |   | 67,635,278 |   |
| Other investments                        |       | 1,037,150             |       | 1,037,150 |   | 859,950 |   | 859,950 |   |
| Cash surrender value life insurance      |       | 2,082,333             |       | 2,082,333 |   | — |   | — |   |
|                                     |       |                  |       |   |   |   |   |   |   |
| Financial liabilities:                   |       |                  |       |   |   |   |   |   |   |
| Deposits                                 |       | 129,431,713           |       | 129,822,713 |   | 96,435,587 |   | 96,937,988 |   |
| Federal funds purchased                  |       | —                |       | — |   | 600,000 |   | 600,000 |   |
| FHLB advances                            |       | 2,000,000             |       | 2,000,000 |   | — |   | — |   |
| Junior subordinated debentures           |       | 3,093,000             |       | 3,093,000 |   | — |   | — |   |
|                                          |            |                       |            |  |  |  |  |  |  |  |

 
| ** **                     | ** ** | **Notional  amount** | ** ** | **Notional  amount** | ** ** |
|--------------------------------|------------|----------------------|------------|----------------------|------------|
| Off-balance-sheet instruments: |       |                 |       |                 |       |
| Commitments                    |       | $                    | 17,990,000 |                 | 19,372,000 |   |
| Stand-by letters of credit     |       | 507,000              |       | 117,360              |       |
|                                |            |                      |            |                      |            |  |

 

40

----

 

**(19)****                         ****Coastal Banking Company, Inc.(Parent Company Only) Financial Information**

 

**Condensed Balance****Sheets**

 
| ** **                                               | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------|------------|-----------------------|------------|
| ** **                                               | ** ** | **2004**              | ** ** | **2003** | ** ** |
| Assets                                                   |       |                  |       |   |   |
|                                                     |       |                  |       |   |   |
| Cash                                                     |       | $                     | 937,211    |   | 1,020,994 |   |
| Investment securities held-to-maturity                   |       | 268,125               |       | — |   |
| Investment in Coastal Banking Company  Statutory Trust I |       | 93,000                |       | — |   |
| Investment in Bank                                       |       | 11,886,443            |       | 7,986,466 |   |
| Premises and equipment                                   |       | 414,904               |       | 414,904 |   |
| Other assets                                             |       | 309,975               |       | 331,103 |   |
|                                                     |       |                  |       |   |   |
|                                                     |       | $                     | 13,909,658 |   | 9,753,467 |   |
|                                                     |       |                  |       |   |   |
| Liabilities and Shareholders’ Equity                |       |                  |       |   |   |
|                                                     |       |                  |       |   |   |
| Junior subordinated debentures                           |       | $                     | 3,093,000  |   | — |   |
| Accrued interest payable                                 |       | 24,608                |       | — |   |
| Total liabilities                                        |       | 3,117,608             |       | — |   |
| Shareholders’ equity                                |       | 10,792,050            |       | 9,753,467 |   |
|                                                     |       | $                     | 13,909,658 |   | 9,753,467 |   |

 

**CondensedStatements of Earnings**

 
| ** **                                                                   | ** ** | **For the years ended December 31,** | ** ** |
|------------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                   | ** ** | **2004**                                  | ** ** | **2003** | ** ** |
|                                                                         |       |                                      |       |   |   |
| Interest and other income                                                    |       | $                                         | 2,349      |   | — |   |
|                                                                         |       |                                      |       |   |   |
| Expenses                                                                     |       |                                      |       |   |   |
| Interest expense                                                             |       | 82,882                                    |       | — |   |
| Other operating expenses                                                     |       | 31,694                                    |       | 47,840 |   |
|                                                                         |       |                                      |       |   |   |
|                                                                         |       | 114,576                                   |       | 47,840 |   |
|                                                                         |       |                                      |       |   |   |
| Loss before equity in undistributed earnings  of subsidiary and income taxes |       | (112,227                                  | )          | (47,840 | ) |
|                                                                         |       |                                      |       |   |   |
| Equity in undistributed earnings of subsidiary                               |       | 1,183,829                                 |       | 894,290 |   |
|                                                                         |       |                                      |       |   |   |
| Income tax benefit                                                           |       | 39,000                                    |       | 18,000 |   |
|                                                                         |       |                                      |       |   |   |
| Net earnings                                                                 |       | $                                         | 1,110,602  |   | 864,450 |   |
|                                                                              |            |                                           |            |  |  |  |  |

 

41

----

 

**Condensed Statement****s of Cash Flows**

 
| ** **                                                                       | ** ** | **For the years ended December 31,** | ** ** |
|----------------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                       | ** ** | **2004**                                  | ** ** | **2003** | ** ** |
| Cash flows from operating activities:                                            |       |                                      |       |   |   |
| Net earnings                                                                     |       | $                                         | 1,110,602  |   | 864,450 |   |
| Adjustments to reconcile net earnings to net  cash used by operating activities: |       |                                      |       |   |   |
| Equity in undistributed earnings of Bank                                         |       | (1,183,829                                | )          | (894,290 | ) |
| Amortization                                                                     |       | 2,792                                     |       |   |   |
| Change in other assets and liabilities                                           |       | 42,944                                    |       | (283,686 | ) |
|                                                                             |       |                                      |       |   |   |
| Net cash used by operating activities                                            |       | (27,491                                   | )          | (313,526 | ) |
|                                                                             |       |                                      |       |   |   |
| Cash flows from investing activities:                                            |       |                                      |       |   |   |
| Capital contribution to Bank                                                     |       | (2,932,500                                | )          | — |   |
| Purchase of investment securities  held-to-maturity                              |       | (268,125                                  | )          | — |   |
| Investment in Coastal Banking Company  Statutory Trust I                         |       | (93,000                                   | )          | — |   |
|                                                                             |       |                                      |       |   |   |
| Net cash used by investing activities                                            |       | (3,293,625                                | )          | — |   |
|                                                                             |       |                                      |       |   |   |
| Cash flows from financing activities:                                            |       |                                      |       |   |   |
| Proceeds from junior subordinated debt                                           |       | 3,093,000                                 |       | — |   |
| Proceeds from exercise of stock options                                          |       | 144,606                                   |       | — |   |
| Cash in lieu of fractional shares                                                |       | (273                                      | )          | — |   |
|                                                                             |       |                                      |       |   |   |
| Net cash provided by financing activities                                        |       | 3,237,333                                 |       | — |   |
|                                                                             |       |                                      |       |   |   |
| Net change in cash and cash equivalents                                          |       | (83,783                                   | )          | (313,526 | ) |
|                                                                             |       |                                      |       |   |   |
| Cash and cash equivalents at beginning of year                                   |       | 1,020,994                                 |       | 1,334,520 |   |
|                                                                             |       |                                      |       |   |   |
| Cash and cash equivalents at end of year                                         |       | $                                         | 937,211    |   | 1,020,994 |   |

 

42

----

 

**COASTAL BANKING COMPANY, INC. ANDSUBSIDIARY**

 

**CORPORATE DATA**

 

**BOARD OF DIRECTORS**

 
| Marjorie Trask  Gray, DMD       |   | Dentist,  Marjorie Gray, DMD                    |
|---------------------------------|--------|-------------------------------------------------|
|                            |   |                                            |
| Dennis O. Green,  CPA           |   | Managing Member,  Celadon LLC                   |
|                            |   |                                            |
| Mark G. Heles                   |   | Owner, President &  CEO                |
|                            |   | Achieve Staffing, Inc.                     |
|                            |   |                                            |
| James W. Holden, Jr.,  DVM |   | Owner, Director                                 |
|                            |   | Holly Hall  Animal Hospital                     |
|                            |   |                                            |
| Ladson F. Howell                |   | Retired,  Attorney                              |
|                            |   | Howell, Gibson &  Hughes, PA           |
|                            |   |                                            |
| James C. Key                    |   | Partner,  Shenandoah Group, L.L.P               |
|                            |   |                                            |
| Randolph C. Kohn                |   | President &  CEO                       |
|                            |   | Coastal Banking  Company, Inc. and         |
|                            |   | Lowcountry  National Bank                       |
|                            |   |                                            |
| Ron Lewis                       |   | Owner, McDonald’s  Restaurants of Beaufort |
|                            |   |                                            |
| Lila N. Meeks                   |   | Vice Chancellor  of Advancement                 |
|                            |   | USC – Beaufort                             |
|                            |   |                                            |
| Robert B. Pinkerton             |   | President &  CEO, Athena Corporation   |
|                            |   |                                            |
| John M. Trask, III         |   | Co-Owner,  Lowcountry Real Estate               |
|                            |   |                                            |
| Matt A. Trumps                  |   | Owner, Tideland  Realty                         |

 

**SENIOR OFFICERS**

 

Randolph C. Kohn, President and Chief Executive Officer

 

James L. Pate, III, Senior Vice President and Chief FinancialOfficer

 

William Gary Horn, Executive Vice President and Senior Credit Officer

 

43

----

 

**COASTAL BANKING COMPANY, INC. ANDSUBSIDIARY**

 

**CORPORATE DATA**

 
| **CORPORATE  OFFICE:**          |   | **GENERAL  COUNSEL:**                             |
|---------------------------------|--------|---------------------------------------------------|
|                            |   |                                              |
| 36 Sea Island  Parkway          |   | Nelson Mullins  Riley & Scarborough, LLP |
| Beaufort, South  Carolina 29907 |   | 104 South Main  Street                            |
| Phone (843) 522-1228            |   | Suite 900                                    |
| Fax: (843) 524-4510             |   | Greenville, SC  29601                             |

 
| **STOCK  TRANSFER DEPARTMENT:** |   | **INDEPENDENT  REGISTERED PUBLIC  ACCOUNTING FIRM:** |
|---------------------------------|--------|------------------------------------------------------|
|                            |   |                                                 |
| First Citizens  Bank            |   | Elliott Davis,  LLC                                  |
| Corporate Trust  – DAC 61  |   | 200 East Broad  Street                               |
| 100 East Tryon  Road            |   | Post Office Box  6286                                |
| Raleigh, North  Carolina 27603  |   | Greenville,  South Carolina 29606                    |

 

**STOCKINFORMATION:**

 

The Common Stock of Coastal Banking Company, Inc. is not listed onany exchange. However, the stock is quoted on the NASDAQ OTC Bulletin Boardunder the symbol “CBCO.OB.” There were approximately 849 shareholders of recordon December 31, 2004. The following table sets forth the high and low bidprices as quoted on the OTC Bulletin Board during the periods indicated. Thequotations reflect inter-dealer prices, without retail mark-up, mark-down, orcommissions, and may not represent actual transactions.

 

 
| ** **     | ** ** | **Years Ended December 31,** | ** ** |
|----------------|------------|-----------------------------------|------------|
| ** **     | ** ** | **2004**                          | ** ** | **2003** | ** ** |
| ** **     | ** ** | **High**                          | ** ** | **Low** | ** ** | **High** | ** ** | **Low** | ** ** |
| First quarter  |       | $                                 | 17.75      |   | $ | 15.24 |   | $ | 9.73 |   | $ | 9.73 |   |
| Second quarter |       | $                                 | 17.75      |   | $ | 15.90 |   | $ | 12.75 |   | $ | 12.00 |   |
| Third quarter  |       | $                                 | 16.50      |   | $ | 15.00 |   | $ | 14.00 |   | $ | 14.00 |   |
| Fourth quarter |       | $                                 | 18.00      |   | $ | 15.25 |   | $ | 17.80 |   | $ | 17.80 |   |

 

The Company hasnever declared or paid a cash dividend and does not expect to do so in theforeseeable future. The ability of the Company to pay cash dividends isdependent upon receiving cash dividends from the Bank. However, federal bankingregulations restrict the amount of cash dividends that can be paid to theCompany from the Bank. All of our outstanding shares of common stock areentitled to share equally in dividends from funds legally available when, andif, declared by the board of directors.

 

**Copiesof the Company’s Annual Report on Form 10-KSB for the fiscal yearended December 31, 2004, as filed with the Securities and ExchangeCommission, will be furnished at no charge to shareholders upon written requestto: James L. Pate, III, Chief Financial Officer, Coastal Banking Company, Inc.,36 Sea Island Parkway, Beaufort, South Carolina 29907.**

 

**ThisAnnual Report serves as the Annual Financial Disclosure Statement furnishedpursuant to Part 350 of the Federal Deposit Insurance Corporation’s Rules andRegulations. This Statement has not been reviewed or confirmed for accuracy orrelevance by the Office of the Comptroller of the Currency.**

 

44

----