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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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FORM 10-KSB



ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934



For the fiscal year ended: December 31, 2003



Commission file number: 000-22734



KS BANCORP, INC.

(Name of small
business issuer in its charter)



|                                                                     |  |                                     
|-------------------------------------------------------------------- |  | ------------------------------------
|North Carolina                                                       |  | 56-1842707                          
|(State or other jurisdiction of incorporation or organization)       |  | (I.R.S. Employer Identification No.)
|                                                                     | 
|1031 North Brightleaf Blvd. P. O. Box 661 Smithfield, North Carolina |  | 27577                               
|(Address of principal executive offices)                             |  | (Zip Code)                          



(919) 938-3101

(Issuers telephone number)



SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:



|                           |  |                                            
|-------------------------- |  | -------------------------------------------
|Common Stock, no par value |  | N/A                                        
|(Title of class)           |  | (Name of each exchange on which registered)



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



Check if there is no disclosure of delinquent filers in response to Item 405 of Regulation S-B contained in this form, and no disclosure
will be contained, to the best of registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-KSB or any amendment to this Form 10-KSB. x



State issuers revenues for its most recent fiscal year: $1,401,336



State the aggregate market value of the voting stock held by non-affiliates
computed by reference to the price at which the stock was sold, or the average bid and asked prices of such stock, as of a specified date within the past 60 days: Common Stock, no par value  $15,140,986 (based on the last price which the stock
was sold prior to March 10, 2004).



State the number of shares outstanding of
each of the issuers classes of common equity, as of the latest practicable date:



|                           |  |                                   
|-------------------------- |  | ----------------------------------
|Common Stock, no par value |  | 1,197,029 shares                  
|(Class)                    |  | (Outstanding at December 31, 2003)



DOCUMENTS
INCORPORATED BY REFERENCE



| | Portions of the Proxy Statement for the Annual Meeting of Stockholders to be held on May 4, 2004 (the Proxy Statement), are incorporated by reference into Part III.
|- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------



Transitional Small Business Disclosure Format (Check
one): Yes ̈No x



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Forward-Looking Statements Disclaimer



This report contains certain forward-looking statements with respect to the financial condition, results of operations
and the business of the KS Bancorp, Inc. (the Company). These forward-looking statements involve risks and uncertainties, and are based on the beliefs and assumptions of management of the Company and on the information available to
management at the time that these disclosures were prepared. These statements can be identified by the use of words like expect, anticipate, estimate and believe, variations of these words, and other
similar expressions. Readers should not place undue reliance on forward-looking statements as a number of important factors could cause actual results to differ materially from those in the forward-looking statements. Factors that could cause actual
results to differ materially include, but are not limited to, (1) competition in KS Bank, Inc.s (the Banks) markets, (2) changes in the interest rate environment, (3) general national, regional or local economic conditions
that are less favorable than expected, resulting in, among other things, a deterioration in credit quality and the possible impairment of collectibility of loans, (4) legislative or regulatory changes, including changes in accounting standards, (5)
significant changes in the federal and state legal and regulatory environment and tax laws, (6) the impact of changes in monetary and fiscal policies, laws, rules and regulations, and (7) other risks and factors identified in the Companys
other filings with the Securities and Exchange Commission. The Company undertakes no obligation to update any forward-looking statements.



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PART I



|ITEM 1. | DESCRIPTION OF BUSINESS
|------- | -----------------------



General



Prior to December 29, 1993, KS Bank, Inc. (the Bank), formerly known as Kenly Savings Bank, Inc., SSB, operated as a mutual North Carolina-chartered savings bank. On December 29, 1993, the Bank converted
from a North Carolina-chartered mutual savings bank to a North Carolina-chartered stock savings bank. In connection with the conversion, all of the issued and outstanding capital stock of the Bank was acquired by KS Bancorp, Inc., a North Carolina
corporation (the Company) that was organized to become the holding company for the Bank. At that time, the Company had an initial public offering of its common stock.



The Company is a bank holding company registered with the Board of Governors of the Federal Reserve System (the
Federal Reserve) under the Bank Holding Company Act of 1956, as amended and the savings bank holding company laws of North Carolina. The Companys executive office is located at 1031 North Brightleaf Blvd., Smithfield, North
Carolina. The Company has no operations and conducts no business of its own other than owning the Bank, holding the loan to the ESOP, and managing its investments. The Companys principal sources of income are earnings on its investments. In
addition, the Company receives dividends that are declared and paid by the Bank on its capital stock.



The Bank was chartered in 1924. It has been a member of the Federal Home Loan Bank system since 1936, and its deposits have been federally insured since
1961. The Banks deposits are insured by the Savings Association Insurance Fund of the Federal Deposit Insurance Corporation (the FDIC) to the maximum extent permitted by law. As a North Carolina-chartered savings bank, the Bank is
regulated and examined by the Commissioner of Banks (the Commissioner) and the FDIC.



The Bank conducts business through seven offices in Kenly, Goldsboro, Wilson, Garner, Clayton, Selma, and Smithfield, North Carolina. At December 31,
2003, the Company had consolidated total assets of $201,516,012, consolidated net loans of $151,772,810, consolidated deposits of $142,250,698, and consolidated stockholders equity of $18,576,864.



The Bank is engaged primarily in the business of attracting retail deposits
from the general public and using such deposits to make mortgage loans secured by real estate. The Bank makes mortgage loans secured by owner-occupied and non-owner occupied residential real estate, loans secured by non-residential properties,
construction loans and equity line of credit loans. The Bank also makes loans that are not secured by real property, such as loans secured by pledged deposit accounts, and various types of secured and unsecured consumer loans. The Banks
primary source of revenue is interest income from its lending activities. The Banks other major sources of revenue are interest and dividend income from investments and mortgage-backed securities, interest income from its interest-earning
deposit balances in other depository institutions, and transaction and fee income from its lending and deposit activities. The Banks major expenses are interest on deposits and borrowings and non-interest expenses such as employee compensation
and benefits, federal deposit insurance premiums, data processing expenses and occupancy expenses.



General economic conditions and related monetary and fiscal policies of depository institution regulatory agencies, including the Federal Reserve, the
FDIC and the Commissioner, significantly influence the operations of depository institutions, including the Bank. Interest rates on competing investments and general market rates of interest influence deposit flow and the Banks cost of funds.
The demand for financing of real estate and other types of loans, which in turn are affected by the interest rates at which such financing may be offered and other factors affecting local demand and availability of funds, influence demand for the
Banks lending activities.



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At December 31, 2003, the Company and the Bank had a total of 72 full-time employees and 4 part-time
employees.



Lending Activities



General. The Bank is engaged primarily in the business of attracting
deposits from the general public and using the deposits to make mortgage loans secured by real estate. The Banks primary source of revenue is interest and fee income from its lending activities, consisting primarily of conventional first
mortgage loans secured by real property located in its primary market area. The Bank also makes loans secured by multi-family and nonresidential properties, construction loans, equity line loans, savings account loans and various types of secured
and unsecured consumer loans. Approximately 80.0% of the Banks gross loan portfolio is secured by real estate. On December 31, 2003, the Banks largest single outstanding loan had a balance of approximately $2 million. In addition to
interest earned on loans, the Bank receives fees in connection with loan originations, loan servicing, loan modifications, late payments, loan assumptions and other miscellaneous services.



Loan Portfolio Composition. The Banks net loan portfolio totaled
approximately $152 million at December 31, 2003, representing 75% of the Banks total assets. Conventional first mortgage loans accounted for 43% of the Banks gross loan portfolio, before net items, on December 31, 2003. Construction
loans and equity line loans represented 18% and 9%, respectively, of the Banks gross loan portfolio, before net items, on that date. See Note 3 of the Notes to Consolidated Financial Statements in Item 7 of this Annual Report. As
of December 31, 2003, 77% of the loans in the Banks gross loan portfolio, before net items, had adjustable interest rates.



The following table sets forth the time to contractual maturity of the Banks loan portfolio at December 31, 2003. Fixed rate loans are shown as due
in the period of contractual maturity. Loans with adjustable rates are shown as being due at the end of the next upcoming adjustment period. Demand loans, loans having no stated maturity and overdrafts are reported as due in one year or less.
Amounts in the table are net of loans in process and are net of unamortized loan fees.



|                |  |                |        |                           |   |                  |  |       |        |  |   |        
|--------------- |  | -------------- | ------ | ------------------------- | - | ---------------- |  | ----- | ------ |  | - | -------
|                |  | One Yr.Or Less |        | More Than1 Year to5 Years |   | More Than5 Years |  | Total
|                |  | (In Thousands)
|Fixed rate      |  | $              | 3,988  |                           | $ | 19,359           |  | $     | 11,265 |  | $ | 34,612 
|Adjustable rate |  |                | 58,819 |                           |   | 59,667           |  |       | 33     |  |   | 118,519
|                |  | $              | 62,807 |                           | $ | 79,026           |  | $     | 11,298 |  | $ | 153,131



The following table
sets forth the dollar amount at December 31, 2003 of all loans maturing or repricing on or after December 31, 2004 that have fixed or adjustable interest rates.



|               |       |                  |   |        |  |   |       
|-------------- | ----- | ---------------- | - | ------ |  | - | ------
|Fixed Rates    |       | Adjustable Rates |   | Total 
|(In Thousands)
|$              | 3,988 |                  | $ | 58,819 |  | $ | 62,807



Although adjustable
rate loans generally present less interest rate risk to the Bank, they are generally considered to involve a greater degree of credit risk than fixed rate loans because borrowers may have difficulty meeting their payment obligations if interest
rates and required payment amounts increase substantially. Substantially all of the fixed-rate loans in the Banks mortgage loan portfolio have due on sale provisions allowing the Bank to declare the unpaid balance due and payable in full upon
the sale or transfer of an interest in the property securing the loan.



Conventional First Mortgages.At December 31, 2003, 42.98% of the Banks gross loan portfolio, before net items, was composed of conventional first mortgage loans. The Banks primary lending activity, which it



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intends to continue to emphasize, is the origination of conventional first mortgage loans to enable borrowers to purchase or refinance one-to-four family
residential real property. The Bank also makes conventional first mortgage loans secured by multi-family residential property and by nonresidential real property. Consistent with the Banks emphasis on being a community-oriented financial
institution, it is and has been the Banks strategy to focus its lending efforts in its primary market area. Loans secured by multi-family residential and nonresidential properties generally are larger than one-to-four family residential loans
and involve a greater degree of risk. Payments on these loans depend to a large degree on results of operations and management of the properties and may be affected to a greater extent by adverse conditions in the real estate market or the economy
in general.



Construction Lending. The Bank makes
various types of construction loans primarily for the construction of single-family dwellings. On December 31, 2003, the aggregate gross outstanding balances of construction loans was approximately $30 million, representing 18% of the Companys
gross loan portfolio, before net items. Some of these loans were made to investors who are constructing properties on a speculative basis; others were made to persons who are constructing properties for the purpose of occupying them. Loans made to
investors are generally pure construction loans which require the payment of interest during the construction period and the payment of the principal in full at the end of the construction period. Loans made to individual property owners
are both pure construction loans and construction-permanent loans which generally provide for the payment of interest only during a construction period, after which the loans convert to a permanent loan at fixed or adjustable interest
rates having terms similar to other permanent loans.



Construction loans are generally considered to involve a higher degree of risk than long-term financing secured by real estate that is already occupied. A lenders risk of loss on a construction loan is dependent largely upon the
accuracy of the initial estimate of the propertys value at the completion of construction and the estimated cost (including interest) of construction. If the estimate of construction costs proves to be inaccurate, the lender may be required to
advance funds beyond the amount originally committed in order to permit completion of construction. If the estimate of anticipated value proves to be inaccurate, the lender may have security that has value insufficient to assure full repayment. In
addition, repayment of loans made to builders to finance construction of properties is often dependent upon the builders ability to sell the property once construction is completed.



Home Equity Lines of Credit.At December 31, 2003, home equity loans totaled $15 million and comprised approximately
9% of the Banks gross loan portfolio, before net items. These loans are generally secured by subordinate liens against residential dwellings. In many of these cases, the Bank holds the first lien on the security. Home equity lines of credit
have terms of up to 15 years and interest rates that are adjustable based upon prime rates. Because these loans involve revolving lines of credit that can be drawn over a period of time, the Bank faces additional risks associated with changes in the
borrowers financial condition. Because home equity loans have adjustable rates with no rate caps (other than usury limitations), increased delinquencies could occur if interest rate increases occur and borrowers are unable to satisfy higher
payment requirements. Home equity loans are generally limited so that amount of such loans, along with any senior indebtedness, does not exceed 100% of the value of the real estate security.



Consumer Loans.During 1997 the Bank began originating consumer loans
and had $2 million in such loans outstanding on December 31, 2003. The Bank makes both secured and unsecured consumer loans. Some consumer loans have fixed interest rates; others have adjustable interest rates. Secured consumer loans have personal
property, such as automobiles, or real property as collateral. Fixed rate consumer loans generally have shorter terms than adjustable rate loans. The Bank intends to increase the amount of consumer loans in its portfolio in future years.



Origination and Sale of Loans.In years prior to 1994, the Bank
generally did not originate its loans with the intention that they would be sold in the secondary market. Loans generally were not originated in conformity with the purchase requirements of the Federal Home Loan Mortgage Corporation
(FHLMC) or Federal National Mortgage Association (FNMA). However, in January 1994 and October, 1994, the Bank opened a mortgage loan origination office in Clayton, North Carolina and a mortgage loan origination office in
Goldsboro, North Carolina, respectively, and began originating loans in conformity with the purchase requirements of the FHLMC and FNMA, so that they could be sold in the secondary market if the Bank determined that such sales were prudent. The Bank
continues to sell mortgages on the secondary market. In addition, the Bank also originates many loans which satisfy its underwriting requirements and are tailored for its local community but do not satisfy various requirements



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imposed by FHLMC and FNMA. Such loans are not readily saleable in the secondary market and could be sold only after the Bank incurred certain costs, such as
costs for surveys and title insurance and/or discounted the purchase price. The Bank has historically found that its origination of nonconforming loans has not resulted in a high level of non-performing assets. In addition, these loans generally
produce a higher yield than are produced by loans which conform to the purchase requirements of FHLMC and FNMA.



Non-performing Assets. When a borrower fails to make a required payment on a loan and does not cure the delinquency promptly, the loan is
classified as delinquent. In this event, the normal procedure followed by the Bank is to make contact with the borrower at prescribed intervals in an effort to bring the loan to a current status. In most cases, delinquencies are cured promptly. If a
delinquency is not cured, the Bank normally, subject to any required prior notice to the borrower, commences foreclosure proceedings. If the loan is not reinstated within the time permitted for reinstatement, or the property is not redeemed prior to
sale, the property may be sold at a foreclosure sale. In foreclosure sales, the Bank may acquire title to the property through foreclosure, in which case the property so acquired is offered for sale and may be financed by a loan involving terms more
favorable than those normally offered. Any property acquired as a result of foreclosure or by deed in lieu of foreclosure is classified as real estate owned until such time as it is sold or otherwise disposed of by the Bank to recover its
investment. As of December 31, 2003, the Bank recorded $1,556,978.62 in real estate acquired in settlement of loans.



The Banks general policy is to place a loan on non-accrual status when the loan becomes 90 days delinquent as it establishes reserves for
uncollected interest. Such interest when ultimately collected is credited to income in the period received. Interest on loans considered to be impaired is treated similarly. Loans delinquent more than 90 days amounted to $1,920,751 and $1,404,753 on
December 31, 2003 and 2002, respectively. See Note 3 to Notes to Consolidated Financial Statements in Item 7 of this Annual Report.



The following table sets forth information with respect to non-performing assets identified by the Bank, including non-accrual loans, real estate owned
and non-performing investments in real estate at the dates indicated. There are no troubled debt restructurings in the years presented.



|                                                   |  |                        |         |   |      |   |         |      |  |   |         |  
|-------------------------------------------------- |  | ---------------------- | ------- | - | ---- | - | ------- | ---- |  | - | ------- | -
|                                                   |  | At December 31,        |        
|                                                   |  | 2003                   |         |   | 2002 |   |         | 2001 | 
|                                                   |  | (Dollars in Thousands) |        
|Total non-accrual loans delinquent 90 days or more |  | $                      | 1,921   |   |      | $ | 1,405   |      |  | $ | 2,394   |  
|Real estate owned                                  |  |                        | 1,085   |   |      |   | 419     |      |  |   | 17      |  
|Total non-performing assets                        |  | $                      | 3,006   |   |      | $ | 1,824   |      |  | $ | 2,411   |  
|                                                   |  |                        |         |   |      |   |         |      |  |   |         |  
|Non-performing loans to total loans                |  |                        | 1.96    | % |      |   | 0.89    | %    |  |   | 1.66    | %
|Non-performing assets to total assets              |  |                        | 1.49    | % |      |   | 0.95    | %    |  |   | 1.47    | %
|Total assets                                       |  | $                      | 201,516 |   |      | $ | 191,059 |      |  | $ | 163,890 |  
|Total loans                                        |  | $                      | 153,131 |   |      | $ | 158,242 |      |  | $ | 144,169 |  



Allowance for Loan
Losses. In originating loans, the Bank recognizes that credit losses will be experienced and that the risk of loss will vary with, among other things, general economic conditions, the types of loans being made, the creditworthiness of borrowers
over the terms of the loans and, in the case of secured loans, the quality of the security for the loans. Managements policy is to maintain an adequate allowance for loan losses based on, among other things, the Banks historical loan
loss experience, evaluation of economic conditions and regular reviews of delinquencies and loan portfolio quality. Specific allowances are provided for individual loans when management believes the uncollectibility of the loan balance is confirmed.
The Banks level of allowances for loan losses at December 31, 2003, 2002 and 2001 was $1,357,877, $1,276,685 and $574 respectively.



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Management continues to monitor the Banks asset quality, to charge off loans against the allowance
for loan losses when appropriate and to provide specific loss reserves when necessary. Although management believes it uses the best information available to make determinations regarding the allowance for loan losses, future adjustments may be
necessary if circumstances change. In addition, regulatory examiners may require the Bank to recognize changes to the allowance for loan losses based on their judgments about information available to them at the time of their examination.



The following table describes the activity related to the
Banks allowance for possible loan losses for the periods indicated.



|                             |  |                         |       |   |      |   |       |      |  |   |      |   |  |      |     |   |  |   |     |  
|---------------------------- |  | ----------------------- | ----- | - | ---- | - | ----- | ---- |  | - | ---- | - |  | ---- | --- | - |  | - | --- | -
|                             |  | Year Ended December 31, |      
|                             |  | 2003                    |       |   | 2002 |   |       | 2001 |  |   | 2000 |   |  | 1999 |    
|                             |  | (In Thousands)          |      
|Balance, beginning of period |  | $                       | 1,276 |   |      | $ | 575   |      |  | $ | 489  |   |  | $    | 392 |   |  | $ | 359 |  
|Provision for loan losses    |  |                         | 352   |   |      |   | 1,014 |      |  |   | 224  |   |  |      | 113 |   |  |   | 36  |  
|Charge-offs                  |  |                         | (270  | ) |      |   | (313  | )    |  |   | (138 | ) |  |      | (10 | ) |  |   | (3  | )
|                             |  |                         |       |   |      |   |       |      |  |   |      |   |  |      |     |   |  |   |     |  
|Balance, end of period       |  | $                       | 1,358 |   |      |   | 1,276 |      |  | $ | 575  |   |  | $    | 489 |   |  | $ | 392 |  
|                             |  |                         |       |   |      |   |       |      |  |   |      |   |  |      |     |   |  |   |     |  



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The following table sets forth the composition of the allowance for possible loan losses by type of loan
at the dates indicated.



|                                              |  |                    |       |                                     |        |   |                    |      |                                     |  |        |                    |  |                                     |     |  |                    |   |                                     |   |     |                    |        |                                     |  |   |     |  |        |  
|--------------------------------------------- |  | ------------------ | ----- | ----------------------------------- | ------ | - | ------------------ | ---- | ----------------------------------- |  | ------ | ------------------ |  | ----------------------------------- | --- |  | ------------------ | - | ----------------------------------- | - | --- | ------------------ | ------ | ----------------------------------- |  | - | --- |  | ------ | -
|                                              |  | At December 31,    |      
|                                              |  | 2003               |       |                                     | 2002   |   |                    | 2001 |                                     |  | 2000   |                    |  | 1999                                |    
|                                              |  | Amount ofAllowance |       | Amount ofAllowanceto TotalAllowance |        |   | Amount ofAllowance |      | Amount ofAllowanceto TotalAllowance |  |        | Amount ofAllowance |  | Amount ofAllowanceto TotalAllowance |     |  | Amount ofAllowance |   | Amount ofAllowanceto TotalAllowance |   |     | Amount ofAllowance |        | Amount ofAllowanceto TotalAllowance | 
|Mortgage loans:                               |  |                    |       |                                     |        |   |                    |      |                                     |  |        |                    |  |                                     |     |  |                    |   |                                     |   |     |                    |        |                                     |  |   |     |  |        |  
|Residential 1-4 family                        |  | $                  | 570   |                                     | 41.98  | % |                    | $    | 363                                 |  | 28.47  | %                  |  | $                                   | 337 |  | 58.66              | % |                                     | $ | 261 |                    | 53.37  | %                                   |  | $ | 218 |  | 55.61  | %
|Residential multi-family                      |  |                    | 14    |                                     | 1.00   | % |                    |      | 297                                 |  | 23.29  | %                  |  |                                     | 20  |  | 3.45               | % |                                     |   | 11  |                    | 2.25   | %                                   |  |   | 10  |  | 2.55   | %
|Nonresidential real estate and other property |  |                    | 378   |                                     | 27.81  | % |                    |      | 243                                 |  | 19.04  | %                  |  |                                     | 62  |  | 10.74              | % |                                     |   | 56  |                    | 11.45  | %                                   |  |   | 43  |  | 10.97  | %
|Home equity and property improvement          |  |                    | 122   |                                     | 9.02   | % |                    |      | 120                                 |  | 9.40   | %                  |  |                                     | 54  |  | 9.47               | % |                                     |   | 65  |                    | 13.29  | %                                   |  |   | 52  |  | 13.27  | %
|Construction                                  |  |                    | 251   |                                     | 18.48  | % |                    |      | 215                                 |  | 16.85  | %                  |  |                                     | 61  |  | 10.52              | % |                                     |   | 49  |                    | 10.03  | %                                   |  |   | 45  |  | 11.48  | %
|                                              |  |                    |       |                                     |        |   |                    |      |                                     |  |        |                    |  |                                     |     |  |                    |   |                                     |   |     |                    |        |                                     |  |   |     |  |        |  
|Total real estate loans                       |  | $                  | 1,335 |                                     | 98.29  | % |                    | $    | 1,238                               |  | 97.05  | %                  |  | $                                   | 54  |  | 92.84              | % |                                     | $ | 442 |                    | 90.39  | %                                   |  | $ | 368 |  | 93.88  | %
|Other loans                                   |  |                    | 23    |                                     | 1.71   | % |                    |      | 38                                  |  | 2.95   | %                  |  |                                     | 41  |  | 7.16               | % |                                     |   | 47  |                    | 9.61   | %                                   |  |   | 24  |  | 6.12   | %
|                                              |  |                    |       |                                     |        |   |                    |      |                                     |  |        |                    |  |                                     |     |  |                    |   |                                     |   |     |                    |        |                                     |  |   |     |  |        |  
|Total allowance for loan losses               |  | $                  | 1,358 |                                     | 100.00 | % |                    | $    | 1,276                               |  | 100.00 | %                  |  | $                                   | 575 |  | 100.00             | % |                                     | $ | 489 |                    | 100.00 | %                                   |  | $ | 392 |  | 100.00 | %
|                                              |  |                    |       |                                     |        |   |                    |      |                                     |  |        |                    |  |                                     |     |  |                    |   |                                     |   |     |                    |        |                                     |  |   |     |  |        |  



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Investment Securities



Interest and dividend income from investment securities, including mortgage-backed securities, generally provides the Banks second largest source of
income after interest on loans. At December 31, 2003, the Banks investment portfolio totaled approximately $35 million and consisted of federal agency securities, mortgage-backed securities and stock of the Federal Home Loan Bank of Atlanta.



As a member of the Federal Home Loan Bank of Atlanta, the Bank
is required to maintain an investment in stock of the Federal Home Loan Bank of Atlanta equal to the greater of 1.0% of the Banks outstanding home loans or 5.0% of its outstanding advances from the Federal Home Loan Bank of Atlanta. No ready
market exists for such stock, which is carried at cost. As of December 31, 2003, the Banks investment in stock of the Federal Home Loan Bank of Atlanta was $2,005,000.



North Carolina regulations require the Bank to maintain a minimum amount of liquid assets. The computation of liquidity
allows the inclusion of mortgage-backed securities and other instruments that are readily marketable, including investments with maturities in excess of five years.



See Note 2 of Notes to Consolidated Financial Statements in Item 7 of this Annual Report.



Deposits and Borrowings



Deposits. Deposits are the primary source of the Banks funds for lending and other investment purposes. In
addition to deposits, the Bank derives funds from loan principal repayments, interest payments, investment income and principal repayments, interest from its own interest-earning deposits, advances from the Federal Home Loan Bank of Atlanta and
otherwise from its operations. Loan repayments are a relatively stable source of funds while deposit inflows and outflows may be significantly influenced by general interest rates and money market conditions. On December 31, 2003, 2002 and 2001, the
Banks deposits totaled $142,251, 138,027 and $128,825, respectively.



The Bank attracts both short-term and long-term deposits from the general public by offering a variety of accounts and rates. The Bank offers savings accounts, negotiable order of withdrawal (NOW)
accounts, money market demand accounts, non-interest-bearing accounts, and fixed interest rate certificates with varying maturities. At December 31, 2003, 75% of the Banks deposits consisted of certificate accounts, 4% consisted of regular
savings accounts, 7% consisted of NOW accounts, 8% consisted of money market accounts and 6% consisted of non-interest-bearing transaction accounts. Of the certificates of deposit described above, $36 million, or 25% had denominations of $100,000 or
greater. Deposit flows are greatly influenced by economic conditions, the general level of interest rates, competition, and other factors, including the restructuring of the thrift industry. The Banks savings deposits traditionally have been
obtained primarily from its primary market area. The Bank utilizes traditional marketing methods to attract new customers and savings deposits, including print, television and radio media advertising and direct mailings. The Bank does not advertise
for deposits outside of its local market area or utilize the services of deposit brokers.



See Note 5 to the Notes to Consolidated Financial Statements in Item 7 of this Annual Report.



Borrowings. Borrowings may be used on a short-term basis to compensate for reductions in the availability of funds from other sources. They may
also be used on a longer term basis for general business purposes. The Banks principal source of long-term borrowings is advances from the Federal Home Loan Bank of Atlanta. The Federal Home Loan Bank system functions in a reserve credit
capacity for savings institutions. As a member, the Bank is required to own capital stock in the Federal Home Loan Bank of Atlanta and is authorized to apply for advances from the Federal Home Loan Bank of Atlanta on the security of that stock and a
floating lien on certain of its real estate secured loans and other assets. Each credit program has its own interest rate and range of maturities. Depending on the program, limitations on the amount of advances are based either on a fixed percentage
of an institutions net worth or on the Federal Home Loan Bank of Atlantas assessment of the institutions creditworthiness. The Bank had $40.1 million outstanding borrowings at December 31, 2003.



Subsidiaries



The Company has no subsidiaries other than the Bank. The Bank has no subsidiaries.



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Market Area



The Banks primary market area consists of Johnston, Wilson, Wayne and Wake counties in North Carolina. This area includes a portion of the Raleigh,
North Carolina metropolitan area and areas south and west of Raleigh.



Employment in the Banks primary market area is diversified among manufacturing, agricultural, retail and wholesale trade, government, services and utilities. The economy in the primary market area is affected by the growth, processing
and sale of tobacco products. Legislative, regulatory and other actions which negatively impact the demand for tobacco products could negatively impact the Banks performance.



Competition



The Bank faces strong competition both in attracting deposits and making real estate and other loans. Its most direct competition for deposits has
historically come from other savings institutions, credit unions and commercial banks located in its primary market area, including large financial institutions that have greater financial and marketing resources available to them. The Bank has also
faced additional significant competition for investors funds from short-term money market securities and other corporate and government securities. The ability of the Bank to attract and retain savings deposits depends on its ability to
provide a rate of return, liquidity and risk comparable to that offered by competing investment opportunities. Based upon comparative data as of June 30, 2003, the Bank had approximately 82% of the deposits in Johnston County, North Carolina,
approximately 2.00% of the deposits in Wilson County, North Carolina, approximately 1.96% of the deposits in Wayne County, North Carolina, and less than .33% of the deposits in Wake County, North Carolina.



The Bank experiences strong competition for real estate loans from other
savings institutions, commercial banks, and mortgage banking companies. The Bank competes for loans primarily through the interest rates and loan fees it charges and the efficiency and quality of services it provides borrowers. Competition may
increase as a result of the reduction of restrictions on the interstate operations of financial institutions.



Supervision and Regulation



Bank holding companies and state savings banks are extensively regulated under both federal and state law. The following is a brief summary of certain statutes and rules and regulations that affect or will affect the Company and the Bank.
This summary is qualified in its entirety by reference to the particular statute and regulatory provisions referred to below and is not intended to be an exhaustive description of the statutes or regulations applicable to the business of the Company
and the Bank. Supervision, regulation and examination of the Company and the Bank by the regulatory agencies are intended primarily for the protection of depositors rather than shareholders of the Company.



Supervision and Regulation of the Company



General.The Company was organized for the purpose of acquiring and
holding all of the capital stock of the Bank to be issued in the conversion. As a savings bank holding company subject to the Bank Holding Company Act of 1956, as amended, the Company is subject to certain regulations of the Federal Reserve. Under
the Bank Holding Company Act, a bank holding company such as the Company, which does not qualify as a financial holding company, is prohibited from engaging in activities other than banking, managing or controlling banks or other permissible
subsidiaries, furnishing services to or performing services for its subsidiaries or engaging in any other activity which the Federal Reserve determines to be so closely related to banking or managing or controlling banks as to be a proper incident
thereto. The Bank Holding Company Act also prohibits the Company from acquiring direct or indirect control of more than 5% of the outstanding voting stock or substantially all of the assets of any bank or savings bank or merging or consolidating
with another bank holding company or savings bank holding company without prior approval of the Federal Reserve.



Additionally, the Bank Holding Company Act prohibits the Company from engaging in, or acquiring ownership or control of, more than 5% of the outstanding
voting stock of any company engaged in a non-banking business unless such business is determined by the Federal Reserve to be so closely related to banking as to be properly incident thereto. The Bank Holding Company Act does not place territorial
restrictions on the activities of such non-banking related activities.



Similarly, Federal Reserve approval (or, in certain cases, non-objection) must be obtained prior to any person acquiring control of the Company. Control is conclusively presumed to exist if, among other things, a person owns, controls, or
has the power to vote 25% or more of any class of voting stock of the holding company or controls in any



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manner the election of a majority of the directors of the holding company. Control is presumed to exist if a person owns, controls, or has the power to vote
more than 10% of any class of voting stock and the stock is registered under Section 12 of the Securities Exchange Act of 1934 or the acquiror will be the largest shareholder after the acquisition.



There are a number of obligations and restrictions imposed on bank holding
companies and their depository institution subsidiaries by law and regulatory policy that are designed to minimize potential loss to the depositors of such depository institutions and FDIC insurance funds in the event the depository institution
becomes in danger of default or is in default. For example, to avoid receivership of an insured depository institution subsidiary, a bank holding company is required to guarantee the compliance of any insured depository institution subsidiary that
has become undercapitalized with the terms of any capital restoration plan filed by such subsidiary with its appropriate federal banking agency up to the lesser of (i) an amount equal to 5% of the institutions total assets at the
time the institution became undercapitalized, or (ii) the amount which is necessary to bring the institution into compliance with all acceptable capital standards as of the time the institution initially fails to comply with such capital restoration
plan. Under a policy of the Federal Reserve with respect to bank holding company operations, a bank holding company is required to serve as a source of financial strength to its subsidiary depository institutions and to commit resources to support
such institutions in circumstances where it might not do so absent such policy. The Federal Reserve under the Bank Holding Company Act also has the authority to require a bank holding company to terminate any activity or to relinquish control of a
non-bank subsidiary (other than a non-bank subsidiary of a bank) upon the Federal Reserves determination that such activity or control constitutes a serious risk to the financial soundness and stability of any bank subsidiary of the bank
holding company.



In addition, the cross-guarantee
provisions of the Federal Deposit Insurance Act, as amended, require insured depository institutions under common control to reimburse the FDIC for any loss suffered as a result of the default of a commonly controlled insured depository institution
or for any assistance provided by the FDIC to a commonly controlled insured depository institution in danger of default. The FDIC may decline to enforce the cross-guarantee provisions if it determines that a waiver is in the best interest of the
deposit insurance funds. The FDICs claim for damages is superior to claims of stockholders of the insured depository institution or any affiliate but is subordinate to claims of depositors, secured creditors and holders of subordinated debt
(other than affiliates) of the commonly controlled insured depository institutions.



As a result of the Companys ownership of the Bank, the Company is registered under the savings bank holding company laws of North Carolina. Accordingly, the Company is also subject to regulation and supervision
by the North Carolina Commissioner of Banks (the Commissioner).



Gramm-Leach-Bliley Act.The federal Gramm-Leach-Bliley Act enacted in 1999 (the GLB Act) dramatically changed various federal laws governing the banking, securities and insurance industries. The GLB
Act has expanded opportunities for banks and bank holding companies to provide services and engage in other revenue-generating activities that previously were prohibited to them. However, this expanded authority also may present us with new
challenges as our larger competitors are able to expand their services and products into areas that are not feasible for smaller, community oriented financial institutions. The GLB Act likely will have a significant economic impact on the banking
industry and on competitive conditions in the financial services industry generally.



USA Patriot Act of 200.The USA Patriot Act of 2001 was enacted in response to the terrorist attacks that occurred in New York, Pennsylvania and Washington, D.C. on September 11, 2001. The Act is intended to
strengthen the ability of U.S. law enforcement and the intelligence community to work cohesively to combat terrorism on a variety of fronts. The potential impact of the Act on financial institutions of all kinds is significant and wide ranging. The
Act contains sweeping anti-money laundering and financial transparency laws and requires various regulations, including standards for verifying customer identification at account opening, and rules to promote cooperation among financial
institutions, regulators, and law enforcement entities in identifying parties that may be involved in terrorism or money laundering.



Sarbanes-Oxley Act of 2002.On July 30, 2002, the Sarbanes-Oxley Act of 2002 was signed into law and became some of the most sweeping federal
legislation addressing accounting, corporate governance and disclosure issues. The impact of the Sarbanes-Oxley Act is wide-ranging as it applies to all public companies and imposes significant new requirements for public company governance and
disclosure requirements. Some of the provisions of the Sarbanes-Oxley Act became effective immediately while others will be implemented over the coming months.



In general, the Sarbanes-Oxley Act mandates important new corporate governance and financial reporting requirements intended to enhance the accuracy
and transparency of public companies reported financial results. It establishes new responsibilities for corporate chief executive officers, chief financial officers and audit committees in the financial reporting process and creates a new
regulatory body to oversee auditors of public companies. It backs



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these requirements with new SEC enforcement tools, increases criminal penalties for federal mail, wire and securities fraud, and creates new criminal
penalties for document and record destruction in connection with federal investigations. It also increases the opportunity for more private litigation by lengthening the statute of limitations for securities fraud claims and providing new federal
corporate whistleblower protection.



The economic and
operational effects of this new legislation on public companies, including us, will be significant in terms of the time, resources and costs associated with complying with the new law. Because the Sarbanes-Oxley Act, for the most part, applies
equally to larger and smaller public companies, we will be presented with additional challenges as a smaller, community-oriented financial institution seeking to compete with larger financial institutions in our market.



Capital Adequacy Guidelines for Holding Companies. The Federal Reserve
has adopted capital adequacy guidelines for bank holding companies and banks that are members of the Federal Reserve system and have consolidated assets of $150 million or more. For bank holding companies with less than $150 million in consolidated
assets, the guidelines are applied on a bank-only basis unless the parent bank holding company (i) is engaged in nonbank activity involving significant leverage or (ii) has a significant amount of outstanding debt that is held by the general public.



Bank holding companies subject to the Federal Reserves
capital adequacy guidelines are required to comply with the Federal Reserves risk-based capital guidelines. Under these regulations, the minimum ratio of total capital to risk-weighted assets (including certain off-balance sheet activities,
such as standby letters of credit) is 8%. At least half of the total capital is required to be Tier I capital, principally consisting of common stockholders equity, non-cumulative perpetual preferred stock, and a limited amount of
cumulative perpetual preferred stock, less certain goodwill items. The remainder (Tier II capital) may consist of a limited amount of subordinated debt, certain hybrid capital instruments and other debt securities, perpetual preferred
stock, and a limited amount of the general loan loss allowance. In addition to the risk-based capital guidelines, the Federal Reserve has adopted a minimum Tier I capital (leverage) ratio, under which a bank holding company must maintain a minimum
level of Tier I capital to average total consolidated assets of at least 3% in the case of a bank holding company which has the highest regulatory examination rating and is not contemplating significant growth or expansion. All other bank holding
companies are expected to maintain a Tier I capital (leverage) ratio of at least 1% to 2% above the stated minimum.



Dividend and Repurchase Limitations. The Company must obtain Federal Reserve approval in order to use more than 10% of its net worth to make stock
repurchases during any 12 month period unless the Company (i) both before and after the redemption satisfies capital requirements for well capitalized state member banks; (ii) received a one or two rating in its last examination; and
(iii) is not the subject of any unresolved supervisory issues. Although the payment of dividends and repurchase of stock by the Company are subject to the requirements and limitations of North Carolina corporate law, except as set forth in this
paragraph, neither the Commissioner nor the FDIC has promulgated any regulations specifically limiting the right of the Company to pay dividends and repurchase shares. The ability of the Company to pay dividends or repurchase shares may be dependent
upon the Companys receipt of dividends from the Bank. The Banks ability to pay dividends is limited.



Capital Maintenance Agreement. In order to acquire control of the Bank, the Company was required to execute a capital maintenance agreement whereby
it has agreed to maintain the Banks capital in an amount sufficient to enable the Bank to satisfy all regulatory capital requirements.



Federal Securities Laws. The Company has registered its common stock with the Securities Exchange Commission pursuant to Section 12(g) of the
Securities Exchange Act of 1934. As a result of such registration, the proxy and tender offer rules, insider trading reporting requirements, annual and periodic reporting and other requirements of the Securities Exchange Act of 1934, as amended, are
applicable to the Company.



Supervision and Regulation of
the Bank



The following is a summary of certain
statutes and regulations applicable to the Bank but is not intended to be exhaustive and is qualified in its entirety by reference to all particular statutory or regulatory provisions. The business of state savings banks is subject to extensive
regulation and supervision under both federal and state law.



General. The Bank is an insured North Carolina-chartered savings bank that is a member of the Federal Home Loan Bank system. Its deposits are insured through the Savings Association Insurance Fund of the FDIC, and it is subject to
supervision and examination by and the regulations and reporting requirements of the FDIC and the Commissioner, which are its primary federal and state banking regulators respectively.



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As an insured institution, the Bank is prohibited from engaging as principal in any activity, or
acquiring or retaining any equity investment of a type or in an amount, that is not permitted for national banks unless (i) the FDIC determines that the activity or investment would pose no significant risk to the Savings Association Insurance Fund,
and (ii) the Bank is, and continues to be, in compliance with all applicable capital standards. A savings bank generally is prohibited from investing more than 15% of its total assets in business, commercial, corporate and agricultural loans and
from directly or indirectly acquiring or retaining any corporate debt security that is not of investment grade (generally referred to as junk bonds).



Subject to limitation by the Commissioner, North Carolina-chartered savings banks may make any loan or investment or engage
in any activity that is permitted to federally-chartered institutions. However, a North Carolina-chartered savings bank cannot invest more than 15% of its total assets in business, commercial, corporate and agricultural loans. In addition to such
lending authority, North Carolina-chartered savings banks are authorized to invest funds, in excess of loan demand, in certain statutorily permitted investments, including but not limited to (i) obligations of the United States, or those guaranteed
by it; (ii) obligations of the State of North Carolina; (iii) bank demand or time deposits; (iv) stock or obligations of the federal deposit insurance fund or a Federal Home Loan Bank; (v) savings accounts of any savings institution as approved by
the board of directors; and (vi) stock or obligations of any agency of the State of North Carolina or of the United States or of any corporation doing business in North Carolina whose principal business is to make education loans.



In addition, the Bank is subject to various regulations promulgated by the
Federal Reserve including, without limitation, Regulation B (Equal Credit Opportunity), Regulation D (Reserves), Regulation E (Electronic Fund Transfers), Regulation O (Loans to Executive Officers, Directors and Principal Shareholders), Regulation Z
(Truth in Lending), Regulation CC (Availability of Funds) and Regulation DD (Truth in Savings).



The FDIC and the Commissioner have broad powers to enforce laws and regulations applicable to the Bank. Among others, these powers include the ability to
assess civil money penalties, to issue cease and desist or removal orders, and to initiate injunctive actions. In general, these enforcement actions may be initiated in response to violations of laws and regulations and the conduct of unsafe and
unsound practices.



Transactions with Affiliates. Under
current federal law, transactions between the Bank and any affiliate are governed by Sections 23A and 23B of the Federal Reserve Act. An affiliate of the Bank is any company or entity that controls, is controlled by or is under common control with
the savings bank. The Company and the Bank are affiliates of each other. Generally, Sections 23A and 23B (i) limit the extent to which the Bank or its subsidiaries may engage in covered transactions with any one affiliate to an amount
equal to 10% of such the Banks capital stock and surplus, and contain an aggregate limit on all such transactions with all affiliates to an amount equal to 20% of such capital stock and surplus and (ii) require that all such transactions be on
terms substantially the same, or at least as favorable, to the Bank or the subsidiary as those provided to a nonaffiliate. The term covered transaction includes the making of loans or other extensions of credit to an affiliate, the
purchase of assets from an affiliate, the purchase of, or an investment in, the securities of an affiliate, the acceptance of securities of an affiliate as collateral for a loan or extension of credit to any person, or issuance of a guarantee,
acceptance or letter of credit on behalf of an affiliate.



Further, current federal law has extended to savings banks the restrictions contained in Section 22(h) of the Federal Reserve Act with respect to loans to directors, executive officers and principal stockholders. Under Section 22(h), loans
to directors, executive officers and stockholders who, directly or indirectly, own more than 10% of any class of voting securities of a savings bank, and certain affiliated entities of any of the foregoing, may not exceed, together with all other
outstanding loans to such person and affiliated entities, the savings banks loans-to-one borrower limit as established by federal law (as discussed below). Section 22(h) also prohibits loans above amounts prescribed by the appropriate federal
banking agency to directors, executive officers or stockholders who own more than 10% of a savings bank, and their respective affiliates, unless such loan is approved in advance by a majority of the disinterested directors of the board of directors
of the savings bank and the Company. Any interested director may not participate in the voting. The Federal Reserve has prescribed the loan amount (which includes all other outstanding loans to such person), as to which such prior board
of director approval is required, as being the greater of $25,000 or 5% of unimpaired capital and unimpaired surplus (up to $500,000). Further, pursuant to Section 22(h) the Federal Reserve requires that loans to directors, executive officers, and
principal stockholders be made on terms substantially the same as offered in comparable transactions to other persons and not involve more than the normal risk of repayment or present other unfavorable features. Section 22(h) also imposes additional
limits on amounts a savings bank can loan to an executive officer or director.



FDIC Insurance Assessments. The Bank is also subject to insurance assessments imposed by the FDIC. The FDIC currently uses a risk-based assessment system that takes into account the risks attributable to
different



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categories and concentrations of assets and liabilities for purposes of calculating deposit insurance assessments payable by insured depository institutions.
The risk-based assessment system categorizes institutions as well capitalized, adequately capitalized or undercapitalized. These three categories are substantially similar to the prompt corrective action
categories (see Prompt Corrective Action, below), with the undercapitalized category including institutions that are undercapitalized, significantly undercapitalized and critically
undercapitalized for prompt corrective action purposes. Institutions also are assigned by the FDIC to one of three supervisory subgroups within each capital group. The particular supervisory subgroup to which an institution is assigned is
based on a supervisory evaluation provided to the FDIC by the institutions primary federal banking regulator and information which the FDIC determines to be relevant to the institutions financial condition and the risk posed to the
deposit insurance fund. An institutions insurance assessment rate then is determined based on the capital category and supervisory subgroup to which it is assigned. Under the risk-based assessment system, there are nine assessment risk
classifications (i.e., combinations of capital groups and supervisory subgroups) to which different assessment rates (ranging from zero to 31 basis points) are applied. In addition, the Bank pays premiums assessed against all banks based on their
deposit levels to service debt on bonds issued to recapitalize the deposit insurance funds.



An institutions deposit insurance may be terminated by the FDIC upon a finding that the institution has engaged in unsafe and unsound practices, is in an unsafe or unsound condition, or has violated any
applicable law, regulation, rule, order, or condition imposed by the FDIC.



Community Reinvestment Act. Under the Community Reinvestment Act as implemented by regulations of the FDIC, an insured institution has a continuing and affirmative obligation consistent with its safe and sound
operation to help meet the credit needs of its entire community, including low and moderate income neighborhoods. The Community Reinvestment Act does not establish specific lending requirements or programs for financial institutions, nor does it
limit an institutions discretion to develop, consistent with the Community Reinvestment Act, the types of products and services that it believes are best suited to its particular community. The Community Reinvestment Act requires the federal
banking regulators, in connection with their examinations of insured institutions, to assess the institutions records of meeting the credit needs of their communities, using the ratings of outstanding, satisfactory,
needs to improve, or substantial noncompliance, and to take that record into account in its evaluation of certain applications by those institutions. All institutions are required to make public disclosure of their Community
Reinvestment Act performance ratings. The Bank received a Satisfactory rating in its last Community Reinvestment Act examination.



Net Worth and Capital Adequacy Requirements Applicable to the Bank. The Bank is required to comply with the capital adequacy standards established
by state and federal laws and regulations. The Commissioner requires that savings banks maintain net worth not less than 5% of its total assets. Intangible assets must be deducted from net worth and assets when computing compliance with this
requirement. The Bank complied with the net worth requirements as of December 31, 2003.



In addition, the FDIC has promulgated risk-based capital and leverage capital guidelines for determining the adequacy of a banks capital, and all applicable capital standards must be satisfied for the Bank to be
considered in compliance with the FDICs requirements. Under the FDICs risk-based capital measure, the minimum ratio (Total Risk-Based Capital Ratio) of a banks total capital to its risk-weighted assets (including
certain off-balance-sheet items, such as standby letters of credit) is 8.0%. At least half of total capital must be composed of common equity, undivided profits, minority interests in the equity accounts of consolidated subsidiaries, qualifying
non-cumulative perpetual preferred stock, and a limited amount of cumulative perpetual preferred stock, less goodwill and certain other intangible assets (Tier 1 Capital). The remainder may consist of certain subordinated debt, certain
hybrid capital instruments and other qualifying preferred stock, a limited amount of loan loss reserves, and net unrealized holding gains on equity securities (Tier 2 Capital). At December 31, 2003, the Banks Total Risk-Based
Capital Ratio and its ratio of Tier 1 Capital to risk-weighted assets (Tier 1 Risk-Based Capital Ratio) were 14.21% and 13.22%, respectively, which were well above the FDICs minimum risk-based capital guidelines.



Under the FDICs leverage capital measure, the minimum ratio (the
Leverage Capital Ratio) of Tier 1 Capital to total assets is 3.0% for banks that meet certain specified criteria, including having the highest regulatory rating. All other banks generally are required to maintain an additional cushion of
100 to 200 basis points above the stated minimum. The FDICs guidelines also provide that banks experiencing internal growth or making acquisitions will be expected to maintain strong capital positions substantially above the minimum levels
without significant reliance on intangible assets, and the FDIC has indicated that it will consider a banks Tangible Leverage Ratio (deducting all intangible assets) and other indicia of capital strength in evaluating proposals for
expansion or new activities. At December 31, 2003, the Banks Leverage Capital Ratio was 9.10%, which was above the FDICs minimum leverage capital guidelines.



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Failure to meet the FDICs capital guidelines could subject a bank to a variety of enforcement
remedies, including issuance of a capital directive, the termination of deposit insurance by the FDIC, a prohibition on the taking of brokered deposits, and certain other restrictions on its business. As described below, substantial additional
restrictions can be imposed upon FDIC-insured depository institutions that fail to meet applicable capital requirements. See Prompt Corrective Action, below. The FDIC also considers interest rate risk (arising when the interest rate
sensitivity of an institutions assets does not match the sensitivity of its liabilities or its off-balance-sheet position) in the evaluation of a banks capital adequacy. Banks with excessive interest rate risk exposure may be required to
maintain higher levels of capital to protect them against that exposure.



Loans-To-One-Borrower. The Bank is subject to the Commissioners loans-to-one-borrower limits. Under these limits, no loans and extensions of credit to any borrower outstanding at one time and not fully
secured by readily marketable collateral shall exceed 15% of the net worth of the savings bank. Loans and extensions of credit fully secured by readily marketable collateral may comprise an additional 10% of net worth. These limits also authorize
savings banks to make loans-to-one-borrower, for any purpose, in an amount not to exceed $500,000. A savings bank also is authorized to make loans-to-one-borrower to develop domestic residential housing units, not to exceed the lesser of $30 million
or 30% of the savings banks net worth, provided that the purchase price of each single-family dwelling in the development does not exceed $500,000 and the aggregate amount of loans made pursuant to this authority does not exceed 150% of the
savings banks net worth. These limits also authorize a savings bank to make loans-to-one-borrower to finance the sale of real property acquired in satisfaction of debts in an amount up to 50% of the savings banks net worth.



As of December 31, 2003, the largest aggregate amount of loans that the
Bank had to any one borrower was $2 million. The Bank does not believe that the loans-to-one-borrower limits will have a significant impact on its business, operations and earnings.



Limits on Rates Paid on Deposits and Brokered Deposits. Regulations promulgated by the FDIC place limitations on the
ability of insured depository institutions to accept, renew or roll-over deposits by offering rates of interest which are significantly higher than the prevailing rates of interest on deposits offered by other insured depository institutions in the
depository institutions normal market area. Under these regulations, well capitalized depository institutions may accept, renew or roll-over such deposits without restriction, adequately capitalized depository
institutions may accept, renew or roll-over such deposits with a waiver from the FDIC (subject to certain restrictions on payments of rates) and undercapitalized depository institutions may not accept, renew, or roll-over such deposits.
The regulations contemplate that the definitions of well capitalized, adequately capitalized and undercapitalized will be the same as the definitions adopted by the FDIC to implement the corrective action
provisions discussed below. See Prompt Corrective Action. As of December 31, 2003, the Bank was considered well capitalized, and, thus, was not subject to the limitations on rates payable on its deposits.



Federal Home Loan Bank System. The Federal Home Loan Bank system
provides a central credit facility for member institutions. As a member of the Federal Home Loan Bank of Atlanta, the Bank is required to own capital stock in the Federal Home Loan Bank of Atlanta in an amount at least equal to the greater of 1% of
the aggregate principal amount of its unpaid residential mortgage loans, home purchase contracts and similar obligations at the end of each calendar year, or 5% of its outstanding advances (borrowings) from the Federal Home Loan Bank of Atlanta. On
December 31, 2003, the Bank was in compliance with this requirement, with an investment in Federal Home Loan Bank of Atlanta of $2,005,000.



Reserve Requirements. Pursuant to regulations of the Federal Reserve Board, all FDIC-insured depository institutions must maintain average daily
reserves against their transaction accounts equal to specified percentages of the balances of such accounts. These percentages are subject to adjustment by the Federal Reserve Board. Because the Banks reserves are required to be maintained in
the form of vault cash or in a non-interest-bearing account at a Federal Reserve Bank, one effect of the reserve requirement is to reduce the amount of the Banks interest-earning assets. At December 31, 2003, the Bank met FDIC reserve
requirements.



Restrictions on Acquisitions. Federal law
generally provides that no person, acting directly or indirectly or through or in concert with one or more other persons, may acquire control, as that term is defined in FDIC regulations, of a state savings bank without
giving at least 60 days written notice to the FDIC and providing the FDIC an opportunity to disapprove the proposed acquisition. Pursuant to regulations governing acquisitions of control, control of an insured institution is conclusively deemed to
have been acquired by, among other things, the acquisition of more than 25% of any class of voting stock. In addition, control is presumed to have been acquired, subject to rebuttal, upon the acquisition of more than 10% of any class of voting
stock. Such acquisitions of control may be disapproved if it is determined, among other things, that (i) the acquisition would substantially lessen competition; (ii) the financial condition of the acquiring person might jeopardize the financial
stability of the savings bank or prejudice



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the interests of its depositors; or (iii) the competency, experience or integrity of the acquiring person or the proposed management personnel indicates that
it would not be in the interest of the depositors or the public to permit the acquisitions of control by such person.



Liquidity. The Bank is subject to the liquidity requirements established by the Commissioner. North Carolina law requires savings banks to maintain
cash and readily marketable investments of not less that 10% of the savings banks total assets. The computation of liquidity under North Carolina regulation allows the inclusion of mortgage-backed securities and investments that, in the
judgment of the Commissioner, have a readily marketable value, including investments with maturities in excess of five years. On December 31, 2003, the Banks liquidity ratio, calculated in accordance with North Carolina regulations, was
approximately 23.6%.



Prompt Corrective Action. Current
federal law establishes a system of prompt corrective action to resolve the problems of undercapitalized institutions. Under this system, the FDIC has established five capital categories (well capitalized, adequately
capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized). The FDIC is required to take certain mandatory supervisory actions and is authorized to take other
discretionary actions with respect to institutions in the three undercapitalized categories. The severity of any action taken will depend upon the capital category in which an institution is placed. Generally, subject to a narrow exception, current
federal law requires the FDIC to appoint a receiver or conservator for an institution that is critically undercapitalized.



Under the FDICs rules implementing the prompt corrective action provisions, an insured, state-chartered savings bank that (i) has a Total Risk-Based
Capital Ratio of 10.0% or greater, a Tier 1 Risk-Based Capital Ratio of 6.0% or greater, and a Leverage Capital Ratio of 5.0% or greater, and (ii) is not subject to any written agreement, order, capital directive, or prompt corrective action
directive issued by the FDIC, is deemed to be well capitalized. A savings bank with a Total Risk-Based Capital Ratio of 8.0% or greater, a Tier 1 Risk-Based Capital Ratio of 4.0% or greater, and a Leverage Capital Ratio of 4.0% or
greater, is considered to be adequately capitalized. A savings bank that has a Total Risk-Based Capital Ratio of less than 8.0%, a Tier 1 Risk-Based Capital Ratio of less than 4.0%, or a Leverage Capital Ratio of less than 4.0%, is
considered to be undercapitalized. A bank that has a Total Risk-Based Capital Ratio of less than 6.0%, a Tier 1 Risk-Based Capital Ratio of less than 3.0%, or a Leverage Capital Ratio of less than 3.0%, is considered to be
significantly undercapitalized, and a savings bank that has a ratio of tangible equity capital to assets equal to or less than 2.0% is deemed to be critically undercapitalized. For purposes of these rules, the term
tangible equity includes core capital elements counted as Tier 1 Capital for purposes of the risk-based capital standards (see  Net Worth and Capital Adequacy Requirements of the Bank), plus the amount of outstanding
cumulative perpetual preferred stock (including related surplus), minus all intangible assets (with certain exceptions). A savings bank may be deemed to be in a capitalization category lower than indicated by its actual capital position if it
receives an unsatisfactory examination rating.



A savings bank
that is categorized as undercapitalized, significantly undercapitalized, or critically undercapitalized, is required to submit an acceptable capital restoration plan to the FDIC. An undercapitalized
savings bank also is generally prohibited from increasing its average total assets, making acquisitions, establishing any branches, or engaging in any new line of business, except in accordance with an accepted capital restoration plan or with the
approval of the FDIC. In addition, the FDIC is given authority with respect to any undercapitalized savings bank to take any of the actions it is required to or may take with respect to a significantly undercapitalized
savings bank if it determines that those actions are necessary to carry out the purpose of the law.



At December 31, 2003, the Bank had the requisite capital levels to qualify as well capitalized.



Interstate Banking. The Bank Holding Company Act, as amended by the
interstate banking provisions of the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994, permits adequately capitalized and managed bank holding companies to acquire control of the assets of banks in any state. Acquisitions are
subject to antitrust provisions that cap at 10% the portion of the total deposits of insured depository institutions in the United States that a single bank holding company may control and generally cap at 30% the portion of the total deposits of
insured depository institutions in a state that a single bank holding company may control. Under certain circumstances, states have the authority to increase or decrease the 30% cap, and states may set minimum age requirements of up to five years on
target banks within their borders.



16



---

Subject to certain conditions and the states right to opt out of certain provisions, the interstate
banking laws also permit interstate branching by allowing a bank in one state to merge with a bank located in a different state. Each state was allowed to accelerate the effective date for interstate mergers by adopting a law authorizing merger
transactions prior to June 1, 1997, or it could opt out and thereby prohibit interstate branching by enacting legislation to that effect prior to that date. The interstate banking laws also permit banks to establish branches in other
states by opening new branches or acquiring existing branches of other banks, provided the laws of those other states specifically permit that form of interstate branching. North Carolina has adopted statutes that, under certain conditions,
authorize out-of-state bank holding companies and banks to acquire or merge with North Carolina banks and to establish or acquire branches in North Carolina.



Restrictions on Dividends and Other Capital Distributions. A North Carolina-chartered stock savings bank may not declare or pay a cash dividend on,
or repurchase any of, its capital stock if the effect of such transaction would be to reduce the net worth of the institution to an amount which is less than the minimum amount required by applicable federal and state regulations.



In addition, the Bank is not permitted to declare or pay a cash dividend or
repurchase any of its capital stock if the effect thereof would be to cause its net worth to be reduced below the amount required for the liquidation account established in connection with the Banks mutual to stock conversion.



Other Federal and North Carolina Regulations. The federal banking
agencies, including the FDIC, have developed joint regulations requiring disclosure of contingent assets and liabilities and, to the extent feasible and practicable, supplemental disclosure of the estimated fair market value of assets and
liabilities. Additional joint regulations require annual examinations of all insured depository institutions by the appropriate federal banking agency, with some exceptions for small, well-capitalized institutions and state-chartered institutions
examined by state regulators, and establish operational and managerial, asset quality, earnings and stock valuation standards for insured depository institutions, as well as compensation standards when such compensation would endanger the insured
depository institution or would constitute an unsafe practice.



The grounds for appointment of a conservator or receiver for a North Carolina savings bank on the basis of an institutions financial condition include: (i) insolvency, in that the assets of the savings bank are less than its
liabilities to depositors and others; (ii) substantial dissipation of assets or earnings through violations of law or unsafe or unsound practices; (iii) existence of an unsafe or unsound condition to transact business; (iv) likelihood that the
savings bank will be unable to meet the demands of its depositors or to pay its obligations in the normal course of business; and (v) insufficient capital or the incurring or likely incurring of losses that will deplete substantially all of the
institutions capital with no reasonable prospect of replenishment of capital without federal assistance.



North Carolina law provides a procedure by which savings institutions may consolidate or merge, subject to approval of the Commissioner. The approval is
conditioned upon findings by the Commissioner that, among other things, such merger or consolidation will promote the best interests of the members or stockholders of the merging institutions.



Future Requirements. Statutes and regulations that contain
wide-ranging proposals for altering the structures, regulations, and competitive relationships of financial institutions are introduced regularly. Neither the Company nor the Bank can predict whether or in what form any proposed statute or
regulation will be adopted or the extent to which the business of the Company and the Bank may be affected by such statute or regulation.



17



---

|ITEM 2. | PROPERTIES
|------- | ----------



At December 31, 2003, the Company conducted its business from the Banks new headquarters office in Smithfield, North Carolina. The Bank also has
branch offices in Kenly, Selma, Goldsboro, Wilson, Clayton and Garner, North Carolina. The following table sets forth certain information regarding the Companys properties as of December 31, 2003. See Note 4 of the Notes to Consolidated
Financial Statements in Item 7 of this Annual Report. In the opinion of management, all properties are in good condition and are adequate for their purpose.



|                                                                                                        |  |                           |           |                |       
|------------------------------------------------------------------------------------------------------- |  | ------------------------- | --------- | -------------- | ------
|Address                                                                                                 |  | Net BookValue of Property |           | Ownedor Leased
|                                                                                                        |  |                          
|Smithfield Corporate Offices and Branch: 1031 North Brightleaf Blvd. Smithfield, North Carolina 27577 * |  | $                         | 2,349,559 |                | Owned 
|                                                                                                        |  |                          
|Kenly Operation offices: 207 West Second Street Kenly, North Carolina 27542                             |  | $                         | 991,464   |                | Owned 
|                                                                                                        |  |                          
|Branch facility: 200 North Church Street Kenly, North Carolina 27542                                    |  | $                         | 487,339   |                | Owned 
|                                                                                                        |  |                          
|Selma 115 West Anderson Street Selma, North Carolina 27576                                              |  | $                         | 92,798    |                | Owned 
|                                                                                                        |  |                          
|Wilson 206 N. Ward Boulevard Wilson, North Carolina 27893                                               |  | $                         | 411,602   |                | Owned 
|                                                                                                        |  |                          
|Clayton 11591 Highway 70 West Clayton, North Carolina 27250                                             |  | $                         | 754,686   |                | Owned 
|                                                                                                        |  |                          
|Goldsboro 1112 E. Ash Street Goldsboro, North Carolina 27530                                            |  | $                         | 678,220   |                | Owned 
|                                                                                                        |  |                          
|Garner 920 7th Avenue Garner, North Carolina 27529                                                      |  | $                         | 0         |                | Leased



|* | This corporate office and branch office previously had separate mailing addresses but now have a single mailing address.
|- | ------------------------------------------------------------------------------------------------------------------------



The total net book value of the Companys furniture and equipment on
December 31, 2003 was $856,951.



|ITEM 3. | LEGAL PROCEEDINGS
|------- | -----------------



In the opinion of management, neither the Company nor the Bank is involved in any pending legal proceedings other than routine, non-material proceedings
occurring in the ordinary course of business.



|ITEM 4. | SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
|------- | ---------------------------------------------------



No matter was submitted to a vote of the Companys stockholders during the quarter ended December 31, 2003.



PART II



|ITEM 5. | MARKET FOR REGISTRANTS COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
|------- | ---------------------------------------------------------------------



Market Information/Holders/Dividends. The table below reflects the stock trading and dividend payment frequency of the Company for
the two-year period ended December 31, 2003. Stock prices reflect bid prices between broker-dealers, prior to any mark-ups, mark-downs or commissions, and may not necessarily represent actual transactions.



18



---

|               |  |           |      |             |   |       |  |   |      
|-------------- |  | --------- | ---- | ----------- | - | ----- |  | - | -----
|               |  | Dividends |      | Stock Price
|               |  | Regular   |      | High        |   | Low  
|2003:          |  |           |      |             |   |       |  |   |      
|First Quarter  |  | $         | 0.16 |             | $ | 17.55 |  | $ | 16.50
|Second Quarter |  |           | 0.16 |             |   | 18.00 |  |   | 17.25
|Third Quarter  |  |           | 0.16 |             |   | 18.00 |  |   | 17.40
|Fourth Quarter |  |           | 0.16 |             |   | 25.00 |  |   | 18.00
|               |  |           |     
|2002:          |  |           |      |             |   |       |  |   |      
|First Quarter  |  | $         | 0.16 |             | $ | 18.28 |  | $ | 15.00
|Second Quarter |  |           | 0.16 |             |   | 18.00 |  |   | 16.00
|Third Quarter  |  |           | 0.16 |             |   | 18.00 |  |   | 16.00
|Fourth Quarter |  |           | 0.16 |             |   | 16.38 |  |   | 16.00



The principal market
for the Companys common stock is the OTC Bulletin Board. There are approximately 335 holders of record of the Companys common stock. As of December 31, 2003, the Company has no compensation plans authorized to issue equity securities and
no outstanding options, warrants or rights. See the section entitled BusinessSupervision and Regulation of the Bank Restrictions on Dividends and Other Capital Distributions in Item 1 of this Annual Report for regulatory
restrictions that limit the ability of the Bank to pay dividends to the Company. The Company has not made any sales of securities without registering the securities under the Securities Act within the last three (3) years, and had no stock
repurchases during fiscal years 2002 or 2003.



19



---

|ITEM 6. | MANAGEMENTS DISCUSSION AND ANALYSIS OR PLAN OF OPERATION
|------- | ---------------------------------------------------------



KS BANCORP INC AND SUBSIDIARY



SELECTED FINANCIAL DATA



|                                     |  |                                          |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|------------------------------------ |  | ---------------------------------------- | ------- | - | ---- | - | ------- | ---- |  | - | ------- | - |  | ---- | ------- | - |  | - | ------- | -
|                                     |  | December 31,                             |        
|                                     |  | 2003                                     |         |   | 2002 |   |         | 2001 |  |   | 2000    |   |  | 1999 |        
|                                     |  | (In Thousands, Except Per Share Amounts) |        
|Financial Condition Data:            |  |                                          |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Total assets                         |  | $                                        | 201,516 |   |      | $ | 191,059 |      |  | $ | 163,890 |   |  | $    | 152,321 |   |  | $ | 138,948 |  
|Investments(1)                       |  |                                          | 38,883  |   |      |   | 31,847  |      |  |   | 20,738  |   |  |      | 14,120  |   |  |   | 17,142  |  
|Loans receivable, net                |  |                                          | 151,773 |   |      |   | 150,839 |      |  |   | 136,383 |   |  |      | 133,312 |   |  |   | 116,363 |  
|Deposits                             |  |                                          | 142,251 |   |      |   | 138,027 |      |  |   | 128,825 |   |  |      | 120,073 |   |  |   | 116,514 |  
|Advances from Federal Home Loan Bank |  |                                          | 40,100  |   |      |   | 34,800  |      |  |   | 16,800  |   |  |      | 15,800  |   |  |   | 6,000   |  
|Stockholders equity                 |  |                                          | 18,577  |   |      |   | 17,511  |      |  |   | 16,799  |   |  |      | 15,843  |   |  |   | 15,442  |  
|Book value per common share(2)       |  |                                          | 15.52   |   |      |   | 15.19   |      |  |   | 14.75   |   |  |      | 13.99   |   |  |   | 13.40   |  
|                                     |  |                                          |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|                                     |  | December 31,                             |        
|                                     |  | 2003                                     |         |   | 2002 |   |         | 2001 |  |   | 2000    |   |  | 1999 |        
|                                     |  | (In Thousands, Except Per Share Amounts) |        
|Operating Data:                      |  |                                          |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Interest income                      |  | $                                        | 11,509  |   |      | $ | 12,204  |      |  | $ | 12,648  |   |  | $    | 12,029  |   |  | $ | 10,626  |  
|Interest expense                     |  |                                          | 4,329   |   |      |   | 5,196   |      |  |   | 7,062   |   |  |      | 6,740   |   |  |   | 5,793   |  
|                                     |  |                                          |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Net interest income                  |  |                                          | 7,180   |   |      |   | 7,008   |      |  |   | 5,586   |   |  |      | 5,289   |   |  |   | 4,833   |  
|Provision for loan losses            |  |                                          | 352     |   |      |   | 1,015   |      |  |   | 224     |   |  |      | 113     |   |  |   | 36      |  
|Noninterest income                   |  |                                          | 1,155   |   |      |   | 867     |      |  |   | 1,066   |   |  |      | 1,705   |   |  |   | 310     |  
|Noninterest expense                  |  |                                          | 5,810   |   |      |   | 4,735   |      |  |   | 4,194   |   |  |      | 3,641   |   |  |   | 3,187   |  
|                                     |  |                                          |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Income before income taxes           |  |                                          | 2,173   |   |      |   | 2,125   |      |  |   | 2,234   |   |  |      | 3,240   |   |  |   | 1,920   |  
|Income tax expense                   |  |                                          | 772     |   |      |   | 789     |      |  |   | 860     |   |  |      | 1,247   |   |  |   | 757     |  
|                                     |  |                                          |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Net income                           |  | $                                        | 1,401   |   |      | $ | 1,336   |      |  | $ | 1,374   |   |  | $    | 1,993   |   |  | $ | 1,163   |  
|                                     |  |                                          |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Selected Other Data:                 |  |                                          |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Basic earnings per share(2)          |  | $                                        | 1.21    |   |      | $ | 1.18    |      |  | $ | 1.23    |   |  | $    | 1.78    |   |  | $ | 1.07    |  
|Diluted earnings per share(2)        |  | $                                        | 1.19    |   |      | $ | 1.15    |      |  | $ | 1.20    |   |  | $    | 1.74    |   |  | $ | .98     |  
|Dividends per common share(2)        |  | $                                        | .64     |   |      | $ | .64     |      |  | $ | .64     |   |  | $    | .64     |   |  | $ | .64     |  
|Dividend payout ratio                |  |                                          | 54      | % |      |   | 56      | %    |  |   | 53      | % |  |      | 37      | % |  |   | 65      | %
|Return on average assets             |  |                                          | .72     | % |      |   | .75     | %    |  |   | .85     | % |  |      | 1.35    | % |  |   | .86     | %
|Return on average equity             |  |                                          | 7.74    | % |      |   | 7.75    | %    |  |   | 8.34    | % |  |      | 12.81   | % |  |   | 7.47    | %
|Average equity to average assets     |  |                                          | 9.36    | % |      |   | 9.73    | %    |  |   | 10.18   | % |  |      | 10.51   | % |  |   | 11.46   | %



|(1) | Includes interest-earning deposits, time deposits,
investment securities, and Federal Home Loan Bank stock.
|--- | -----------------------------------------------------------------------------------------------------------



|(2) | Restated for 25% stock split occurring during 2001.
|--- | ---------------------------------------------------



20



---

General



KS Bancorp, Inc. (KS Bancorp or the Company) is a savings bank holding company which owns all of the common stock of KS Bank, Inc.
(the Bank), a North Carolina-chartered capital stock savings bank. KS Bancorps principal business activity consists of the ownership of the Bank. The principal business of the Bank is accepting deposits from the general public and
using those deposits and other sources of funds to make loans in the Banks primary market area of Johnston, Wilson, Wayne and Wake counties.



The Banks results of operations depend primarily on its net interest income, which is the difference between interest income from interest-earning
assets and interest expense on interest-bearing liabilities. The Banks operations are also affected by noninterest income, such as fees from presold mortgages, customer deposit account service charges, and other sources of revenue. The
Banks principal operating expenses, aside from interest expense, consist of compensation and employee benefits, federal deposit insurance premiums, office occupancy costs, data processing expenses, and other general and administrative
expenses.



The following discussion and analysis is intended to
assist readers in understanding the results of operations and changes in financial position for the years ended December 31, 2003 and 2002, respectively. The discussion contains certain forward-looking statements consisting of estimates with respect
to the financial condition, results of operations and other business of the Company that are subject to various factors which could cause actual results to differ materially from those estimates. Factors which could influence the estimates include
changes in the national, regional and local market conditions, legislative and regulatory conditions, and interest rates.



Capital Resources and Liquidity



KS Bancorp currently conducts no business other than holding the capital stock of the Bank. KS Bancorps primary source of funds, other than income
from its investments, is dividends from the Bank, which are subject to regulatory restrictions as discussed in Note 12 to the consolidated financial statements in Item 7 of this Annual Report. During 2003 and 2002, the Bank paid dividends of
$600,000 and $500,000, respectively, to KS Bancorp. KS Bancorp declared and paid cash dividends of $742,313 and $731,925 during 2003 and 2002, respectively. Although the Company anticipates that it will continue to declare cash dividends on a
regular basis, the Board of Directors will continue to review its policy on the payment of dividends on an ongoing basis, and such payment will be subject to future earnings, cash flows, capital needs, and regulatory restrictions.



The Company has not repurchased any of its common stock during either 2003 or
2002. Since the mutual to stock conversion, the Company has repurchased 187,501 shares for a total cost of approximately $3.3 million.



The objective of the Banks liquidity management is to ensure the availability of sufficient cash flows to meet all financial commitments and to
capitalize on opportunities for expansion. Liquidity management addresses the Banks ability to meet deposit withdrawals either on demand or at contractual maturity, to repay borrowings as they mature and to make new loans and investments as
opportunities arise.



A significant liquidity source for the
Bank is cash provided by operating activities. These operating activities generated cash of $3.6 million and $406,000 for the years ended December 31, 2003 and 2002, respectively. Historically, in addition to cash provided by operating activities,
financing activities have provided the Bank with sources of funds for asset growth and liquidity. For the years ended December 31, 2003 and 2002, deposits grew by $4.3 million and $9.2 million, respectively. As of December 31, 2003 and 2002, the
Bank had $40.1 million and $34.8 million, respectively, in outstanding borrowings from the Federal Home Loan Bank (FHLB). During 2003 and 2002, the Bank used the cash provided by the aforementioned sources primarily to fund increasing
loan demand, the acquisition of capital assets as well as purchases of investment securities. During 2003 and 2002, loans outstanding increased by $1.0 million and $15.2 million, respectively. Liquid assets, consisting of cash and due from banks,
time deposits, and investment securities, increased by $6.9 million, or 22.3%, from $31.0 million at December 31, 2002 to $37.9 million at December 31, 2003. In the future, liquidity may be supplemented by loan sales and securitization programs,
which the Bank may use to facilitate the timely liquidation of assets if and when it is deemed desirable.



21



---

Asset/Liability Management



The Banks asset/liability management, or interest rate risk management, program is focused primarily on evaluating and
managing the composition of its assets and liabilities in view of various interest rate scenarios. Factors beyond the Banks control, such as market interest rates and competition, may also have an impact on the Banks interest income and
interest expense.



In the absence of other factors, the yield
or return associated with the Banks earning assets generally will increase from existing levels when interest rates rise over an extended period of time and, conversely, interest income will decrease when interest rates decline. In general,
interest expense will increase when interest rates rise over an extended period of time and, conversely, interest expense will decrease when interest rates decline.



Interest Rate Gap Analysis



As a part of its interest rate risk management policy, the Bank calculates an interest rate gap. Interest rate gap analysis is a
common, though imperfect, measure of interest rate risk, which measures the relative dollar amounts of interest-earning assets and interest-bearing liabilities which reprice within a specific time period, either through maturity or rate adjustment.
The gap is the difference between the amounts of such assets and liabilities that are subject to repricing. A negative gap for a given period means that the amount of interest-bearing liabilities maturing or otherwise
repricing within that period exceeds the amount of interest-earning assets maturing or otherwise repricing within the same period. Accordingly, in a declining interest rate environment, an institution with a negative gap would generally be expected,
absent the effects of other factors, to experience a decrease in the cost of its liabilities greater than the decrease in the yield on its assets and its income should be positively affected. Conversely, the cost of funds for an institution with a
negative gap would generally be expected to increase more quickly than the yield on its assets in a rising interest rate environment, and such institutions net interest income generally would be expected to be adversely affected by rising
interest rates. Changes in interest rates generally have the opposite effect on an institution with a positive gap.



22



---

The following table sets forth the amounts of interest-earning assets and interest-bearing liabilities
outstanding at December 31, 2003 which are projected to reprice or mature in each of the future time periods shown. Except as stated below, the amounts of assets and liabilities shown which reprice or mature within a particular period were
determined in accordance with the contractual terms of the assets or liabilities. Loans with adjustable rates are shown as being due at the end of the next upcoming adjustment period. Money market deposit accounts and negotiable order of withdrawal
or other transaction accounts are assumed to be subject to immediate repricing and depositor availability and have been placed in the shortest period. In making the gap computations, none of the assumptions sometimes made regarding prepayment rates
and deposit decay rates have been used for any interest-earning assets or interest-bearing liabilities. In addition, the table does not reflect scheduled principal payments which will be received throughout the lives of the loans. The interest rate
sensitivity of the Banks assets and liabilities illustrated in the following table would vary substantially if different assumptions were used or if actual experience differs from that indicated by such assumptions.



|                                                                                   |  |                                         |         |    |                            |   |        |                  |  |   |        |   |  |   |         |  
|---------------------------------------------------------------------------------- |  | --------------------------------------- | ------- | -- | -------------------------- | - | ------ | ---------------- |  | - | ------ | - |  | - | ------- | -
|                                                                                   |  | Terms to Repricing at December 31, 2003 |        
|                                                                                   |  | 1 Year orLess                           |         |    | More Than1 Year to 5 Years |   |        | More Than5 Years |  |   | Total  |  
|                                                                                   |  | (Dollars in thousands)                  |        
|INTEREST-EARNING ASSETS:                                                           |  |                                         |         |    |                            |   |        |                  |  |   |        |   |  |   |         |  
|Loans:                                                                             |  |                                         |         |    |                            |   |        |                  |  |   |        |   |  |   |         |  
|Fixed rates                                                                        |  | $                                       | 3,988   |    |                            | $ | 19,359 |                  |  | $ | 11,265 |   |  | $ | 34,612  |  
|Variable rates                                                                     |  |                                         | 58,819  |    |                            |   | 59,667 |                  |  |   | 33     |   |  |   | 118,519 |  
|Interest-earning deposits with banks                                               |  |                                         | 4,033   |    |                            |   |       |                  |  |   |       |   |  |   | 4,033   |  
|Time deposits                                                                      |  |                                         |        |    |                            |   | 100    |                  |  |   |       |   |  |   | 100     |  
|Investment securities                                                              |  |                                         |        |    |                            |   | 14,395 |                  |  |   | 18,350 |   |  |   | 32,745  |  
|Federal Home Loan Bank stock                                                       |  |                                         |        |    |                            |   |       |                  |  |   | 2,005  |   |  |   | 2,005   |  
|                                                                                   |  |                                         |         |    |                            |   |        |                  |  |   |        |   |  |   |         |  
|Total interest-earning assets                                                      |  | $                                       | 66,840  |    |                            | $ | 93,521 |                  |  | $ | 31,653 |   |  | $ | 192,014 |  
|                                                                                   |  |                                         |         |    |                            |   |        |                  |  |   |        |   |  |   |         |  
|INTEREST-BEARING LIABILITIES:                                                      |  |                                         |         |    |                            |   |        |                  |  |   |        |   |  |   |         |  
|Deposits                                                                           |  | $                                       | 109,343 |    |                            | $ | 21,708 |                  |  | $ | 11,200 |   |  | $ | 142,251 |  
|Advances from Federal Home Loan Bank                                               |  |                                         | 6,200   |    |                            |   | 17,100 |                  |  |   | 16,800 |   |  |   | 40,100  |  
|                                                                                   |  |                                         |         |    |                            |   |        |                  |  |   |        |   |  |   |         |  
|Total interest-bearing liabilities                                                 |  | $                                       | 115,543 |    |                            | $ | 38,808 |                  |  | $ | 28,000 |   |  | $ | 182,351 |  
|                                                                                   |  |                                         |         |    |                            |   |        |                  |  |   |        |   |  |   |         |  
|INTEREST SENSITIVITY GAP PER PERIOD                                                |  | $                                       | (48,703 | )  |                            | $ | 54,713 |                  |  | $ | 3,653  |   |  | $ | 9,663   |  
|CUMULATIVE INTEREST SENSITIVITY GAP                                                |  | $                                       | (48,703 | )  |                            | $ | 6,010  |                  |  | $ | 9,663  |   |  | $ | 9,663   |  
|CUMULATIVE GAP AS A PERCENTAGE OF TOTAL INTEREST-EARNING ASSETS                    |  |                                         | (25.36  | )% |                            |   | 3.13   | %                |  |   | 5.03   | % |  |   | 5.03    | %
|CUMULATIVE INTEREST-EARNING ASSETS AS A PERCENTAGE OF INTEREST-BEARING LIABILITIES |  |                                         | 57.85   | %  |                            |   | 103.89 | %                |  |   | 105.30 | % |  |   | 105.30  | %



23



---

Analysis of Net Interest Income



Net interest income represents the difference between income derived from interest-earning assets and interest expense
incurred on interest-bearing liabilities. Net interest income is affected by the difference between yields on interest-earning assets and rates paid on interest-bearing liabilities (interest rate spread) and the relative amounts of
interest-earning assets and interest-bearing liabilities outstanding during the period. The following table reflects the average yields on assets and average costs of liabilities for the years ended December 31, 2003, 2002, and 2001. Such average
yields and costs are derived by dividing income or expense by the average monthly balance of interest-earning assets or interest-bearing liabilities, respectively, for the periods presented.



|                                                                         |  |                                  |         |   |          |   |              |      |      |                 |  |   |          |   |              |   |        |                 |      |   |          |   |              |   |  |   |        |  |      |  
|------------------------------------------------------------------------ |  | -------------------------------- | ------- | - | -------- | - | ------------ | ---- | ---- | --------------- |  | - | -------- | - | ------------ | - | ------ | --------------- | ---- | - | -------- | - | ------------ | - |  | - | ------ |  | ---- | -
|                                                                         |  | For the Years Ended December 31, |        
|                                                                         |  | 2003                             |         |   | 2002     |   |              | 2001 |     
|                                                                         |  | Average Balance                  |         |   | Interest |   | Average Rate |      |      | Average Balance |  |   | Interest |   | Average Rate |   |        | Average Balance |      |   | Interest |   | Average Rate |  
|                                                                         |  | (Dollars in thousands)           |        
|Interest-earning assets:                                                 |  |                                  |         |   |          |   |              |      |      |                 |  |   |          |   |              |   |        |                 |      |   |          |   |              |   |  |   |        |  |      |  
|Loans(1)                                                                 |  | $                                | 151,893 |   |          | $ | 10,478       |      | 6.90 | %               |  | $ | 148,475  |   |              | $ | 11,237 |                 | 7.57 | % |          | $ | 138,691      |   |  | $ | 11,739 |  | 8.46 | %
|Investment securities(2)                                                 |  |                                  | 27,526  |   |          |   | 986          |      | 3.58 | %               |  |   | 17,410   |   |              |   | 911    |                 | 5.23 | % |          |   | 13,186       |   |  |   | 798    |  | 6.05 | %
|Interest-earning deposits(3)                                             |  |                                  | 5,474   |   |          |   | 45           |      | 0.82 | %               |  |   | 4,863    |   |              |   | 56     |                 | 1.15 | % |          |   | 4,133        |   |  |   | 111    |  | 2.69 | %
|                                                                         |  |                                  |         |   |          |   |              |      |      |                 |  |   |          |   |              |   |        |                 |      |   |          |   |              |   |  |   |        |  |      |  
|Total interest-earning assets                                            |  |                                  | 184,893 |   |          |   | 11,509       |      | 6.23 | %               |  |   | 170,748  |   |              |   | 12,204 |                 | 7.15 | % |          |   | 156,010      |   |  |   | 12,648 |  | 8.11 | %
|                                                                         |  |                                  |         |   |          |   |              |      |      |                 |  |   |          |   |              |   |        |                 |      |   |          |   |              |   |  |   |        |  |      |  
|Other assets                                                             |  |                                  | 8,412   |   |          |   |              |      |      |                 |  |   | 6,394    |   |              |   |        |                 |      |   |          |   | 5,732        |   |  |   |        |  |      |  
|                                                                         |  |                                  |         |   |          |   |              |      |      |                 |  |   |          |   |              |   |        |                 |      |   |          |   |              |   |  |   |        |  |      |  
|Total assets                                                             |  | $                                | 193,305 |   |          |   |              |      |      |                 |  | $ | 177,142  |   |              |   |        |                 |      |   |          | $ | 161,742      |   |  |   |        |  |      |  
|                                                                         |  |                                  |         |   |          |   |              |      |      |                 |  |   |          |   |              |   |        |                 |      |   |          |   |              |   |  |   |        |  |      |  
|Interest-bearing liabilities:                                            |  |                                  |         |   |          |   |              |      |      |                 |  |   |          |   |              |   |        |                 |      |   |          |   |              |   |  |   |        |  |      |  
|Money market and NOW deposits                                            |  | $                                | 19,190  |   |          |   | 144          |      | 0.75 | %               |  | $ | 20,059   |   |              |   | 219    |                 | 1.09 | % |          | $ | 16,535       |   |  |   | 344    |  | 2.08 | %
|Savings                                                                  |  |                                  | 5,893   |   |          |   | 39           |      | 0.66 | %               |  |   | 5,481    |   |              |   | 79     |                 | 1.44 | % |          |   | 4,228        |   |  |   | 67     |  | 1.58 | %
|Time                                                                     |  |                                  | 106,441 |   |          |   | 2,967        |      | 2.79 | %               |  |   | 103,090  |   |              |   | 3,765  |                 | 3.65 | % |          |   | 100,820      |   |  |   | 5,663  |  | 5.62 | %
|FHLB advances                                                            |  |                                  | 34,531  |   |          |   | 1,179        |      | 3.41 | %               |  |   | 25,310   |   |              |   | 1,134  |                 | 4.48 | % |          |   | 17,473       |   |  |   | 988    |  | 5.65 | %
|                                                                         |  |                                  |         |   |          |   |              |      |      |                 |  |   |          |   |              |   |        |                 |      |   |          |   |              |   |  |   |        |  |      |  
|Total interest bearing liabilities                                       |  |                                  | 166,055 |   |          |   | 4,329        |      | 2.61 | %               |  |   | 153,940  |   |              |   | 5,197  |                 | 3.38 | % |          |   | 139,056      |   |  |   | 7,062  |  | 5.08 | %
|                                                                         |  |                                  |         |   |          |   |              |      |      |                 |  |   |          |   |              |   |        |                 |      |   |          |   |              |   |  |   |        |  |      |  
|Noninterest-bearing deposits                                             |  |                                  | 8,723   |   |          |   |              |      |      |                 |  |   | 5,147    |   |              |   |        |                 |      |   |          |   | 2,962        |   |  |   |        |  |      |  
|Other liabilities                                                        |  |                                  | 432     |   |          |   |              |      |      |                 |  |   | 821      |   |              |   |        |                 |      |   |          |   | 3,255        |   |  |   |        |  |      |  
|Stockholders equity                                                     |  |                                  | 18,095  |   |          |   |              |      |      |                 |  |   | 17,234   |   |              |   |        |                 |      |   |          |   | 16,469       |   |  |   |        |  |      |  
|                                                                         |  |                                  |         |   |          |   |              |      |      |                 |  |   |          |   |              |   |        |                 |      |   |          |   |              |   |  |   |        |  |      |  
|Total liabilities and stockholders equity                               |  | $                                | 193,305 |   |          |   |              |      |      |                 |  | $ | 177,142  |   |              |   |        |                 |      |   |          | $ | 161,742      |   |  |   |        |  |      |  
|                                                                         |  |                                  |         |   |          |   |              |      |      |                 |  |   |          |   |              |   |        |                 |      |   |          |   |              |   |  |   |        |  |      |  
|Net interest income and interest rate spread                             |  |                                  |         |   |          | $ | 7,180        |      | 3.62 | %               |  |   |          |   |              | $ | 7,007  |                 | 3.77 | % |          |   |              |   |  | $ | 5,586  |  | 3.03 | %
|                                                                         |  |                                  |         |   |          |   |              |      |      |                 |  |   |          |   |              |   |        |                 |      |   |          |   |              |   |  |   |        |  |      |  
|Net interest-earning assets and net interest margin                      |  | $                                | 18,838  |   |          |   |              |      | 3.88 | %               |  | $ | 16,808   |   |              |   |        |                 | 4.10 | % |          | $ | 16,954       |   |  |   |        |  | 3.58 | %
|                                                                         |  |                                  |         |   |          |   |              |      |      |                 |  |   |          |   |              |   |        |                 |      |   |          |   |              |   |  |   |        |  |      |  
|Ratio of average interest-earning assets to interest-bearing liabilities |  |                                  | 111.34  | % |          |   |              |      |      |                 |  |   | 110.92   | % |              |   |        |                 |      |   |          |   | 112.19       | % |  |   |        |  |      |  
|                                                                         |  |                                  |         |   |          |   |              |      |      |                 |  |   |          |   |              |   |        |                 |      |   |          |   |              |   |  |   |        |  |      |  



|(1) | Includes non-accruing loans, which are considered immaterial for average balance purposes
|--- | -----------------------------------------------------------------------------------------



|(2) | Includes investment securities and Federal Home Loan Bank stock
|--- | ---------------------------------------------------------------



|(3) | Includes time deposits
|--- | ----------------------



24



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Rate/Volume Analysis



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



|                              |  |                                      |     |   |                                       |   |        |       |  |   |        |   |      |   |       |       |   |        |   |  |   |        |  
|----------------------------- |  | ------------------------------------ | --- | - | ------------------------------------- | - | ------ | ----- |  | - | ------ | - | ---- | - | ----- | ----- | - | ------ | - |  | - | ------ | -
|                              |  | Year Ended December 31,2003 vs. 2002 |     |   | Year Ended December 31, 2002 vs. 2001 |  
|                              |  | Increase (Decrease) Due to           |     |   | Increase (Decrease) Due to            |  
|                              |  | Volume                               |     |   | Rate                                  |   |        | Total |  |   | Volume |   | Rate |   |       | Total |  
|                              |  | (Dollars in Thousands)               |    
|Interest income:              |  |                                      |     |   |                                       |   |        |       |  |   |        |   |      |   |       |       |   |        |   |  |   |        |  
|Loans                         |  | $                                    | 247 |   |                                       | $ | (1,006 | )     |  | $ | (759   | ) |      | $ | 784   |       | $ | (1,286 | ) |  | $ | (502   | )
|Investments                   |  |                                      | 446 |   |                                       |   | (371   | )     |  |   | 75     |   |      |   | 238   |       |   | (125   | ) |  |   | 113    |  
|Interest-earning deposits     |  |                                      | 6   |   |                                       |   | (17    | )     |  |   | (11    | ) |      |   | 14    |       |   | (69    | ) |  |   | (55    | )
|                              |  |                                      |     |   |                                       |   |        |       |  |   |        |   |      |   |       |       |   |        |   |  |   |        |  
|Total interest income         |  |                                      | 699 |   |                                       |   | (1,394 | )     |  |   | (695   | ) |      |   | 1,036 |       |   | (1,480 | ) |  |   | (444   | )
|                              |  |                                      |     |   |                                       |   |        |       |  |   |        |   |      |   |       |       |   |        |   |  |   |        |  
|Interest expense:             |  |                                      |     |   |                                       |   |        |       |  |   |        |   |      |   |       |       |   |        |   |  |   |        |  
|Money market and NOW deposits |  |                                      | (8  | ) |                                       |   | (67    | )     |  |   | (75    | ) |      |   | 56    |       |   | (181   | ) |  |   | (125   | )
|Savings                       |  |                                      | 4   |   |                                       |   | (44    | )     |  |   | (40    | ) |      |   | 19    |       |   | (7     | ) |  |   | 12     |  
|Time                          |  |                                      | 108 |   |                                       |   | (906   | )     |  |   | (798   | ) |      |   | 105   |       |   | (2,003 | ) |  |   | (1,898 | )
|FHLB advances                 |  |                                      | 364 |   |                                       |   | (319   | )     |  |   | 45     |   |      |   | 397   |       |   | (251   | ) |  |   | 146    |  
|                              |  |                                      |     |   |                                       |   |        |       |  |   |        |   |      |   |       |       |   |        |   |  |   |        |  
|Total interest expense        |  |                                      | 468 |   |                                       |   | (1,336 | )     |  |   | (868   | ) |      |   | 577   |       |   | (2,442 | ) |  |   | (1,865 | )
|                              |  |                                      |     |   |                                       |   |        |       |  |   |        |   |      |   |       |       |   |        |   |  |   |        |  
|Net interest income           |  | $                                    | 231 |   |                                       | $ | (58    | )     |  | $ | 173    |   |      | $ | 459   |       | $ | 962    |   |  | $ | 1,421  |  
|                              |  |                                      |     |   |                                       |   |        |       |  |   |        |   |      |   |       |       |   |        |   |  |   |        |  



Comparison of
Financial Condition at December 31, 2003 and 2002



Consolidated total assets increased by $10.5 million during the year ended December 31, 2003, from $191.0 million at December 31, 2002 to $201.5 million at December 31, 2003. During the year, the Company generated loan growth of $1.0
million, as loans increased to $153.1 million. In addition liquid assets (consisting of cash and cash equivalents and investment securities) increased by $6.9 million from $31.0 million at December 31, 2002 to $37.9 million at December 31, 2003.
Both the loan and liquid asset growth was funded by an increase in customer deposits of $4.2 million and an increase in advances from the Federal Home Loan Bank of $5.3 million. The increase in deposits resulted from an increase in our core
deposits, which grew from $31.6 million at December 31, 2002 to $35.3 million at December 31, 2003. These core deposits, which consist of savings, money market, NOW and noninterest-bearing accounts, represent a more stable and less expensive source
of funding than do certificates of deposit.



Total
stockholders equity was $18.6 million at December 31, 2003 as compared with $17.5 million at December 31, 2002, an increase of $1.1 million. The increase is primarily due to our net income during the year of $1.4 million plus the combined
proceeds and tax benefits from stock options exercised during the year of $441,000 less the cash dividends paid by the Company during the period of $742,000, or $.64 per share. At December 31, 2003, the capital for both the Company and the Bank
continued to exceed all applicable regulatory guidelines.



Comparison of Results of Operations for the Years Ended December 31, 2003 and 2002



Net Income



Net income
for the year ended December 31, 2003 was $1.4 million, or $1.21 per share, as compared with net income of $1.3 million, or $1.18 per share, for the year ended December 31, 2002, an increase of $66,000 or $0.04 per share. This overall improvement in
our earnings resulted primarily from a reduction in the provision for loan losses of $663,000 in 2003. The 2002 provision for loan losses reflected changes in the methodology used to calculate the allowance. In addition, an increase in non-interest
income contributed to the increase in our earnings in 2003. These matters are discussed in the applicable sections that follow.



25



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Net Interest Income



Like most financial institutions, the primary component of earnings for the Company is net interest income. Net interest income is the difference between
interest income, principally from loan and investment securities portfolios, and interest expense, principally on customer deposits and borrowings. Changes in net interest income result from changes in volume, spread and margin. For this purpose,
volume refers to the average dollar level of interest-earning assets and interest-bearing liabilities, spread refers to the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities, and
margin refers to net interest income divided by average interest-earning assets. Margin is influenced by the level and relative mix of interest-earning assets and interest-bearing liabilities, as well as by levels of noninterest-bearing liabilities
and capital.



Net interest income increased slightly during
2003 from $7.0 million during 2002 to $7.2 million during 2003, an increase of $173,000. This increase was attributable an increase in the level of our average net interest-earning assets during the year, the effects of which were offset somewhat by
a decrease in the net yield on our average interest-earning assets from 4.10% during 2002 to 3.88% during 2003. This decrease in our net yield resulted from the overall decrease in interest rates during the year, which impacted the rates we earn on
our assets more significantly than the rates we pay for our deposits and borrowings.



Provision for Loan Losses



Our allowance for
loan losses is established through charges to earnings in the form of a provision for loan losses. We increase our allowance for loan losses by provisions charged to operations and by recoveries of amounts previously charged off, and we reduce our
allowance by loans charged off. We evaluate the adequacy of the allowance at least quarterly. In evaluating the adequacy of the allowance, we consider the growth, composition and industry diversification of the portfolio, historical loan loss
experience, current delinquency levels, adverse situations that may affect a borrowers ability to repay estimated value of any underlying collateral, prevailing economic conditions and other relevant factors deriving from our history of
operations.



We follow a loan review program designed to
evaluate the credit risk in our loan portfolio. Through this loan review process, we maintain an internally classified watch list that helps management assess the overall quality of the loan portfolio and the adequacy of the allowance for loan
losses. In establishing the appropriate classification for specific assets, management considers, among other factors, the estimated value of the underlying collateral, the borrowers ability to repay, the borrowers payment history and
the current delinquent status. As a result of this process, certain loans are categorized as substandard, doubtful or loss and reserves are allocated based on managements judgment and historical experience. Testing by independent third parties
contracted with to perform reviews of our loans helps to validate this process.



The provision for loan losses was $352,000 and $1,015,000 for the years ended December 31, 2003 and 2002, respectively. The increased level in the provision for loan losses during 2002 resulted from changes in the
methodology used to calculate the allowance suggested by the Banks regulators. These changes primarily involved the criteria used to classify loans, and resulted in an increase in the number and amount of loans classified as substandard. This
revised methodology was utilized during 2003 to estimate the level of the allowance for loan losses. There were net loan charge-offs of $271,000 during the year ended December 31, 2003 as compared with net charge-offs of $313,000 during the year
ended December 31, 2002. At December 31, 2003, non-accrual loans aggregated $1.9 million versus $1.6 million at December 31, 2002, while the allowance for loan losses at the end of 2003 stood at $1.4 million or .89% of gross loans versus $1.3
million and .84% at the end of 2002. Although management attempts to maintain the allowance at a level deemed adequate, future additions to the allowance may be necessary based upon changes in market conditions. In addition, various regulatory
agencies periodically review our allowance for loan losses. These agencies may require us to make adjustments based upon their judgments about information available to them at the time of their examination. Management believes that the allowance is
adequate to absorb losses inherent in the loan portfolio. At December 31, 2003, management believes that the allowance for loan losses is sufficient to absorb losses inherent in the Banks loan portfolio.



Non-interest Income



Non-interest income for 2003 was $1.1 million compared to the $867,000 that was earned during 2002, an increase of $233,000.
Our non-interest income was higher in 2003 primarily because of increases in our fee income and a one time gain on the sale of the Banks consumer credit card line totaling $49,000.



26



---

Our major recurring components of non-interest income, service charges on deposit accounts, and fees from
presold mortgages both increased during 2003. Service charges on deposit accounts increased $103,000 from $552,000 in 2002 to $655,000. This increase resulted largely from an increase in the volume of our deposit accounts and the emphasis placed
upon generating fee income during the year. Fees from presold mortgages increased $46,000 from $274,000 in 2002 to $320,000 in 2003 due to a higher level of mortgage loan refinancings caused by the lower interest rate environment. Also, contributing
to the increase were gains on the sale of foreclosed assets totaling $65,280.



Non-interest Expenses



Non-interest expenses
increased to $5.8 million during the year ended December 31, 2003 as compared with $4.7 million for the year ended December 31, 2002, an increase of $1.1 million. The largest components of this increase were an increase in compensation and benefits
of $700,000, an increase in the level of expenses related to retaining and sustaining forclosed assets of $123,000, an increase in occupancy and equipment costs of $64,000, an increase in data processing costs of $59,000, and an increase in
advertising expense of $50,000. The increase in compensation and benefits resulted from the addition of employees for our new branch location, employee raises and bonuses, and increases in the cost of group health insurance. The increase in the
costs we incurred to retain and sustain foreclosed assets during the year resulted from the significant increase, $665,000, in the level of those assets during the year. Our occupancy and equipment costs rose primarily as result of the construction
of our new headquarters and branch in Smithfield. The primarly reason for the increase in advertising is the result of the Banks promotion of two new products, online banking, and bounce protection; as well as the promotion of the grand
opening of the banks new branch in Smithfield. The remainder of the increases in our non-interest expenses were attributable to the continued overall growth and development of business in its market areas.



Provision for Income Taxes



The provision for income taxes, as a percentage of income before income
taxes, was 35.5% and 37.1% for the years ended December 31, 2003 and 2002, respectively.



Critical Accounting Policies and Estimates



The Companys discussion and analysis of its financial condition and results of operations are based upon its consolidated financial statements, which have been prepared in accordance with accounting principles
generally accepted in the United States. The preparation of these financial statements requires the Company to make estimates and judgments regarding uncertainties that affect the reported amounts of assets, liabilities, revenues and expenses. On an
ongoing basis, the Company evaluates its estimates which are based upon historical experience and on other assumptions that are believed to be reasonable under the circumstances. Actual results may differ from these estimates under different
assumptions or conditions.



The Companys significant
accounting policies are described in Note 1 to the consolidated financial statements found in Item 7 of this Annual Report. The Company considers the following accounting policies to be most critical in their potential effect on its financial
position or results of operations:



Allowance for Loan Losses



The most critical estimate concerns the Companys
allowance for loan losses. The Company records provisions for loan losses based upon known problem loans and estimated deficiencies in the existing loan portfolio. The Companys methodology for assessing the appropriations of the allowance for
loan losses consists of two key components, which are a specific allowance for identified problem or impaired loans and a formula allowance for the remainder of the portfolio.



Identified problem and impaired loans are measured for impairment based on the present value of expected future cash flows
discounted at the loans effective interest rate, the loans observable market price or the fair value of the collateral, if the loan is collateral dependent. This evaluation is inherently subjective as it requires material estimates that
may be susceptible to significant change. The adequacy of the allowance is also reviewed by management based upon its evaluation of then-existing economic and business conditions affecting the key lending areas of the Company and other conditions,
such as new loan products, collateral values, loan concentrations, changes in the mix and volume of the loan portfolio; trends in portfolio credit quality, including delinquency and



27



---

charge-off rates; and current economic conditions that may affect a borrowers ability to repay. Although management believes it has established and
maintained the allowance for loan losses at appropriate levels, future adjustments may be necessary if economic, real estate and other conditions differ substantially from the current operating environment.



Interest Income Recognition



Interest on loans is included in income as earned based upon interest rates
applied to unpaid principal. Interest is not accrued on loans 90 days or more past due unless the loans are adequately secured and in the process of collection. Interest is not accrued on other loans when management believes collection is doubtful.
All loans considered impaired are non-accruing. Interest on non-accruing loans is recognized as payments are received or when the ultimate collectibility of interest is no longer considered doubtful. When a loan is placed on non-accrual status, all
interest previously accrued is reversed against current-period interest income.



Impact of Inflation and Changing Prices



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



Off-Balance Sheet Arrangements



The Bank has various financial instruments (outstanding commitments) with off-balance sheet risk that are issued in the normal course of business to the meet the financing needs of its customers. See Note 8 to the consolidated financial
statements included in Item 7 of this Annual Report for more information regarding these commitments and contingent liabilities.



Recent Accounting Pronouncements



See Note 1 to the Companys consolidated financial statements in Item 7 of this Annual Report for a discussion of recent accounting pronouncements
and managements assessment of their potential impact on the Companys consolidated financial statements.



Guide 3 Tables



See Exhibit 99.1 attached hereto and incorporated herein by reference for financial information required by Industry Guide 3 which is not provided elsewhere in this Annual Report.



Forward-looking Information



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



28



---

|ITEM 7. | FINANCIAL STATEMENTS
|------- | --------------------



INDEPENDENT AUDITORS REPORT



To the Board of Directors

KS Bancorp, Inc.

Kenly, North Carolina



We have audited the
accompanying consolidated statements of financial condition of KS Bancorp, Inc. and subsidiary as of December 31, 2003 and 2002, and the related consolidated statements of income, stockholders equity and cash flows for the years then ended.
These consolidated financial statements are the responsibility of the Companys management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.



We conducted our audits in accordance with auditing standards generally accepted in the
United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We
believe that our audits provide a reasonable basis for our opinion.



In our
opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of KS Bancorp, Inc. and subsidiary as of December 31, 2003 and 2002, and the results of their operations and their cash
flows for the years then ended in conformity with accounting principles generally accepted in the United States of America.



/s/    Dixon Hughes PLLC

Sanford, North Carolina

January 16, 2004



29



---

KS BANCORP, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION

December 31, 2003 and 2002



|                                                                                                                         |  |      |             |   |      |   |             |  
|------------------------------------------------------------------------------------------------------------------------ |  | ---- | ----------- | - | ---- | - | ----------- | -
|                                                                                                                         |  | 2003 |             |   | 2002 |  
|ASSETS                                                                                                                   |  |      |             |   |      |   |             |  
|Cash and due from banks:                                                                                                 |  |      |             |   |      |   |             |  
|Interest-earning                                                                                                         |  | $    | 4,032,621   |   |      | $ | 6,745,705   |  
|Noninterest-earning                                                                                                      |  |      | 980,016     |   |      |   | 890,216     |  
|Time deposits                                                                                                            |  |      | 100,000     |   |      |   |            |  
|Investment securities:                                                                                                   |  |      |             |   |      |   |             |  
|Available for sale                                                                                                       |  |      | 32,745,441  |   |      |   | 23,296,697  |  
|Held to maturity (fair value of $62,995 at December 31, 2002)                                                            |  |      |            |   |      |   | 64,301      |  
|Federal Home Loan Bank stock, at cost                                                                                    |  |      | 2,005,000   |   |      |   | 1,740,000   |  
|Presold mortgages in process of settlement                                                                               |  |      | 103,900     |   |      |   | 1,418,600   |  
|Loans                                                                                                                    |  |      | 153,130,687 |   |      |   | 152,115,935 |  
|Less allowance for loan losses                                                                                           |  |      | (1,357,877  | ) |      |   | (1,276,685  | )
|                                                                                                                         |  |      |             |   |      |   |             |  
|Net loans                                                                                                                |  |      | 151,772,810 |   |      |   | 150,839,250 |  
|Accrued interest receivable                                                                                              |  |      | 944,749     |   |      |   | 1,034,178   |  
|Foreclosed real estate, net                                                                                              |  |      | 1,085,490   |   |      |   | 419,743     |  
|Property and equipment, net                                                                                              |  |      | 6,887,891   |   |      |   | 3,947,851   |  
|Other assets                                                                                                             |  |      | 858,094     |   |      |   | 662,233     |  
|                                                                                                                         |  |      |             |   |      |   |             |  
|Total assets                                                                                                             |  | $    | 201,516,012 |   |      | $ | 191,058,774 |  
|                                                                                                                         |  |      |             |   |      |   |             |  
|LIABILITIES AND STOCKHOLDERS EQUITY                                                                                     |  |      |             |   |      |   |             |  
|Liabilities:                                                                                                             |  |      |             |   |      |   |             |  
|Deposits                                                                                                                 |  | $    | 142,250,698 |   |      | $ | 138,026,837 |  
|Advances from Federal Home Loan Bank                                                                                     |  |      | 40,100,000  |   |      |   | 34,800,000  |  
|Accrued interest payable                                                                                                 |  |      | 226,859     |   |      |   | 308,682     |  
|Accrued expenses and other liabilities                                                                                   |  |      | 361,591     |   |      |   | 412,664     |  
|                                                                                                                         |  |      |             |   |      |   |             |  
|Total liabilities                                                                                                        |  |      | 182,939,148 |   |      |   | 173,548,183 |  
|                                                                                                                         |  |      |             |   |      |   |             |  
|Commitments and contingencies (Note 8)                                                                                   |  |      |             |   |      |   |             |  
|Stockholders Equity:                                                                                                    |  |      |             |   |      |   |             |  
|Preferred stock, authorized 5,000,000 shares; none issued                                                                |  |      |            |   |      |   |            |  
|Common stock, no par value, authorized 20,000,000 shares; issued and outstanding 1,197,029 in 2003 and 1,153,177 in 2002 |  |      | 5,419,996   |   |      |   | 4,962,494   |  
|Unearned ESOP shares                                                                                                     |  |      |            |   |      |   | (39,000     | )
|Retained earnings, substantially restricted                                                                              |  |      | 13,114,454  |   |      |   | 12,455,432  |  
|Accumulated other comprehensive income                                                                                   |  |      | 42,414      |   |      |   | 131,665     |  
|                                                                                                                         |  |      |             |   |      |   |             |  
|Total stockholders equity                                                                                               |  |      | 18,576,864  |   |      |   | 17,510,591  |  
|                                                                                                                         |  |      |             |   |      |   |             |  
|                                                                                                                         |  | $    | 201,516,012 |   |      | $ | 191,058,774 |  
|                                                                                                                         |  |      |             |   |      |   |             |  



See
Notes to Consolidated Financial Statements.



30



---

KS BANCORP, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF INCOME

Years Ended December 31, 2003 and 2002



|                                                    |  |      |            |      |   |           
|--------------------------------------------------- |  | ---- | ---------- | ---- | - | ----------
|                                                    |  | 2003 |            | 2002
|Interest and dividend income:                       |  |      |            |      |   |           
|Loans, including fees                               |  | $    | 10,477,677 |      | $ | 11,236,509
|Investment securities:                              |  |      |            |      |   |           
|Taxable                                             |  |      | 787,883    |      |   | 821,277   
|Tax-exempt                                          |  |      | 129,715    |      |   | 20,542    
|Dividends                                           |  |      | 69,078     |      |   | 69,792    
|Interest-earning deposits                           |  |      | 45,113     |      |   | 56,045    
|                                                    |  |      |            |      |   |           
|Total interest income                               |  |      | 11,509,466 |      |   | 12,204,165
|                                                    |  |      |            |      |   |           
|Interest expense:                                   |  |      |            |      |   |           
|Deposits                                            |  |      | 3,149,833  |      |   | 4,063,122 
|Advances from Federal Home Loan Bank                |  |      | 1,179,445  |      |   | 1,133,548 
|                                                    |  |      |            |      |   |           
|Total interest expense                              |  |      | 4,329,278  |      |   | 5,196,670 
|                                                    |  |      |            |      |   |           
|Net interest income                                 |  |      | 7,180,188  |      |   | 7,007,495 
|Provision for loan losses                           |  |      | 352,027    |      |   | 1,014,552 
|                                                    |  |      |            |      |   |           
|Net interest income after provision for loan losses |  |      | 6,828,161  |      |   | 5,992,943 
|                                                    |  |      |            |      |   |           
|Noninterest income:                                 |  |      |            |      |   |           
|Service charges on deposit accounts                 |  |      | 655,317    |      |   | 552,488   
|Fees from presold mortgages                         |  |      | 319,668    |      |   | 273,946   
|Gain on sale of foreclosed real estate              |  |      | 65,280     |      |   |          
|Other                                               |  |      | 114,978    |      |   | 41,049    
|                                                    |  |      |            |      |   |           
|Total noninterest income                            |  |      | 1,155,243  |      |   | 867,483   
|                                                    |  |      |            |      |   |           
|Noninterest expenses:                               |  |      |            |      |   |           
|Compensation and benefits                           |  |      | 3,491,859  |      |   | 2,789,246 
|Occupancy and equipment                             |  |      | 644,502    |      |   | 581,493   
|Data processing                                     |  |      | 519,308    |      |   | 460,532   
|Advertising                                         |  |      | 160,364    |      |   | 109,848   
|Foreclosed real estate                              |  |      | 139,562    |      |   | 17,226    
|Other                                               |  |      | 854,154    |      |   | 777,053   
|                                                    |  |      |            |      |   |           
|Total noninterest expenses                          |  |      | 5,809,749  |      |   | 4,735,398 
|                                                    |  |      |            |      |   |           
|Income before income taxes                          |  |      | 2,173,655  |      |   | 2,125,028 
|Income tax expense                                  |  |      | 772,319    |      |   | 789,482   
|                                                    |  |      |            |      |   |           
|Net income                                          |  | $    | 1,401,336  |      | $ | 1,335,546 
|                                                    |  |      |            |      |   |           
|Basic earnings per share                            |  | $    | 1.21       |      | $ | 1.18      
|                                                    |  |      |            |      |   |           
|Diluted earnings per share                          |  | $    | 1.19       |      | $ | 1.15      
|                                                    |  |      |            |      |   |           



See
Notes to Consolidated Financial Statements.



31



---

KS BANCORP, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY

Years Ended December 31, 2003 and 2002



|                                                            |  |                        |   |  |                     |           |   |                   |   |            |                      |  |   |                                        |   |  |       |         |   |  |   |            |  
|----------------------------------------------------------- |  | ---------------------- | - |  | ------------------- | --------- | - | ----------------- | - | ---------- | -------------------- |  | - | -------------------------------------- | - |  | ----- | ------- | - |  | - | ---------- | -
|                                                            |  | Shares of Common Stock |   |  | Common Stock Amount |           |   | Retained Earnings |   |            | Unearned ESOP Shares |  |   | Accumulated Other Comprehensive Income |   |  | Total |        
|Balance, December 31, 2001                                  |  | 1,139,213              |   |  | $                   | 4,815,656 |   |                   | $ | 11,851,811 |                      |  | $ | (78,000                                | ) |  | $     | 209,846 |   |  | $ | 16,799,313 |  
|Comprehensive income:                                       |  |                        |   |  |                     |           |   |                   |   |            |                      |  |   |                                        |   |  |       |         |   |  |   |            |  
|Net income                                                  |  |                       |   |  |                     |          |   |                   |   | 1,335,546  |                      |  |   |                                       |   |  |       |        |   |  |   | 1,335,546  |  
|Other comprehensive loss, net of taxes:                     |  |                        |   |  |                     |           |   |                   |   |            |                      |  |   |                                        |   |  |       |         |   |  |   |            |  
|Net decrease in fair value of securities available for sale |  |                       |   |  |                     |          |   |                   |   |           |                      |  |   |                                       |   |  |       | (78,181 | ) |  |   | (78,181    | )
|                                                            |  |                        |   |  |                     |           |   |                   |   |            |                      |  |   |                                        |   |  |       |         |   |  |   |            |  
|Total comprehensive income                                  |  |                        |   |  |                     |           |   |                   |   |            |                      |  |   |                                        |   |  |       |         |   |  |   | 1,257,365  |  
|                                                            |  |                        |   |  |                     |           |   |                   |   |            |                      |  |   |                                        |   |  |       |         |   |  |   |            |  
|Common stock issued pursuant to:                            |  |                        |   |  |                     |           |   |                   |   |            |                      |  |   |                                        |   |  |       |         |   |  |   |            |  
|Stock options exercised                                     |  | 13,964                 |   |  |                     | 83,788    |   |                   |   |           |                      |  |   |                                       |   |  |       |        |   |  |   | 83,788     |  
|Compensation (Note 11)                                      |  |                       |   |  |                     | 63,050    |   |                   |   |           |                      |  |   |                                       |   |  |       |        |   |  |   | 63,050     |  
|Release of unearned shares                                  |  |                       |   |  |                     |          |   |                   |   |           |                      |  |   | 39,000                                 |   |  |       |        |   |  |   | 39,000     |  
|Cash dividends declared ($.64 per share)                    |  |                       |   |  |                     |          |   |                   |   | (731,925   | )                    |  |   |                                       |   |  |       |        |   |  |   | (731,925   | )
|                                                            |  |                        |   |  |                     |           |   |                   |   |            |                      |  |   |                                        |   |  |       |         |   |  |   |            |  
|Balance, December 31, 2002                                  |  | 1,153,177              |   |  |                     | 4,962,494 |   |                   |   | 12,455,432 |                      |  |   | (39,000                                | ) |  |       | 131,665 |   |  |   | 17,510,591 |  
|Comprehensive income:                                       |  |                        |   |  |                     |           |   |                   |   |            |                      |  |   |                                        |   |  |       |         |   |  |   |            |  
|Net income                                                  |  |                       |   |  |                     |          |   |                   |   | 1,401,336  |                      |  |   |                                       |   |  |       |        |   |  |   | 1,401,336  |  
|Other comprehensive loss, net of taxes:                     |  |                        |   |  |                     |           |   |                   |   |            |                      |  |   |                                        |   |  |       |         |   |  |   |            |  
|Net decrease in fair value of securities available for sale |  |                       |   |  |                     |          |   |                   |   |           |                      |  |   |                                       |   |  |       | (89,251 | ) |  |   | (89,251    | )
|                                                            |  |                        |   |  |                     |           |   |                   |   |            |                      |  |   |                                        |   |  |       |         |   |  |   |            |  
|Total comprehensive income                                  |  |                        |   |  |                     |           |   |                   |   |            |                      |  |   |                                        |   |  |       |         |   |  |   | 1,312,085  |  
|                                                            |  |                        |   |  |                     |           |   |                   |   |            |                      |  |   |                                        |   |  |       |         |   |  |   |            |  
|Common stock issued pursuant to:                            |  |                        |   |  |                     |           |   |                   |   |            |                      |  |   |                                        |   |  |       |         |   |  |   |            |  
|Stock options exercised                                     |  | 46,628                 |   |  |                     | 279,768   |   |                   |   |           |                      |  |   |                                       |   |  |       |        |   |  |   | 279,768    |  
|Current income tax benefit                                  |  |                       |   |  |                     | 161,397   |   |                   |   |           |                      |  |   |                                       |   |  |       |        |   |  |   | 161,397    |  
|Stock traded to exercise options                            |  | (2,776                 | ) |  |                     | (61,040   | ) |                   |   |           |                      |  |   |                                       |   |  |       |        |   |  |   | (61,040    | )
|Compensation (Note 11)                                      |  |                       |   |  |                     | 77,377    |   |                   |   |           |                      |  |   |                                       |   |  |       |        |   |  |   | 77,377     |  
|Release of unearned shares                                  |  |                       |   |  |                     |          |   |                   |   |           |                      |  |   | 39,000                                 |   |  |       |        |   |  |   | 39,000     |  
|Cash dividends declared ($.64 per share)                    |  |                       |   |  |                     |          |   |                   |   | (742,314   | )                    |  |   |                                       |   |  |       |        |   |  |   | (742,314   | )
|                                                            |  |                        |   |  |                     |           |   |                   |   |            |                      |  |   |                                        |   |  |       |         |   |  |   |            |  
|Balance, December 31, 2003                                  |  | 1,197,029              |   |  | $                   | 5,419,996 |   |                   | $ | 13,114,454 |                      |  | $ |                                       |   |  | $     | 42,414  |   |  | $ | 18,576,864 |  
|                                                            |  |                        |   |  |                     |           |   |                   |   |            |                      |  |   |                                        |   |  |       |         |   |  |   |            |  



See
Notes to Consolidated Financial Statements.



32



---

KS BANCORP, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH FLOWS

Years Ended December 31, 2003 and 2002



|                                                                                  |  |      |             |   |      |   |             |  
|--------------------------------------------------------------------------------- |  | ---- | ----------- | - | ---- | - | ----------- | -
|                                                                                  |  | 2003 |             |   | 2002 |  
|Cash Flows From Operating Activities:                                             |  |      |             |   |      |   |             |  
|Net income                                                                        |  | $    | 1,401,336   |   |      | $ | 1,335,546   |  
|Adjustments to reconcile net income to net cash provided by operating activities: |  |      |             |   |      |   |             |  
|Depreciation                                                                      |  |      | 311,089     |   |      |   | 300,232     |  
|Amortization of net premiums                                                      |  |      | 174,060     |   |      |   | 32,254      |  
|Deferred income taxes                                                             |  |      | 21,910      |   |      |   | (306,933    | )
|Provision for loan losses                                                         |  |      | 352,027     |   |      |   | 1,014,552   |  
|Gain on sale of available-for-sale securities                                     |  |      | (1,202      | ) |      |   |            |  
|Gain on sale of foreclosed real estate                                            |  |      | (65,280     | ) |      |   |            |  
|Shares allocated to ESOP contribution                                             |  |      | 116,377     |   |      |   | 102,050     |  
|Changes in assets and liabilities:                                                |  |      |             |   |      |   |             |  
|(Increase) decrease in:                                                           |  |      |             |   |      |   |             |  
|Presold mortgages in process of settlement                                        |  |      | 1,314,700   |   |      |   | (1,153,600  | )
|Other assets                                                                      |  |      | (1,671      | ) |      |   | (144,909    | )
|Accrued interest receivable                                                       |  |      | 89,429      |   |      |   | (32,862     | )
|Increase (decrease) in:                                                           |  |      |             |   |      |   |             |  
|Accrued interest payable                                                          |  |      | (81,823     | ) |      |   | (187,908    | )
|Accrued expenses and other liabilities                                            |  |      | (32,210     | ) |      |   | (552,741    | )
|                                                                                  |  |      |             |   |      |   |             |  
|Net cash provided by operating activities                                         |  |      | 3,598,742   |   |      |   | 405,681     |  
|                                                                                  |  |      |             |   |      |   |             |  
|Cash Flows From Investing Activities:                                             |  |      |             |   |      |   |             |  
|Net investment in time deposits                                                   |  |      | (100,000    | ) |      |   |            |  
|Proceeds from maturities, prepayments, and calls of available-for-sale securities |  |      | 15,501,102  |   |      |   | 11,662,508  |  
|Proceeds from sales of available-for-sale securities                              |  |      | 1,541,659   |   |      |   |            |  
|Proceeds from maturity and calls of held-to-maturity securities                   |  |      | 64,301      |   |      |   | 26,989      |  
|Purchase of available for sale securities                                         |  |      | (26,808,317 | ) |      |   | (22,519,714 | )
|Purchase of Federal Home Loan Bank stock                                          |  |      | (265,000    | ) |      |   | (732,500    | )
|Net change in loans receivable                                                    |  |      | (2,657,954  | ) |      |   | (15,429,624 | )
|Proceeds from sale of foreclosed real estate                                      |  |      | 771,900     |   |      |   |            |  
|Purchase of property and equipment                                                |  |      | (3,251,129  | ) |      |   | (300,804    | )
|                                                                                  |  |      |             |   |      |   |             |  
|Net cash used by investing activities                                             |  |      | (15,203,438 | ) |      |   | (27,293,145 | )
|                                                                                  |  |      |             |   |      |   |             |  



See
Notes to Consolidated Financial Statements.



33



---

KS BANCORP, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH FLOWS

Years Ended December 31, 2003 and 2002



|                                                                       |  |      |             |   |      |   |            |  
|---------------------------------------------------------------------- |  | ---- | ----------- | - | ---- | - | ---------- | -
|                                                                       |  | 2003 |             |   | 2002 |  
|Cash Flows From Financing Activities:                                  |  |      |             |   |      |   |            |  
|Net increase in deposits                                               |  | $    | 4,223,861   |   |      | $ | 9,201,436  |  
|Decrease in advance payments from borrowers for taxes and insurance    |  |      | (18,863     | ) |      |   | (3,635     | )
|Advances from Federal Home Loan Bank                                   |  |      | 22,500,000  |   |      |   | 22,000,000 |  
|Principal payments - Federal Home Loan Bank advances                   |  |      | (17,200,000 | ) |      |   | (4,000,000 | )
|Cash dividends paid                                                    |  |      | (742,314    | ) |      |   | (731,925   | )
|Proceeds from exercise of stock options, net                           |  |      | 218,728     |   |      |   | 83,788     |  
|                                                                       |  |      |             |   |      |   |            |  
|Net cash provided by financing activities                              |  |      | 8,981,412   |   |      |   | 26,549,664 |  
|                                                                       |  |      |             |   |      |   |            |  
|Net decrease in cash and cash equivalents                              |  |      | (2,623,284  | ) |      |   | (337,800   | )
|Cash and cash equivalents:                                             |  |      |             |   |      |   |            |  
|Beginning                                                              |  |      | 7,635,921   |   |      |   | 7,973,721  |  
|                                                                       |  |      |             |   |      |   |            |  
|Ending                                                                 |  | $    | 5,012,637   |   |      | $ | 7,635,921  |  
|                                                                       |  |      |             |   |      |   |            |  
|Supplemental Disclosure of Cash Flow Information:                      |  |      |             |   |      |   |            |  
|Cash payments for:                                                     |  |      |             |   |      |   |            |  
|Interest                                                               |  | $    | 4,411,101   |   |      | $ | 5,384,578  |  
|                                                                       |  |      |             |   |      |   |            |  
|Income taxes                                                           |  | $    | 797,158     |   |      | $ | 1,125,609  |  
|                                                                       |  |      |             |   |      |   |            |  
|Supplemental Disclosure of Noncash Investing and Financing Activities: |  |      |             |   |      |   |            |  
|Transfer from loans to real estate acquired in settlement of loans     |  | $    | 1,408,367   |   |      | $ | 402,365    |  
|                                                                       |  |      |             |   |      |   |            |  
|Change in unrealized losses on available for sale securities, net      |  | $    | (89,251     | ) |      | $ | (78,181    | )
|                                                                       |  |      |             |   |      |   |            |  
|Increase in loans receivable through sale of foreclosed real estate    |  | $    | 36,000      |   |      | $ |           |  
|                                                                       |  |      |             |   |      |   |            |  



See
Notes to Consolidated Financial Statements.



34



---

|Note 1. | Nature of Business and Significant Accounting Policies
|------- | ------------------------------------------------------



Organization and operations



In December 1993, pursuant to a Plan of Conversion approved by its members and regulators, Kenly Savings Bank, Inc., SSB amended and restated its charter to effect its
conversion from a North Carolina-chartered mutual savings bank to a North Carolina-chartered stock savings bank and became a wholly owned subsidiary of KS Bancorp, Inc. (KS Bancorp or the Company), a holding company formed in
connection with the conversion. On January 1, 1999, Kenly Savings Bank, Inc., SSB changed its name to KS Bank, Inc. (the Bank). The Companys principal business activities consist of the ownership of the Bank and a loan to the ESOP
for its purchase of the Companys common stock, which was paid in full during 2003. The Bank originates mortgage, commercial and consumer loans within its primary lending area of Johnston, Wilson, Wayne and Wake counties.



Basis of presentation



The consolidated financial statements include the accounts of KS Bancorp and its wholly
owned subsidiary, the Bank. All significant intercompany accounts and transactions have been eliminated in consolidation.



Use of estimates



The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported
amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those
estimates. Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan losses.



Cash and cash equivalents



For purposes of the consolidated statements of cash flows, cash and cash equivalents include cash and balances due from banks.



Investment securities



Debt securities that management has the positive intent and ability to hold to maturity are
classified as held to maturity and recorded at amortized cost. Securities not classified as held to maturity, including equity securities with readily determinable fair values, are classified as available for sale and
recorded at fair value, with unrealized gains and losses excluded from earnings and reported in other comprehensive income.



Purchase premiums and discounts are recognized in interest income using the interest method over the terms of the securities. Declines in the fair value of
held-to-maturity and available-for-sale securities below their cost that are deemed to be other than temporary are reflected in earnings as realized losses. Gains and losses on the sale of securities are recorded on the trade date and are determined
using the specific identification method.



35



---

|Note 1. | Nature of Business and Significant Accounting Policies (Continued)
|------- | ------------------------------------------------------------------



Loans



Loans that management has the intent and ability to hold for the foreseeable future or until maturity are reported at their outstanding principal adjusted for any
charge-offs, the allowance for loan losses, and any deferred fees or costs on originated loans and unamortized premiums or discounts on purchased loans. Loan origination fees and certain direct origination costs are capitalized and recognized as an
adjustment of the yield of the related loan. Interest is not accrued on loans 90 days or more past due unless the loans are adequately secured and in the process of collection. Interest is not accrued on other loans when management believes
collection is doubtful. When interest accrual is discontinued, all unpaid accrued interest is reversed. Interest income is subsequently recognized only to the extent cash payments are received.



Allowance for loan losses



The allowance for loan losses is established as losses are estimated to have occurred
through a provision for loan losses charged to earnings. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance.



The allowance for loan losses is evaluated on a regular basis by management
and is based upon managements periodic review of the collectibility of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrowers ability to repay, estimated
value of any underlying collateral and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available. In addition, regulatory
examiners may require the Bank to recognize adjustments to the allowance for loan losses based on their judgments about information available to them at the time of their examination.



A loan is considered impaired when, based on current information and events, it is probable that the Bank will be unable to collect the
scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting
scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls
on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrowers prior payment record, and the amount of the
shortfall in relation to the principal and interest owed. Impairment is measured on a loan-by-loan basis for commercial and construction loans by either the present value of expected future cash flows discounted at the loans effective interest
rate, the loans obtainable market price, or the fair value of the collateral if the loan is collateral dependent.



Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Accordingly, the Bank does not separately identify individual consumer and
residential loans for impairment disclosures.



36



---

|Note 1. | Nature of Business and Significant Accounting Policies (Continued)
|------- | ------------------------------------------------------------------



Presold mortgages in process of settlement



As a part of normal business operations, the Company originates residential mortgage loans
that have been pre-approved by secondary investors. The terms of the loans are set by the secondary investors and are transferred to them at par within several weeks of the Company initially funding the loan. The Company receives origination fees
from borrowers and servicing release premiums from the investors that are recognized on the income statement in the line item fees from presold mortgages. Between the initial funding of the loans by the Company and the subsequent
reimbursement by the investors, the Company carries the loans on its consolidated statements of financial condition at cost.



Foreclosed real estate



Real estate acquired through, or in lieu of, loan foreclosure is initially recorded at fair value at the date of foreclosure establishing a new cost basis. After
foreclosure, valuations of the property are periodically performed by management and the real estate is carried at the lower of cost or fair value minus estimated cost to sell. Revenue and expenses from operations and changes in the valuation
allowance are included in foreclosed real estate expense.



Property and
equipment



Property and equipment is stated at cost less accumulated
depreciation. Depreciation is calculated on the straight-line method over the estimated useful lives of the assets. The estimated lives for buildings are 40 years and the estimated lives for equipment and fixtures range from 3 to 20 years. Leasehold
improvements are amortized over the terms of the respective leases or the estimated useful lives of the improvements, whichever is shorter. Repairs and maintenance costs are charged to operations as incurred, and additions and improvements to
premises and equipment are capitalized. Upon sale or retirement, the cost and related accumulated depreciation are removed from the accounts and any gains or losses are reflected in current operations.



Federal Home Loan Bank stock



As a requirement for membership, the Bank invests in stock of the Federal Home Loan Bank of
Atlanta (FHLB). This investment is carried at cost.



Income
taxes



Deferred taxes are provided on a liability method whereby
deferred tax assets are recognized for deductible temporary differences and deferred tax liabilities are recognized for taxable temporary differences. Temporary differences are the differences between the reported amounts of assets and liabilities
and their tax bases. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or all of the deferred tax assets will not be realized. Deferred tax assets and
liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment.



37



---

|Note 1. | Nature of Business and Significant Accounting Policies (Continued)
|------- | ------------------------------------------------------------------



Stock compensation plans



Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for Stock-Based Compensation, encourages all
entities to adopt a fair value based method of accounting for employee stock compensation plans, whereby compensation cost is measured at the grant date based on the value of the award and is recognized over the service period, which is usually the
vesting period. However, it also allows an entity to continue to measure compensation cost for those plans using the intrinsic value based method of accounting prescribed by Accounting Principles Board Opinion No. 25, Accounting for Stock Issued
to Employees, whereby compensation cost is the excess, if any, of the quoted market price of the stock at the grant date (or other measurement date) over the amount an employee must pay to acquire the stock. In December 2002, the FASB issued
SFAS No. 148, Accounting for Stock-Based Compensation - Transition and Disclosure. SFAS No. 148 amends SFAS No. 123 to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for
stock-based employee compensation. In addition, this Statement amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based
employee compensation and the effect of the method used on reported results. The Company continues to account for its stock-based compensation in accordance with APB 25 and has adopted the disclosure provisions of Statement 148 effective for all
periods presented herein where applicable. However, the Company has not issued any stock options or stock-based compensation since the enactment of SFAS No. 123. Therefore, the pro forma disclosures of net income and earnings per share and other
disclosures as if the fair value based method of accounting had been applied are not applicable.



Retirement plans



The
Banks employee stock ownership plan (the ESOP) covers substantially all of its employees. Contributions to the plan are based upon amounts necessary to fund the amortization requirements of the ESOPs debt to the Company,
subject to compensation limitations, and are charged to expense. The ESOP debt was paid in full during 2003. During 2003, the Bank discontinued its defined contribution retirement plan. There are no accrued unfunded amounts with respect to this
discontinued plan.



The Bank also has a 401(k) retirement plan which is
available to substantially all employees. The Bank matches voluntary contributions by participating employees.



Additionally, the Bank has a Supplemental Executive Retirement Plan covering senior executives. The Bank finances the future anticipated benefits to be provided under this plan through contributions to whole life
insurance policies.



Earnings per share



Basic earnings per share represents income available to common stockholders divided by the
weighted-average number of common shares outstanding during the period. Diluted earnings per share reflect additional common shares that would have been outstanding if dilutive potential common shares had been issued, as well as any adjustment to
income that would result from the assumed issuance. Potential common shares that may be issued by the Company relate solely to outstanding stock options and are determined using the treasury stock method. None of the Companys outstanding stock
options were anti-dilutive in 2003 or 2002.



38



---

|Note 1. | Nature of Business and Significant Accounting Policies (Continued)
|------- | ------------------------------------------------------------------



Earnings per share (Continued)



The basic and diluted weighted average shares outstanding are as follows:



|                                                               |  |           |  |          
|-------------------------------------------------------------- |  | --------- |  | ---------
|                                                               |  | 2003      |  | 2002     
|Weighted average shares outstanding                            |  | 1,162,215 |  | 1,144,711
|Less weighted average unallocated ESOP shares                  |  | 2,960     |  | 9,460    
|                                                               |  |           |  |          
|Weighted average outstanding shares used for basic EPS         |  | 1,159,255 |  | 1,135,251
|Plus incremental shares from assumed exercise of stock options |  | 18,586    |  | 25,798   
|                                                               |  |           |  |          
|Weighted average outstanding shares used for diluted EPS       |  | 1,177,841 |  | 1,161,049
|                                                               |  |           |  |          



There were no adjustments required to
be made to net income in the computation of diluted earnings per share.



Comprehensive income



Accounting principles generally
require that recognized revenue, expenses, gains and losses be included in net income. Although certain changes in assets and liabilities, such as unrealized gains and losses on available-for-sale securities, are reported as a separate component of
the equity section of the balance sheet, such items, along with net income, are components of comprehensive income. Unrealized gains and losses on available for sale securities are the Companys only component of accumulated other comprehensive
income.



The components of other comprehensive income (loss) and related tax
effects are as follows:



|                                                                  |  |      |          |   |      |   |          |  
|----------------------------------------------------------------- |  | ---- | -------- | - | ---- | - | -------- | -
|                                                                  |  | 2003 |          |   | 2002 |  
|Unrealized gains (losses) arising during the year                 |  | $    | (142,752 | ) |      | $ | (126,098 | )
|Tax effect                                                        |  |      | 54,270   |   |      |   | 47,917   |  
|                                                                  |  |      |          |   |      |   |          |  
|                                                                  |  |      | (88,482  | ) |      |   | (78,181  | )
|                                                                  |  |      |          |   |      |   |          |  
|Reclassification adjustment for (gains) losses realized in income |  |      | (1,202   | ) |      |   |         |  
|Tax effect                                                        |  |      | 433      |   |      |   |         |  
|                                                                  |  |      |          |   |      |   |          |  
|                                                                  |  |      | (769     | ) |      |   |         |  
|                                                                  |  |      |          |   |      |   |          |  
|Net of tax amount                                                 |  | $    | (89,251  | ) |      | $ | (78,181  | )
|                                                                  |  |      |          |   |      |   |          |  



Off-balance-sheet risk



In the ordinary course of business, the Bank has entered into
commitments to extend credit, including commitments under credit card arrangements and equity lines of credit. Such financial instruments are recorded when they are funded.



39



---

|Note 1. | Nature of Business and Significant Accounting Policies (Continued)
|------- | ------------------------------------------------------------------



Fair value of financial instruments



The estimated fair values required under Statement of Financial Accounting Standards (SFAS) No. 107, Disclosures About Fair
Value of Financial Instruments,have been determined by the Company using available market information and appropriate valuation methodologies. However, considerable judgment is necessarily required to develop the estimates of fair value.
Accordingly, the estimates presented in the accompanying Note 15 for the fair value of the Companys financial instruments are not necessarily indicative of the amounts the Company could realize in a current market exchange. The use of
different market assumptions or estimation methodologies may have a material effect on the estimated fair value amounts.



The fair value estimates presented in Note 15 are based on pertinent information available to management as of December 31, 2003 and 2002, respectively. Although
management is not aware of any factors that would significantly affect the estimated fair value amounts, such amounts have not been comprehensively revalued for purposes of these financial statements since those dates and, therefore, current
estimates of fair value may differ significantly from the amounts presented herein. The following methods and assumptions were used by the Company in estimating its fair value disclosures for financial instruments.



Cash and due from banks, time deposits, presold mortgages in process of settlement, and
accrued interest receivable



The carrying amounts reported in the
statement of financial condition for these instruments approximate their fair values due to the short-term nature of these instruments.



Investment securities



Investment securities include debt and mortgage-backed securities which are publicly traded. Market values for these securities are based on quoted market prices.



Federal Home Loan Bank stock



The carrying value of Federal Home Loan Bank stock approximates fair value based on the
redemption provisions of the Federal Home Loan Bank.



Loans



The fair value for substantially all loans has been estimated by
discounting the projected future cash flows at December 31, 2003 and 2002, using the rate on that date at which similar loans would be made to borrowers with similar credit ratings and for similar maturities or repricing periods. The discount rate
used has been adjusted by an estimated credit risk factor to approximate the adjustment that would be applied in the marketplace for any nonperforming loans. Certain prepayment assumptions have also been made depending upon the original contractual
lives of the loans. For certain loans which are indexed and adjust with other quoted rates, the carrying basis is considered to approximate fair value.



Deposits



The fair value of deposits with no stated maturities, including transaction accounts and passbook savings accounts, is estimated to be equal to the amount payable on demand as of December 31, 2003 and 2002. The fair
value of certificates of deposit is based upon the discounted value of future contractual cash flows. The discount rate is estimated using the rates offered on December 31, 2003 and 2002 for deposits of similar remaining maturities.



40



---

|Note 1. | Nature of Business and Significant Accounting Policies (Continued)
|------- | ------------------------------------------------------------------



Advances from the Federal Home Loan Bank



The fair value of these advances is based upon the discounted value using current rates at which borrowings of similar maturity could be
obtained.



Accrued interest payable



The carrying amounts of accrued interest payable approximate their fair value.



New accounting standards



In January 2003, the FASB issued FASB Interpretation No. (FIN) 46, Consolidation of
Variable Interest Entities. This interpretation addresses the consolidation by business enterprises of variable interest entities as defined in the interpretation. In December 2003, the FASB issued a revision to FIN 46 (FIN 46R) to clarify some
of the provisions of FIN 46 and to exempt certain entities from its requirements. FIN 46R is effective for public entities that have interests in structures that are commonly referred to as special-purpose entities for periods ending after December
15, 2003. Application by public entities, other than small business issuers, for all other types of variable interest entities is required in financial statements for periods ending after March 15, 2004. Application by small business issuers to
variable interest entities other than special-purpose entities is required for periods ending after December 15, 2004. The Company is in the process of determining the impact of FIN 46 and FIN 46R on its consolidated financial statements.



In November 2003, the Emerging Issues Task Force (EITF) reached a partial
consensus on Issue 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments. Issue 03-1 requires certain quantitative and qualitative disclosures for investments subject to SFAS No. 115, Accounting
for Certain Investments in Debt and Equity Securities, that are impaired at the balance sheet date but for which an other-than-temporary impairment has not been recognized. The Company adopted the partial consensus on Issue 03-1 during 2003 and
has provided the new disclosures in Note 2. The EITF is expected to continue deliberating other aspects of Issue 03-1, including when to recognize other-than-temporary impairment.



Reclassifications



Certain amounts in the 2002 consolidated financial statements have been reclassified to conform to the 2003 presentation. The reclassifications had no effect on net
income or stockholders equity as previously reported.



41



---

|Note 2. | Investment Securities
|------- | ---------------------



Investment securities consist of the following:



|                           |  |                |            |                        |   |                         |  |   |                        |   |  |   |           
|-------------------------- |  | -------------- | ---------- | ---------------------- | - | ----------------------- |  | - | ---------------------- | - |  | - | ----------
|                           |  | 2003          
|                           |  | Amortized Cost |            | Gross Unrealized Gains |   | Gross Unrealized Losses |  |   | Estimated Market Value
|Available for sale:        |  |                |            |                        |   |                         |  |   |                        |   |  |   |           
|Debt securities:           |  |                |            |                        |   |                         |  |   |                        |   |  |   |           
|Federal agency securities  |  | $              | 11,500,024 |                        | $ | 13,670                  |  | $ | (67,565                | ) |  | $ | 11,446,129
|Municipal securities       |  |                | 5,716,350  |                        |   | 70,447                  |  |   | (13,216                | ) |  |   | 5,773,581 
|Mortgage-backed securities |  |                | 15,460,658 |                        |   | 73,805                  |  |   | (8,732                 | ) |  |   | 15,525,731
|                           |  |                |            |                        |   |                         |  |   |                        |   |  |   |           
|                           |  | $              | 32,677,032 |                        | $ | 157,922                 |  | $ | (89,513                | ) |  | $ | 32,745,441
|                           |  |                |            |                        |   |                         |  |   |                        |   |  |   |           
|                           | 
|                           |  | 2002          
|                           |  | Amortized Cost |            | Gross Unrealized Gains |   | Gross Unrealized Losses |  |   | Estimated Market Value
|Held to maturity:          |  |                |            |                        |   |                         |  |   |                        |   |  |   |           
|Debt securities:           |  |                |            |                        |   |                         |  |   |                        |   |  |   |           
|Mortgage-backed securities |  | $              | 64,301     |                        | $ |                        |  | $ | (1,306                 | ) |  | $ | 62,995    
|                           |  |                |            |                        |   |                         |  |   |                        |   |  |   |           
|Available for sale:        |  |                |            |                        |   |                         |  |   |                        |   |  |   |           
|Debt securities:           |  |                |            |                        |   |                         |  |   |                        |   |  |   |           
|Federal agency securities  |  | $              | 9,700,000  |                        | $ | 129,264                 |  | $ |                       |   |  | $ | 9,829,264 
|Municipal securities       |  |                | 3,075,668  |                        |   | 17,018                  |  |   | (25,433                | ) |  |   | 3,067,253 
|Mortgage-backed securities |  |                | 10,308,666 |                        |   | 91,514                  |  |   |                       |   |  |   | 10,400,180
|                           |  |                |            |                        |   |                         |  |   |                        |   |  |   |           
|                           |  | $              | 23,084,334 |                        | $ | 237,796                 |  | $ | (25,433                | ) |  | $ | 23,296,697
|                           |  |                |            |                        |   |                         |  |   |                        |   |  |   |           



The amortized cost and estimated
market value of debt securities at December 31, 2003 by contractual maturity are as shown below.



|                                    |  |                      |   |  |               |            |                       |   |           
|----------------------------------- |  | -------------------- | - |  | ------------- | ---------- | --------------------- | - | ----------
|                                    |  | WeightedAverageYield |   |  | AmortizedCost |            | EstimatedMarket Value
|Available for sale:                 |  |                      |   |  |               |            |                       |   |           
|Due in one year through five years  |  | 2.89                 | % |  | $             | 14,443,364 |                       | $ | 14,394,978
|Due in five years through ten years |  | 5.29                 | % |  |               | 1,416,263  |                       |   | 1,444,545 
|Due in excess of ten years          |  | 5.16                 | % |  |               | 1,356,747  |                       |   | 1,380,188 
|                                    |  |                      |   |  |               |            |                       |   |           
|                                    |  |                      |   |  | $             | 17,216,374 |                       | $ | 17,219,711
|                                    |  |                      |   |  |               |            |                       |   |           



The amortized cost and estimated
market value of mortgage-backed securities by contractual maturities are not reported because the actual maturities may be, and often are, significantly different from contractual maturities.



42



---

|Note 2. | Investment Securities (Continued)
|------- | ---------------------------------



For the year ended December 31, 2003, proceeds from sales of securities available for sale amounted to approximately
$1,543,000 and gross realized gains and losses amounted to approximately $14,000 and ($13,000), respectively. There were no sales of securities available for sale during the year ended December 31, 2002.



Securities with a fair value of $4,050,000 and $4,300,000 at December 31, 2003 and 2002,
respectively, were pledged to secure public monies on deposit and the Banks depository relationship with the Federal Reserve Bank.



The following table shows investments gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities have
been in a continuous unrealized loss position, at December 31, 2003. These unrealized losses on investment securities are a result of volatility in the market during 2003 and relate to nine federal agency securities, two municipal securities, and
one mortgage-backed security. All unrealized losses on investment securities are considered by management to be temporary given the credit ratings on these investment securities and the short duration of the unrealized loss.



|                                      |  |                     |            |                   |   |            |  |                   |   |            |   |                   |  |   |            |  |   |       
|------------------------------------- |  | ------------------- | ---------- | ----------------- | - | ---------- |  | ----------------- | - | ---------- | - | ----------------- |  | - | ---------- |  | - | ------
|                                      |  | Less Than 12 Months |            | 12 Months or More |   | Total     
|                                      |  | Fair value          |            | Unrealized losses |   | Fair value |  | Unrealized losses |   | Fair value |   | Unrealized losses
|Securities available for sale:        |  |                     |            |                   |   |            |  |                   |   |            |   |                   |  |   |            |  |   |       
|Federal agencies securities           |  | $                   | 8,932,459  |                   | $ | 67,565     |  | $                 |  |            | $ |                  |  | $ | 8,932,459  |  | $ | 67,565
|Municipal securities                  |  |                     | 1,266,617  |                   |   | 13,216     |  |                   |   |            |   |                   |  |   | 1,266,617  |  |   | 13,216
|Mortgage-backed securities            |  |                     | 1,450,374  |                   |   | 8,732      |  |                   |  |            |   |                  |  |   | 1,450,374  |  |   | 8,732 
|                                      |  |                     |            |                   |   |            |  |                   |   |            |   |                   |  |   |            |  |   |       
|Total temporarily impaired securities |  | $                   | 11,649,450 |                   | $ | 89,513     |  | $                 |  |            | $ |                  |  | $ | 11,649,450 |  | $ | 89,513
|                                      |  |                     |            |                   |   |            |  |                   |   |            |   |                   |  |   |            |  |   |       



|Note 3. | Loans
|------- | -----



Loans consist of the following:



|                                        |  |      |             |   |      |   |             |  
|--------------------------------------- |  | ---- | ----------- | - | ---- | - | ----------- | -
|                                        |  | 2003 |             |   | 2002 |  
|Conventional first mortgage loans       |  | $    | 70,428,797  |   |      | $ | 81,912,045  |  
|Construction loans                      |  |      | 30,290,086  |   |      |   | 26,669,331  |  
|Equity-line loans                       |  |      | 14,780,962  |   |      |   | 14,868,808  |  
|Loans on deposit accounts               |  |      | 415,450     |   |      |   | 444,000     |  
|Consumer loans                          |  |      | 2,391,988   |   |      |   | 4,655,198   |  
|Commercial loans                        |  |      | 45,571,775  |   |      |   | 30,137,036  |  
|                                        |  |      |             |   |      |   |             |  
|                                        |  |      | 163,879,058 |   |      |   | 158,686,418 |  
|                                        |  |      |             |   |      |   |             |  
|Less:                                   |  |      |             |   |      |   |             |  
|Undisbursed portion of loans in process |  |      | 10,411,225  |   |      |   | 6,278,716   |  
|Unamortized loan fees                   |  |      | 337,146     |   |      |   | 291,767     |  
|Allowance for loan losses               |  |      | 1,357,877   |   |      |   | 1,276,685   |  
|                                        |  |      |             |   |      |   |             |  
|                                        |  |      | 12,106,248  |   |      |   | 7,847,168   |  
|                                        |  |      |             |   |      |   |             |  
|                                        |  | $    | 151,772,810 |   |      | $ | 150,839,250 |  
|                                        |  |      |             |   |      |   |             |  
|Weighted average yield                  |  |      | 6.27        | % |      |   | 6.89        | %
|                                        |  |      |             |   |      |   |             |  



43



---

|Note 3. | Loans (Continued)
|------- | -----------------



The following summarizes transactions in the allowance for loan losses:



|                                  |  |                          |           |   |      |   |           |  
|--------------------------------- |  | ------------------------ | --------- | - | ---- | - | --------- | -
|                                  |  | Years Ended December 31, |          
|                                  |  | 2003                     |           |   | 2002 |  
|Balance, beginning                |  | $                        | 1,276,685 |   |      | $ | 574,695   |  
|Provision for loan losses         |  |                          | 352,027   |   |      |   | 1,014,552 |  
|Charge-offs:                      |  |                          |           |   |      |   |           |  
|Conventional first mortgage loans |  |                          | (147,167  | ) |      |   | (49,408   | )
|Consumer loans                    |  |                          | (72,866   | ) |      |   | (117,562  | )
|Commercial loans                  |  |                          | (127,505  | ) |      |   | (156,592  | )
|Recoveries                        |  |                          | 76,703    |   |      |   | 11,000    |  
|                                  |  |                          |           |   |      |   |           |  
|Net charge-offs                   |  |                          | (270,835  | ) |      |   | (312,562  | )
|                                  |  |                          |           |   |      |   |           |  
|Balance, ending                   |  | $                        | 1,357,877 |   |      | $ | 1,276,685 |  
|                                  |  |                          |           |   |      |   |           |  



No loans have been restructured during
2003 or 2002. Loans totaling $1,920,751 and $1,404,753 were considered impaired as of December 31, 2003 and 2002, respectively, and consist entirely of nonaccrual loans. Impaired loans had related allowances for loan losses of $192,075 and $140,475
at December 31, 2003 and 2002, respectively. The average recorded investment in impaired loans during the years ended December 31, 2003 and 2002 was $1,182,918 and $1,165,963, respectively. At December 31, 2003, loans greater than 90 days past due
still accruing interest totaled $480,103. For the years ended December 31, 2003 and 2002, the Company recognized no interest income from impaired loans during the time within the years that the loans were impaired.



Loans outstanding to the Companys officers and directors (including their affiliates)
are shown below. In the opinion of management, these loans were made at lending terms and rates available to the general public and do not involve more than the normal risks of collectibility.



|                                 |  |      |           |  
|-------------------------------- |  | ---- | --------- | -
|                                 |  | 2003 |          
|Balance, beginning               |  | $    | 1,481,000 |  
|Loans of newly elected directors |  |      | 2,210,000 |  
|Originations                     |  |      | 196,000   |  
|Repayments                       |  |      | (70,000   | )
|                                 |  |      |           |  
|Balance, ending                  |  | $    | 3,817,000 |  
|                                 |  |      |           |  



44



---

|Note 4. | Property and Equipment
|------- | ----------------------



Following is a summary of property and equipment at December 31, 2003 and 2002:



|                           |  |      |            |   |      |   |            |  
|-------------------------- |  | ---- | ---------- | - | ---- | - | ---------- | -
|                           |  | 2003 |            |   | 2002 |  
|Land                       |  | $    | 1,778,662  |   |      | $ | 1,314,294  |  
|Buildings and improvements |  |      | 4,688,821  |   |      |   | 2,302,422  |  
|Furniture and equipment    |  |      | 2,701,759  |   |      |   | 2,096,053  |  
|Construction in progress   |  |      |           |   |      |   | 205,849    |  
|                           |  |      |            |   |      |   |            |  
|                           |  |      | 9,169,242  |   |      |   | 5,918,618  |  
|Accumulated depreciation   |  |      | (2,281,351 | ) |      |   | (1,970,767 | )
|                           |  |      |            |   |      |   |            |  
|Total                      |  | $    | 6,887,891  |   |      | $ | 3,947,851  |  
|                           |  |      |            |   |      |   |            |  



Depreciation and amortization
amounting to $311,089 and $300,232 for the years ended December 31, 2003 and 2002, respectively, is included in occupancy and equipment expense.



The Company leases, under a noncancelable arrangement, a branch facility in Garner, North Carolina for $5,250 per month. Future rentals under this lease are as follows:



|     |  |   |        
|---- |  | - | -------
|2004 |  | $ | 63,000 
|2005 |  |   | 63,000 
|2006 |  |   | 63,000 
|2007 |  |   | 15,750 
|     |  |   |        
|     |  | $ | 204,750
|     |  |   |        



This lease contains an option to
extend for a five year period, the cost of which is not included above. Rental expense amounted to $64,800 and $65,550 during the years ended December 31, 2003 and 2002, respectively.



|Note 5. | Deposits
|------- | --------



Deposits consist of the following:



|                                             |  |      |             |   |      |   |             |  
|-------------------------------------------- |  | ---- | ----------- | - | ---- | - | ----------- | -
|                                             |  | 2003 |             |   | 2002 |  
|Regular savings accounts, 1.0%               |  | $    | 6,039,360   |   |      | $ | 5,580,030   |  
|NOW accounts, 0.25% to 1.0%                  |  |      | 10,152,936  |   |      |   | 9,493,798   |  
|Money market deposit accounts, .50% to 1.75% |  |      | 11,137,141  |   |      |   | 8,880,918   |  
|Noninterest-bearing accounts                 |  |      | 7,994,314   |   |      |   | 7,607,848   |  
|                                             |  |      |             |   |      |   |             |  
|                                             |  |      | 35,323,751  |   |      |   | 31,562,594  |  
|                                             |  |      |             |   |      |   |             |  
|Certificates:                                |  |      |             |   |      |   |             |  
|0.00% - 2.99%                                |  |      | 76,919,038  |   |      |   | 36,996,074  |  
|3.00% - 4.50%                                |  |      | 27,652,441  |   |      |   | 62,073,137  |  
|4.51% - 6.50%                                |  |      | 2,274,876   |   |      |   | 5,312,628   |  
|6.51% and above                              |  |      | 80,592      |   |      |   | 2,082,404   |  
|                                             |  |      |             |   |      |   |             |  
|                                             |  |      | 106,926,947 |   |      |   | 106,464,243 |  
|                                             |  |      |             |   |      |   |             |  
|                                             |  | $    | 142,250,698 |   |      | $ | 138,026,837 |  
|                                             |  |      |             |   |      |   |             |  
|Weighted average cost of funds               |  |      | 1.92        | % |      |   | 2.66        | %
|                                             |  |      |             |   |      |   |             |  



45



---

|Note 5. | Deposits (Continued)
|------- | --------------------



Certificate accounts are summarized by maturity at December 31, 2003 as follows:



|                |  |      |            |      |   |            |  |      |           |       |   |           |  |   |            
|--------------- |  | ---- | ---------- | ---- | - | ---------- |  | ---- | --------- | ----- | - | --------- |  | - | -----------
|                |  | 2004 |            | 2005 |   | 2006       |  | 2007 |           | Total
|0.00% - 2.99%   |  | $    | 58,039,850 |      | $ | 14,738,310 |  | $    | 3,456,736 |       | $ | 684,142   |  | $ | 76,919,038 
|3.00% - 4.50%   |  |      | 13,744,760 |      |   | 6,849,491  |  |      | 4,716,564 |       |   | 2,341,626 |  |   | 27,652,441 
|4.51% - 6.50%   |  |      | 2,154,488  |      |   | 120,388    |  |      |          |       |   |          |  |   | 2,274,876  
|6.51% and above |  |      | 80,592     |      |   |           |  |      |          |       |   |          |  |   | 80,592     
|                |  |      |            |      |   |            |  |      |           |       |   |           |  |   |            
|                |  | $    | 74,019,690 |      | $ | 21,708,189 |  | $    | 8,173,300 |       | $ | 3,025,768 |  | $ | 106,926,947
|                |  |      |            |      |   |            |  |      |           |       |   |           |  |   |            



The aggregate amount of time deposits
in denominations of $100,000 or more at December 31, 2003 and 2002 was $35,645,345 and $33,817,625, respectively. These time deposits mature as follows:



|                    |  |        |           
|------------------- |  | ------ | ----------
|                    |  | Amount
|Maturity            |  |        |           
|Less than 3 months  |  | $      | 7,975,306 
|3 to 6 months       |  |        | 4,846,755 
|6 to 12 months      |  |        | 9,345,912 
|More than 12 months |  |        | 13,477,372
|                    |  |        |           
|                    |  | $      | 35,645,345
|                    |  |        |           



Interest expense on deposits is
summarized below:



|                              |  |                          |           |   |      |   |           |  
|----------------------------- |  | ------------------------ | --------- | - | ---- | - | --------- | -
|                              |  | Years Ended December 31, |          
|                              |  | 2003                     |           |   | 2002 |  
|Regular savings accounts      |  | $                        | 39,282    |   |      | $ | 78,716    |  
|NOW and money market accounts |  |                          | 143,928   |   |      |   | 218,804   |  
|Certificates                  |  |                          | 2,973,559 |   |      |   | 3,776,954 |  
|                              |  |                          |           |   |      |   |           |  
|                              |  |                          | 3,156,769 |   |      |   | 4,074,474 |  
|Forfeitures                   |  |                          | (6,936    | ) |      |   | (11,352   | )
|                              |  |                          |           |   |      |   |           |  
|                              |  | $                        | 3,149,833 |   |      | $ | 4,063,122 |  
|                              |  |                          |           |   |      |   |           |  



46



---

|Note 6. | Advances From Federal Home Loan Bank
|------- | ------------------------------------



Advances from the Federal Home Loan Bank consist of the following:



|            |  |                         |  |               |      |  |      |              |            |  |   |           
|----------- |  | ----------------------- |  | ------------- | ---- |  | ---- | ------------ | ---------- |  | - | ----------
|            |  | Maturing in Year Ending |  | Interest Rate |      |  |      | December 31,
|Type        |  |                         |  |               | 2003 |  | 2002
|Fixed       |  | 2003                    |  | 6.41%         |      |  |      | $            |           |  | $ | 6,000,000 
|Convertible |  | 2010                    |  | 5.57%         |      |  |      |              | 5,000,000  |  |   | 5,000,000 
|Convertible |  | 2011                    |  | 4.83%         |      |  |      |              | 1,800,000  |  |   | 1,800,000 
|Convertible |  | 2011                    |  | 4.98%         |      |  |      |              | 2,000,000  |  |   | 2,000,000 
|Convertible |  | 2011                    |  | 4.67%         |      |  |      |              | 2,000,000  |  |   | 2,000,000 
|Variable    |  | 2003                    |  | 1.30%         |      |  |      |              |           |  |   | 8,000,000 
|Fixed       |  | 2003                    |  | 2.13%         |      |  |      |              |           |  |   | 1,600,000 
|Fixed       |  | 2004                    |  | 2.73%         |      |  |      |              | 1,600,000  |  |   | 1,600,000 
|Fixed       |  | 2005                    |  | 3.43%         |      |  |      |              | 1,800,000  |  |   | 1,800,000 
|Fixed       |  | 2003                    |  | 2.13%         |      |  |      |              |           |  |   | 1,600,000 
|Fixed       |  | 2004                    |  | 2.49%         |      |  |      |              | 1,600,000  |  |   | 1,600,000 
|Fixed       |  | 2005                    |  | 3.02%         |      |  |      |              | 1,800,000  |  |   | 1,800,000 
|Convertible |  | 2013                    |  | 2.91%         |      |  |      |              | 6,000,000  |  |   |          
|Convertible |  | 2006                    |  | 1.21%         |      |  |      |              | 5,000,000  |  |   |          
|Fixed       |  | 2006                    |  | 2.43%         |      |  |      |              | 1,500,000  |  |   |          
|Fixed       |  | 2005                    |  | 2.22%         |      |  |      |              | 1,000,000  |  |   |          
|Fixed       |  | 2006                    |  | 2.87%         |      |  |      |              | 2,000,000  |  |   |          
|Fixed       |  | 2007                    |  | 3.56%         |      |  |      |              | 2,000,000  |  |   |          
|Fixed       |  | 2007                    |  | 3.43%         |      |  |      |              | 2,000,000  |  |   |          
|Variable    |  | 2004                    |  | 1.17%         |      |  |      |              | 3,000,000  |  |   |          
|            |  |                         |  |               |      |  |      |              |            |  |   |           
|            |  |                         |  |               |      |  |      | $            | 40,100,000 |  | $ | 34,800,000
|            |  |                         |  |               |      |  |      |              |            |  |   |           



Pursuant to collateral agreements with
the Federal Home Loan Bank (FHLB), advances are collateralized by all of the Companys FHLB stock and qualifying first mortgage loans pledged in the form of a blanket floating lien. The balance of qualifying first mortgage loans as of December
31, 2003 was approximately $66 million. This agreement with the FHLB provides for a line of credit up to 25% of the Banks assets. The maximum amount outstanding under the line of credit at any month-end during 2003 was $40.1 million.



|Note 7. | Income Taxes
|------- | ------------



At December 31, 2003, retained earnings contain certain historical additions to bad debt reserves for income tax purposes of $1,221,000 for which no deferred taxes have been provided because the Bank does not intend
to use these reserves for purposes other than to absorb losses. If amounts which qualified as bad debt deductions are used for purposes other than to absorb bad debt losses or adjustments arising from the carryback of net operating losses, income
taxes may be imposed at the then existing rates. In the future, if the Bank does not meet the income tax requirements necessary to permit the deduction of an allowance for bad debts, the Banks effective tax rate would be increased to the
maximum percent under existing law. Unrecorded deferred income taxes on pre 1988 tax bad debt reserves amounted to approximately $465,000 at December 31, 2003.



47



---

|Note 7. | Income Taxes (Continued)
|------- | ------------------------



Significant components of deferred taxes at December 31, 2003 and 2002 are as follows:



|                                                    |  |              |         |      |   |        
|--------------------------------------------------- |  | ------------ | ------- | ---- | - | -------
|                                                    |  | December 31,
|                                                    |  | 2003         |         | 2002
|Deferred tax assets:                                |  |              |         |      |   |        
|Allowance for loan losses                           |  | $            | 523,462 |      | $ | 492,162
|Deferred compensation and directors death benefits |  |              | 80,563  |      |   | 74,975 
|Other                                               |  |              | 47,421  |      |   | 24,650 
|                                                    |  |              |         |      |   |        
|Total deferred tax assets                           |  |              | 651,446 |      |   | 591,787
|                                                    |  |              |         |      |   |        
|Deferred tax liabilities:                           |  |              |         |      |   |        
|Accumulated depreciation                            |  |              | 306,779 |      |   | 177,180
|Federal Home Loan Bank stock                        |  |              | 84,540  |      |   | 84,540 
|Tax bad debt reserves                               |  |              |        |      |   | 48,030 
|Unrealized net appreciation, investments            |  |              | 25,995  |      |   | 80,698 
|                                                    |  |              |         |      |   |        
|Total deferred tax liabilities                      |  |              | 417,314 |      |   | 390,448
|                                                    |  |              |         |      |   |        
|Net deferred tax assets                             |  | $            | 234,132 |      | $ | 201,339
|                                                    |  |              |         |      |   |        



The significant components of the
provision for income taxes for the years ended December 31, 2003 and 2002 are as follows:



|                                  |  |                          |         |      |   |           |  
|--------------------------------- |  | ------------------------ | ------- | ---- | - | --------- | -
|                                  |  | Years Ended December 31, |        
|                                  |  | 2003                     |         | 2002 |  
|Current tax provision:            |  |                          |         |      |   |           |  
|Federal                           |  | $                        | 635,541 |      | $ | 965,924   |  
|State                             |  |                          | 114,868 |      |   | 130,491   |  
|                                  |  |                          |         |      |   |           |  
|                                  |  |                          | 750,409 |      |   | 1,096,415 |  
|                                  |  |                          |         |      |   |           |  
|Deferred tax provision (benefit): |  |                          |         |      |   |           |  
|Federal                           |  |                          | 17,988  |      |   | (251,996  | )
|State                             |  |                          | 3,922   |      |   | (54,937   | )
|                                  |  |                          |         |      |   |           |  
|                                  |  |                          | 21,910  |      |   | (306,933  | )
|                                  |  |                          |         |      |   |           |  
|Net provision for income taxes    |  | $                        | 772,319 |      | $ | 789,482   |  
|                                  |  |                          |         |      |   |           |  



The difference between the provision
for income taxes and the amounts applied by applying the statutory federal income tax rate of 34% to income before income taxes is summarized below:



|                                          |  |      |         |   |      |   |        
|----------------------------------------- |  | ---- | ------- | - | ---- | - | -------
|                                          |  | 2003 |         |   | 2002
|Expense computed at statutory rate of 34% |  | $    | 739,043 |   |      | $ | 722,510
|Effect of state income taxes              |  |      | 78,401  |   |      |   | 49,866 
|Other, net                                |  |      | (45,125 | ) |      |   | 17,106 
|                                          |  |      |         |   |      |   |        
|                                          |  | $    | 772,319 |   |      | $ | 789,482
|                                          |  |      |         |   |      |   |        



48



---

|Note 8. | Concentration of Credit Risk, Off-Balance-Sheet Risk and Commitments
|------- | --------------------------------------------------------------------



The Bank is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial
instruments include commitments to extend credit and equity lines of credit. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the statement of financial condition. The
contract or notional amounts of those instruments reflect the extent of involvement the Bank has in particular classes of financial instruments.



The Banks exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit is represented by
the contractual notional amount of those instruments. The Bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments.



A summary of the contract amount of the Banks exposure to off-balance-sheet risk is as follows:



|                                                                    |  |              |            |      |   |           
|------------------------------------------------------------------- |  | ------------ | ---------- | ---- | - | ----------
|                                                                    |  | December 31,
|                                                                    |  | 2003         |            | 2002
|Financial instruments whose contract amounts represent credit risk: |  |              |            |      |   |           
|Commitments to extend credit                                        |  | $            | 2,245,000  |      | $ | 5,519,228 
|Undisbursed lines of credit                                         |  |              | 22,825,971 |      |   | 18,990,738
|Standby letters of credit                                           |  |              |           |      |   | 109,810   



The Bank evaluates each
customers credit worthiness on a case-by-case basis. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration
dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The collateral
obtained by the Bank upon extension of credit is based on managements credit evaluation of the customer. The collateral held is the underlying real estate.



During 2003, the Bank sold its consumer credit card business to an unrealted financial institution. As required under the terms of this
transaction, the Bank has guaranteed accounts of certain customers. As of December 31, 2003, the Banks exposure under this guarantee agreement totaled approximately $103,000.



|Note 9. | Employee Benefits
|------- | -----------------



The Bank has a 401(k) retirement plan which contains provisions for specified matching contributions by the Bank. The Bank funds contributions as they accrue and 401(k) expense totaled $73,945 and $67,208 for the
years ended December 31, 2003 and 2002, respectively.



During 2002, the Bank
discontinued its defined contribution retirement plan. Contributions to the plan amounted to $0 and $56,008 for the years ended December 31, 2003 and 2002, respectively.



49



---

|Note 9. | Employee Benefits (Continued)
|------- | -----------------------------



During 2001, the Bank adopted a Supplemental Executive Retirement Plan (SERP) for its senior executives. The Company
has purchased life insurance policies in order to provide future funding of benefit payments. Plan benefits will accrue and vest during the period of employment and will be paid in fixed monthly benefit payments over ten years commencing with the
officers retirement at any time after attainment of age sixty-five. Benefits will accrue based upon the performance of the underlying life insurance policies both during employment and after retirement. During 2003 and 2002, expense
attributable to this plan amounted to $43,044 and $37,279, respectively.



The
accounting and reporting aspects of the Banks ESOP plan are described in Note 11.



Employment agreements -The Company has entered into employment agreements with two of its executive officers to ensure a stable and competent management basis. The agreements provide for benefits as spelled out in the contracts and
cannot be terminated by the Board of Director, except for cause, without prejudicing the officers rights to receive certain vested rights, including compensation. In the event of a change in control of the Company, as outlined in the
agreements, the acquirer will be bound to the terms of the contracts.



|Note 10. | Deferred Compensation for Directors
|-------- | -----------------------------------



The Bank has a deferred compensation plan for its directors to be paid in the form of death benefits. The death benefits vest to each director in amounts ranging from
$2,000 to a maximum of $20,000 depending upon years of service. At December 31, 2003 and 2002, the Bank had accrued $90,000 and $88,551, respectively, which represents the present value of the death benefits based on directors life
expectancies. Expense associated with the plan amounted to $1,500 and $12,000 for the years ended December 31, 2003 and 2002, respectively.



|Note 11. | Employee Stock Ownership Plan
|-------- | -----------------------------



The Bank has an employee stock ownership plan (the ESOP) to benefit employees with 1,000 hours of annual service and who have attained age 21. The ESOP is
funded by contributions made by the Bank.



The ESOP borrowed funds from the
Company to partially finance its purchase of the common stock of the Company. The loan bears interest at 7.5% and matured December 29, 2003. The loan was repaid by the ESOP with contributions made by the Bank and earnings on the ESOPs assets.
At December 31, 2003 and 2002, the outstanding balance of the loan receivable from the ESOP was $0 and $39,000 respectively, which is presented as a reduction of stockholders equity. Shares purchased by the ESOP are held in suspense for
allocation among participants as the loan is repaid. Through December 31, 2003, the ESOP had purchased 80,497 shares of the Companys common stock. At December 31, 2003 all shares had been allocated. As of December 31, 2002, 6,500 shares had
not been allocated. Based upon the market value of the Companys stock at December 31, 2002, the fair value of the unallocated shares amounted to approximately $105,000.



Dividends on unallocated shares may be used by the ESOP to repay the debt to the Company and are not reported as dividends in the financial
statements. Dividends on allocated or committed to be allocated shares are credited to the accounts of the participants and reported as dividends in the financial statements.



50



---

|Note 11. | Employee Stock Ownership Plan (Continued)
|-------- | -----------------------------------------



Contributions are allocated among participants on the basis of compensation in the year of allocation. Benefits
become 100% vested after five years of credited service. Forfeitures of noninvested benefits will be reallocated among remaining participating employees in the same proportion as contributions.



The Company has the obligation to redeem the holdings of plan participants in the event the
participants request the Company to do so upon their retirement and if shares cannot be sold through the open market. The market value of the ESOP shares was approximately $1,630,000 at December 31, 2003.



The Bank has charged expense of $119,302 and $108,786 for the years ended December 31, 2003
and 2002, respectively, in connection with the ESOP. The expense for 2003 and 2002 includes, in addition to the cash contribution necessary to fund the ESOPs annual principal and interest installment on the loan to the Company, $77,377 and
$63,050, respectively, which represents the difference between the fair market value of the shares which have been committed to be released to participants, and the cost of these shares to the ESOP.



|Note 12. | Regulatory Matters
|-------- | ------------------



The Bank is subject to the capital requirements of the FDIC and the Administrator of the North Carolina Savings Institutions Division.



The FDIC requires the Bank to have a minimum leverage ratio of Tier I Capital (principally consisting of retained earnings and common
stockholders equity, less any intangible assets) to total assets of 3%. The FDIC also requires the Bank to have a ratio of total capital to risk-weighted assets of 8%, of which at least 4% must be in the form of Tier I capital. The North
Carolina Administrator requires a net worth equal to at least 5% of total assets.



At December 31, 2003 and 2002, the Bank complied with all the capital requirements as shown below:



|                                                       |  |                                  |            |   |                               |   |            |                     |  |   |                         |   |  |   |            |  
|------------------------------------------------------ |  | -------------------------------- | ---------- | - | ----------------------------- | - | ---------- | ------------------- |  | - | ----------------------- | - |  | - | ---------- | -
|                                                       |  | 2003                             |           
|                                                       |  | Leverage Ratio of Tier 1 Capital |            |   | Tier 1 Risk- Adjusted Capital |   |            | Risk- Based Capital |  |   | NC Savings Bank Capital |  
|Consolidated stockholders equity at December 31, 2003 |  | $                                | 18,576,864 |   |                               | $ | 18,576,864 |                     |  | $ | 18,576,864              |   |  | $ | 18,576,864 |  
|Unrealized gains on investment securities              |  |                                  | (42,414    | ) |                               |   | (42,414    | )                   |  |   | (42,414                 | ) |  |   | (42,414    | )
|Holding companys equity at December 31, 2003          |  |                                  | (491,174   | ) |                               |   | (491,174   | )                   |  |   | (491,174                | ) |  |   | (491,174   | )
|Loan loss allowances                                   |  |                                  |           |   |                               |   |           |                     |  |   | 1,357,877               |   |  |   | 1,357,877  |  
|                                                       |  |                                  |            |   |                               |   |            |                     |  |   |                         |   |  |   |            |  
|Regulatory capital                                     |  |                                  | 18,043,276 |   |                               |   | 18,043,276 |                     |  |   | 19,401,153              |   |  |   | 19,401,153 |  
|Minimum capital requirement                            |  |                                  | 5,948,340  |   |                               |   | 5,459,360  |                     |  |   | 10,918,720              |   |  |   | 10,066,850 |  
|                                                       |  |                                  |            |   |                               |   |            |                     |  |   |                         |   |  |   |            |  
|Excess                                                 |  | $                                | 12,094,936 |   |                               | $ | 12,583,916 |                     |  | $ | 8,482,433               |   |  | $ | 9,334,303  |  
|                                                       |  |                                  |            |   |                               |   |            |                     |  |   |                         |   |  |   |            |  



51



---

|Note 12. | Regulatory Matters (Continued)
|-------- | ------------------------------



|                                                            |  |                                  |             |   |                               |   |             |                     |  |   |                         |   |  |   |             |  
|----------------------------------------------------------- |  | -------------------------------- | ----------- | - | ----------------------------- | - | ----------- | ------------------- |  | - | ----------------------- | - |  | - | ----------- | -
|                                                            |  | 2003                             |            
|                                                            |  | Leverage Ratio of Tier 1 Capital |             |   | Tier 1 Risk- Adjusted Capital |   |             | Risk- Based Capital |  |   | NC Savings Bank Capital |  
|Total tangible Bank only assets at December 31, 2003        |  | $                                |            |   |                               | $ |            |                     |  | $ |                        |   |  | $ | 201,337,000 |  
|Average tangible Bank only assets December 31, 2003 quarter |  |                                  | 198,278,000 |   |                               |   |            |                     |  |   |                        |   |  |   |            |  
|Risk-weighted Bank only assets at December 31, 2003         |  |                                  |            |   |                               |   | 136,484,000 |                     |  |   | 136,484,000             |   |  |   |            |  
|Capital as a percentage of assets:                          |  |                                  |             |   |                               |   |             |                     |  |   |                         |   |  |   |             |  
|Actual                                                      |  |                                  | 9.10        | % |                               |   | 13.22       | %                   |  |   | 14.21                   | % |  |   | 9.64        | %
|Required                                                    |  |                                  | 3.00        | % |                               |   | 4.00        | %                   |  |   | 8.00                    | % |  |   | 5.00        | %
|                                                            |  |                                  |             |   |                               |   |             |                     |  |   |                         |   |  |   |             |  
|Excess                                                      |  |                                  | 6.10        | % |                               |   | 9.22        | %                   |  |   | 6.21                    | % |  |   | 4.64        | %
|                                                            |  |                                  |             |   |                               |   |             |                     |  |   |                         |   |  |   |             |  
|                                                            | 
|                                                            |  | 2002                             |            
|                                                            |  | Leverage Ratio of Tier 1 Capital |             |   | Tier 1 Risk- Adjusted Capital |   |             | Risk- Based Capital |  |   | NC Savings Bank Capital |  
|Consolidated stockholders equity at December 31, 2002      |  | $                                | 17,510,591  |   |                               | $ | 17,510,591  |                     |  | $ | 17,510,591              |   |  | $ | 17,510,591  |  
|Unrealized gains on investment securities                   |  |                                  | (131,665    | ) |                               |   | (131,665    | )                   |  |   | (131,665                | ) |  |   | (131,665    | )
|Holding companys equity at December 31, 2002               |  |                                  | (235,669    | ) |                               |   | (235,669    | )                   |  |   | (235,669                | ) |  |   | (235,669    | )
|Loan loss allowances                                        |  |                                  |            |   |                               |   |            |                     |  |   | 1,276,685               |   |  |   | 1,276,685   |  
|                                                            |  |                                  |             |   |                               |   |             |                     |  |   |                         |   |  |   |             |  
|Regulatory capital                                          |  |                                  | 17,143,257  |   |                               |   | 17,143,257  |                     |  |   | 18,419,942              |   |  |   | 18,419,942  |  
|Minimum capital requirement                                 |  |                                  | 5,725,950   |   |                               |   | 5,003,760   |                     |  |   | 10,007,520              |   |  |   | 9,548,000   |  
|                                                            |  |                                  |             |   |                               |   |             |                     |  |   |                         |   |  |   |             |  
|Excess                                                      |  | $                                | 11,417,307  |   |                               | $ | 12,139,497  |                     |  | $ | 8,412,422               |   |  | $ | 8,871,942   |  
|                                                            |  |                                  |             |   |                               |   |             |                     |  |   |                         |   |  |   |             |  



52



---

|Note 12. | Regulatory Matters (Continued)
|-------- | ------------------------------



|                                                            |  |                                  |             |   |                               |   |             |                     |  |   |                         |   |  |   |             |  
|----------------------------------------------------------- |  | -------------------------------- | ----------- | - | ----------------------------- | - | ----------- | ------------------- |  | - | ----------------------- | - |  | - | ----------- | -
|                                                            |  | 2002                             |            
|                                                            |  | Leverage Ratio of Tier 1 Capital |             |   | Tier 1 Risk- Adjusted Capital |   |             | Risk- Based Capital |  |   | NC Savings Bank Capital |  
|Total tangible Bank only assets at December 31, 2002        |  | $                                |            |   |                               | $ |            |                     |  | $ |                        |   |  | $ | 190,961,000 |  
|Average tangible Bank only assets December 31, 2002 quarter |  |                                  | 190,865,000 |   |                               |   |            |                     |  |   |                        |   |  |   |            |  
|Risk-weighted Bank only assets at December 31, 2002         |  |                                  |            |   |                               |   | 125,094,000 |                     |  |   | 125,094,000             |   |  |   |            |  
|Capital as a percentage of assets:                          |  |                                  |             |   |                               |   |             |                     |  |   |                         |   |  |   |             |  
|Actual                                                      |  |                                  | 8.98        | % |                               |   | 13.70       | %                   |  |   | 14.72                   | % |  |   | 9.65        | %
|Required                                                    |  |                                  | 3.00        | % |                               |   | 4.00        | %                   |  |   | 8.00                    | % |  |   | 5.00        | %
|                                                            |  |                                  |             |   |                               |   |             |                     |  |   |                         |   |  |   |             |  
|Excess                                                      |  |                                  | 5.98        | % |                               |   | 9.70        | %                   |  |   | 6.72                    | % |  |   | 4.65        | %
|                                                            |  |                                  |             |   |                               |   |             |                     |  |   |                         |   |  |   |             |  



Under the FDIC prompt corrective
action regulations, a savings institution is considered to be well capitalized if its ratio of total capital to risk-weighted assets is at least 10%, its ratio of Tier I capital to risk-weighted assets is at least 6.0%, and its ratio of Tier I
capital to total average assets is at least 5.0%.



The Bank meets all of the
above requirements at December 31, 2003 and is considered to be well capitalized under the prompt corrective action regulations.



At the time of its conversion from a mutual to a stock charter, the Bank established a liquidation account in an amount equal to its net worth as of September 30, 1993
for the benefit of all holders of deposit accounts with an aggregate balance in excess of $50 on March 31, 1993. In the unlikely event of a complete liquidation of the Bank (and only in such event), each eligible account holder will be entitled to
his or her interest in the liquidation account prior to any payments to holders of common stock. An eligible account holders interest in the liquidation account will be computed on December 31 each year and is reduced, or will cease to exist,
if the funds in the related deposit account are withdrawn. The interest of an eligible account holder in the liquidation account will never be increased, even if there is an increase in the related deposit account after March 31, 1993.



Subject to applicable law, the Board of Directors of the Company and the Bank may each
provide for the payment of dividends. Future declarations of cash dividends, if any, by the Company may depend upon dividend payments by the Bank to the Company. The Bank paid dividends of $600,000 and $500,000 to the Company during 2003 and 2002,
respectively. The Company declared and paid dividends of $742,314 and $731,925 to stockholders during 2003 and 2002, respectively. Subject to regulations promulgated by the North Carolina Administrator, the Bank will not be permitted to pay
dividends on its common stock if its stockholders equity would be reduced below the amount required for the liquidation account or its capital requirement.



53



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|Note 13. | Stock Option and Bonus Compensation Plan
|-------- | ----------------------------------------



The Company has an Employee Stock Option Plan which provides for the granting of options to purchase shares of the Companys common stock to certain key employees
and a Nonqualified Stock Option Plan which provides for the granting of options to purchase shares of the Companys common stock to non-employee directors. An aggregate of 134,827 and 67,414 shares, respectively, of common stock was reserved
under the plans. The exercise price of the options is not less than 100% of the fair value of the common stock on the date the options were granted, and pursuant to the plan, options may not be exercised until specified time restrictions have lapsed
and option periods may not exceed ten (10) years.



A summary of activity in the
plans for the years ended December 31, 2003 and 2002 is as follows:



|                                 |  |         |   |      |                                 |      |        |         |   |                                 |   |     
|-------------------------------- |  | ------- | - | ---- | ------------------------------- | ---- | ------ | ------- | - | ------------------------------- | - | ----
|                                 |  | 2003    |   | 2002
|                                 |  | Shares  |   |      | Weighted Average Exercise Price |      | Shares |         |   | Weighted Average Exercise Price
|Outstanding at beginning of year |  | 46,628  |   |      | $                               | 6.00 |        | 60,592  |   |                                 | $ | 6.00
|Granted                          |  |        |   |      |                                 |     |        |        |   |                                 |   |    
|Exercised                        |  | (46,628 | ) |      |                                 | 6.00 |        | (13,964 | ) |                                 |   | 6.00
|Forfeited                        |  |        |   |      |                                 |     |        |        |   |                                 |   |    
|                                 |  |         |   |      |                                 |      |        |         |   |                                 |   |     
|Outstanding at end of year       |  |        |   |      | $                               |     |        | 46,628  |   |                                 | $ | 6.00
|                                 |  |         |   |      |                                 |      |        |         |   |                                 |   |     



All options under the Nonqualified
Stock Option Plan were exercisable at December 31, 2002 and were fully exercised before their expiration date in December 2003. Accordingly, at December 31, 2003 there were no options outstanding under this plan. As of December 31, 2002 there were
35,355 options outstanding under this plan.



All options under the Employee
Stock Option Plan were all exercisable at December 31, 2002 and were fully exercised before their expiration date in December 2003. Accordingly, at December 31, 2003 there were no options outstanding under this plan. As of December 31, 2002 there
were 11,273 options outstanding under this plan.



Additionally, the Company has
a bonus compensation plan which provides that incentive compensation will be payable annually to those directors and employees who hold unexercised options issued pursuant to the Employee Stock Option Plan and the Nonqualified Stock Option Plan for
Directors. Incentive compensation is paid annually equal to the number of unexercised options granted under the plans times the amount of dividends declared per common share outstanding. Pursuant to Board approval, effective January 1, 1999, only
outstanding options under the Nonqualified Stock Option Plan for Directors are eligible for the annual incentive compensation. Expense amounted to $7,712 and $16,861 in connection with the bonus compensation plan during 2003 and 2002, respectively.



54



---

|Note 14. | Employment Agreements
|-------- | ---------------------



The Company has entered into employment agreements with two of its executive officers to ensure a stable and competent management base. The agreements provide for
benefits as spelled out in the contracts and cannot be terminated by the Board of Directors, except for cause, without prejudicing the officers rights to receive certain vested rights, including compensation. In the event of a change in
control of the Company, as outlined in the agreements, the acquirer will be bound to the terms of the contracts.



|Note 15. | Fair Value of Financial Instruments
|-------- | -----------------------------------



The following table presents the carrying amounts and estimated fair values of the Companys financial instruments at December 31, 2003 and 2002.



|                                           |  |                 |             |            |   |                 |  |            |             |  |   |            
|------------------------------------------ |  | --------------- | ----------- | ---------- | - | --------------- |  | ---------- | ----------- |  | - | -----------
|                                           |  | 2003            |             | 2002      
|                                           |  | Carrying Amount |             | Fair Value |   | Carrying Amount |  | Fair Value
|Financial assets:                          |  |                 |             |            |   |                 |  |            |             |  |   |            
|Cash and cash equivalents                  |  | $               | 5,012,637   |            | $ | 5,012,637       |  | $          | 7,635,921   |  | $ | 7,635,921  
|Time deposits                              |  |                 | 100,000     |            |   | 100,000         |  |            |            |  |   |           
|Accrued interest receivable                |  |                 | 944,749     |            |   | 944,749         |  |            | 1,034,178   |  |   | 1,034,178  
|Investment securities:                     |  |                 |             |            |   |                 |  |            |             |  |   |            
|Held to maturity                           |  |                 |            |            |   |                |  |            | 64,301      |  |   | 62,995     
|Available for sale                         |  |                 | 32,677,032  |            |   | 32,745,441      |  |            | 23,296,697  |  |   | 23,296,697 
|Federal Home Loan Bank stock               |  |                 | 2,005,000   |            |   | 2,005,000       |  |            | 1,740,000   |  |   | 1,740,000  
|Presold mortgages in process of settlement |  |                 | 103,900     |            |   | 103,900         |  |            | 1,418,600   |  |   | 1,418,600  
|Loans, net                                 |  |                 | 151,772,810 |            |   | 153,111,000     |  |            | 150,839,250 |  |   | 153,409,000
|Financial liabilities:                     |  |                 |             |            |   |                 |  |            |             |  |   |            
|Deposits                                   |  |                 | 142,250,698 |            |   | 140,796,000     |  |            | 138,026,837 |  |   | 137,688,000
|Advances from Federal Home Loan Bank       |  |                 | 40,100,000  |            |   | 39,673,000      |  |            | 34,800,000  |  |   | 35,311,000 
|Accrued interest payable                   |  |                 | 226,859     |            |   | 226,859         |  |            | 308,682     |  |   | 308,682    



55



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|Note 16. | Parent Company Financial Data
|-------- | -----------------------------



The following is a summary of the condensed financial statements of KS Bancorp, Inc. as of and for the years ended December 31, 2003 and 2002:



Condensed Balance Sheets

December 31, 2003 and 2002



|                                            |  |                        |        |      |   |        |  
|------------------------------------------- |  | ---------------------- | ------ | ---- | - | ------ | -
|                                            |  | 2003                   |        | 2002 |  
|                                            |  | (Dollars in thousands) |       
|Assets                                      |  |                        |        |      |   |        |  
|Cash and due from banks                     |  | $                      | 329    |      | $ | 248    |  
|Investment in Subsidiary                    |  |                        | 18,085 |      |   | 17,275 |  
|Other assets                                |  |                        | 179    |      |   | 115    |  
|                                            |  |                        |        |      |   |        |  
|                                            |  | $                      | 18,593 |      | $ | 17,638 |  
|                                            |  |                        |        |      |   |        |  
|Liabilities and Stockholders Equity        |  |                        |        |      |   |        |  
|Liabilities:                                |  |                        |        |      |   |        |  
|Accrued expenses and other liabilities      |  | $                      | 17     |      | $ | 128    |  
|Stockholders equity:                       |  |                        |        |      |   |        |  
|Common stock                                |  |                        | 5,420  |      |   | 4,962  |  
|Unearned ESOP shares                        |  |                        |       |      |   | (39    | )
|Accumulated other comprehensive income      |  |                        | 42     |      |   | 132    |  
|Retained earnings, substantially restricted |  |                        | 13,114 |      |   | 12,455 |  
|                                            |  |                        |        |      |   |        |  
|                                            |  | $                      | 18,593 |      | $ | 17,638 |  
|                                            |  |                        |        |      |   |        |  



Condensed Statements of
Income

Years Ended December 31, 2003 and 2002



|                                 |  |                        |       |   |      |   |       |  
|-------------------------------- |  | ---------------------- | ----- | - | ---- | - | ----- | -
|                                 |  | 2003                   |       |   | 2002 |  
|                                 |  | (Dollars in thousands) |      
|Equity in earnings of subsidiary |  | $                      | 1,422 |   |      | $ | 1,352 |  
|Interest income                  |  |                        | 7     |   |      |   | 11    |  
|Other income                     |  |                        |      |   |      |   |      |  
|Other expense                    |  |                        | (41   | ) |      |   | (16   | )
|Income taxes                     |  |                        | 13    |   |      |   | (11   | )
|                                 |  |                        |       |   |      |   |       |  
|Net income                       |  | $                      | 1,401 |   |      | $ | 1,336 |  
|                                 |  |                        |       |   |      |   |       |  



56



---

|Note 16. | Parent Company Financial Data (Continued)
|-------- | -----------------------------------------



Condensed Statements of Cash Flows

Years Ended December 31, 2003 and 2002



|                                                              |  |                        |        |   |      |   |        |  
|------------------------------------------------------------- |  | ---------------------- | ------ | - | ---- | - | ------ | -
|                                                              |  | 2003                   |        |   | 2002 |  
|                                                              |  | (Dollars in thousands) |       
|Cash Flows from Operating Activities:                         |  |                        |        |   |      |   |        |  
|Net income                                                    |  | $                      | 1,401  |   |      | $ | 1,336  |  
|Noncash items included in net income:                         |  |                        |        |   |      |   |        |  
|Equity in earnings of KS Bank                                 |  |                        | (1,422 | ) |      |   | (1,352 | )
|Change in assets and liabilities:                             |  |                        |        |   |      |   |        |  
|(Increase) decrease in other assets                           |  |                        | 97     |   |      |   | (12    | )
|Increase (decrease) in accrued expenses and other liabilities |  |                        | (111   | ) |      |   | (25    | )
|                                                              |  |                        |        |   |      |   |        |  
|Net cash provided by in operating activities                  |  |                        | (35    | ) |      |   | (53    | )
|                                                              |  |                        |        |   |      |   |        |  
|Cash Flows from Investing Activities:                         |  |                        |        |   |      |   |        |  
|Upstream dividend received from KS Bank                       |  |                        | 600    |   |      |   | 500    |  
|                                                              |  |                        |        |   |      |   |        |  
|Net cash provided by investing activities                     |  |                        | 600    |   |      |   | 500    |  
|                                                              |  |                        |        |   |      |   |        |  
|Cash Flows from Financing Activities:                         |  |                        |        |   |      |   |        |  
|Cash dividends paid                                           |  |                        | (742   | ) |      |   | (732   | )
|Repayment of ESOP debt                                        |  |                        | 39     |   |      |   | 39     |  
|Exercise of stock options, net                                |  |                        | 219    |   |      |   | 83     |  
|                                                              |  |                        |        |   |      |   |        |  
|Net cash used in financing activities                         |  |                        | (484   | ) |      |   | (610   | )
|                                                              |  |                        |        |   |      |   |        |  
|Net increase (decrease) in cash:                              |  |                        | 81     |   |      |   | (163   | )
|Beginning                                                     |  |                        | 248    |   |      |   | 411    |  
|                                                              |  |                        |        |   |      |   |        |  
|Ending                                                        |  | $                      | 329    |   |      | $ | 248    |  
|                                                              |  |                        |        |   |      |   |        |  



57



---

|ITEM 8. | CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
|------- | ------------------------------------------------------------------------------------



There have been no changes in or disagreements with the Companys independent certified public accountants. The Audit
Committee of the Board of Directors of the Company has selected Dixon Hughes PLLC as the Companys independent auditor for the fiscal year ending December 31, 2004. Such selection is being submitted for ratification to the Companys
shareholders at the 2004 Annual Meeting.



|ITEM 8A. | CONTROLS AND PROCEDURES
|-------- | -----------------------



The Companys management, under the supervision and with the participation of the Chief Executive Officer and the Chief Financial Officer of the
Company (its principal executive officer and principal financial officer, respectively) have concluded based on their evaluation as of the end of the period covered by this Annual Report, that the Companys disclosure controls and procedures
are effective to ensure that information required to be disclosed by the Company in the reports filed or submitted by it under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods
specified in the applicable rules and forms, and include controls and procedures designed to ensure that information required to be disclosed by the Company in such reports is accumulated and communicated to the Companys management, including
the Chief Executive Officer and the Chief Financial Officer of the Company, as appropriate to allow timely decisions regarding required disclosure.



There have been no significant changes in internal control over financial reporting during the period covered by this Annual Report that have materially
affected, or are reasonably likely to materially affect, the Companys internal control over financial reporting.



PART III



|ITEM 9. | DIRECTORS AND EXECUTIVE OFFICERS OF THE COMPANY
|------- | -----------------------------------------------



The Company has adopted a Code of Ethics that applies to all its employees. The Company will provide any person without charge, upon request, a copy of
the Companys Code of Ethics. Such a request may be made in writing to the Companys principal address, as listed on the cover of this Annual Report.



The other information required by this Item 9 appears on pages 5 through 9 of the Companys Proxy Statement for the 2004 Annual Meeting of
Stockholders (the Proxy Statement), which is incorporated herein by reference.



|ITEM 10. | EXECUTIVE COMPENSATION
|-------- | ----------------------



The information required by this Item 10 appears on pages 9 and 10 of the Companys Proxy Statement.



|ITEM 11. | SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
|-------- | --------------------------------------------------------------



The Company did not have any compensation plans under which securities are authorized for issuance as of the end of fiscal year 2003. The other information required by
this Item 11 appears on pages 3 through 5 of the Proxy Statement.



|ITEM 12. | CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
|-------- | ----------------------------------------------



The information required by this Item 12 appears on page 12 of the Companys Proxy Statement



58



---

|ITEM 13. | EXHIBITS AND REPORTS ON FORM 8-K
|-------- | --------------------------------



|13(a) | Exhibits
|----- | --------



A listing of the exhibits to this Report on Form 10-KSB is set forth on the Index to Exhibits which immediately precedes such exhibits and is incorporated herein by reference.



|13(b) | The Company filed a report on Form 8-K announcing third quarter earnings and declaring a dividend on October 27, 2003.
|----- | ----------------------------------------------------------------------------------------------------------------------



|ITEM 14. | PRINCIPAL ACCOUNTANT FEES AND SERVICES
|-------- | --------------------------------------



The information required by this Item 14 appears on page 13 of the Companys Proxy Statement



59



---

SIGNATURES



Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.



|                     |  |  |  |                  |  |                    |  |                                                     
|-------------------- |  |  |  | ---------------- |  | ------------------ |  | ----------------------------------------------------
|                     |  |  |  | KS BANCORP, INC.
|                     |  |  | 
|Date: March 29, 2004 |  |  |  | By:              |  | /s/ Harold T. Keen
|                     |  |  |  |                  |  |                    | 
|                     |  |  |  |                  |  |                    |  | Harold T. Keen President and Chief Executive Officer



Pursuant to the
requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated:



|                                                   |  |                                                    |  |               
|-------------------------------------------------- |  | -------------------------------------------------- |  | --------------
|Signature                                          |  | Title                                              |  | Date          
|                                                   |  |                                                   
|/s/ Harold T. KeenHarold T. Keen                   |  | President and Chief Executive Officer and Director |  | March 29, 2004
|                                                   |  |                                                   
|/s/ Earl W. Worley, Jr.Earl W. Worley, Jr.         |  | Senior Vice President and Chief Financial Officer  |  | March 29, 2004
|                                                   |  |                                                   
|/s/ A. Carroll ColemanA. Carroll Coleman           |  | Director                                           |  | March 29, 2004
|                                                   |  |                                                   
|/s/ Robert E. FieldsRobert E. Fields               |  | Director                                           |  | March 29, 2004
|                                                   |  |                                                   
|/s/ R. Harold HinnantR. Harold Hinnant             |  | Director                                           |  | March 29, 2004
|                                                   |  |                                                   
|/s/ James C. ParkerJames C. Parker                 |  | Director                                           |  | March 29, 2004
|                                                   |  |                                                   
|/s/ R. Elton ParrishR. Elton Parrish               |  | Director                                           |  | March 29, 2004
|                                                   |  |                                                   
|/s/ Ralph Edward Scott, Jr.Ralph Edward Scott, Jr. |  | Director                                           |  | March 29, 2004
|                                                   |  |                                                   
|/s/ Sidney E. SaulsSidney E. Sauls                 |  | Director                                           |  | March 29, 2004
|                                                   |  |                                                   
|/s/ Gordon C. WoodruffGordon C. Woodruff           |  | Director                                           |  | March 29, 2004



60



---

INDEX TO EXHIBITS



|             |  |                                                                                                                                                                                                              
|------------ |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit No.  |  | Description                                                                                                                                                                                                  
|             | 
|Exhibit 3(i) |  | Certificate of Incorporation, incorporated herein by reference to Exhibit 3.1 to the Registration Statement on Form S-1, Registration No. 33-69522, dated September 25, 1993, and amended on
November 3, 1993
|             | 
|3(ii)        |  | Bylaws, incorporated herein by reference to Exhibit 3.2 to the Registration Statement on Form S-1, Registration No. 33-69522, dated September 25, 1993 and amended on November 3,
1993.                      
|             | 
|4            |  | Specimen Stock Certificate, incorporated by reference to Exhibit 4.1 to the Registration Statement on Form S-1, Registration No. 33-69522, dated September 25, 1993, and amended on November 3,
1993         
|             | 
|11           |  | See Note 1 to Consolidated Financial Statements set forth at page 39 of the this Annual Report for the Statement Regarding Computation of Per Share Earnings.                                                
|             | 
|21           |  | See Item 1 of this Annual Report  Description of Business  Subsidiaries.                                                                                                                                 
|             | 
|23(i)        |  | Consent of Dixon Hughes PLLC                                                                                                                                                                                 
|             | 
|31.1         |  | Certification of Chief Executive Officer Pursuant to Rule 13a-14(a) under the Securities and Exchange Act of 1934.                                                                                           
|             | 
|31.2         |  | Certification of Chief Executive Officer Pursuant to Rule 13a-14(a) under the Securities and Exchange Act of 1934.                                                                                           
|             | 
|32           |  | Certification Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. 1350)                                                                                                                     
|             | 
|99.1         |  | Tables of Additional Financial Information Required by Industry Guide 3                                                                                                                                      



61