10-Q 1 fsb10qsb2-06.txt SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2006 Commission File Number 000-28037 FIRST SOUTH BANCORP, INC. (Exact Name of registrant as specified in its charter) SOUTH CAROLINA 57-1086258 (State of Incorporation) (IRS Employer Identification number) 1450 John B. White, Sr., Blvd. Spartanburg, South Carolina 29306 (Address of Principal Executive Office) (864) 595-0455 (Registrant's Telephone Number) Check whether the registrant (1) has filed all reports to be filed by Section 13 or 15(d) of the Exchange Act during the past 12 months (or for such shorter period that the Issuer was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES {X} N0 { } Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of "accelerated filer and a large accelerated filer" in Rule 12b-2 of the Exchange Act. (Check one): Large accelerated filer ( ) Accelerated filer ( ) Non-accelerated filer(X) Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act. ( ) Yes (X) No State the number of shares outstanding of each of the registrant's classes of common equity, as of the latest practical date: Common Stock, no par value, 2,122,937 shares outstanding on August 7, 2006. FIRST SOUTH BANCORP, INC. FORM 10-Q INDEX

2 PART I - FINANCIAL INFORMATION Item 1 - Financial Statements FIRST SOUTH BANCORP, INC AND SUBSIDIARY Consolidated Balance Sheets (Dollar amounts in thousands)

See Notes to Consolidated Unaudited Financial Statements 3 FIRST SOUTH BANCORP, INC. AND SUBSIDIARY Consolidated Statements of Operations

See Notes to Consolidated Unaudited Financial Statements 4 FIRST SOUTH BANCORP, INC. AND SUBSIDIARY Consolidated Statements of Comprehensive Income (Dollar amounts in thousands) (Unaudited) Six Months Ended June 30 ------- 2006 2005 ---- ---- Net Income ......................................... $ 2,504 $ 860 Other comprehensive (loss): Change in unrealized holdings gains & losses on available for sale securities ........ (226) (76) Income tax benefit on other comprehensive income (loss) .................... 86 29 ------- ------- Total other comprehensive (loss) .................. (140) (47) ------- ------- Comprehensive income ............................... $ 2,364 $ 813 See Notes to Consolidated Unaudited Financial Statements 5 FIRST SOUTH BANCORP, INC. AND SUBSIDIARY Consolidated Statements of Cash Flows (Dollar amounts in thousands)

See Notes to Consolidated Unaudited Financial Statements 6 FIRST SOUTH BANCORP, INC. AND SUBSIDIARY Notes to Unaudited Consolidated Financial Statements Note 1. Basis of Presentation and Use of Estimates The accompanying unaudited financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with instructions to Form 10-Q and Regulation S-X of the Securities and Exchange Commission. Accordingly, they do not contain all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. However, in the opinion of management, all adjustments considered necessary for a fair presentation have been included. Operating results for the six months ended June 30,2006 are not necessarily indicative of the results that may be expected for the year ended December 31, 2006. For further information, please refer to the financial statements and footnotes thereto for the Company's fiscal year ended December 31, 2005, contained in the Company's 2005 Annual Report on Form 10-KSB. The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiary, the Bank. All significant intercompany balances and transactions have been eliminated in consolidation. Use of Estimates - The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect reported amounts of assets and liabilities and disclosure of contingent liabilities at the date of the financial statements, as well as the amounts of income and expenses during the reporting period. Actual results could differ from those estimates. Note 2. Accounting for Stock-Based Compensation The Company implemented SFAS No. 123(R),Share-Based Payment, on January 1, 2006. However, actions by the board of directors whereby the vesting of all unvested stock options was accelerated to December 30, 2005, avoided recognition of pre- tax compensation expense by the Company related to the adoption of SFAS 123 (R). As a result, the adoption of SFAS No. 123 (R) has no impact on the financial presentation of results of operations of the Company. The schedule below reflects pro forma information had the Company accounted for stock options in 2005 using the fair value method under SFAS No.123. (Dollar amounts in thousands, except per share amounts)

7 FIRST SOUTH BANCORP, INC. AND SUBSIDIARY In 2005 the fair value of each option grant was estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions used for the three-month periods ended March 31, 2005; a dividend yield of 0%, expected volatility of 50%, risk-free interest rate of 4.33%, and expected lives of 10 years for the options. Note 3 - Earnings per Share Earnings per share has been determined under the provisions of statement of Financial Accounting Standards No. 128, Earnings Per Share. For the six months ended June 30, 2006 and 2005, basic earnings per share has been computed based upon the weighted average common shares outstanding of 2,114,169 and 1,703,059, respectively. Earnings per share for the second quarter of 2006 compared to that of the second quarter of 2005, $.60 versus ($.01), respectively, is discussed in the Net Income section under the Management's Discussion and Analysis or Plan of Operation heading. The only potential stock of the Company as defined in Statement of Financial Accounting Standards No. 128, Earnings Per Share, is stock options granted to various officers and employees of the Bank. The following is a summary of the diluted earnings per share calculation for the six months ended June 30, 2006 and 2005 (Dollars in thousands, except share and per share data): Six Months Ended June 30, -------- 2006 2005 ---- ---- Net Income (in thousands) .................... $ 2,504 $ 860 Weighted average outstanding shares .......... 2,114,169 1,703,059 Basic Earnings Per Share ..................... $ 1.18 $ 0.50 Weighted average outstanding shares .......... 2,114,169 1,703,059 Dilutive effect of stock options ............. 53,992 84,777 ---------- ---------- Weighted average diluted shares .............. 2,168,161 1,787,836 Diluted earnings per share ........................................ $ 1.15 $ 0.48 Note 4 - Impact of Recently Issued Accounting Standards In February 2006, the FASB issued SFAS No. 155, Accounting for Certain Hybrid Financial Instruments, an amendment of FASB Statements No. 133 and 140. This Statement amends SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, and SFAS No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities, and resolves issues in Statement No. 133 Implementation Issue No. D1, Application of Statement 133 to Beneficial Interests in Securitized Financial Assets. The provisions of this statement are effective for all financial instruments acquired or issued after the beginning of an entity's first fiscal year that begins after September 15, 2006. The adoption of SFAS No. 155 is not expected to have a material impact on the consolidated financial statements of the Company. 8 FIRST SOUTH BANCORP, INC. AND SUBSIDIARY In March 2006, the FASB issued SFAS No. 156, Accounting for Servicing of Financial Assets, an amendment of FASB Statement No. 140. This statement amends SFAS No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, a replacement of FASB Statement 125 with respect to the accounting for separately recognized servicing assets and servicing liabilities. The provisions of this statement are effective for fiscal years beginning after September 15, 2006. The adoption of SFAS No. 156 is not expected to have a material impact on the consolidated financial statements of the Company. Other accounting standards that have been issued or proposed by the FASB or other standards-setting bodies that do not require adoption until a future date are not expected to have a material impact on the consolidated financial statements upon adoption. Note 5 - Stock Split On April 3, 2006, the Board of Directors of the Company approved a six-for-five split of the common stock effected in the form of a stock dividend for shareholders of record on April 20, 2006. Accordingly, all share and per share information presented throughout the financial statements have been restated to reflect the effect of the stock split. 9 Forward Looking Statements Statements included in this Form 10-Q which are not historical in nature are intended to be, and are hereby identified as "forward-looking statements" for purposes of the safe harbor provided by Section 21E of the Securities and Exchange Act of 1934, as amended. Words such as "estimate", "project", "intend", "expect", "believe", "anticipate", "plan", and similar expressions identify forward looking statements. The Company cautions readers that forward looking statements, including without limitation, those relating to the Company's new offices, future business prospects, revenues, working capital, liquidity, capital needs, adequacy of allowance for loan losses, interest costs, and income, are subject to certain risks and uncertainties that could cause actual results to differ from those indicated in forward looking statements, due to several important factors herein identified, among others, and other risks and factors identified from time to time in the Company's reports filed with the Securities and Exchange Commission. These forward-looking statements are based on current expectations, estimates and projections about our industry, management's beliefs, and assumptions made by management. Such information includes, without limitation, discussions as to estimates, expectations, beliefs, plans, strategies, and objectives concerning the Company's future financial and operating performance. These statements are not guarantees of future performance and are subject to risks, uncertainties and assumptions that are difficult to predict, particularly in light of the fact that the Company is a relatively new company with limited operating history. Therefore, actual results may differ from those expressed or forecasted in such forward-looking statements. The risks and uncertainties include, but are not limited to: o The Company's growth and ability to maintain growth; o government monetary and fiscal policies, as well as legislative and regulatory changes; o the effect of interest rate changes on our level and composition of deposits, loan demand and the value of our loan collateral and securities; o the effects of competition from other financial institutions operating in the Company's market areas and elsewhere, including institutions operating locally, regionally, nationally and internationally; o failure of assumptions underlying the establishment of the allowance for loan losses, including the value of collateral securing loans; and o loss of consumer confidence and economic disruptions resulting from terrorist activities. The Company undertakes no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. In light of these risks, uncertainties, and assumptions, the forward-looking events discussed in this report might not occur. 10 Item 2. Management's Discussion and Analysis or Plan of Operation This discussion is intended to assist in understanding the financial condition and results of operations of the Company, and should be read in conjunction with the financial statements and related notes contained elsewhere herein and in the Company's 2005 annual report on Form 10-KSB. Because the Bank is responsible for all of the Company's operations, the discussion will refer to the results of operations of the Bank. RESULTS OF OPERATIONS: Net Income For the first six months of 2006, First South Bancorp, Inc. earned a net income of approximately $2.504 million, or $ 1.15 per diluted share, compared to approximately $860 thousand, or $ .50 per diluted share, for the same period in 2005. Earnings per share increased by 130%. The 191% increase in net income is attributed to several factors including a 25.4% increase in net interest income from $5.996 million during the first six months in 2005 to $7.519 million during the same period in 2006. The provision for loan losses increased by $119 thousand, or 28.1%, from $423 thousand in the first six months of 2005 to $542 thousand during the same period in 2006. Non-interest income increased by 62.1% from $438 thousand in 2005 to $710 thousand during the first six months of 2006. Most of the $272 thousand increase resulted from a $72.4 thousand increase in loan brokerage fees and a $134.2 thousand increase in investment brokerage service fees. Non-interest expense during the first six months decreased 19.4%, from $4.679 million in 2005 to $3.769 million in the same period in 2006. With all of the standard major categories of non-interest expense, salaries and benefits, $481 thousand, occupancy, $59 thousand, and other operating, $227 thousand, experiencing an combined increase of $767 thousand, the overall $910 thousand non-interest expense decrease clearly resulted from the litigation settlement expense of $1.677 million recorded in June of 2005. For the three month period ending June 30, 2006, First South Bancorp, Inc. earned a net income of approximately $1.291 million, or $ .60 per diluted share, compared to an approximate loss of $14 thousand, or a loss just under $.01 per diluted share, for the same period in 2005. Though a number of factors contributed to the $1.305 million net difference between the second quarter income of 2006 and 2005, specifically non-interest income increased $325 thousand in 2006, salaries and benefits expense increased $311 thousand in 2006, occupancy expense increased $53 thousand in 2006, net interest income increased $653 thousand in 2006 and provision for income taxes increased $757 thousand in 2006, the most significant contributing factor to this difference was the $1.677 million litigation settlement expense recorded in June of 2005. Profitability Earnings of financial institutions are most commonly measured through ROAA (return on average assets) and ROAE (return on average equity). Return on average assets is the income for the period, annualized, divided by the average assets for the period. Return on average equity is the income for the period, annualized, divided by the average equity for the period. As is shown in Table One, ROAA and ROAE for the first six months of 2006 were 1.46% and 15.59%, respectively. 11 Table One Selected Earnings Ratios at or for the Six Months Ending June 30, ---------------------------------------- 2006 2005 ---- ---- Return on Average Assets ........... 1.46% 0.57% Return on Average Equity ........... 15.59% 6.19% Dividend Payout Ratio .............. N/A N/A Average Stockholders Equity as a Percentage of Average Assets ........................... 9.36% 9.13% Excluding periods when other than ordinary course of business revenues or expenditures are recorded, such as the litigation expense experienced by the Company in 2005, performance results as measured by ROAA and ROAE can be primarily attributed to changes in the volume and composition of earning assets and the interest rate environment. Details of these changes are provided in the following discussion of net interest income. Net Interest Income Net interest income, the major component of First South Bancorp's income, is the amount by which interest and fees on earning assets exceeds the interest paid on interest-bearing liabilities, primarily deposits. Net interest income for the first six months of 2006 increased over that of the same period in 2005 by $1.523 million, or 25.4%. This increase was almost exclusively the result of an economic environment in which interest rates were rising and the Company's earning assets were repricing higher and more rapidly than interest-bearing liabilities. Total average earning assets exceeded total average interest-bearing liabilities during the first six months of 2006 by $38.029 million, as compared to $36.302 million during the same period in 2005. The yield on earning assets for the six month period ending in 2006, as compared to the same period in 2005, increased 157 basis points. The funding cost of interest-bearing liabilities during the first six months of 2006, as compared to the same period in 2005, increased 124 basis points, or 33 basis points less than increase in the yield on earning assets. The net result of the volume and rate changes between the two first six month periods was an improvement of 33 basis points in the interest spread between earning assets and interest-bearing liabilities for the first six months of 2006. The increase in net interest income in the second quarter of 2006, as compared to that of the same period in 2005, resulted from a combination of factors. Average earning assets during the second quarter of 2006 exceeded average interest-bearing liabilities by $39.5 million compared to a difference between earning assets and interest-bearing liabilities in the second quarter of 2005 of $35.1 million. The volume differential coupled with an increase in the interest spread in 2006 of 11 basis points, from 3.77% in 2005 to 3.88% in 2006, combined to produce a 2006 second quarter increase in net interest income over that of the same period in 2005 of $653 thousand. Table Two includes a detailed comparison of the average balances, yields and rates for the interest sensitive segments of the Company's balance sheets for the six months ended June 30, 2006 and 2005. 12

13 Non-interest Income Non-interest income for the first six months of 2006 increased $272 thousand to $710 from $438 thousand during the same period in 2005, a 62.1% increase. Service charges decreased by $20 thousand from $155 thousand during the first six months of 2005 to $135 thousand during the same period in 2006. This decrease resulted primarily from the increase in 2006 of the earnings allowance interest rate which resulted in a larger credit against business account service charges determined through full account analysis. The largest dollar increase in any of the three major categories of non-interest income was experienced in the area of commissions and fees. The $241 thousand increase in total commissions and fees in 2006 over the same six month period in 2005 was most directly related to the $72.4 thousand increase in loan brokerage fees and the $134.2 thousand increase in investment brokerage service fees. Non-interest income in the second quarter of 2006 exceeded that of the same period in 2005 by $325 thousand. Though service charge income decreased $12 thousand in the second quarter of 2006, as compared to that of the same period in 2005, all other categories of non-interest income, but primarily commissions and fees, increased in 2006 over 2005. The category of commission and fees experienced the greatest increase, from $137 thousand in the second quarter of 2005 to $474 thousand during the same period in 2006. Commissions and fees resulting from mortgage loan, investment brokerage, and loans brokerage services accounted for $239 thousand, or 71%, of the total $337 thousand increase. Table Three provides a six month 2006 to 2005 comparison of various categories of non-interest income. Table Three Summary of Total Noninterest Income for the Six Months Ended June 30, 2006 and 2005 (Amounts in thousands) 2006 2005 ---- ---- Service Charges ............................. $135 $155 Commissions & Fees .......................... 494 253 Other Noninterest Income .................... 81 30 ---- ---- Total ....................................... $710 $438 Non-interest Expense Non-interest expense for the first six months of 2006 decreased 19.4%, from $4.679 million in 2005 to $3.769 million in 2006. With increases in all of the standard major categories of non-interest expense, salaries & benefits - $481 thousand, occupancy - $59 thousand, and other operating - $227 thousand, experiencing a combined increase of $767 thousand, the overall $910 thousand decrease clearly resulted from the expense incurred in June of 2005 related to the $1.677 million litigation settlement expense. Non-interest expense for the second quarter of 2006, compared to the same period in 2005, declined by $910 thousand. Exclusive of the unusual non-interest expense in the second quarter of 2005 associated with the litigation settlement expense of $1.677 million, which alone was the basis for the $910 thousand decrease in non-interest expense in the second quarter of 2006 compared to the same period in 2005, all standard categories of non-interest expense increased in 2006. Compared to the second quarter of 2005, expenses in the second quarter of 2006 for salaries and benefits increased $311 thousand, or 33.8%, occupancy expense increased $53 thousand, or 29.6%, other operating expense $140 thousand, or 34.9% The major contributing factors to the 2006 increase in each category of non-interest expense were the addition of two additional employees and office expansions in the Columbia and Bluffton branch locations. 14 Table Four provides a six month 2006 to 2005 comparison of various categories of non-interest expense. Table Four Summary of Total Non-interest Expense For the Six Months Ended June 30, 2006 and 2005 (Amounts in thousands) 2006 2005 ---- ---- Salaries & Employee Benefits .................. $2,330 $1,849 Occupancy & Equipment ......................... 440 381 Other expense ................................. 999 772 Net Litigation Settlement ..................... - 1,677 ------ ------ Total ......................................... $3,769 $4,679 Income Taxes The provision for income taxes for the six months ended June 30, 2006 was $1.414 million as compared to $472 thousand during the same six month period in 2005, a 199.6% increase. This increase was due to the $2.586 million, or 194.1%, increase in pretax income in 2006. CHANGES IN FINANCIAL POSITION Investment portfolio During the first six months of 2006, nine government agency issues totaling $8,500,000 were purchased. The average annual yield on these purchased investments is 5.68 %. During the same period, two government agency issues totaling $4,000,000 with an average annual yield of 3.02% matured. During the same period, $326.4 in principal pay-downs with an average coupon yield of 4.99% were recorded on mortgage-backed investments.

*Excludes equity securities with no readily determinable market value of $1.269 million on December 31, 2005 and $1.326 million on June 30, 2006. Loan portfolio During the twelve month period between June 30, 2005 and June 30, 2006, loans increased by $43.1 million, or 17.0%. The percentage composition of the loan portfolio, as shown in Table Six, changed slightly with the percentage of total real estate loans to total loans increasing by .6% and the percentage of commercial and industrial loans to total loans decreasing by .6%. As shown in Table Seven, on June 30, 2006 Variable Rate Loans comprised 78.7% of the total loan portfolio. On June 30, 2006, there were thirteen loans totaling $3.2 million on non-accrual status.

Excludes loans on non-accrural status of $3.152 million The allowance for loan losses, which represents management's estimate of the losses inherent in the loan portfolio, is analyzed monthly in accordance with a board approved plan. This judgmental analysis is based on a model that assigns a risk rating on each individual loan and considers the loss risks associated with various risk categories in relationship to the current and forecasted economic environment. Management also monitors the overall portfolio, as well as the level of reserves maintained by peer banks. The monthly provision for loan losses may fluctuate based on the results of this analysis. The increase of $119 thousand in loan loss provision for the six months ending June 30, 2006, as compared to the same period in 2005, was primarily due to the application of the bank's formula for calculating the allowance for loan losses based on loan grades and the growth the bank experienced. The loan portfolio during the first six months of 2006 experienced a downgrading pertaining to some outstanding loans in the portfolio. Table Eight provides the results of the year-to-date analysis for six month ending June 30, 2006 and 2005, as well as the amounts charged to this reserve as a loss and credited to this reserve as a recovery. Table Eight Analysis of the Allowance for Loan Losses for the Six Months Ended June 30 2006 2005 ---- ---- Balance at Beginning of Year ............ $3,000,000 $2,900,000 Provision Charged to Operations ......... 542,000 423,000 Loans Charged-Off ....................... (206,000) (325,000) Loan Recoveries ......................... 14,000 2,000 ---------- ---------- Balance at End Of Period ................ $3,350,000 $3,000,000 Interest rate risk Financial institutions are subject to interest rate risk to the degree that their interest bearing liabilities (consisting principally of customer deposits) mature or reprice more or less frequently, or on a different basis, than their interest earning assets (generally consisting of intermediate or long-term loans and investment securities). The match between the scheduled repricing and maturities of the Bank's earning assets and interest bearing liabilities within defined time periods is referred to as "gap" analysis. The Bank's Asset/Liability Management Committee is responsible for managing the risks associated with changing interest rates and their impact on earnings. The regular evaluation of the sensitivity of net interest income to changes in interest rates is an integral element of the interest rate risk management 17 process. At June 30, 2006, the cumulative one-year gap for the Bank was a negative, or liability sensitive, $5.5 million. At June 30, 2006, the cumulative five-year gap for the Bank was a positive, or asset sensitive, $20.6 million. A positive gap means that assets would reprice faster than liabilities if interest rates changed. The Bank's gap is within policy limits which were established to reduce the adverse impact on earnings which movements in interest rates can cause. Intense competition in the Bank's markets continues to pressure quality loan rates downward while conversely pressuring deposit rates upward. Table Nine demonstrates how the relationship between interest-bearing assets and interest-bearing liabilities was calculated for June 30, 2006.

18 Liquidity Liquidity is the ability to meet current and future obligations through liquidation or the maturity of existing assets or the acquisition of additional liabilities. Adequate liquidity is necessary to meet the requirements of customers for loans and deposit withdrawals in the most timely and economical manner. Some liquidity is ensured by maintaining assets which may be immediately converted into cash at minimal cost (amounts due from banks and federal funds sold). However, the most manageable sources of liquidity are composed of liabilities, with the primary focus on liquidity management being the ability to obtain deposits within the Bank's service area. Core deposits (total deposits less wholesale time deposits) provide a relatively stable funding base, and were equal to 61% of total assets at March 31, 2006. Asset liquidity is provided from several sources, including amounts due from banks and federal funds sold, and funds from maturing loans. The Bank is a member of the FHLB of Atlanta and, as such, has the ability to increase its borrowings from that institution. The bank also has $12 million available through lines of credit with other banks as an additional source of liquidity funding. Management believes that the Bank's overall liquidity sources are adequate to meet its operating needs. Off-Balance Sheet Arrangements The Company, through the operations of the Bank, makes contractual commitments to extend credit in the ordinary course of its business activities. These commitments are legally binding agreements to lend money to customers of the Bank at predetermined interest rates for a specific period of time. At June 30, 2006, the Bank had issued commitments to extend credit of $49.3 million through various types of lending arrangements. Of these commitments, 62.9 %, or $31.0 million, expire within one year, and 37.1 %, or $18.3 million, expiring in more than one year. Past experience indicates that many of theses commitments to extend credit will expire unused. The Company evaluates each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Company upon the extension of credit, is based on the credit evaluation of the borrower. Collateral varies, but may include accounts receivable, inventory, property, plant and equipment, commercial and residential real estate. Capital Resources Tier 1 capital for the Company during the six month period between December 31, 2005 and June 30, 2006, increased $2.641 resulting from a $2.504 million increase in retained earnings and the exercising of stock options in the amount of $137 thousand. The Company and the Bank are subject to regulatory capital adequacy standards. Under these standards, financial institutions are required to maintain certain minimum capital ratios of capital to risk-weighted assets and average total assets. Under the provisions of the Federal Deposit Insurance Corporation Improvement Act of 1991, federal financial institutions regulatory authorities are required to implement prescribed "prompt corrective action" upon the deterioration of the capital position of a bank. If the capital position of an affected institution were to fall below certain levels, increasingly stringent regulatory corrective actions are mandated. At June 30, 2006, the Bank met all of the requirements to be well capitalized. The Bank's and Company's June 30, 2006 capital ratios are presented in the following table, compared with the FDIC's "well capitalized" ratios and the minimum ratios under the FDIC and Federal Reserve regulatory definitions and guidelines: 19

20 Item 3. Quantitative and Qualitative Disclosures About Market Risk. The Company's exposure to market risk is primarily related to the risk of loss from adverse changes in market prices and rates. This risk arises principally from interest rate risk inherent in the Company's lending, deposit gathering and borrowing activities. Management actively monitors and manages its interest rate risk exposure. Although the Company manages other risks, such as credit quality and liquidity risk in the normal course of business, management considers interest rate risk to be its most significant market risk, and this risk could potentially have the largest material effect on the Company's financial condition and results of operations. Other types of market risk, such as commodity price risk and foreign currency exchange risk, do not arise in the normal course of the Company's community banking operations. The Company periodically uses a simulation model to assist in the management of interest rate risk. Since the model incorporates the use of estimated changes in growth and mix of both earning assets and interest-bearing liabilities over established time periods, as well as projected changes in interest rates, the resulting "What-if" scenarios are heavily dependant on accurate forecasts and can not be relied on as indicative of actual future results. As of June 30, 2006, there was no significant change from the interest sensitivity analysis performed and disclosed in the 2005 Annual Report on Form 10-KSB filed with the Securities and Exchange Commission. 21 Item 4 - Controls and Procedures (a) Based on the evaluation required by 17 C.F.R. Section 240.13a-15(b) or 240.15d-15(b) of the Company's disclosure controls and procedures (as defined in 17 C.F.R. Sections 240.13a-15(e) and 240.15d-15(e)), the Company's chief executive officer and chief financial officer concluded that such controls and procedures, as of the end of the period covered by this quarterly report, were effective. (b There has been no change in the Company's internal control over financial reporting during the most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company's internal control over financial reporting. PART II - OTHER INFORMATION Item 4 - Submission of Matters to a Vote of Security Holders a) The Corporation held its annual meeting of shareholders on May 17,2006 b) The following persons were elected as directors of the Corporation, each to serve a three year term until the Annual Meeting of Shareholders in 2009. Name Shares Voted Broker For Withhold Non-Votes --- -------- --------- Roger A. F. Habisreutinger 1,262,573 75,662 0 Chandrakant V. Shanbhag 1,262,573 75,662 0 Other directors to continue serving after the meeting are: Harold E. Fleming, Joel C. Griffin, Herman E. Ratchford Barry L. Slider, and David G. White Item 6 - Exhibits Exhibit No. Description 31.1 13a-14(a)/15d-14(a) Certifications of Chief Executive Officer 31.2 13a-14(a)/15d-14(a) Certifications of Chief Financial Officer 32 Section 1350 Certifications 22 SIGNATURE Pursuant to the requirements of the Securities and Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. First South Bancorp, Inc. s/Barry L. Slider August 11, 2006 --------------------------------------------- Barry L. Slider, President and Chief Executive Officer s/V. Lewis Shuler --------------------------------------------- V. Lewis Shuler, Executive Vice President (Principal Accounting Officer) 23 Exhibit Index Exhibit No. Description 31.1 13a-14(a)/15d-14(a) Certifications of Chief Executive Officer 31.2 13a-14(a)/15d-14(a) Certifications of Chief Financial Officer 32 Section 1350 Certifications 24

FIRST SOUTH BANCORP INC 10-Q