10-Q 1 fsb10-q2dqtr07.txt UNITED STATES 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, 2007 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, 2,161,038 shares outstanding on August 13, 2007. FIRST SOUTH BANCORP, INC. FORM 10-Q INDEX PART I - FINANCIAL INFORMATION Page Item 1. Financial Statements (Unaudited) Consolidated Balance Sheets.................................3 Consolidated Statements of Income...........................4 Consolidated Statements of Comprehensive Income.............5 Consolidated Statements of Cash Flows.......................6 Notes to Unaudited Consolidated Financial Statements......7-9 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations............................9-21 Item 3. Quantitative and Qualitative Disclosures about Market Risk..22 Item 4.T Controls and Procedures ....................................23 Part II- OTHER INFORMATION Item 4. Submission of Matters to a Vote of Security Holders........24 Item 6. Exhibits...................................................25 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 unaudited consolidated financial statements. 3 FIRST SOUTH BANCORP, INC. AND SUBSIDIARY Consolidated Statements of Income

See notes to unaudited consolidated financial statements. 4 FIRST SOUTH BANCORP, INC. AND SUBSIDIARY Consolidated Statements of Comprehensive Income (Dollar amounts in thousands)

See notes to unaudited consolidated financial statements. 5 FIRST SOUTH BANCORP, INC. AND SUBSIDIARY Consolidated Statements of Cash Flows (Dollar amounts in thousands)

See notes to unaudited consolidated 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 and three months ended June 30, 2007 are not necessarily indicative of the results that may be expected for the year ended December 31, 2007. For further information, please refer to the financial statements and footnotes thereto for the Corporation's fiscal year ended December 31, 2006, contained in the Corporation's 2006 Annual Report on Form 10-K. The consolidated financial statements include the accounts of the Corporation 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 - 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 quarters ended June 30, 2007 and 2006, basic earnings per share has been computed based upon the weighted average common shares outstanding of 2,160,785 and 2,110,679, respectively. The only potential dilutive security 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 prior to 2006. The following is a summary of the diluted earnings per share calculation for the three months ended June 30, 2007 and 2006 (Dollars in thousands, except share and per share data):

7 Note 3 - Impact of Recently Issued Accounting Standards 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 SFAS No. 125 with respect to the accounting for separately recognized servicing assets and servicing liabilities. The provisions of this statement were effective as of the beginning of the Company's 2007 fiscal year. The adoption of SFAS No. 156 did not have a material impact on the Company's financial position and results of operations. In July 2006, FASB issued Interpretation No. 48, "Accounting for Uncertainty in Income Taxes--an interpretation of SFAS No. 109" ("FIN 48"), which clarifies the accounting for uncertainty in tax positions. This interpretation requires that the Company recognize in its financial statements, the impact of a tax position, if that position is more likely than not of being sustained on audit, based on the technical merits of the position. The provisions of FIN 48 were effective as of the beginning of the Company's 2007 fiscal year, with the cumulative effect of the change in accounting principle recorded as an adjustment to opening retained earnings. The Company adopted FIN 48 effective January 1, 2007. The adoption of FIN 48 did not have a material impact on the Company's financial position and results of operations. In September 2006, FASB issued SFAS No. 157, "Fair Value Measurements" ("SFAS No. 157"), which enhances existing guidance for measuring assets and liabilities using fair value and requires additional disclosure about the use of fair value for measurement. The Statement is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. The Company will be required to adopt SFAS No. 157 in the first quarter of 2008, and is currently evaluating the impact of the adoption of SFAS No. 157 on its financial position and results of operations, including the valuation methods and support for the assumptions that underlie the valuation. During the first quarter of 2007, FASB issued SFAS No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities" ("SFAS 159"), which permits entities to choose and measure many financial instruments and certain other items at fair value. The Company will be required to adopt SFAS No. 159 in the first quarter of 2008, and is currently evaluating the impact of the adoption of SFAS No. 159 on its financial position and results of operations. In September 2006, the Emerging Issues Task Force issued EITF Issue 06-4, "Accounting for Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements" ("EITF Issue 06-4"). EITF Issue 06-4 requires that, for endorsement split-dollar insurance arrangements that provide a benefit to an employee that extends to postretirement periods, an employer should recognize a liability for future benefits in accordance with SFAS No. 106 or APB No. 12 based on the substantive agreement of the employee. If the employer has effectively agreed to maintain a life insurance policy during postretirement periods, the costs of the life insurance policy during the postretirement periods should be accrued in accordance with either FASB Statement No. 106 or APB No. 12. If the employer has agreed to provide a death benefit, the employer should recognize a liability for the future death benefit in accordance with either SFAS No. 106 or APB No. 12. EITF Issue 06-4 is effective for fiscal years beginning after December 15, 2007. The Company is currently evaluating the impact of EITF Issue 06-4 on its financial statements. 8 Note 4 - Other Borrowed Funds Other borrowed funds consisted of a 10 year $10 million one year convertible advance at 4.115% issued on April 5, 2007 and a 10 year $5 million six month convertible advance at 4.06% issued on April 5, 2007 from the Federal Home Loan Bank of Atlanta Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 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 2006 annual report on Form 10-K. Because the Bank is responsible for all of the Company's operations, the discussion will refer to the results of operations of the Bank. 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 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. 9 RESULTS OF OPERATIONS: THREE MONTH PERIOD ENDED JUNE 30, 2007, COMPARED TO THE SAME PERIOD ENDED JUNE 30, 2006, AND SIX MONTH PERIOD ENDED JUNE 30, 2007, COMPARED TO JUNE 30, 2006. Net Income For the quarter ended June 30, 2007, the Company earned a net profit of $739 thousand, a decrease of $551 thousand, or 42.7%, from the same period in 2006. Diluted per share quarterly earnings were $.34 in 2007 and $.59 in 2006. The decrease in earnings in 2007, as compared to the same quarter in 2006, can be primarily attributed to the $442 thousand, or 12.7%, decrease in net interest income after provision, the $320 thousand, or 58.6%, decrease in non-interest income, and the $102 thousand, or 5.1%, increase in non-interest expense discussed below. Correspondingly, the provision for income taxes for the second quarter of 2007 has decreased $313 thousand as compared to the second quarter of 2006. This offsets the overall decrease to income before taxes of $864 thousand, or 42.8%, in the second quarter of 2007 as compared to the second quarter of 2006. For the first six months of 2007, the Company earned a net income of approximately $1.565 million, or $.72 per diluted share, compared to approximately $2.504 million, or $1.15 per diluted share, for the same period in 2006. Earnings per share decreased by 37.4% in the first six months of 2007 as compared to the same period in 2006. The decrease in net income of 37.5% is attributed to several factors including a $807 thousand, or 11.6%, decrease in net interest income after the provision, a decrease in non-interest income of $212 thousand, or 29.9%, and an increase in non-interest expense of $448 thousand, or 11.9%, during the first six months in 2007 as compared to the same period in 2006. Correspondingly, the provision for income taxes for the first six months of 2007 has decreased $528 thousand, or 37.3%. The decrease in the provision for the first six months of 2007 as compared to the first six months of 2006 offsets the overall decrease in income before tax of $939 thousand, or 37.5%, for the first six months of 2007 as compared to the same period in 2006. 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 three month period ending June 30, 2007 were 0.83% and 8.01%, respectively. For the first six months of 2007 as is shown in Table One, ROAA and ROAE were 0.89% and 8.53%, respectively. 10 Table One

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 quarter ended June 30, 2007 decreased by $208 thousand, or 5.6%, as compared to the 2006 quarter. Net interest income for the first six months of 2007 decreased by $448 thousand, or 6.0%, over the same period in 2006. This decrease can be largely attributed to the change in the economic environment between the first six months of 2006 and 2007. During the first six months of 2006, interest rates were rising and the Company's earning assets were repricing more rapidly than interest-bearing liabilities. During the first six months of 2007 when interest rates were stable, the repricing frequency of interest-bearing liabilities, especially in the area of time deposits, exceeded that of earning assets. The extent to which the earnings in 2007 were negatively impacted by the change in the economic environment between the two first six month periods is shown in Table Two. The average yield on earning assets increased in 2007 over that of 2006 by 37 basis points (8.56%-8.19%), while the cost of interest-bearing liabilities between the two periods increased 86 basis points (4.97% - 4.11%). In addition, contributing to the negative effect of the change in the economic environment between the periods are changes in the Company's balance sheet. The increase in average earning assets of $9.5 million in the first six months as compared to the same period in 2006 exceeded the $7.9 million increase in interest-bearing liabilities by $1.6 million. Although the growth in average earning assets exceeded interest bearing liabilities, it was not sufficient to offset the pace of repricing for average interest-bearing liabilities. The net effect of these combined changes between the two first six month periods resulted in a 49 basis point (3.59% - 4.08%) decrease in the interest spread from 2006 to 2007. In addition, the competition from new community banks and new branch offices of older banks in the Spartanburg, Columbia, and Bluffton areas of South Carolina has increased the interest expense of interest-bearing liabilities and reduced the interest income of loans. 11 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, 2007 and 2006. Table Two Net Interest Income and Average Balance Analysis for the Six Months Ended June 30, 2007 and 2006 (Amounts in thousands)

(1) Annualized 12 Noninterest Income Noninterest income for the second quarter of 2007 decreased $320 thousand, or 58.6%, to $226 thousand for the second quarter of 2007 from $546 thousand for the second quarter of 2006. The decrease is primarily composed of a $177 thousand decrease in brokerage service commissions, and a $118 thousand decrease in loan brokerage commissions in the second quarter of 2007 compared to the second quarter in 2006. The Loan Brokerage department was terminated as of December 2006, therefore no income from this activity has been reported in 2007. Noninterest income for the first six months of 2007 decreased $212 thousand, or 29.9%, from the $710 thousand amount recorded during the first six months in 2006. This decrease is the net effect of an increase in Other Non-interest Income of $21 thousand, a decrease in Commission & Fees of $347 thousand, and a decrease in Service Charges of $21 thousand. The decrease in Commissions and Fees is predominately a decrease in Brokerage Service Commissions of $166k and Loan Brokerage Commissions of $130k. The Loan Brokerage department was terminated as of December 2006, therefore no income from this activity has been reported in 2007. As shown in Table Three, service charge income decreased by $21 thousand from $135 thousand during the first six months of 2006 to $114 thousand during the same period in 2007. This decrease resulted primarily from the increase in 2007, as compared to that of the same period in 2006, of the earnings allowance interest rate which resulted in a larger credit to business accounts as an offset against service charges determined through full account analysis. Table Three provides a three and six month 2007 to 2006 comparison of various categories of noninterest income.

Noninterest Expense Noninterest expense for the second quarter of 2007 increased by $102 thousand, or 5.1% compared to the second quarter of 2006. The increase consisted primarily of a $48 thousand increase in salaries and benefits, and a $23 increase for loss on sale of bank owned assets. As discussed below increases in salary and benefits are related to increases in the number of personnel at the end of the second quarter of 2007 as compared to the end of the second quarter in 2006. Noninterest expense for the first six months of 2007 increased by $448 thousand, or 11.9%, over the first six months total in 2006 of $3.8 million. The increase in salaries and employee benefits, and the increase in other noninterest expenses were the primary reasons for the overall increase in noninterest expense. Salaries and benefits increased 10.8% from the first six months 2006 total of $2.3 million. This increase was primarily the result of an increase in 13 the number of employees from 62 to 66 during the period ending June 30, 2006 to June 30, 2007. The increase in employees is consistent with the bank's efforts regarding future growth plans. Other noninterest expenses increased 13.3% from the first six months 2006 total of $999 thousand. This increase is primarily the result of an increase in loss on sale of bank owned assets of $54 thousand and an increase in other loan related fees of $29 for the first six months of 2007 from the first six months of 2006. Table Four provides a three and six month 2007 to 2006 comparison of the various categories of noninterest expense.

Income Taxes Provision for income taxes for the three month period ending June 30, 2007 decreased $313, or 42.9%, to $416 compared to $729 thousand for the three month period ending June 30, 2006. This decrease resulted from the corresponding decrease in income before tax of $864 thousand, or 42.8% between the second quarter of 2007 and 2006. Provision for income taxes for the six months ended June 30, 2007 was $886 thousand as compared to $1.414 million in 2006 during the same period, a 37.3% decrease. This decrease was due to the overall decrease in income before taxes of $1.467 million, or 37.4%, in 2007 as compared to that of 2006. CHANGES IN FINANCIAL POSITION Investment portfolio During the first six months of 2007, there were $1 million in purchases, $4 million in maturities, and $184 thousand of paydowns. There were no calls of investment portfolio holdings during the first six months of 2007. As compared to the same period in 2006, the annual yield of the investment portfolio during the first six months of 2007 increased by 71 basis points to 5.25% from 4.54%. 14

Excludes equity securities with no readily deteminable market value of $741 thousand on December 31, 2006 and $1.311 million on June 30, 2007. Loan portfolio From December 31, 2006 to June 30, 2007 total loans grew from $296.5 million to $310.5 million, or 4.75%. The percentage composition of the loan portfolio, as shown in Table Six, changed slightly as the percentage of real estate loans declined by 1.10% of the total portfolio from 82.8% on December 31, 2006 to 81.7% on June 30, 2007. Commercial and industrial loans increased by 1.02% as a percentage of the loan portfolio from 17.05% on December 31, 2006 to 18.07% as of June 30, 2007. As shown in Table Seven, Variable Rate Loans comprised 76.3% of the total loan portfolio. On June 30, 2007, there were ten loans totaling $1.6 million on non-accrual status. 15

Excludes loans on non-accrual status of $1.6 million 16 The allowance for loan losses is analyzed monthly in accordance with a board approved plan. This judgmental analysis is based on a model that assigns a risk rating to each individual loan and considers the loss risks associated with the various categories of loans in relationship to the current and forecasted economic environment. Management also monitors the overall loan portfolio, as well as the level of reserves being maintained by peer banks. The monthly provision for loan losses may fluctuate based on the results of this analysis. Of the $901 thousand provision amount credited to the loan loss reserve during the first six months of 2007, $667 thousand or 74.0%, of the total was credited as a replacement of reserves covering the amount of net loan losses during the period. $234 thousand, or 26.0%, of the total provision amount credited during the first six months was made to cover loan growth. Table Eight provides the results of the year-to-date analysis for the six months ending June 30, 2007 and 2006, 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, (Amounts in thosands) 2007 2006 ---- ---- Balance at Beginning of Year .............. $ 3,275 $ 3,000 Provision Charged to Operations ........... 901 542 Loans Charged-Off ......................... (736) (206) Loan Recoveries ........................... 14 14 ------- ------- Balance at End Of Period .................. $ 3,454 $ 3,350 ======= ======= 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 part of interest rate risk management. At June 30, 2007, the cumulative one-year gap for the Bank was negative, or liability sensitive, $28.6 million. At June 30, 2007, the cumulative five-year gap for the Bank was positive $39.4 million. A positive gap means that assets would reprice faster than liabilities if interest rates changed, while interest-bearing liabilities reprice faster than assets in a negative gap position. 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, 2007. 17

* - Amortized Cost ** - Excludes $1.6 million in loans on non-accrural status. *** - Net of investment in FSBS Capital Trust of $155 thousand. 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 63.1% of total assets at June 30, 2007. 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 the Bank's borrowings from that institution increased by $15 million for the first six months of 2007. These borrowings were made on a variable rate (daily rate) credit basis. 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. Capital Resources The increase in Tier 1 capital for the Company during the six month period between December 31, 2006 and June 30, 2007 resulted from a $1.6 million increase in retained earnings and the exercising of stock options in the amount of $74.4 thousand. The most significant contributors to the difference between Tier 1 Capital between the Company and the Bank at June 30, 2007, are the $5 million Trust Preferred issuance proceeds, considered Tier 1 Capital at the holding company level and Tier 2 Capital at the bank level, and the $1.826 million received from the exercise of stock options, which is in compliance with the Board's intention to keep at this time that amount of capital at the holding company level. 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, 2007 the Company and the Bank met all of their applicable capital requirements. The Bank's and Company's June 30, 2007 capital ratios are presented in the following table, compared with the "well capitalized" and minimum ratios under the FDIC regulatory definitions and guidelines: 19

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, 2007, the Bank had issued commitments to extend credit of $62.5 million and standby letters of credit of $1.6 million through various types of lending arrangements. Of these commitments, 54.6 %, or $35.0 million, expire within one year, and 45.4 %, or $29.1 million, expiring in more than one year. Past experience indicates that many of these 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. 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 risks, 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, 2007, there was no significant change from the interest sensitivity analysis performed and disclosed in the 2006 Annual Report on Form 10-K filed with the Securities and Exchange Commission. Item 4.T - Controls and Procedures 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. 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. 21 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 June 27, 2007. 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. Shares Voted Broker Name For Withold Non-Votes ---- --- ------- --------- Harold E. Fleming 1,649,478 156,657 0 Joel C. Griffin 1,649,478 156,567 0 Barry L. Slider 1,645,098 161,037 0 Other directors to continue serving after the meeting are: Roger A. F. Habisreutinger, Chandrakant V. Shanbhag, Herman E. Ratchford, and David G. White c) Ratification of the selection of Cherry, Bekaert & Holland, L.L.P., as the registrant's independent auditors was approved with the following vote of shares: Broker FOR AGAINST ABSTAIN Non-Votes ----- ------- ------- --------- 1,700,410 109,835 270 0 22 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 23 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 14, 2007 ------------------------------------------- Barry L. Slider, President and CEO s/V. Lewis Shuler --------------------------------------------- V. Lewis Shuler, Executive Vice President (Principal Accounting Officer) 24 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 25

FIRST SOUTH BANCORP INC 10-Q