UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-K

FOR ANNUAL AND TRANSITION REPORTS
PURSUANT TO SECTIONS 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

(Mark One)

þ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2004

OR

o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                                                              to                                                             

Commission file number 000-11448

LSB BANCSHARES, INC.

Registrant’s telephone number, including area code (336) 248-6500

Securities registered pursuant to Section 12(b) of the Act:

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, Par Value $5.00 Per Share

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

     Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive

proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o

     Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes þ No o

     The aggregate market value of the voting stock held by nonaffiliates, computed by reference to the price at which the common equity was last sold, as of the last business day of the registrant’s most recently completed second fiscal quarter was $133,103,400.

     There were 8,582,159 shares of the registrant’s common stock outstanding as of February 23, 2005.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the registrant’s Proxy Statement for the Annual Meeting of shareholders to be held on April 20, 2005 are incorporated by reference into Part III of this Form 10-K.

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LSB BANCSHARES, INC.
AND SUBSIDIARIES

FORM 10-K FOR THE FISCAL YEAR ENDED DECEMBER 31, 2004

TABLE OF CONTENTS

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PART I

FORWARD-LOOKING STATEMENTS

This Form 10-K contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements represent expectations and beliefs of LSB Bancshares, Inc. (“Bancshares”) including but not limited to Bancshares’ operations, performance, financial condition, growth or strategies. These forward-looking statements are identified by words such as “expects”, “anticipates”, “should”, or other similar statements about future events. For this purpose, any statements contained in this Form 10-K that are not statements of historical fact may be deemed to be forward-looking statements. These forward-looking statements involve estimates, assumptions by management, risks and uncertainties that could cause actual results to differ materially from current projections depending on a variety of important factors, including without limitation the potential impact of changes in interest rates, effects of future economic conditions, the effects of competition, the ability of Bancshares to continue its growth strategy, Bancshares’ dependence on management and key personnel, and legislative and regulatory changes. Additional factors that could cause actual results to differ materially from those anticipated by forward-looking statements are listed in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” which begins on page 13 below, and are discussed in Bancshares’ filings with the Securities and Exchange Commission, including without limitation its Annual Reports on Form 10-K, its Quarterly Reports on Form 10-Q and its Current Reports on Form 8-K.

Item 1. Business.

REGISTRANT. Bancshares is a bank holding company incorporated on December 8, 1982 under the laws of the State of North Carolina, headquartered in Lexington, North Carolina and registered under the Federal Bank Holding Company Act of 1956, as amended (the “FBHCA”). Bancshares’ principal executive offices are located at One LSB Plaza, Lexington, North Carolina 27292. Its telephone number is (336) 248-6500.

Bancshares’ principal business is providing banking and other financial services through its banking subsidiary, Lexington State Bank (the “Bank”). Bancshares is the parent holding company of the Bank, a North Carolina chartered commercial bank. The principal assets of Bancshares are all outstanding shares of the Bank’s common stock. As part of its operations, Bancshares is not dependent upon a single customer or a few customers whose loss would have a material adverse effect on Bancshares. At December 31, 2004, Bancshares and its subsidiaries had consolidated assets of $915 million and 420 employees.

SUBSIDIARY BANK. The Bank is chartered under the laws of the State of North Carolina to engage in the business of general banking. The Bank employs 397 people. Founded in 1949, the Bank offers a complete array of services in commercial banking including accepting deposits, corporate cash management, discount brokerage, IRA plans, mortgage production, secured and unsecured loans and trust functions through twenty-six offices in seventeen communities located in Davidson, Forsyth, Stokes, Guilford, Randolph and Wake counties in North Carolina. The Bank also provides banking services through automated teller machines (“ATMs”) and cash dispensers, “LSB By Net” online banking and 24-hour “LSB By Phone” banking. The Bank operates the only independent trust department in Davidson County, providing estate planning, estate and trust administration, IRA trusts, personal investment accounts and pension and profit-sharing trusts.

NON-BANK SUBSIDIARIES. The Bank has two wholly-owned non-bank subsidiaries: Peoples Finance Company of Lexington, Inc. (“Peoples Finance”) and LSB Investment Services, Inc. (“LSBIS”).

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Peoples Finance was founded under the laws of the State of North Carolina in 1983. The Bank acquired Peoples Finance on January 1, 1984. Peoples Finance employs 12 people and operates from three offices located in Lexington, King and Archdale, North Carolina as a finance company licensed under the laws of the State of North Carolina. As a finance company, Peoples Finance offers secured and unsecured loans to individuals up to a maximum of $10,000, as well as dealer originated loans.

LSBIS was incorporated under the laws of the State of North Carolina in 1994 and began operations on December 1, 1994. It offers a full range of uninsured, nondeposit investment products, including mutual funds, annuities, stocks and bonds and insurance services. LSBIS employs 11 people and operates from the Bank’s home office, as well as offices located in Welcome, Winston-Salem, King and Wallburg, North Carolina. LSBIS offers products through Uvest Investment Services, an independent broker-dealer, which is a member of the National Association of Securities Dealers, Inc. (“NASD”) and the Securities Investor Protection Corporation (“SIPC”). Investments are neither deposits nor obligations of the Bank, nor are they guaranteed or insured by any depository institution, the Federal Deposit Insurance Corporation (“FDIC”), or any other government agency.

COMPETITION. Commercial banking in the Bank’s service area is highly competitive. The Bank and Bancshares as its holding company face competition from national and state banks, thrift institutions, credit unions, investment banking and brokerage firms, and mortgage and finance companies in the attraction of deposit accounts and in the origination of mortgage, commercial, and consumer loans. The Bank’s most direct competition for deposits has historically derived from other commercial banks located in and around the counties in which it maintains banking offices. The Bank also competes for deposits with regional and super-regional banks, money market instruments and mutual funds. The Bank competes for loans principally through the interest rates and loan fees it charges and the efficiency and quality of services it provides borrowers. Its competition for loans also comes principally from other commercial banks, including offices of regional and super-regional banks, located in and around the counties in which it maintains banking offices. Competition for deposits and loans is likely to continue to increase as a result of legislative, regulatory and technological changes and the continuing trend of consolidation in the financial services industry. Technological advances, for example, have lowered barriers to market entry, allowed banks to expand their geographic reach by providing services over the Internet and made it possible for non-depository institutions to offer products and services that traditionally have been provided by banks. Recent legislation permits affiliation among banks, securities firms and insurance companies, and further legislation will likely continue to change the competitive environment in which Bancshares does business.

GENERAL HIGHLIGHTS OF BUSINESS IN 2004.

Financial Summary. Net income for 2004 was $8,380,000 or $0.97 per diluted share, compared to $8,578,000 or $1.00 per diluted share in 2003, a decrease of 3% in earnings per share. Net interest income for 2004 decreased 2% compared with net interest income for 2003, reflecting compression of Bancshares’ net interest margin. Noninterest income decreased 3% from 2003 as mortgage financing income was off 61% relative to 2003. Noninterest expense increased 3% during the same period. The provision for loan losses was $3,017,000 in 2004 compared to $5,215,000 in 2003. Nonperforming assets (including nonaccrual loans, accruing loans more than 90 days past due, renegotiated troubled debt and other real estate owned) totaled $4,111,000 at December 31, 2004, down 29% from $5,815,000 at December 31, 2003. The allowance for loan losses was $7,962,000 or 1.12% of loans, at the end of 2004, compared to $7,846,000, or 1.18% of loans, at the end of 2003. In 2004, return on average assets was 0.94% and return on average shareholders’ equity was 9.26%. As of December 31, 2004, assets increased 5%, deposits increased 3% and loans increased 7% compared to December 31, 2003. As of December 31, 2004, shareholders’ equity totaled $90,742,000, which represents an equity-to-asset ratio of 9.9%. For

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additional financial information, please review Item 6, “Selected Financial Data,” and Item 8, “Financial Statements and Supplementary Data,” which begin on page 13 and page 32 below, respectively.

Business Developments During the Last Fiscal Year. Bancshares penetrated new North Carolina markets in 2004 to better position itself for accelerated balance sheet growth. For instance, during the second quarter of 2004, Bancshares opened a full service bank branch located at 120 East Main Street in Jamestown. In addition, in the summer of 2004, Bancshares built and opened the first stand-alone drive-thru bank in Davidson County, a five-lane facility with an ATM and closed circuit television connections between customers and bank tellers, located at 500 South Main Street in Lexington.

Bancshares also took steps to improve efficiency by altering its existing markets. For example, Bancshares modernized and consolidated its Bank branch network in Lexington by expanding and renovating its Talbert Boulevard Bank facilities, closing a small limited-service South Main Street Bank office and consolidating a Bank office located in north Lexington with another Lexington office located on U.S. Highway 64 West. Bancshares closed a small loan center located at 300 East Center Street in Lexington and opened a loan production and mortgage origination office located on Spring Forest Road in Raleigh, North Carolina.

Bancshares also reorganized lending activities of the Bank. Bancshares stimulated growth in the Bank’s lending efforts by establishing an indirect lending program, which allows the Bank to provide new and used automobile financing for customers while they are still at the car dealership, and revitalizing its car dealer relationships. Bancshares also strengthened the Bank’s underwriting and collection processes by reorganizing its credit administration process into two groups: (a) Risk Management, which is principally focused on credit review and managing special assets; and (b) Commercial/Consumer Banking Services, which is principally focused on credit administration and loan operations.

Lastly, Bancshares took steps to improve internal operations and processes of the Bank. For example, the Bank recently began installing Fast Teller, which is an online teller system that will automate virtually all of the transactions of the Bank’s customers. This system will also provide data to a teller management system that will accurately measure transaction volume within specific time intervals, which will greatly improve efficiency and productivity. In 2004, the Bank installed a new item processing system that complies with the Check Clearing for the 21st Century Act (the “Check 21 Act”) and also completed a major data processing conversion, which enhances the Bank’s Internet banking services.

For additional information regarding the business of Bancshares and its subsidiaries during 2004, please review Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” which begins on page 13 below.

REGULATION

General. As a bank holding company, Bancshares is subject to supervision, examination and regulation by the Board of Governors of the Federal Reserve System. The Bank is chartered by the State of North Carolina and as such is subject to supervision, examination and regulation by the Office of the Commissioner of Banks of the State of North Carolina (the “Banking Commission”). The Bank is also a member of the FDIC and is therefore subject to supervision and examination by that agency. In addition to federal and state banking laws and regulations, Bancshares and its subsidiaries are subject to other federal and state laws and regulations, and supervision and examination by other state and federal regulatory agencies, including the Securities and Exchange Commission (the “SEC”), the NASD and state securities regulators.

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The following is a brief summary of some of the statutes, rules and regulations which directly or indirectly affect the operations and management of Bancshares and its subsidiaries. This summary is qualified in its entirety by reference to the particular statutory and regulatory provisions referred to below and is not intended to be an exhaustive description of all applicable statutes or regulations. Any change in applicable laws or regulations may have a material adverse effect on Bancshares’ business and prospects.

Regulation of Bancshares. As mentioned above, Bancshares is a bank holding company within the meaning of the FBHCA. Under the FBHCA, Bancshares’ activities, and the activities of the companies which it controls or in which it holds more than five percent of the voting stock, are limited to banking or managing or controlling banks or furnishing services to or performing services for its subsidiaries, or any other activity which the Federal Reserve determines to be a proper incident to the business of banking. Some of the activities that the Federal Reserve has determined by regulation to be proper incidents to the business of banking, and thus permissible for bank holding companies such as Bancshares, include (a) making or servicing loans and certain types of leases and related activities; (b) engaging in certain insurance and discount brokerage activities; (c) underwriting and dealing in government securities and certain other securities and financial instruments; (d) providing certain data processing and data transmission services; (e) acting in certain circumstances as a fiduciary or investment or financial advisor; (f) management consulting and counseling activities; (g) issuing and selling retail monetary instruments such as money orders, savings bonds and travelers’ checks and providing check printing and courier services; (h) operating trust companies and non-bank depository institutions such as savings associations; and (i) making investments in corporations or projects designed primarily to promote community welfare. Generally, a bank holding company is required to obtain prior approval from the Federal Reserve to engage in any new activity not previously approved by the Federal Reserve or to acquire more than five percent of any class of voting stock of any company or any bank which is not already majority-owned by such bank holding company.

Bancshares is also subject to the North Carolina Bank Holding Company Act of 1984 (the “NCBHCA”). As required by the NCBHCA, Bancshares, by virtue of its ownership of the Bank, has registered as a bank holding company with the Banking Commission. The NCBHCA prohibits Bancshares from acquiring or controlling certain non-bank banking institutions which have offices in North Carolina.

Regulation of the Bank. As mentioned above, the Bank is organized as a North Carolina state chartered bank subject to regulation, supervision and examination by the Federal Reserve and the Banking Commission and to regulation by the FDIC. Federal and state laws and regulations impose various requirements upon the Bank, including those related to required reserves against deposits, allowable investments, loans, mergers, consolidations, issuance of securities, payment of dividends, establishment of branches, limitations on credit to subsidiaries and other aspects of the business of such subsidiaries. The federal and state banking agencies have broad authority and discretion in connection with their supervisory and enforcement activities and examination policies, including policies involving the classification of assets and the establishment of loan loss allowances for regulatory purposes. Such actions by these regulators prohibit member banks from engaging in unsafe or unsound banking practices. The Bank is also subject to certain reserve requirements established by the Federal Reserve Board.

Other Regulations. The operations and management of Bancshares and its subsidiaries are subject to the statutes, rules and regulations briefly summarized below.

Check Clearing for the 21st Century Act. Most banks, such as the Bank, use check-imaging technology to capture digital images of the fronts and backs of checks as they are processed through high-speed check sorters. The Check 21 Act authorizes banks to replace the physical transportation of checks with an electronic transfer of check images.

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The key feature of the Check 21 Act is the creation of a new negotiable instrument called a “substitute check.” A substitute check is a paper reproduction of an original check that meets certain content and format requirements imposed by the Check 21 Act. Under the Check 21 Act, banks will be able to create substitute checks from the original deposited paper checks and process them electronically under a uniform electronic processing system. All banks were required to accept substitute checks beginning October 28, 2004. However, no bank is required to create substitute checks and may continue to use the paper check clearing process instead.

Under the Check 21 Act, substitute checks are subject to all of the consumer protections granted in the Uniform Commercial Code and certain regulations promulgated by the Federal Reserve Board. The Check 21 Act also requires banks to provide a brief notice about substitute checks to customers and establishes further warranties and indemnifications to protect consumers.

Gramm-Leach Bliley Financial Modernization Act of 1999. The Gramm-Leach-Bliley Financial Modernization Act of 1999 (the “GLB Act”) modernized the federal bank regulatory framework by allowing the consolidation of banking institutions with other types of financial services firms, subject to various restrictions and requirements. In general, the GLB Act repealed most of the federal statutory barriers which separated commercial banking firms from insurance and securities firms and authorized the consolidation of such firms in a financial services holding company.

The USA PATRIOT Act. After the September 11, 2001, terrorist attacks in New York and Washington, D.C., the United States government acted in several ways to tighten control on activities perceived to be connected to money laundering and terrorist funding by enacting the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (the “USA PATRIOT Act”). A series of orders were issued under the USA PATRIOT Act which identify terrorists and terrorist organizations and require the blocking of property and assets of, as well as prohibiting all transactions or dealings with, such terrorists, terrorist organizations and those that assist or sponsor them. The USA PATRIOT Act also requires each financial institution (a) to establish an anti-money laundering program; (b) to establish due diligence policies, procedures and controls with respect to its private banking accounts and correspondent banking accounts involving foreign individuals and certain foreign banks; and (c) to avoid establishing, maintaining, administering, or managing correspondent accounts in the United States for, or on behalf of, a foreign bank that does not have a physical presence in any country. In addition, the United States Treasury Department issued regulations in cooperation with the federal banking agencies, the SEC, the Commodity Futures Trading Commission and the Department of Justice to require customer identification and verification, expand the money-laundering program requirement to the major financial services sectors, and facilitate and permit the sharing of information between law enforcement and financial institutions, as well as among the financial institutions themselves. The United States Treasury Department also has created the Treasury USA PATRIOT Act Task Force to work with other financial regulators, the regulated community, law enforcement and consumers to continually improve the regulations.

Sarbanes-Oxley Act of 2002. The Sarbanes-Oxley Act of 2002 (“SOX”) comprehensively revised the laws affecting corporate governance, accounting obligations and corporate reporting for companies with equity or debt securities registered under the Exchange Act (such as Bancshares). In particular, SOX established (a) new requirements for audit committees, including independence, expertise, and responsibilities; (b) additional responsibilities regarding financial statements for the Chief Executive Officer and Chief Financial Officer of the reporting company; (c) new standards for auditors and regulation of audits; (d) increased disclosure and reporting obligations for the reporting company and their directors and executive officers; and (e) new and increased civil and criminal penalties for violations of the securities laws.

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Various Consumer Protection Laws. In connection with its lending and leasing activities, Bancshares and its subsidiaries are subject to a number of federal and state laws designed to protect borrowers and promote lending to various sectors of the economy and population. These laws include the Equal Credit Opportunity Act, the Fair Credit Reporting Act, the Truth in Lending Act, the Home Mortgage Disclosure Act, and the Real Estate Settlement Procedures Act, and state law counterparts.

Federal law currently contains extensive customer privacy protection provisions. Under these provisions, a financial institution must provide to its customers, at the inception of the customer relationship and annually thereafter, the institution’s policies and procedures regarding the handling of customers’ nonpublic personal financial information. These provisions also provide that, except for certain limited exceptions, an institution may not provide such personal information to unaffiliated third parties unless the institution discloses to the customer that such information may be so provided and the customer is given the opportunity to opt out of such disclosure. Federal law makes it a criminal offense, except in limited circumstances, to obtain or attempt to obtain customer information of a financial nature by fraudulent or deceptive means.

AVAILABLE INFORMATION. Bancshares’ Internet address is www.lsbnc.com. Bancshares makes available, free of charge, on or through its website, its Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), and beneficial ownership reports on Forms 3, 4 and 5 as soon as reasonably practicable after electronically filing such material with, or furnishing it to, the SEC.

Item 2. Properties.

Bancshares’ principal executive offices are located at One LSB Plaza, Lexington, North Carolina 27292. This five-story office building totals 74,800 square feet and also serves as the home office of the Bank. A majority of the major staff functions are located within this office complex, which is owned by the Bank.

The Bank operates twenty-six offices and ten off-premise ATM locations. The Bank owns fourteen branches, while eleven branches, the mortgage origination office and the off-premise ATM locations are leased. The Bank’s leased properties are subject to leases that expire on various dates from February 1, 2005 to February 28, 2010. The Bank operates branches at the following locations:

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*   ATM available at this location.

Peoples Finance operates from (a) a 1,800 square foot, one-story building located at 203 East Center Street, Lexington, North Carolina 27292, which it owns; (b) a 1,200 square foot, one-story building located at 614-M South Main Street, King, North Carolina 27021, which it leases; and (c) a 1,200 square foot, one-story building located at 11246 North Main Street, Suite 306, Archdale, North Carolina 27263, which it leases.

LSBIS operates from (a) a 800 square foot space in the principal office of the Bank, which it leases; (b) a 100 square foot space in the building located at 10335 North N.C. Highway 109, Wallburg, North

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Carolina 27373, which it leases; (c) a 250 square foot space in the building located at 6123 Old U.S. Highway 52, Welcome, North Carolina 27374, which it leases; (d) a 300 square foot space in the building located at 161 South Stratford Road, Winston-Salem, North Carolina 27104, which it leases; and (e) a 100 square foot space in the building located at 647 South Main Street, King, North Carolina 27021, which it leases.

Except as described herein, Bancshares, the Bank, Peoples Finance and LSBIS own all properties free and clear of encumbrances.

Item 3. Legal Proceedings.

From time to time, Bancshares and its subsidiaries are involved in litigation arising from the ordinary course of their business. As of the date of this report, neither Bancshares nor any of its subsidiaries are involved in any legal proceedings that would have a materially adverse affect on their financial condition or results of operations.

Item 4. Submission of Matters to a Vote of Security Holders.

There were no matters submitted to a vote of shareholders during the quarter ended December 31, 2004.

PART II

Item 5. Market for Registrant’s Common Equity, Related Shareholder Matters and Issuer Purchases of Equity Securities.

Bancshares’ common stock is traded on the Nasdaq National Market® under the symbol LXBK. The following table shows the high, low and closing sales prices reported on the Nasdaq National Market® and cash dividends declared per share for the indicated periods.

As of February 23, 2005, there were 2,802 record holders of Bancshares’ common stock.

The following table sets forth certain information regarding outstanding options and shares for future issuance under equity compensation plans as of December 31, 2004. Individual equity compensation arrangements are aggregated and included within this table. This table excludes any plan, contract or arrangement that provides for the issuance of options, warrants or other rights that are given to

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Bancshares’ shareholders on a pro rata basis and any employee benefit plan that is intended to meet the qualification requirements of Section 401(a) of the Internal Revenue Code of 1986, as amended.

The Board of Directors of Bancshares has authorized a repurchase program for shares of its common stock in the open market or privately negotiated transactions on a time-to-time and ongoing basis, depending upon market conditions and subject to compliance with all applicable securities laws and regulations. The repurchase plan is intended to help Bancshares achieve its goal of building shareholder value and maintaining appropriate capital levels. The plan was originally announced in November 1998 with extensions approved in August 1999 and May 2004. The plan will expire on May 31, 2006. The original plan authorized 300,000 shares as have each of the extensions, for a total authorized repurchase amount of 900,000 shares. Bancshares did not repurchase any shares under the plan during the fourth quarter ended December 31, 2004.

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Item 6. Selected Financial Data.

The following table should be read in conjunction with Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operation,” and Item 8, “Financial Statements and Supplementary Data,” which begin on page 13 and page 32 below, respectively.

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

The following discussion should be read in conjunction with Item 6, “Selected Financial Data,” and Item 8, “Financial Statements and Supplementary Data,” which begin on page 13 above and page 32 below, respectively.

The following discussion and analysis should also be read in conjunction with management’s annual report on internal control over financial reporting and the audit report of Turlington and Company, L.L.P., Bancshares’ registered public accounting firm, which begin on page 59 and page 33 below, respectively.

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This report contains certain forward-looking statements related to anticipated future operating and financial performance, and other similar statements of expectations. These forward-looking statements are based on estimates, beliefs and assumptions made by management and are not guarantees of future performance. Actual results may differ from those expressed or implied as the result of various factors, including: (1) the strength of the United States economy generally and the strength of the local economies in which Bancshares conducts operations may be different than expected, resulting in, among other things, a deterioration in credit quality or a reduced demand for credit, including the resultant effect on Bancshares’ loan portfolio and allowance for loan losses; (2) the effects of, and changes in, trade, monetary and fiscal policies and laws, including interest rate policies of the Board of Governors of the Federal Reserve System; (3) inflation, interest rate, market and monetary fluctuations; (4) adverse conditions in the stock market, the public debt market and other capital markets (including changes in interest rate conditions) and the impact of such conditions on Bancshares’ capital markets and capital management activities, including, without limitation, Bancshares’ private equity investment activities and brokerage activities; (5) the timely development of competitive new products and services by Bancshares and the acceptance of these products and services by new and existing customers; (6) the willingness of customers to accept third party products marketed by Bancshares; (7) the willingness of customers to substitute competitors’ products and services for Bancshares’ products and services and vice versa; (8) the impact of changes in financial services’ laws and regulations (including laws concerning taxes, banking and securities); (9) technological changes; (10) changes in consumer spending and saving habits; (11) the effect of corporate restructurings, acquisitions and/or disposition, and the failure to achieve the expected revenue growth and/or expense savings from such corporate restructurings, acquisitions and/or dispositions; (12) the growth and profitability of Bancshares’ noninterest or fee income being less than expected; (13) unanticipated regulatory or judicial proceedings; (14) the impact of changes in accounting policies by the SEC; (15) adverse changes in financial performance and/or condition of Bancshares’ borrowers which could impact repayment of such borrowers’ outstanding loans; and (16) Bancshares’ success at managing the risks involved in the foregoing. Bancshares cautions that the foregoing list of important factors is not exclusive. Bancshares does not undertake to update any forward-looking statement, whether written or oral, that may be made from time to time by or on behalf of Bancshares.

Introduction

Bancshares is a bank holding company headquartered in Lexington, North Carolina. Its principal assets are all of the outstanding shares of common stock of its commercial bank subsidiary. Founded in 1949, the Bank operates as a North Carolina chartered commercial bank serving customers through twenty-six offices in seventeen communities located in Davidson, Forsyth, Stokes, Guilford, Randolph and Wake counties in North Carolina. Bancshares expanded its operations during 2004 through the opening of a mortgage loan production office in the Raleigh-Durham area of North Carolina. In the third quarter, the Bank completed the modernization and consolidation of its branch network in Lexington in order to better serve its customers. This was accomplished through the closing of one office and the consolidation of two other offices into existing branches. Through the Bank and the Bank’s two non-bank subsidiaries, Peoples Finance and LSBIS, Bancshares provides a wide range of financial services to individuals and corporate customers.

Bancshares’ results of operations are dependent primarily on the results of operations of the Bank and thus are dependent to a significant extent on net interest income, which is the difference between the income earned on its loan and investment portfolios and its cost of funds, consisting of interest paid on deposits and borrowings. The Bank’s noninterest income has become increasingly important to its performance through fees earned by its non-bank subsidiary LSBIS. Results of operations are also affected by Bancshares’ provision for loan losses, mortgage loan sales activities, service charges and other fee income, and noninterest expense. Bancshares’ noninterest expense principally consists of

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compensation and employee benefits, office occupancy and equipment expense, data processing, professional fees, and advertising and business promotion expenses. Bancshares’ results of operations are also significantly affected by general economic and competitive conditions, particularly changes in interest rates, government policies and actions of regulatory authorities.

The Bank (and Bancshares as its holding company) faces competition in both the attraction of deposit accounts and in the origination of mortgage, commercial, and consumer loans. Its most direct competition for deposits has historically derived from other commercial banks located in and around the counties in which it maintains banking offices. The Bank also competes for deposits with both regional and super-regional banks, and money market instruments and mutual funds. The Bank competes for loans principally through the interest rates and loan fees it charges and the efficiency and quality of services it provides borrowers. Its competition for loans also comes principally from other commercial banks, including offices of regional and super-regional banks, located in and around the counties in which it maintains banking offices. Competition for deposits and loans is likely to continue to increase as a result of legislative, regulatory and technological changes and the continuing trend of consolidation in the financial services industry. Technological advances, for example, have lowered barriers to market entry, allowed banks to expand their geographic reach by providing services over the Internet and made it possible for non-depository institutions to offer products and services that traditionally have been provided by banks. Recent legislation permits affiliation among banks, securities firms and insurance companies, and further legislation will likely continue to change the competitive environment in which Bancshares does business.

Critical Accounting Policies

The accounting and reporting policies of the Bank and its subsidiaries comply with generally accepted accounting principles in the United States and conform to standards within the industry. Bancshares believes that its most significant accounting policies deal with:

	•	The allowance for loan loss, as it requires the most subjective and complex judgments from senior management. Management considers several factors in determining the allowance for loan loss. These include economic conditions, advice of regulators, historical experience and factors affecting particular borrowers. Changes in the assumptions of these policies could result in a significant impact on the Bank’s financial statements. For further information, see the Asset Quality and Allowance for Loan Losses section and Note 1, “Summary of Significant Accounting Policies,” in the “Notes to Consolidated Financial Statements.”
	•	Pension and postretirement benefit plans to employees. The calculation of obligations and related expenses under these plans requires the use of actuarial valuation methods and assumptions. Actuarial valuations and the determination of future market values of plan assets are subject to management judgment and may differ significantly if different assumptions are used. Please refer to Note 14, “Pension and Employee Benefit Plans,” in the “Notes to Consolidated Financial Statements” for disclosures related to Bancshares’ benefits plans, including quantitative disclosures reflecting the impact that changes in certain assumptions would have on service and interest costs and benefit obligations.

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Overview

The discussion presented herein is intended to provide an overview of the financial condition, changes in financial condition and results of operations of Bancshares and its wholly-owned subsidiary, the Bank, for the years 2004, 2003 and 2002. The consolidated financial statements include the accounts and results of operations of the Bank’s wholly-owned subsidiaries, Peoples Finance and LSBIS. The intent of the discussion and analysis is to provide the reader with pertinent information about Bancshares and its subsidiaries in the areas of liquidity, capital resources, results of operation, off-balance sheet arrangements, contractual obligations, financial position, asset quality and interest sensitivity. It should be read in conjunction with the audited financial statements, notes and supplemental tables provided herein.

Results of Operations

For 2004, Bancshares reported net income of $8.380 million or $.97 per diluted share compared to $8.578 million or $1.00 per diluted share for 2003 and $10.214 million or $1.20 per diluted share for 2002. The decline in net income for the current year was the result of lower net interest income, a slight decline in noninterest income and a modest increase in noninterest expense. Lower net interest income in 2004 was largely attributable to reduced mortgage-financing activity and a decline in the net interest margin. As the economy began to improve in 2004, the Federal Reserve began a series of interest rate increases resulting in added pressure to Bancshares’ net interest margin. In July 2004, the prime interest rate was increased to 4.25% after thirteen consecutive deductions over a three-year period. That increase in the prime interest rate was followed by four more increases to end the year at 5.25%. The increase in interest rates during the second half of 2004 resulted in slower mortgage refinancing activity and reduced interest income as well as mortgage related noninterest income.

The net interest margin decreased during 2004, ending the year at 4.75% compared to 4.89% for 2003 and 4.86% for 2002. As a result, the net interest income for 2004, on a tax equivalent basis, declined $729,000 or 1.8% compared to a gain in 2003 of $1.901 million or 4.9%. Noninterest income declined $454,000 or 3.1% in 2004 compared to an increase in 2003 of $2.517 million or 21.0% compared to 2002. Noninterest expense for 2004 increased $1.253 million or 3.4% compared to $4.394 million or 13.71% for 2003. The provision for loan losses in 2004 was $3.017 million, down $2.198 million or 42.1% from 2003. Return on average assets for 2004 was 0.94% compared to 0.98% for 2003 and 1.21% in 2002. Return on average shareholders’ equity for 2004 was 9.26% compared to 9.66% in 2003 and 12.28% in 2002.

Balance sheet growth gained in all categories during 2004. Loan growth led the way with an increase in 2004 of $48.739 million or 7.3% compared to growth in 2003 of $17.898 million or 2.8%. Consolidated assets in 2004 increased $47.082 million or 5.4% compared to 2003, which increased $16.113 million or 1.9% over 2002. Deposit growth for 2004 was $19.773 million or 2.8% compared to a 2003 increase of $6.021 million or 0.9%.

Net Interest Income

Net interest income for the Bank represents the dollar amount by which income generated from earning assets exceeds its cost of funds. Net interest income is the primary source of revenue for the Bank. Interest-earning assets consist primarily of loans and investment securities. These assets are subject to credit risk and interest rate risk, which are discussed in detail in “Asset Quality and Allowance for Loan Losses.” Net interest income is affected by various factors, among which are the volume of interest-earning assets and interest-bearing liabilities and the interest rates earned and paid on those assets and liabilities. Table 1 provides an analysis of average volumes, yields and rates and net interest income on a

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tax-equivalent basis for the three years ended December 31, 2004, 2003 and 2002. Tax-exempt income has been adjusted to a tax equivalent basis.

Average Balances and Net Interest Income Analysis

[TABLE 1]

Fully taxable equivalent basis¹(In thousands)