First South Bancorp, Inc. (the "Company") was formed for the purpose of issuing common stock and owning 100% of the stock of First South Bank (the "Bank") and operating through the Bank a commercial banking business. Therefore, the discussion below focuses primarily on the Bank's results of operations. The Bank has one significant operating segment, the providing of general commercial banking services to its markets located in the state of North Carolina. The Company's common stock is traded on the NASDAQ Global Select Market under the symbol "FSBK".

Comparison of Financial Condition at June 30, 2012 and December 31, 2011. Total assets declined to $742.0 million at June 30, 2012, from $746.9 million at December 31, 2011. Earning assets declined to $674.8 million at June 30, 2012, from $681.5 million at December 31, 2011, reflecting the net change in the composition of earning assets, as discussed below. The ratio of earning assets to total assets was 90.94% at June 30, 2012, compared to 91.24% at December 31, 2011.

Interest-bearing overnight deposits in financial institutions increased to $22.3 million at June 30, 2012, from $18.5 million at December 31, 2011. Overnight deposits are available to fund loan originations, deposit withdrawals, securities purchases, liquidity management activities and daily operations of the Bank.

Investment securities available for sale increased to $165.0 million at June 30, 2012, from $138.5 million at December 31, 2011, reflecting the net of purchases, sales, principal repayments and securitizations of certain mortgage loans. The Bank may sell investment securities to support a more balanced sensitivity to future interest rate changes and may securitize mortgage loans held for sale into mortgage-backed securities to support adequate liquidity levels. During the six months ended June 30, 2012, the Bank sold $32.3 million of investment securities available for sale, compared to $2.4 million sold in the six months ended June 30, 2011. Also, during the six months ended June 30, 2012, $38.2 million of mortgage loans held for sale were securitized into mortgage-backed securities available for sale, compared to $8.6 million securitized in the six months ended June 30, 2011. During the six months ended June 30, 2012, the Bank implemented a strategy to diversify its investment portfolio through the purchase of certain tax-exempt municipal securities. At June 30, 2012, the balance of newly acquired municipal securities was $18.6 million, compared to no municipal securities held at December 31, 2011. See "Note 4. Investment Securities" of "Notes to Consolidated Financial Statements (Unaudited)" for additional disclosure information.

Loans held for sale declined to $4.4 million at June 30, 2012, from $6.4 million at December 31, 2011. Proceeds from loan sales were $8.4 million for the six months ended June 30, 2012, compared to $9.8 million sold during the six months ended June 30, 2011. Proceeds from loan sales are primarily used to fund liquidity needs of the Bank, including loan originations, deposit withdrawals, repayment of borrowings, investment security purchases and general banking operations. Loans serviced for others increased to $326.0 million at June 30, 2012, from $319.4 million at December 31, 2011.

Loans and leases receivable held for investment, net of deferred loan fees, declined to $501.1 million at June 30, 2012, from $534.0 million at December 31, 2011. During the six months ended June 30, 2012, certain loans held for investment were foreclosed upon and transferred to other real estate owned. In addition, a portion of funds from principal repayments on loans held for investment was used to fund the liquidity needs of the Bank.

Total loans on non-accrual status and restructured loans (TDRs) on non-accrual status declined to $37.8 million at June 30, 2012, from $43.0 million at December 31, 2011. Loans on non-accrual status declined to $12.6 million at June 30, 2012, from $21.6 million at December 31, 2011. TDRs on non-accrual status increased to $25.2 million at June 30, 2012, from $21.4 million at December 31, 2011. Performing TDRs on full accrual status declined to $8.3 million at June 30, 2012, from $25.4 million at December 31, 2011. Certain performing TDRs have been restored to full accrual status, as they need not continue to be reported as a restructure in calendar years after the year in which the restructuring took place, if the loan is in compliance with its modified terms and yields a market rate.

The economy continues to present a challenging credit environment for the Bank and its customers. Economic pressure continues to impact market values of housing and other real estate property in the Bank's market area and credit quality of certain borrowers. Management believes it has thoroughly evaluated its non-performing loans and they are either well collateralized or adequately reserved. However, there can be no assurance in the future that regulators, increased risks in the loan portfolio, adverse changes in economic conditions or other factors will not require further adjustments to the allowance for credit losses.

Aside from the loans defined as non-accrual, over 90 days past due, classified, or restructured, there were no loans at June 30, 2012, where known information about possible credit problems of borrowers caused management to have serious concerns as to the ability of the borrowers to comply with their current loan repayment terms. There were $725,000 of loans that were accruing interest and contractually over 90 days past due at June 30, 2012. These primarily represent loans that have matured and are in process of renewal. Additional gross interest income of approximately $14,000 was recorded on these loans as of June 30, 2012.

Loans are generally placed on non-accrual status, and accrued but unpaid interest is reversed, when in management's judgment, it is determined that the collectability of interest, but not necessarily principal, is doubtful. Generally, this occurs when payment is delinquent in excess of 90 days. Consumer loans that have become more than 180 days past due are generally charged off or a specific allowance may be provided for any expected loss. All other loans are charged off when management concludes that they are uncollectible.

Based on an impairment analysis of the Bank's loan and lease portfolio, there were $85.0 million of loans classified as impaired at June 30, 2012, net of $12.0 million in write-downs, compared to $78.9 million classified as impaired at December 31, 2011, net of $13.4 million in write-downs. At June 30, 2012 and December 31, 2011, the allowance for loan and lease losses included $1.3 million and $1.6 million specifically provided for impaired loans, respectively. A loan is considered impaired, based on current information and events, if it is probable that the Bank will be unable to collect the scheduled payments of principal and interest when due according to the contractual terms of the loan arrangement. All collateral-dependent loans are measured for impairment based on the fair value of the collateral, while uncollateralized loans and other loans determined not to be collateral dependent are measured for impairment based on the present value of expected future cash flows discounted at the historical effective interest rate. The Bank uses several factors in determining if a loan is impaired. The internal asset classification procedures include a thorough review of significant loans and lending relationships and include the accumulation of related data. This data includes loan payments status, borrowers' financial data and borrowers' operating factors such as cash flows, operating income or loss, and various other matters.

See "Note 5. Loans Receivable", "Note 6. Allowance for Credit Losses" and "Note
7. Troubled Debt Restructurings" of "Notes to Consolidated Financial Statements (Unaudited)" for additional information.

Other real estate owned acquired from foreclosures increased to $17.8 million at June 30, 2012, from $17.0 million at December 31, 2011, reflecting the net of additions, disposals and fair value adjustments. During the six months ended June 30, 2012 there were $5.7 million of additions, $3.1 million of disposals, and $1.8 million of fair value adjustments. Other real estate owned consists of residential and commercial properties, developed lots and raw land. The Bank believes the adjusted carrying values of these properties are representative of their fair market values, although there can be no assurances that the ultimate sales will be equal to or greater than the carrying values. See "Note 8. Other Real Estate Owned" and "Note 9. Fair Value Measurement" of "Notes to Consolidated Financial Statements (Unaudited)" for additional information.

Total deposits declined to $634.6 million at June 30, 2012, from $642.6 million at December 31, 2011. Demand accounts (personal and business checking accounts and money market accounts) increased to $261.3 million at June 30, 2012, from $243.7 million at December 31, 2011. Time deposits declined to $343.0 million at June 30, 2012, from $369.9 million at December 31, 2011. The Bank attempts to manage its cost of deposits by monitoring the volume and rates paid on maturing certificates of deposits in relationship to current funding needs and market interest rates. The Bank did not renew certain higher rate maturing time deposits during the six months ended June 30, 2012 and was able to reprice new and maturing time deposits at lower rates. See "Interest Expense" below for additional information regarding the Bank's cost of funds.

Borrowed money consisting primarily of repurchase agreements declined to $1.8 million at June 30, 2012, from $2.1 million at December 31, 2011. Repurchase agreements represent funds held in cash management accounts for commercial banking customers. There were no FHLB advances outstanding at June 30, 2012 or December 31, 2011. The Bank may use lower costing FHLB borrowings as a funding source, providing an effective means of managing its overall cost of funds. At June 30, 2012, the Bank had $64.8 million of credit available with the FHLB and $40.0 million of pre-approved but unused lines of credit, collectively totaling $104.8 million.

Stockholders' equity increased to $86.2 million at June 30, 2012, from $84.1 million at December 31, 2011, reflecting the net effect of earnings and changes in accumulated other comprehensive income. The equity to assets ratio was 11.61% at June 30, 2012, compared to 11.26% at December 31, 2011. See "Consolidated Statements of Changes in Stockholders' Equity" for additional information.

Accumulated other comprehensive income increased to $4.8 million at June 30, 2012, from $3.7 million at December 31, 2011, reflecting the net unrealized gains in the available for sale investment securities portfolio based on current market prices. See "Note 3. Comprehensive Income" of "Notes to Consolidated Financial Statements (Unaudited)" for additional information.

There were 1,502,951 treasury shares held totaling $32.0 million at both June 30, 2012 and December 31, 2011. Treasury shares are used for general purposes including the exercise of stock options and providing shares for potential future stock splits.

The Bank is subject to various capital requirements administered by federal and state banking agencies. A significant event during the quarter ended June 30, 2012 was the infusion of $10.0 million of new capital into the Bank from the Company, resulting from an inter-company income tax strategy. Pursuant to a Tax Sharing Agreement between the Bank and the Company, each entity pays their applicable share of estimated income taxes. Over time, the Company had accumulated an income tax receivable of approximately $11.6 million, while the primary source of its income has been generated at the Bank level. Conversely, the Bank had accumulated an income tax payable of approximately $8.4 million. As a result of implementing the inter-company income tax strategy, the Bank made a cash purchase of the $11.6 million income tax receivable from the Company, resulting in a $3.2 million net income tax receivable on the Bank's books. Subsequent to the income tax transaction, the Company invested $10.0 million into the Bank in the form of additional paid-in-capital and maintained a cash position of approximately $1.6 million for future investment and normal operating expenses. The Bank's regulatory capital ratios as of June 30, 2012 increased significantly from December 31, 2011 as indicated below.

                                      6/30/12       12/31/11
First South Bank Regulatory Capital    Ratio         Ratio
Total Risk-Based Capital Ratio           18.01 %        15.22 %
Tier 1 Risk-Based Capital Ratio          16.74 %        13.95 %
Tier 1 Leverage Ratio                    11.59 %        10.02 %

Comparison of Operating Results - Three and Six months ended June 30, 2012 and 2011. Net income for the three and six months ended June 30, 2012 increased to $481,000 and $943,000, from $382,000 and $709,000 for the three and six months ended June 30, 2011. Diluted earnings per share were $0.05 and $0.10 for the three and six months ended June 30, 2012, compared to $0.04 and $0.07 per share for the three and six months ended June 30, 2011.

Net earnings during the three and six months ended June 30, 2012 and 2011 were influenced by the amount of provisions for credit losses necessary to maintain the allowance for loan and lease losses at an adequate level; a decline in the volume of average earning assets; expenses attributable to other real estate owned properties; while being partially offset by a reduction in interest expense and gains on mortgage loan and investment securities sales. The current economy continues to present a challenging credit environment for the Bank and for some of its customers. As the Bank addresses and manages through these challenges, it remains focused on long-term strategies. These strategies include remediating problem assets, maintaining adequate levels of capital and liquidity, improving efficiency in operations, building core customer relationships and improving franchise value along with stockholder value. The Bank continues to maintain a strong capital position in excess of the well-capitalized regulatory guidelines, and combined with strengthening of the allowance for credit losses should enhance future earnings as economic conditions substantially improve.

Key performance ratios are return on average assets (ROA) and return on average equity (ROE). ROA was .26% and .25% for the three and six months ended June 30, 2012, compared to .19% and .18% for the three and six months ended June 30, 2011. ROE was 2.26% and 2.22% for the three and six months ended June 30, 2012, compared to 1.90% and 1.76% for the three and six months ended June 30, 2011.

Interest Income. Interest income declined to $8.8 million and $17.7 million for the three and six months ended June 30, 2012, from $10.2 million and $20.1 million for the three and six months ended June 30, 2011. The reduction in the amount of interest income is due primarily to lower interest rates during the comparative reporting periods, and a decline in the volume of average interest-earning assets. Average interest-earning assets declined to $676.0 million and $676.3 million for the three and six months ended June 30, 2012, from $704.8 million and $705.8 million for the three and six months ended June 30, 2011. The reduction in average interest-earning assets reflects the net effect of the decrease in loans and leases receivable; sales, purchases and principal payments on investment securities; and the volume of other real estate owned and non-performing loans discussed above. The yield on average interest-earning assets declined to 5.24% and 5.25% for the three and six months ended June 30, 2012, from 5.78% and 5.69% for the three and six months ended June 30, 2011. The yield on average interest-earning assets has also been impacted by the decline in interest rates and average interest-earning assets during the comparative reporting periods.

Interest Expense. Interest expense declined to $1.3 million and $2.8 million for the three and six months ended June 30, 2012, from $2.0 million and $4.1 million for the three and six months ended June 30, 2011, reflecting a decline in interest rates between the comparative reporting periods and a decline in the volume of average interest-bearing liabilities. The cost of funds improved to .83% and .85% for the three and six months ended June 30, 2012, from 1.14% and 1.16% for the three and six months ended June 30, 2011. The Company was able to improve its cost of funds by a combination of the growth in lower costing demand accounts, pricing new time deposits and repricing of maturing time deposits within the lower interest rate environment. Average deposits and borrowings declined to $650.5 million and $650.1 million for the three and six months ended June 30, 2012, from $704.6 million and $706.5 million for the three and six months ended June 30, 2011.

Net Interest Income. Net interest income declined to $7.5 million and $15.0 million for the three and six months ended June 30, 2012, from $8.2 million and $16.0 million for the three and six months ended June 30, 2011. The interest rate spread (the difference between the yield on average earning assets and the cost of average deposits and borrowings) declined to 4.41% and 4.40% for the three and six months ended June 30, 2012, from to 4.64% and 4.53% for the three and six months ended June 30, 2011. The tax equivalent net yield on interest-earning assets (net interest income divided by average interest-earning assets) declined to 4.44% for both the three and six months ended June 30, 2012, from 4.64% and 4.53% for the three and six months ended June 30, 2011. The changes in interest rate spread and net yield on interest-earning assets is a result of the interest rate environment and volume levels of interest-earning assets and interest-bearing liabilities outstanding during the comparative reporting periods.

The following tables contain information relating to the Company's average statement of financial condition and reflect the yield on average earning assets and the average cost of funds for the three and six months ended June 30, 2012 and 2011. Average balances are derived from month end balances. The Company does not believe that using month end balances rather than average daily balances has caused any material difference in the information presented. The average loan balances listed in interest earning assets do not include nonaccrual loan balances. The interest rate spread represents the difference between the yield on earning assets and the average cost of funds. The net yield on earning assets represents net interest income divided by average earning assets.

Tax equivalent yields related to certain investment securities exempt from federal income tax are stated on a fully taxable basis, using a 34% federal tax rate and reduced by a disallowed portion of the tax exempt interest income.

Yield/Cost Analysis                        Quarter Ended June 30, 2012                   Quarter Ended June 30,  2011
                                                                    (Dollars in thousands)
                                                                    Average                                       Average
                                       Average                       Yield/           Average                      Yield/
                                       Balance        Interest        Cost            Balance       Interest        Cost
Interest earning assets:
Loans receivable                     $   503,740     $    7,447         5.91 %      $   559,792     $   8,906         6.36 %
Investments and deposits                 172,301          1,371         3.25 %(1)       145,000         1,282         3.54 %
Total earning assets                     676,041          8,818         5.24 %          704,792        10,188         5.78 %
Nonearning assets                         66,649                                         86,852
Total assets                         $   742,690                                    $   791,644

Interest bearing liabilities:
Deposits                             $   543,519          1,250          .92 %      $   590,733         1,925         1.30 %
Borrowings                                 1,754              1          .23 %            2,395             1          .17 %
Junior subordinated debentures            10,310             91         3.53 %           10,310            84         3.26 %
Total interest-bearing liabilities       555,583          1,342          .97 %          603,438         2,010         1.33 %
Noninterest bearing demand
deposits                                  94,869              0          .00 %          101,162             0          .00 %
Total sources of funds                   650,452          1,342          .83 %          704,600         2,010         1.14 %
Other liabilities and
stockholders' equity:
Other liabilities                          7,221                                          6,527
Stockholders' equity                      85,017                                         80,517
Total liabilities and
stockholders' equity                 $   742,690                                    $   791,644
Net interest income                                  $    7,476                                     $   8,178
Interest rate spread                                                    4.41 %                                        4.64 %
Net yield on earning assets                                             4.44 %(1)                                     4.64 %
Ratio of earning assets to
interest bearing liabilities                                          121.68 %                                      116.80 %




Yield/Cost Analysis                        Six Months Ended June 30, 2012                  Six Months Ended June 30, 2011
                                                                       (Dollars in thousands)
                                                                      Average                                         Average
                                        Average                        Yield/           Average                        Yield/
                                        Balance         Interest        Cost            Balance         Interest        Cost
Interest earning assets:
Loans receivable                      $    509,960      $  15,114         5.93 %      $    567,915      $  17,730         6.24 %
Investments and deposits                   166,365          2,618         3.15 %(1)        137,835          2,350         3.41 %
Total earning assets                       676,325         17,732         5.25 %           705,750         20,080         5.69 %
Nonearning assets                           66,245                                          87,662
Total assets                          $    742,570                                    $    793,412

Interest bearing liabilities:
Deposits                              $    541,787          2,571          .95 %      $    592,809          3,902         1.32 %
Borrowings                                   1,767              2          .23 %             3,543             29         1.64 %
Junior subordinated debentures              10,310            183         3.55 %            10,310            165         3.20 %
Total interest-bearing liabilities         553,864          2,756         1.00 %           606,662          4,096         1.35 %
Noninterest bearing demand deposits         96,235              0          .00 %            99,693              0          .00 %
Total sources of funds                     650,099          2,756          .85 %           706,355          4,096         1.16 %
Other liabilities and stockholders'
equity:
Other liabilities                            7,606                                           6,724
Stockholders' equity                        84,865                                          80,333
Total liabilities and stockholders'
equity                                $    742,570                                    $    793,412
Net interest income                                     $  14,976                                       $  15,984
Interest rate spread                                                      4.40 %                                          4.53 %
Net yield on earning assets                                               4.44 %(1)                                       4.53 %
Ratio of earning assets to interest
bearing liabilities                                                     122.11 %                                        116.33 %

(1) Shown as a tax-adjusted yield

Provision for Credit Losses. The Bank's methodology for determining its provision for credit losses includes amounts specifically allocated to credits that are individually determined to be impaired, as well as general provisions allocated to groups of loans that have not been individually assessed for impairment. The Bank recorded $775,000 and $2.6 million of provisions for credit losses in the three and six months ended June 30, 2012, compared to $3.1 million and $5.5 million in the three and six months ended June 30, 2011. The provision for credit losses is necessary to maintain the allowance for credit losses at a level that management believes is adequate to absorb probable future losses in the loan portfolio. See "Note 6. Allowance for Credit Losses" of "Notes to Consolidated Financial Statements (Unaudited)" and "Allowance for Credit Losses" and "Critical Accounting Policies - Loan Impairment and Allowance for Credit Losses" below for additional disclosure information.

Allowance for Credit Losses. The Bank maintains allowances for loan and lease losses and unfunded loan commitments (collectively the "allowance for credit losses") at levels management believes are adequate to absorb probable losses inherent in the loan and lease portfolio and in unfunded loan commitments. The Bank has developed policies and procedures for assessing the adequacy of the allowance for credit losses that reflect the assessment of credit risk and impairment analysis. This assessment includes an analysis of qualitative and quantitative trends in the levels of classified loans. In developing this analysis, the Bank relies on historical loss experience, estimates and exercises judgment in assessing credit risk. Future assessments of credit risk may yield different results, depending on changes in the qualitative and quantitative trends, which may require adjustments in the allowance for credit losses.

The Bank uses various modeling, calculation methods and estimation tools for measuring credit risk and performing impairment analysis, which is the basis used in developing the allowance for credit losses. The factors supporting the allowance do not diminish the fact that the entire allowance for credit losses is available to absorb probable losses in both the loan and leases portfolio and in unfunded loan commitments. The Bank's principal focus is on the adequacy of the total allowance for credit losses. Based on the overall credit quality of the loan and lease receivable portfolio, management believes the Bank has established the allowance for credit losses pursuant to generally accepted accounting principles, and has taken into account the views of its regulators and the current economic environment. Management reassesses the information upon which it bases the allowance for credit losses not greater than quarterly and believes their accounting decisions remain accurate. However, there can be no assurance in the future that regulators, increased risks in the loan and lease portfolio, changes in economic conditions and other factors will not require additional adjustments to the allowance for credit losses.

The allowance for credit losses was $14.3 million at June 30, 2012, compared to $15.4 million December 31, 2011. The ratio of the allowance for credit losses to loans and leases was 2.82% at June 30, 2012, compared to 2.85% at December 31, 2011. Net charge offs against the allowance for credit losses were $1.2 million and $3.8 million recorded in the three and six months ended June 30, 2012, compared to $3.7 million and $5.7 million in the three and six months ended June 30, 2011. See "Note 6. Allowance for Credit Losses" and "Note 9. Fair Value . . .