ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following management's discussion and analysis focuses on the consolidated financial condition of the Company at June 30, 2012 as compared to December 31, 2011, and the consolidated results of operations for the six month period ended June 30, 2012 compared to the same period in 2011. The purpose of this discussion is to provide the reader with a more thorough understanding of the Consolidated Financial Statements. This discussion should be read in conjunction with the interim Consolidated Financial Statements and related footnotes.

FORWARD-LOOKING STATEMENTS

Certain statements contained in this Quarterly Report are not historical facts but rather are forward-looking statements that are subject to certain risks and uncertainties. When used herein, the terms "anticipates", "plans", "expects", "believes", and similar expressions as they relate to the Company or its management are intended to identify forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The Company's actual results, performance or achievements may materially differ from those expressed or implied in the forward-looking statements. Risks and uncertainties that could cause or contribute to such material differences include, but are not limited to, general economic conditions, interest rate environment, competitive conditions in the financial services industry, changes in law, governmental policies and regulations, and rapidly changing technology affecting financial services. Other factors not currently anticipated may also materially and adversely affect the Company's results of operations, cash flows and financial position. There can be no assurance that future results will meet expectations. While the Company believes that the forward-looking statements in this report are reasonable, the reader should not place undue reliance on any forward-looking statement.

The Company does not undertake, and specifically disclaims any obligation, to publicly revise any forward-looking statements to reflect events or circumstances after the date of such statements or to reflect the occurrence of anticipated or unanticipated events, except as may be required by applicable law.

FINANCIAL CONDITION

Total assets were $566.7 million at June 30, 2012, compared to $551.2 million at December 31, 2011, representing an increase of $15.5 million, or 2.8%. Cash and cash equivalents decreased $14.4 million, or 17.5%, during the six month period ended June 30, 2012, primarily as a result of increases in loans. Securities increased $3.7 million, or 2.9%, during the first six months of 2012 as bonds were purchased within the US government agency portfolio. Net loans increased $19.5 million, or 6.1%, while deposits increased $11.1 million, or 2.5%, during the six month period. Short-term borrowings of securities sold under repurchase agreement increased $4.1 million and Federal Home Loan Bank ("FHLB") advances decreased $2.3 million, during the period as advances matured and required amortized payments were made on outstanding advances at the FHLB.

Net loans increased $19.5 million, or 6%, during the six month period ended June 30, 2012. Commercial loans including commercial real estate loans increased $12 million, or 6%, home equity lines increased $587 thousand, or 2%, real estate mortgage loans increased $4 million, or 7%, construction and land development loans increased $3 million, or 14%, and consumer loans remained stable over December 31, 2011. Consumers continued to refinance their mortgage loans for lower long-term rates. During the fourth quarter 2011 and first six months of 2012 the bank originated and retained fifteen year fixed rate mortgage loans for its portfolio.

The allowance for loan losses as a percentage of total loans was 1.30% at June 30, 2012, an increase from 1.26% at December 31, 2011. Outstanding loan balances increased 6.1% to $344 million at June 30, 2012 while net charge-offs of $22 thousand were offset by a provision of $411 thousand to the allowance for loan losses for the six months ended June 30, 2012. Non-performing loans increased $516 thousand or 14.8% from December 31, 2011.

                                       June 30,        December 31,       June 30,
     (Dollars in thousands)              2012              2011             2011
     Non-performing loans              $   4,005      $        3,489      $   3,559
     Other real estate                         5                  10            415
     Allowance for loan losses             4,471               4,082          4,054
     Total loans                         344,116             324,182        316,581
     Allowance: loans                       1.30 %              1.26 %         1.28 %
     Allowance: non-performing loans        1.1x                1.2x           1.1x

The ratio of gross loans to deposits was 75.7% at June 30, 2012, compared to 73.1% at December 31, 2011. The increase in this ratio is the result of loan volume increases outpacing increases in deposits during the six months ended June 30, 2012.

The Company had net unrealized gains of $3 million within its securities portfolio at June 30, 2012, compared to net unrealized gains of $2 million at December 31, 2011. The Company has no exposure to government-sponsored enterprise preferred stocks, collateralized debt obligations or trust preferred securities. Management has considered industry analyst reports, sector credit reports and the volatility within the bond market in concluding that the gross unrealized losses of $63 thousand within the total portfolio as of June 30, 2012, were primarily the result of customary and expected fluctuations in the bond market and not necessarily the expected cash flows of the individual securities. As a result, all security impairments detailed above on June 30, 2012, are considered temporary and no impairment loss relating to these securities has been recognized.

Short-term borrowings consisting of overnight repurchase agreements with retail customers increased $4.1 million from December 31, 2011 and other borrowings decreased $2.3 million as the Company used cash from interest-earning deposits in other banks to repay required maturities and monthly payments on advances from the FHLB.

Deposits increased $11.2 million, or 2.5% from December 31, 2011 with non-interest bearing deposits increasing $7.2 million and interest-bearing deposit accounts increasing $4.0 million. By deposit type, increases were recognized in statement and passbook savings accounts and money market savings accounts for the period ended June 30, 2012.

Total shareholders' equity amounted to $51.2 million, or 9.0% of total assets, at June 30, 2012, compared to $49.4 million, or 9.0% of total assets, at December 31, 2011. The increase in shareholders' equity during the six months ended June 30, 2012 was due to net income of $2.2 million, an increase of $535 thousand in other comprehensive income and dividends declared of $1 million partially offset the above increases. The Company and its subsidiary bank met all regulatory capital requirements at June 30, 2012.

RESULTS OF OPERATIONS

Three months ended June 30, 2012 and 2011

For the quarter ended June 30, 2012, the Company recorded net income of $1.1 million or $0.41 per share, as compared to net income of $972 thousand, or $0.35 per share for the quarter ended June 30, 2011. The $169 thousand increase in net income for the quarter was a result of net interest income increasing $301 thousand and other noninterest income increasing $250 thousand. These gains were partially offset by an increase in noninterest expense of $277 thousand and an increase in the federal income tax provision of $90 thousand. Return on average assets and return on average equity were 0.82% and 8.98%, respectively, for the three month period of 2012, compared to 0.87% and 8.06%, respectively for 2011.

Average Balance Sheets and Net Interest Margin Analysis



                                                         For the three months ended June 30,
                                                         2012                            2011
                                                Average         Average         Average        Average
(Dollars in thousands)                          balance          rate           balance         rate
ASSETS
Due from banks-interest bearing               $    57,108           0.29 %     $  19,025           0.23 %
Federal funds sold                                    145           0.00              89           0.11
Taxable securities                                118,045           2.41          73,771           3.33
Tax-exempt securities                              13,690           5.85          12,134           5.07
Loans                                             339,829           5.07         319,906           5.37

Total earning assets                              528,817           3.98 %       424,925           4.78 %
Other assets                                       33,474                         23,280

TOTAL ASSETS                                  $   562,291                      $ 448,205