UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

(Mark One)

[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended June 30, 2006

OR

[   ] 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 000-29829

PACIFIC FINANCIAL CORPORATION
(Exact name of registrant as specified in its charter)

Washington 91-1815009
(State or other jurisdiction of
incorporation or organization)		 (IRS Employer Identification No.)

1101 S. Boone Street
Aberdeen, Washington 98520-5244
(360) 533-8870
(Address, including zip code, and telephone
number, including area code, of Registrant's principal executive offices)

        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 [ X ] No [ ]

        Indicate by check mark whether the registrant is a large accelerated filer, accelerated filer or non-accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

                        Large accelerated filer [ ]                      Accelerated Filer [X]                         Non-accelerated filer [ ]

        Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [ X ]

        The number of shares of the issuer’s common stock, par value $1.00 per share, outstanding as of July 31, 2006, was 6,480,362 shares.

TABLE OF CONTENTS

PART I FINANCIAL INFORMATION 3

ITEM 1.
FINANCIAL STATEMENTS
3

CONDENSED CONSOLIDATED BALANCE SHEETS
JUNE 30, 2006 AND DECEMBER 31, 2005
3

CONDENSED CONSOLIDATED STATEMENTS OF INCOME
THREE AND SIX MONTHS ENDED JUNE 30, 2006 AND 2005
4

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
SIX MONTHS ENDED JUNE 30, 2006 AND 2005
5

CONDENSED CONSOLIDATED STATEMENTS OF SHAREHOLDERS'
EQUITY SIX MONTHS ENDED JUNE 30, 2006 AND 2005
7

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
8

ITEM 2.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
13

ITEM 3.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT
MARKET RISK
19

ITEM 4.
CONTROLS AND PROCEDURES
20

PART II
OTHER INFORMATION
21

ITEM 1.
LEGAL PROCEEDINGS
21

ITEM 1A.
RISK FACTORS
21

ITEM 2.
UNREGISTERED SALES OF EQUITY SECURITIES AND
USE OF PROCEEDS
21

ITEM 3.
DEFAULTS UPON SENIOR SECURITIES
21

ITEM 4.
SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
21

ITEM 5.
OTHER INFORMATION
21

ITEM 6.
EXHIBITS
21

SIGNATURES
 21

PART I - FINANCIAL INFORMATION

ITEM 1 - FINANCIAL STATEMENTS

PACIFIC FINANCIAL CORPORATION
Condensed Consolidated Balance Sheets
(Dollars in thousands) (Unaudited)

June 30, 2006 December 31, 2005
Assets            
   Cash and due from banks   $ 16,206   $ 11,223  
   Interest bearing balances with banks    284    283  
   Federal funds sold    6,920    —  
   Investment securities available for sale    30,623    29,748  
   Investment securities held-to-maturity    6,308    6,504  
   Federal Home Loan Bank stock, at cost    1,858    1,858  
   Loans held for sale    9,470    10,111  
   Loans    413,096    398,870  
   Allowance for credit losses    5,233    5,296  
   Loans, net     407,863    393,574  

   Premises and equipment		    
11,242		    
10,085		  
   Foreclosed real estate    22    37  
   Accrued interest receivable    2,532    2,364  
   Cash surrender value of life insurance    9,556    9,394  
   Goodwill    11,282    11,282  
   Other intangible assets    1,942    745  
   Other assets    3,737    2,201  
Total assets    $ 519,845   $ 489,409  

Liabilities and shareholders' equity 		  
   Deposits:  
     Non-interest bearing   $ 81,852   $ 86,264  
     Interest bearing    347,768    313,462  
   Total deposits     429,620    399,726  

   Accrued interest payable		    
865		    
547		  
   Secured borrowings    1,936    2,150  
   Short-term borrowings    —    3,985  
   Long-term borrowings    22,500    24,500  
   Junior subordinated debentures    13,403    5,155  
   Other liabilities    1,563    6,746  
   Total liabilities     469,887    442,809  

Commitments and contingencies 		  

Shareholders' equity 		  
   Common Stock (par value $1); 25,000,000 shares  
     authorized; 6,480,362 shares issued and outstanding  
     at June 30, 2006 and 6,464,536 at December 31, 2005    6,480    6,464  
   Additional paid-in capital    25,623    25,386  
   Retained earnings    18,408    15,073  
   Accumulated other comprehensive loss    (553 )  (323 )
   Total shareholders' equity     49,958    46,600  

Total liabilities and shareholders' equity 		   $ 519,845   $ 489,409  

See notes to condensed financial statements.

3

PACIFIC FINANCIAL CORPORATION
Condensed Consolidated Statements of Income
Three and six months ended June 30, 2006 and 2005
(Dollars in thousands, except per share data)
(Unaudited)


THREE MONTHS ENDED
JUNE 30,		 SIX MONTHS ENDED
JUNE 30,
2006 2005 2006 2005
Interest and dividend income                    
Loans   $ 8,287   $ 6,852   $ 15,978   $ 12,976  
Investment securities and FHLB dividends    377    438    737    888  
Deposits with banks and federal funds sold    99    107    174    179  
Total interest and dividend income    8,763    7,397    16,889    14,043  

Interest expense		  
Deposits    2,465    1,510    4,588    2,814  
Other borrowings    399    374    769    589  
Total interest expense    2,864    1,884    5,357    3,403  

Net interest income		    5,899    5,513    11,532    10,640  
Provision for credit losses    —    300    —    600  
Net interest income after provision for     5,899    5,213    11,532    10,040  
   credit losses   

Non-interest income 		  
Service charges on deposits    380    384    756    705  
Gain on sales of loans    506    455    886    734  
Gain (loss) on sale of investments available for sale    —    (7 )  —    2  
Gain on sale of foreclosed real estate    5    —    5    —  
Gain on sale of premises and equipment    —    10    2    90  
Other operating income    198    192    386    389  
Total non-interest income    1,089    1,034    2,035    1,920  

Non-interest expense 		  
Salaries and employee benefits    2,619    2,505    5,150    4,919  
Occupancy and equipment    622    482    1,153    949  
Other    1,225    1,114    2,477    2,111  
Total non-interest expense     4,466    4,101    8,780    7,979  

Income before income taxes 		    2,522    2,146    4,787    3,981  
Provision for income taxes    777    650    1,452    1,195  

Net income 		   $ 1,745   $ 1,496   $ 3,335    2,786  

Comprehensive income		    1,593   $ 1,395   $ 3,105    2,590  

Earnings per common share: 		  
   Basic   $ 0.27   $ 0.23   $ 0.51   $ 0.43  
   Diluted    0.27    0.23    0.51   $ 0.43  
Weighted average shares outstanding:   
   Basic    6,480,362    6,421,951    6,479,281    6,421,675  
   Diluted    6,577,400    6,541,074    6,576,123    6,533,503  

See notes to condensed consolidated financial statements.

4

PACIFIC FINANCIAL CORPORATION
Condensed Consolidated Statements of Cash Flows
Six months ended June 30, 2006 and 2005
(Dollars in thousands)
(Unaudited)

2006 2005
OPERATING ACTIVITIES            
Net income   $ 3,335   $ 2,786  
Adjustments to reconcile net income to net cash provided by  
    (used in) operating activities:  
   Provision for credit losses    —    600  
   Depreciation and amortization    630    521  
   Stock dividends received    —    (8 )
   Origination of loans held for sale    (46,325 )  (49,825 )
   Proceeds of loans held for sale    47,852    45,852  
   Gain on sales of loans    (886 )  (734 )
   Gain on sale of investment securities    —    (2 )
   Gain on sale of foreclosed real estate    (5 )  —  
   Gain on sale of premises and equipment    (2 )  (90 )
   Increase in accrued interest receivable    (168 )  (38 )
   Increase in accrued interest payable    318    45  
   Other    (1,818 )  (1,753 )
   Net cash provided by (used in) operating activities     2,931    (2,646 )

INVESTING ACTIVITIES 		  
   Net increase in federal funds    (6,920 )  (966 )
   Increase in interest bearing deposits with banks    (1 )  (2,548 )
   Purchase of securities available for sale    (2,511 )  (4,321 )
   Proceeds from maturities of investments held to maturity    192    321  
   Proceeds from sales of securities available for sale    —    3,645  
   Proceeds from maturities of securities available for sale    1,210    3,830  
   Net increase in loans     (14,382 )  (17,093 )
   Proceeds from sales of foreclosed real estate    20    —  
   Additions to premises and equipment    (1,759 )  (1,274 )
   Proceeds from sales of premises and equipment    4    114  
    Deposit assumption and transfer    (1,268 )  —  
   Net cash used in investing activities     (25,415 )  (18,292 )

FINANCING ACTIVITIES 		  
   Net increase in deposits    29,894    22,185  
   Net decrease in short-term borrowings    (3,985 )  —  
   Net decrease in secured borrowings    (214 )  1,942  
   Proceeds from issuance of long-term borrowings    2,000    8,000  
   Repayments of long-term borrowings    (4,000 )  (5,000 )
   Proceeds from junior subordinated debentures    8,248    —  
   Issuance of common stock    243    7  
   Payment of cash dividends    (4,719 )  (4,624 )
   Net cash provided by financing activities     27,467    22,510  
  

See notes to condensed consolidated financial statements.

5


   Net increase in cash and due from banks 		    4,983    1,572  

CASH AND DUE FROM BANKS 		  
   Beginning of period    11,223    10,213  
   End of period   $ 16,206   $ 11,785  

SUPPLEMENTAL DISCLOSURES OF CASH FLOW
INFORMATION 		  
   Cash payments for:  
     Interest   $ 4,964   $ 3,358  
     Income Taxes    1,132    1,635  

SUPPLEMENTAL SCHEDULE OF NONCASH INVESTING
ACTIVITIES 		  
   Change in fair value of securities available for sale, net of tax    (230 )  (196 )



6

PACIFIC FINANCIAL CORPORATION
Condensed Consolidated Statements of Shareholders’ Equity
Six months ended June 30, 2006 and 2005
(Dollars in thousands)
(Unaudited)

COMMON
STOCK		 ADDITIONAL
PAID-IN
CAPITAL		 RETAINED
EARNINGS		 ACCUMULATED
OTHER
COMPREHENSIVE
INCOME
(LOSS)		 TOTAL

Balance January 1, 2005 		   
$ 		6,421  
$ 		25,003  
$ 		13,746  
$ 		133  
$ 		45,303  

Other comprehensive income:		  
   Net income            2,786        2,786  
   Change in fair value of securities                (196 )  (196 )
      available for sale, net  
   Comprehensive income                     2,590  

Issuance of common stock		    2    5            7  
Stock compensation expense    12    12  
Balance June 30, 2005    $ 6,423   $ 25,020   $ 16,532    ($ 63 ) $ 47,912  

Balance January 1, 2006 		   $ 6,464   $ 25,386   $ 15,073    ($ 323 ) $ 46,600  

Other comprehensive income:		  
   Net income            3,335        3,335  
   Change in fair value of securities                (230 )  (230 )
      available for sale, net  
   Comprehensive income                     3,105  

Issuance of common stock		    16    227            243  
Stock compensation expense        10            10  
Balance June 30, 2006    $ 6,480   $ 25,623   $ 18,408    ($ 553 ) $ 49,958  



7

PACIFIC FINANCIAL CORPORATION
Notes to Condensed Consolidated Financial Statements (unaudited)

Note 1 – Basis of Presentation

The accompanying unaudited consolidated financial statements have been prepared by Pacific Financial Corporation (“Pacific” or the “Company”) in accordance with accounting principles generally accepted in the United States of America for interim financial information and with instructions to Form 10-Q. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the six months ended June 30, 2006, are not necessarily indicative of the results anticipated for the year ending December 31, 2006. Certain information and footnote disclosures included in the Company’s consolidated financial statements for the year ended December 31, 2005, have been condensed or omitted from this report. Accordingly, these statements should be read with the financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2005.

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates.

All dollar amounts in tables, except earnings per share tables and per share information, are stated in thousands.

Note 2 – Earnings per Share

The following table illustrates the computation of basic and diluted earnings per share.

THREE MONTHS ENDED
JUNE 30,		 SIX MONTHS ENDED
JUNE 30
2006 2005 2006 2005
Basic:                    
Net income   $1,745,000   $1,496,000   $3,335,000   $2,786,000  
Weighted average shares  
   Outstanding    6,480,362    6,421,951    6,479,281    6,421,675  
Basic earnings per share   $0.27   $0.23   $0.51   $0.43  

Diluted: 		  
Net income   $1,745,000   $1,496,000   $3,335,000   $2,786,000  
Weighted average shares  
   Outstanding    6,480,362    6,421,951    6,479,281    6,421,675  

Effect of dilutive stock options		    97,038    119,123    96,842    111,828  
Weighted average shares  
   Outstanding assuming dilution    6,577,400    6,541,074    6,576,123    6,533,503  
Diluted Earnings Per Share   $0.27   $0.23   $0.51   $0.43  

As of June 30, 2006 and 2005, there were 322,600 and 248,600 shares, respectively, subject to outstanding options to acquire common stock with exercises prices in excess of the current market value. These shares are not included in the table above, as exercise of these options would be dilutive to shareholders.

8

Note 3 – Investment Securities

Investment securities consist principally of short and intermediate term debt instruments issued by the U.S. Treasury, other U.S. government agencies, state and local government units, and other corporations.

Securities Held to Maturity AMORTIZED
COST		 UNREALIZED
GAINS		 UNREALIZED
LOSSES
 FAIR
VALUE

June 30, 2006 		                   
U.S. Government Securities   $ 1,051   $ —   $ 22   $ 1,029  
State and Municipal Securities    5,257    17    60    5,214  
      Total    $ 6,308   $ 17   $ 82   $ 6,243  


Securities Available for Sale AMORTIZED
COST		 UNREALIZED
GAINS		 UNREALIZED
LOSSES		 FAIR
VALUE

June 30, 2006 		                   
U.S. Government Securities   $ 13,622   $ 19   $ 464   $ 13,177  
State and Municipal Securities    12,739    50    237    12,552  
Corporate Securities    2,060    1    76    1,985  
Mutual Funds    3,041    —    132    2,909  

      Total 		  
$
31,462 		 
$
70 		 
$
909 		 
$
30,623 		 

For all the above investment securities, the unrealized losses are generally due to changes in interest rates and, as such, are considered to be temporary by management. The Company has evaluated the securities shown above and anticipates full recovery of amortized cost with respect to these securities at maturity or sooner in the event of a more favorable market interest rate environment. The Company regularly reviews its investment portfolio to determine whether any of its securities are other than temporarily impaired. In addition to accounting and regulatory guidance, in determining whether a security is other than temporarily impaired, the Company considers duration and amount of each unrealized loss, the financial condition of the issuer, and the prospects for a change in market or net asset value within a reasonable period of time. We also consider that the contractual cash flow of certain mortgage backed securities are guaranteed by an agency of the United States Government.



9

Note 4 – Allowance for Credit Losses

THREE MONTHS
ENDED
JUNE 30,		 SIX MONTHS
ENDED
JUNE 30,		 TWELVE MONTHS
ENDED
DECEMBER 31,

2006
2005
2006
2005
2005

Balance at beginning of period		     $ 5,202   $ 4,544   $ 5,296   $ 4,236   $ 4,236  
Provision for credit losses    —    300    —    600    1,100  
Charge-offs    (4 )  (7 )  (104 )  (7 )  (65 )
Recoveries    35    5    41    13    25  
Net (charge-offs) recoveries    31    (2 )  (63 )  6    (40 )

Balance at end of period		   $ 5,233   $ 4,842   $ 5,233   $ 4,842   $ 5,296  

Note 5 – Stock Based Compensation

Prior to January 1, 2006, the Company accounted for stock option plans under recognition and measurement principles of Accounting Principles Bulletin (APB) Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations. No stock-based employee compensation cost was reflected in net income for previous awards, as all options granted under the plans had an exercise price equal to the market value of the underlying common stock on the date of grant.

Effective January 1, 2006, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 123R, “Share-Based Payment”, which requires measurement of compensation cost for all stock based awards based on the grant date fair value and recognition of compensation cost over the service period of stock based awards. The Company has adopted SFAS No. 123R using the modified prospective method, which provides for no restatement of prior periods and no cumulative adjustment to equity accounts. It also provides for expense recognition for both new and existing unvested stock-based awards. Stock based compensation expense during the six months ended June 30, 2006 was $10,000 ($7,000 net of tax). Future compensation expense for unvested awards outstanding as of June 30, 2006 is estimated to be $80,000 recognized over a weighted average period of 2.2 years. Cash received from the exercise of stock options during the six months ended June 30, 2006 totaled $10,000.

The fair value of stock options granted during the six months ended June 30, 2006 and 2005 is determined using the Black-Scholes option pricing model based on assumptions noted in the following table. Expected volatility is based on historical volatility of the Company’s common shares. The expected term of stock options granted is based on the simplified method, which is the simple average between contractual term and vesting period. The risk-free rate is based on the expected term of stock options and the applicable U.S. Treasury yield in effect at the time of grant.

Grant period ended Expected
Life		 Risk Free
Interest Rate		 Expected
Volatility		 Dividend
Yield		 Average
Fair Value

June 30, 2006		      6.5 years    4.9%  16.53%  4.83%  $1.88  
June 30, 2005    10 years    4.4%  17.27%  4.43%  $4.52  

10

A summary of stock option activity under the stock option plans as of June 30, 2006 and changes during the six months ended June 30, 2006 and 2005 are presented below:

June 30, 2006 Shares Weighted
Average
Exercise Price		 Weighted
Average
Remaining
Contractual
Term ( Years)		 Aggregate
Instrinsic
Value

Outstanding beginning of period 		     687,674  
$		 13.28          
Granted    57,000    15.13          
Exercised    (900 )  11.11          
Forfeited    —    —          
    
    
          
Outstanding end of period     743,774   $ 13.43    6.5   $ 1,134  

Exercisable end of period 		    
613,368 		  $
13.33 		   
6.4 		  $
992 		 


June 30, 2006 Shares Weighted
Average
Exercise Price		 Weighted
Average
Remaining
Contractual
Term ( Years)		 Aggregate
Instrinsic
Value

Outstanding beginning of period 		     619,794  
$		 12.51          
Granted    115,500    16.25          
Exercised    (1,000 )  6.18          
Forfeited    (10,000 )  17.13          
    
    
          
Outstanding end of period     724,294   $ 13.04    7.0   $ 1,050  

Exercisable end of period 		    
342,309 		  $
10.94 		   
5.9 		  $
1,217 		 

A summary of the status of the Company’s nonvested options as of June 30, 2006 and 2005 and changes during the six months then ended is presented below:

2006


Shares		 Weighted
Average Fair
Value		 2005


Shares		 Weighted
Average Fair
Value

Non-vested beginning of period 		     144,006  
$ 		2.00    362,104    3.30  
Granted    57,000    1.82    115,500    4.52  
Vested    (70,600 )  1.23    (85,619 )  1.82  
Forfeited    —    —    (10,000 )  5.13  
Non-vested end of period     130,406   $ 2.36    381,985   $ 3.95  

The total intrinsic value of stock options exercised during the six months ended June 30, 2006 and 2005 was $4,000 and $9,000, respectively. There is no intrinsic value for options granted during the six months ended June 30, 2005.

11

The following table illustrates the effect on net income and earnings per share had the Company applied the fair value recognition provisions of SFAS No. 123R to the three and six months ended June 30, 2005.

      Three
       Months
      Ended		       Six
      Months
     Ended

Net income, as reported		     $1,496,000   $2,786,000  

Add stock compensation expense		    12,000    12,000  

Less total stock-based compensation expense		  
   determined under fair value method for all  
   qualifying awards, net of tax    54,000    108,000  

Pro forma net income		    1,454,000    2,690,000  

Earnings per share basic - as reported		   $0.23   $0.43  
Earnings per share basic - pro forma    0.23    0.42  
Earnings per share diluted - as reported    0.23    0.43  
Earnings per share diluted - pro forma    0.22    0.41  

Note 6 – Operating Segments

The Company has operating segments which have been aggregated into one reporting segment as provided in SFAS No. 131 “Disclosures About Segments of an Enterprise and Related Information.”

Note 7 – Commitments and Contingencies

Because of the nature of its activities, the Company is subject to various pending and threatened legal actions which arise in the ordinary course of business. In the opinion of management, liabilities arising from these claims, if any, will not have a material effect on the financial position of the Company.

Note 8 – Junior Subordinated Debentures

In June 2006, the Company issued $8,248,000 of junior subordinated debentures to PFC Statutory Trust II, a Delaware trust that was formed for the exclusive purpose of issuing trust preferred securities. The trust purchased the debentures with the proceeds of the sale of its common securities to the Company for $248,000 and trust preferred securities to an institutional investor for $8,000,000. The subordinated debentures and trust preferred securities mature on July 7, 2036 and are redeemable at the Company’s option on or after July 7, 2011. The debentures bear interest, payable quarterly, at a variable rate, reset quarterly, equal to 160 basis points over the three month London Interbank Offered Rate (LIBOR). The Company has unconditionally guaranteed distributions on, and payments on liquidation and redemption of, the trust preferred securities.

Note 9 – Expansion of Banking Operations

On June 23, 2006, the registrant’s wholly owned subsidiary, The Bank of the Pacific, completed a deposit transfer and assumption transaction with an Oregon-based bank for a $1,267,500 premium.  In connection with completion of the transaction, the Oregon Department of Consumer and Business Services issued a Certificate of Authority to the Bank authorizing it to conduct a banking business in the State of Oregon.  The premium, and the resultant right to conduct business in Oregon, has been recorded as an indefinite-lived intangible asset.

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ITEM 2 — MANAGEMENT’S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS

A Warning About Forward-Looking Information

        This document contains forward-looking statements that are subject to risks and uncertainties. These statements are based on the beliefs and assumptions of our management, and on information currently available to them. Forward-looking statements include the information concerning our possible future results of operations set forth under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and statements preceded by, followed by or that include the words “believes,” “expects,” “anticipates,” “intends,” “plans,” “estimates” or similar expressions.

        Any forward-looking statements in this document are subject to risks relating to, among other things, the following:

    1.        competitive pressures among depository and other financial institutions may impede our ability to attract and retain borrowers, depositors and other customers, retain key employees, and maintain our interest margins and fee income;


    2.        changes in the interest rate environment may reduce margins or decrease the value of our securities;


    3.        our growth strategy may not be successful if we fail to accurately assess market opportunities as we expand our operations, asset quality if we acquire assets, or anticipated capital requirements for new initiatives, or if we experience significant difficulty integrating acquired businesses or assets;


    4.        general economic or business conditions, either nationally or in the regions in which we do business, may be less favorable than expected, resulting in, among other things, a deterioration in credit quality or a reduced demand for credit; and


    5.        a lack of liquidity in the market for our common stock may make it difficult or impossible for you to liquidate your investment in our stock or lead to distortions in the market price of our stock.


        Our management believes the forward-looking statements in this report are reasonable; however, you should not place undue reliance on them. Forward-looking statements are not guarantees of performance. They involve risks, uncertainties and assumptions. Many of the factors that will determine our future results and share value are beyond our ability to control or predict. We undertake no obligation to update forward-looking statements.



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Overview

Pacific Financial Corporation is a bank holding company headquartered in Aberdeen, Washington. The Company’s wholly-owned subsidiary, The Bank of the Pacific (the “Bank”), is a state chartered bank, also located in Washington. The Company also has two wholly-owned subsidiary trusts known as PFC Statutory Trust I and II (the “Trusts”) that were formed December 2005 and May 2006, respectively, in connection with the issuance of pooled trust preferred securities. The Company was incorporated in the State of Washington on February 12, 1997, pursuant to a holding company reorganization of the Bank.

The Company conducts its banking business through the Bank, which operates 18 branches located in communities in Grays Harbor, Pacific, Whatcom, Skagit and Wahkiakum counties in the state of Washington and one loan production office in Clatsop County, Oregon. During the three months ended June 30, 2006, the Bank received regulatory approval to establish its first full-service branch in Oregon, which is anticipated to open August 2006. In addition, the Bank has entered into a contract to construct a new branch in the Barkley district of Bellingham, Washington. The Bank provides loan and deposit services to customers, who are predominantly small and middle-market businesses and middle-income individuals.

Recent Accounting Pronouncements

In June 2006, the Financial Accounting Standards Board issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes (FIN 48). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with SFAS Statement No. 109, Accounting for Income Taxes. FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN 48 will be effective for us beginning April 1, 2007. We have not yet evaluated the effect FIN 48 will have on our financial statements and related disclosures.

Results of Operations

Net income. For the three months ended June 30, 2006, Pacific’s net income was $1,745,000 compared to $1,496,000 for the same period in 2005. For the six months ended June 30, 2006, net income was $3,335,000 compared to $2,786,000 for the same period in 2005. Increases in net income for the three and six month periods resulted from an increase in net interest income for the periods, as described below, and no provision for credit loss being required in the periods, as well as increases in non-interest income arising from greater gains on sales of loans, as compared to the same periods in 2005. These increases were partially offset by increased non-interest expense for the periods arising out of greater staffing and benefit expenses, increased professional fees, and increased occupancy expense.

Net interest income. Net interest income for the three and six months ended June 30, 2006 increased $386,000, or 7.00%, and $892,000, or 8.38%, respectively, compared to the same periods in 2005. The increase is primarily related to the increase in interest income as a result of the rise in short-term interest rates and increased balances of interest earning assets. See the table on the following page and the accompanying discussion for further information on interest income and expense. The net interest margin (net interest income divided by average earning assets) decreased to 5.08% for the six months ended June 30, 2006 from 5.17% for the same period last year. The decline in net interest margin is due primarily to an increase in cost of funds from 2.09% to 2.94% for the six months ended June 30, 2005 and 2006, respectively. We have, however, been able to maintain a stable net interest margin in part due to our continued focus on variable rate loans and fixed rate loan terms of not longer than three years.

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The following table sets forth information with regard to average balances of the interest earning assets and interest bearing liabilities and the resultant yields or cost, net interest income, and the net interest margin on a tax equivalent basis. Loans held for sale and non-accrual loans are included in total loans.

Six Months Ended June 30,

(dollars in thousands) Average
Balance		 2006
Interest
Income
(Expense)		 Avg
Rate		 Average
Balance		 2005
Interest
Income
(Expense)		 Avg
Rate

Interest Earning Assets 		                           
     Loans (1)   $ 408,884   $ 16,014 *  7.83 % $ 354,976   $ 12,994 *  7.32 %
     Taxable securities    20,970    416    3.97    25,365    553    4.36  
     Tax-exempt securities    16,029    485 *  6.05    16,017    508 *  6.34  
     Federal Home Loan Bank stock    1,858    —    —    1,854    —    —  
     Interest earning deposits with banks    7,360    174    4.73    13,595    179    2.63  

Total interest earning assets 		   $ 455,101   $ 17,089    7.51 % $ 411,807   $ 14,234    6.91 %

    Cash and due from banks		    11,614            9,345          
    Bank premises and equipment (net)    10,826            7,093          
    Other assets    25,480            27,139          
    Allowance for credit losses    (5,261 )          (4,524 )        

Total assets 		   $ 497,760           $ 450,860          

Interest Bearing Liabilities 		  
     Savings and interest bearing demand   $ 197,547   $ (2,093 )  2.12 % $ 189,078   $ (1,361 )  1.44 %
     Time deposits    131,821    (2,495 )  3.79    110,810    (1,453 )  2.62  
     Total deposits     329,368    (4,588 )  2.79    299,888    (2,814 )  1.88  

     Short-term borrowings		    2,779    (74 )  5.33    —    —    —  
     Long-term borrowings    24,467    (447 )  3.65    21,454    (336 )  3.13  
     Secured borrowings    1,944    (74 )  7.61    4,704    (253 )  10.76  
     Junior subordinated debentures    5,611    (174 )  6.20    —    —    —  
     Total borrowings     34,801    (769 )  4.42    26,158    (589 )  4.50  

Total interest-bearing liabilities 		   $ 364,169   $ (5,357 )  2.94 % $ 326,046   $ (3,403 )  2.09 %

     Demand deposits		    82,249            74,020          
     Other liabilities    3,249            2,581          
     Shareholders' equity    48,093            48,213          

Total liabilities and shareholders' equity 		  
$
497,760 		   
$
450,860		          

Net interest income 		       $ 11,732 *         $ 10,831 *    

Net interest spread 		            5.16 %          5.26 %
Net interest margin             5.08 %          5.17 %

* Tax equivalent basis – 34% tax rate used

(1)   Interest income on loans include loan fees of $683,000, and $1,304,000 in 2006 and 2005, respectively.

Interest and dividend income for the three and six months ended June 30, 2006, increased $1,366,000, or 18.47%, and $2,846,000, or 20.27%, respectively compared to the same periods in 2005. Loans averaged $408.9 million with an average yield of 7.83% for the six months ended June 30, 2006 compared to average loans of $354.9 million with an average yield of 7.32% for the same period in 2005. The Company continues to experience loan growth with strong loan demand during the current period.

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Interest expense for the three and six months ended June 30, 2006 increased $980,000, or 52.0%, and $1,954,000, or 57.4%, respectively, compared to the same periods in 2005. The increase is primarily attributable to increased deposit balances and increased rates paid on certain deposits, as well as expense related to Pacific’s junior subordinated debentures. Average interest-bearing deposit balances for the six months ended June 30, 2006 and 2005 were $329.4 million and $299.9 million, respectively, with an average cost of 2.79% and 1.88%, respectively.

Average secured borrowings for the six months ended June 30, 2006 and 2005 were $1,944,000 and $4,704,000, respectively. The secured borrowings represent borrowings collateralized by participation interests in loans originated by the Company. These borrowings are repaid as payments are made on the underlying loans, bearing interest rates ranging from 6.5% to 8.5%. Average long and short term borrowings for the six months ended June 30, 2006 were $27,246,000 with an average cost of 3.82% compared to $21,454,000 with an average cost of 3.13% for the same period in 2005.

Provision and allowance for credit losses. The allowance for credit losses reflects management’s current estimate of the amount required to absorb losses on existing loans and commitments to extend credit.  Loans deemed uncollectible are charged against and reduce the allowance. Periodically, a provision for credit losses is charged to current expense. This provision acts to replenish the allowance for credit losses and to maintain the allowance at a level that management deems adequate.

There is no precise method of predicting specific credit losses or amounts that ultimately may be charged off on segments of the loan portfolio. The determination that a loan may become uncollectible, in whole or in part, is a matter of judgment. Similarly, the adequacy of the allowance for credit losses can be determined only on a judgmental basis, after full review, including (a) consideration of economic conditions and the effect on particular industries and specific borrowers; (b) a review of borrowers’ financial data, together with industry data, the competitive situation, the borrowers’ management capabilities and other factors; (c) a continuing evaluation of the loan portfolio, including monitoring by lending officers and staff credit personnel of all loans which are identified as being of less than acceptable quality; (d) an in-depth appraisal, on a monthly basis, of all loans judged to present a possibility of loss (if, as a result of such monthly appraisals, the loan is judged to be not fully collectible, the carrying value of the loan is reduced to that portion considered collectible); and (e) an evaluation of the underlying collateral for secured lending, including the use of independent appraisals of real estate properties securing loans. A formal analysis of the adequacy of the allowance is conducted quarterly and is reviewed by the Board of Directors. Based on this analysis, management considers the allowance for credit losses to be adequate at June 30, 2006.

Periodic provisions for credit losses are made to maintain the allowance for credit losses at an appropriate level. The provisions are based on an analysis of various factors including historical loss experience based on volumes and types of loans, volumes and trends in delinquencies and non-accrual loans, trends in portfolio volume, results of internal and independent external credit reviews, and anticipated economic conditions. For additional information, please see the discussion under the heading “Critical Accounting Policy” in Item 7 of our Annual Report on Form 10-K for the year ended December 31, 2005.

During the three and six months ended June 30, 2006, no loan loss provision was required for probable credit losses, compared to $300,000 and $600,000 for the same periods in 2005. For the three months ended June 30, 2006, net recoveries were $31,000 compared to $2,000 of net charge-offs for the same period in 2005. For the six months ended June 30, 2006, net charge-offs were $63,000 compared to $6,000 of net recoveries for the same period in 2005, and compared to $40,000 in net charge-offs during the twelve months ended December 31, 2005. The ratio of net charge-offs to average loans outstanding for the three months ended June 30, 2006 and 2005 was .01% and .00%, respectively, and .02% and .00% for the six months ended June 30, 2006 and 2005, respectively.

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At June 30, 2006, the allowance for credit losses stood at $5,233,000 compared to $5,296,000 at December 31, 2005, and $4,842,000 at June 30, 2005. The increase over June 30, 2005 was attributable to the additions in loan loss provision that was allocated to the allowance for credit losses as a result of continued growth in the loan portfolio during 2005. The slight decrease in 2006 is related primarily to one charge-off amount totaling $100,000. The ratio of the allowance to total loans outstanding including loans held for sale was 1.24%, 1.29% and 1.31%, respectively, at June 30, 2006, December 31, 2005, and June 30, 2005.

Non-performing assets and foreclosed real estate owned. Non-performing assets totaled $6,716,000 at June 30, 2006. This represents 1.59% of total loans including loans held for sale, compared to $6,769,000 or 1.66% at December 31, 2005, and $8,327,000 or 2.25% at June 30, 2005. Non-accrual loans at June 30, 2006 totaled $5,966,000. This relates primarily to one borrower involved in the forest products industry. Although the borrower is continuing operations and making principal and interest payments as agreed, the deteriorating financial condition of the borrower creates the potential the Company may not be able to collect all principal and interest according to the terms of the loan. Subsequent to June 30, 2006, Pacific began recognizing interest income on a cash basis for this borrower due to improved financial operations and reduction of principal balances to the estimated collateral value. Of the non-accrual loans outstanding, $3,452,000 are guaranteed by the United States Department of Agriculture representing 57.9% of non-accrual loans outstanding. Based on current analysis, management has made provisions in the loan loss reserves for potential losses associated with non-accrual loans. Foreclosed real estate consists of one property secured by real estate.

ANALYSIS OF NON-PERFORMING ASSETS

(in thousands) JUNE 30,
2006		 DECEMBER 31,
2005		 JUNE 30,
2005

Accruing loans past due 90 days or more		     $ 728   $ 82   $ —  

Non-accrual loans		    5,966    6,650    8,287  

Foreclosed real estate		    22    37    40  

TOTAL		   $ 6,716   $ 6,769   $ 8,327  

Non-interest income and expense. Non-interest income for the three and six months ended June 30, 2006 increased $55,000 and $115,000, respectively, compared to the same periods in 2005. The primary reason for the increase was gain on sale of loans. Gain on sale of loans totaled $506,000 and $455,000, respectively, for the three months ended June 30, 2006 and 2005 and totaled $886,000 and $734,000, respectively for the six months ended June 30, 2006 and 2005. This increase is attributable to increased pricing of loans sold in the secondary market over the prior year. Commitment to sell and sale price are established at the time of origination of loans to limit any potential price risk. Management expects flat growth in mortgage banking activity for the remainder of the year. Additionally, during the six months ended June 30, 2005, the Company recognized a gain on sale of fixed assets totaling $80,000.

Non-interest expense for the three and six months ended June 30, 2006 increased $365,000 and $801,000, respectively, compared to the same periods in 2005. Increased staffing, benefits, and professional fees were the major contributing factors to increased non-interest expense, as well as other operating expenses incurred in the opening of the Raymond and Anacortes, Washington branches in January and May 2006. Full time equivalent employees at June 30, 2006 were 196 compared to 171 at June 30, 2005.

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Income taxes. The federal income tax provision for the three and six months ended June 30, 2006 was $777,000 and $1,452,000, respectively, an increase of $127,000 and $257,000 compared to the same periods in 2005. The effective tax rate for the three and six months ended June 30, 2006 was 30.8% and 30.3%.

Financial Condition

Assets. Total assets were $519,845,000 at June 30, 2006, an increase of $30,436,000, or 6.2%, over year-end 2005. Loans, including loans held for sale, were $422,566,000 at June 30, 2006, an increase of $13,585,000, or 3.3%, over year-end 2005. The increase in the portfolio was primarily a result of increases in commercial loans and real estate construction loans. Total deposits were $429,620,000 at June 30, 2006, an increase of $29,894,000, or 7.5%, compared to December 31, 2005. The $29,894,000 increase is comprised of a $4,412,000 decrease in non-interest bearing accounts, $203,000 increase in NOW accounts, $8,899,000 increase in money market accounts, $9,244,000 decrease in savings accounts and a $34,448,000 increase in certificates of deposits.

Loans. Loan detail by category, including loans held for sale, as of June 30, 2006 and December 31, 2005 follows:

June 30,
2006		 December 31,
2005

Commercial and industrial		     $118,270   $101,327  
Agricultural    21,487    25,359  
Real estate mortgage    188,608    183,353  
Real estate construction    83,737    87,621  
Installment    8,571    8,487  
Credit cards and other    1,893    2,834  
Total Loans    422,566    408,981  
Allowance for credit losses    (5,233 )  (5,296 )
Net Loans   $417,333   $403,685  

Liquidity.     Adequate liquidity is available to accommodate fluctuations in deposit levels, fund operations, and provide for customer credit needs and meet obligations and commitments on a timely basis. The Bank’s primary sources of funds are customer deposits, maturities of investment securities, sales of securities available for sale, loan sales, loan repayments, net income and other borrowings. When necessary, liquidity can be increased by taking advances available from the Federal Home Loan Bank of Seattle. The Bank maintains credit facilities with correspondent banks totaling $37,000,000, none of which were used at June 30, 2006. In addition, the Bank has a credit line with the Federal Home Loan Bank of Seattle for up to 20% of assets, $22,500,000 of which was used at June 30, 2006. For its funds, the Company relies on dividends from the Bank, proceeds from the exercise of stock options, and proceeds from the issuance of trust preferred securities, all of which are used for various corporate purposes.

During the three months ended June 30, 2006, Pacific completed a private placement of $8 million of trust preferred securities through PFC Statutory Trust II. The trust used the proceeds from the offering, combined with the proceeds from the sale of common securities to the Company, to purchase $8,248,000 of Junior Subordinated Debentures of the Company (the “Debentures”). The Debentures bear interest, payable quarterly, at a variable rate, reset quarterly, equal to 160 basis points over the three month London Interbank Offered Rate (LIBOR). The trust preferred securities and Debentures will mature on

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July 7, 2036. For additional information regarding trust preferred securities, see Pacific’s Annual Report on Form 10-K for the year ended December 31, 2005, under the heading “Management’s Discussion and Analysis of Financial Condition and Results of Operations –Liquidity”.

Capital.     Total shareholders’ equity was $49,958,000 at June 30, 2006, an increase of $3,358,000, or 7.2%, compared to December 31, 2005. The Federal Reserve and the Federal Deposit Insurance Commission have established minimum guidelines that mandate risk-based capital requirements for bank holding companies and member banks. Under the guidelines, risk percentages are assigned to various categories of assets and off-balance sheet items to calculate a risk-adjusted capital ratio. Regulatory minimum risk-based capital guidelines require Tier 1 capital to risk-weighted assets of 4% and total capital to risk-weighted assets of 8%. The Company’s Tier 1 and Total Risk Based Capital ratios were 11.55% and 12.75%, respectively, at June 30, 2006 compared with 9.44% and 10.69%, respectively at December 31, 2005.

Additionally, to qualify as “well-capitalized”, the Bank must have a Tier 1 risk based capital ratio of at least 6%, total risk based capital of at least 10%, and a leverage ratio of a least 5%. The Bank qualified as “well-capitalized” at June 30, 2006.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Interest rate, credit, and operations risks are the most significant market risks which affect the Company’s performance. The Company relies on loan review, prudent loan underwriting standards and an adequate allowance for possible credit losses to mitigate credit risk.

An asset/liability management simulation model is used to measure interest rate risk. The model produces regulatory oriented measurements of interest rate risk exposure. The model quantifies interest rate risk by simulating forecasted net interest income over a 12-month time period under various interest rate scenarios, as well as monitoring the change in the present value of equity under the same rate scenarios. The present value of equity is defined as the difference between the market value of assets less current liabilities. By measuring the change in the present value of equity under various rate scenarios, management is able to identify interest rate risk that may not be evident from changes in forecasted net interest income.

The Company is currently asset sensitive, meaning that interest earning assets mature or re-price more quickly than interest-bearing liabilities in a given period. Therefore, a significant increase in market rates of interest could improve net interest income. Conversely, a decreasing rate environment may adversely affect net interest income.

It should be noted that the simulation model does not take into account future management actions that could be undertaken should actual market rates change during the year. Also, the model simulation results are not exact measures of the Company’s actual interest rate risk. They are rather only indicators of rate risk exposure, based on assumptions produced in a simplified modeling environment designed to heighten sensitivity to changes in interest rates. The rate risk exposure results of the simulation model typically are greater than the Company’s actual rate risk. That is due to the conservative modeling environment, which generally depicts a worst-case situation. Management has assessed the results of the simulation reports as of June 30, 2006, and believes that there has been no material change since December 31, 2005.

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ITEM 4. CONTROLS AND PROCEDURES

The Company’s disclosure controls and procedures are designed to ensure that information the Company must disclose in its reports filed or submitted under the Securities Exchange Act of 1934 (“Exchange Act”) is recorded, processed, summarized, and reported on a timely basis. Our management has evaluated, with the participation and under the supervision of our chief executive officer (CEO) and chief financial officer (CFO), the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Exchange Act) as of the end of the period covered by this report. Based on this evaluation, our CEO and CFO have concluded that, as of such date, the Company’s disclosure controls and procedures are effective in ensuring that information relating to the Company, including its consolidated subsidiaries, required to be disclosed in reports that it files under the Exchange Act is (1) recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and (2) accumulated and communicated to our management, including our CEO and CFO, as appropriate to allow timely decisions regarding required disclosures.

No change in the Company’s internal control over financial reporting occurred during our last fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.



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PART II – OTHER INFORMATION

      ITEM 1. LEGAL PROCEEDINGS

      None.

      ITEM 1A. RISK FACTORS

      There has been no material change from the risk factors previously reported in the Company’s Annual Report on Form 10-K for the year ended December 31, 2005.

      ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

      None.

      ITEM 3. DEFAULTS UPON SENIOR SECURITIES

      None.

     ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

      Previously reported.

      ITEM 5. OTHER INFORMATION

      None.

      ITEM 6. EXHIBITS

      See Exhibit Index immediately following signatures below.

SIGNATURES

        Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

PACIFIC FINANCIAL CORPORATION

DATED: August 8, 2006
By: /s/ Dennis A. Long
     Dennis A. Long
     Chief Executive Officer
   
By: /s/ Denise Portmann
     Denise Portmann
     Chief Financial Officer

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EXHIBIT INDEX

EXHIBIT NO. EXHIBIT
31.1 Certification of CEO under Rule 13a - 14(a) of the Exchange Act.
31.2 Certification of CFO under Rule 13a - 14(a) of the Exchange Act.
32 Certification of CEO and CFO under 18 U.S.C. Section 1350.




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