** **

**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

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**FORM 10-Q**

**(MarkOne)**

**x**                              QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2006

**o**                                 TRANSITIONREPORT UNDER SECTION 13 OR 15(d) OF THE EXCHANGE ACT

**CommissionFile No. 0-31267**

**IWT TESORO CORPORATION**

(Exact name of registrantas specified in its charter)

| **Nevada**                       |   | **91-2048019**          |
|----------------------------------|--------|-------------------------|
| (State or other  jurisdiction of |   | (I.R.S. Employer        |
| incorporation or  organization)  |   | Identification  Number) |

 

**101 Post Road West, Suite10, Westport, CT  06880**

(Address of principalexecutive offices)

**(203) 221-2770**

(Registrant’s telephonenumber, including area code)

Indicate by check, mark whether the registrant: (1) hasfiled all reports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorter periodthat the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days:

x Yes  oNo

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer, or a non-accelerated filer.Large accelerated filer o          Acceleratedfiler          Non-acceleratedfiler. x

Indicate by check mark whether the registrant is ashell company (as defined in Rule 12b-2 of the Exchange Act)  x Yes  o No

Indicatethe number of shares outstanding of each of the issuer’s class of commonequity, as of August XX, 2006: 11,928,600 shares

 

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**IWT TESOROCORPORATION AND SUBSIDIARIESFORM 10-QFor the Six months ended June 30, 2006INDEX**
| **PART I**  | **FINANCIAL INFORMATION**                                                                                |   |
|-------------|----------------------------------------------------------------------------------------------------------|--------|
| ** **  | ** **                                                                                               |   |
| Item I.     | Financial Statements                                                                                     |   |
|        |                                                                                                     |   |
|        | Consolidated  Balance Sheets as of June 30, 2006 and December 31, 2005                                   | 3      |
|        | Consolidated  Statements of Operations for the Three Months and Six Months Ended June 30,  2006 and 2005 | 4      |
|        | Consolidated  Statements of Stockholders’ Equity for the Six Months Ended June 30, 2006             | 5      |
|        | Consolidated  Statements of Cash Flows for the Six Months Ended June 30, 2006 and 2005                   | 6      |
|        | Notes to the  Consolidated Interim Financial Statements                                                  | 7      |
|        |                                                                                                     |   |
| Item 2.     | Management’s  Discussion and Analysis of Financial Condition and Results of Operations              | 18     |
| Item 3.     | Quantitative  and Qualitative Disclosures About Market Risk                                              | 22     |
| Item 4.     | Controls and  Procedures                                                                                 | 22     |
|        |                                                                                                     |   |
| **PART II** | **OTHER  INFORMATION**                                                                                   |   |
| ** **  |                                                                                                     |   |
| Item 1.     | Legal Proceedings                                                                                        | 22     |
| Item 2.     | Unregistered  Sales of Equity Securities and Use of Proceeds                                             | 22     |
| Item 3.     | Default Upon  Senior Securities.                                                                         | 22     |
| Item 4.     | Submission of  Matters to a vote of Security Holders                                                     | 23     |
| Item 6.     | Exhibits                                                                                                 | 23     |

 

2

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**PART 1 — FINANCIALINFORMATION**

**ITEM 1:**                   FINANCIALSTATEMENTS

**IWT TESORO CORPORATIONAND SUBSIDIARIES**CONSOLIDATEDBALANCE SHEETS(Unaudited)
| ** **                                                                                                       | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                                                                                       | ** ** | **2006**          | ** ** | **2005**              | ** ** |
| ASSETS                                                                                                           |       |              |       |                  |       |
| Current Assets:                                                                                                  |       |              |       |                  |       |
| Cash                                                                                                             |       | $                 | 310,785    |                  | $          | 552,042 |   |
| Accounts receivable, net of allowance for doubtful  accounts and returns of $390,232 and $292,662, respectively  |       | 11,581,543        |       | 9,910,551             |       |
| Inventories                                                                                                      |       | 30,822,150        |       | 32,212,007            |       |
| Deposit on purchase of inventories                                                                               |       | 387,177           |       | 860,614               |       |
| Prepaid expenses                                                                                                 |       | 339,914           |       | 293,047               |       |
| Total current assets                                                                                             |       | 43,441,569        |       | 43,828,261            |       |
|                                                                                                             |       |              |       |                  |       |
| Property and  equipment, net                                                                                     |       | 2,057,674         |       | 2,120,422             |       |
|                                                                                                             |       |              |       |                  |       |
| Other assets                                                                                                     |       | 1,126,670         |       | 1,013,886             |       |
|                                                                                                             |       | $                 | 46,625,913 |                  | $          | 46,962,569 |   |
| LIABILITIES AND  STOCKHOLDERS’ EQUITY                                                                       |       |              |       |                  |       |
|                                                                                                             |       |              |       |                  |       |
| Current Liabilities:                                                                                             |       |              |       |                  |       |
| Accounts payable                                                                                                 |       | $                 | 16,806,914 |                  | $          | 20,165,306 |   |
| Accrued expenses and other liabilities                                                                           |       | 1,799,396         |       | 1,561,119             |       |
| Accrued restructuring charges                                                                                    |       | 11,451            |       | —                |       |
| Current portion of capital lease obligations                                                                     |       | 63,310            |       | 71,770                |       |
| Current portion of notes payable, other                                                                          |       | 30,199            |       | 29,645                |       |
| Note payable, other (net of discounts of $185,675)                                                               |       | 1,814,325         |       | —                |       |
| Current portion of convertible debt                                                                              |       | 800,007           |       | —                |       |
| Note payable, revolving line of credit                                                                           |       | 23,170,771        |       | 22,625,500            |       |
| Total current liabilities                                                                                        |       | 44,496,373        |       | 44,453,340            |       |
|                                                                                                             |       |              |       |                  |       |
| Long-Term Debt:                                                                                                  |       |              |       |                  |       |
| Note payable, convertible debt (net of discounts of  $4,764,095 and $4,444,448, respectively)                    |       | 1,435,898         |       | 555,552               |       |
| Embedded derivative liability, at fair value                                                                     |       | 1,607,229         |       | 5,954,462             |       |
| Capital lease obligations, net of current portion                                                                |       | 65,799            |       | 97,860                |       |
| Notes payable other, net of current portion                                                                      |       | 63,550            |       | 78,157                |       |
| Total long-term debt                                                                                             |       | 3,172,476         |       | 6,686,031             |       |
| Total liabilities                                                                                                |       | 47,668,849        |       | 51,139,371            |       |
|                                                                                                             |       |              |       |                  |       |
| Commitments and  Contingencies                                                                                   |       |              |       |                  |       |
|                                                                                                             |       |              |       |                  |       |
| Stockholders’ Equity:                                                                                       |       |              |       |                  |       |
| Preferred stock, $0.001 par value, 25,000,000  authorized; none issued                                           |       | —            |       | —                |       |
| Common stock, $0.001 par value, 100 million shares  authorized; 11,928,600 and 11,701,102 issued and outstanding |       | 11,929            |       | 11,701                |       |
| Additional paid in capital                                                                                       |       | 5,981,093         |       | 4,189,396             |       |
| Accumulated deficit                                                                                              |       | (7,035,958        | )          | (8,377,899            | )          |
| Total stockholders’ deficit                                                                                 |       | (1,042,936        | )          | (4,176,802            | )          |
|                                                                                                             |       | $                 | 46,625,913 |                  | $          | 46,962,569 |   |

 

See notes to the consolidated interim financialstatements.

3

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** **

**IWTTESORO CORPORATION AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OFOPERATIONS(Unaudited)**
| ** **                                   | ** ** | **The three months ended** | ** ** | **The six months ended** | ** ** |
|----------------------------------------------|------------|-------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                   | ** ** | **June 30,**                         | ** ** | **June 30,**                       | ** ** |
| ** **                                   | ** ** | **2006**                                  | ** ** | **2005**                                | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                         |       |                                      |       |                                    |       |   |   |   |   |
| Net Sales                                    |       | $                                         | 16,940,815 |                                    | $          | 14,317,461 |   | $ | 32,972,034 |   | $ | 27,904,510 |   |
| Cost of Goods  Sold                          |       | 10,748,471                                |       | 8,602,396                               |       | 20,966,261 |   | 17,165,389 |   |
| Gross Profit                                 |       | 6,192,344                                 |       | 5,715,065                               |       | 12,005,773 |   | 10,739,121 |   |
| Operating Expenses:                          |       |                                      |       |                                    |       |   |   |   |   |
| Warehouse and distribution                   |       | 2,638,498                                 |       | 1,925,995                               |       | 4,992,852 |   | 3,611,386 |   |
| Sales and marketing                          |       | 1,421,269                                 |       | 1,643,882                               |       | 2,957,999 |   | 3,227,631 |   |
| General and administrative                   |       | 1,931,431                                 |       | 1,687,400                               |       | 3,915,079 |   | 3,228,236 |   |
| Restructuring charge                         |       | 585,680                                   |       | —                                  |       | 585,680 |   | — |   |
|                                         |       | 6,576,878                                 |       | 5,257,277                               |       | 12,451,610 |   | 10,067,253 |   |
| Income (Loss)  from Operations               |       | (384,534                                  | )          | 457,788                                 |       | (445,837 | ) | 671,868 |   |
| Other Expenses:                              |       |                                      |       |                                    |       |   |   |   |   |
| Interest expense                             |       | (1,336,671                                | )          | (335,170                                | )          | (2,418,047 | ) | (604,760 | ) |
| Change in fair value of derivative           |       | 324,130                                   |       | —                                  |       | 4,347,233 |   | — |   |
| Other                                        |       | (111,126                                  | )          | 41,694                                  |       | (141,408 | ) | 148,685 |   |
|                                         |       | (1,123,667                                | )          | (293,476                                | )          | 1,787,778 |   | (456,075 | ) |
| Income (Loss)  Before Income Taxes           |       | (1,508,201                                | )          | 164,312                                 |       | 1,341,941 |   | 215,793 |   |
|                                         |       |                                      |       |                                    |       |   |   |   |   |
| Income Tax  Benefit (Expense)                |       | —                                    |       | —                                  |       | — |   | — |   |
| Net Income  (Loss)                           |       | $                                         | (1,508,201 | )                                       | $          | 164,312 |   | $ | 1,341,941 |   | $ | 215,793 |   |
| Earnings (Loss) Per  Share:                  |       |                                      |       |                                    |       |   |   |   |   |
| Basic                                        |       | $                                         | (0.13      | )                                       | $          | 0.01 |   | $ | 0.11 |   | $ | 0.02 |   |
| Diluted                                      |       | $                                         | (0.13      | )                                       | $          | 0.01 |   | $ | 0.10 |   | $ | 0.02 |   |
|                                         |       |                                      |       |                                    |       |   |   |   |   |
| Weighted Average Common  Shares Outstanding: |       |                                      |       |                                    |       |   |   |   |   |
|                                         |       |                                      |       |                                    |       |   |   |   |   |
| Basic                                        |       | 11,927,146                                |       | 11,698,333                              |       | 11,788,211 |   | 11,697,721 |   |
| Diluted                                      |       | 11,927,146                                |       | 12,161,081                              |       | 12,958,321 |   | 12,160,469 |   |

 

See notes to the consolidated interim financialstatements.

4

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** **

**IWTTESORO CORPORATION AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OFSTOCKHOLDERS’ EQUITY (DEFICIT)(Unaudited)**
| ** **                                                           | ** ** | ** **            | ** ** | ** **       | ** ** | **Additional** | ** ** | **Accumulated** | ** ** | ** ** | ** ** |
|----------------------------------------------------------------------|------------|-----------------------|------------|------------------|------------|----------------|------------|-----------------|------------|------------|------------|
| ** **                                                           | ** ** | **Common Stock** | ** ** | **Paid in** | ** ** | **Earnings**   | ** ** | ** **      | ** ** |
| ** **                                                           | ** ** | **Shares**            | ** ** | **Amount**       | ** ** | **Capital**    | ** ** | **Deficit**     | ** ** | **Total**  | ** ** |
|                                                                 |       |                  |       |             |       |           |       |            |       |       |       |
| Balance,  December 31, 2005                                          |       | 11,701,102            |       | $                | 11,701     |           | $          | 4,189,396       |       | $          | (8,377,899 | ) | $ | (4,176,802 | ) |
|                                                                 |       |                  |       |             |       |           |       |            |       |       |       |
| Issuance of shares to employees and directors for  services rendered |       | 6,300                 |       | 7                |       | 12,785         |       | —          |       | 12,792     |       |
|                                                                 |       |                  |       |             |       |           |       |            |       |       |       |
| Stock option compensation expense                                    |       | —                |       | —           |       | 60,152         |       | —          |       | 60,152     |       |
|                                                                 |       |                  |       |             |       |           |       |            |       |       |       |
| Issuance of shares as prepaid interest on  subordinated debt         |       | 221,198               |       | 221              |       | 486,415        |       | —          |       | 486,636    |       |
|                                                                 |       |                  |       |             |       |           |       |            |       |       |       |
| Discount on convertible debt                                         |       | —                |       | —           |       | 1,232,345      |       | —          |       | 1,232,345  |       |
|                                                                 |       |                  |       |             |       |           |       |            |       |       |       |
| Net income, six months ended June 30, 2006                           |       | —                |       | —           |       | —         |       | 1,341,941       |       | 1,341,941  |       |
|                                                                 |       |                  |       |             |       |           |       |            |       |       |       |
| Balance, June 30, 2006                                               |       | 11,928,600            |       | 11,929           |       | $              | 5,981,093  |            | $          | (7,035,958 | )          | $ | (1,042,936 | ) |
|                                                                      |            |                       |            |                  |            |                |            |                 |            |            |            |  |  |  |  |

 

See notes to the consolidated interim financialstatements.

5

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**IWTTESORO CORPORATION AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF CASHFLOWS(Unaudited)**
| ** **                                                                     | ** ** | **Six Months Ended** | ** ** |
|--------------------------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                                     | ** ** | **June 30,**              | ** ** | **June 30,** | ** ** |
| ** **                                                                     | ** ** | **2006**                       | ** ** | **2005** | ** ** |
| Cash flows from  operating activities:                                         |       |                           |       |   |   |
| Net income                                                                     |       | 1,341,941                      |       | 215,793 |   |
| Adjustments to  reconcile net income to net cash used in operating activities: |       |                           |       |   |   |
| Non-cash restructuring charge                                                  |       | 478,794                        |       | — |   |
| Depreciation and amortization                                                  |       | 353,630                        |       | 188,619 |   |
| Amortization of loan discount                                                  |       | 1,213,659                      |       | — |   |
| Change in fair value of embedded derivative                                    |       | (4,347,233                     | )          | — |   |
| Common stock issued for services and compensation                              |       | 12,792                         |       | 10,600 |   |
| Stock option compensation expense                                              |       | 60,152                         |       | — |   |
| Provision for doubtful accounts and reserve for  returns                       |       | 97,570                         |       | 18,896 |   |
| Loss on disposal of property and equipment                                     |       | 80,156                         |       | 16,900 |   |
| Changes in  operating assets and liabilities:                                  |       |                           |       |   |   |
| (Increase)  Decrease in:                                                       |       |                           |       |   |   |
| Accounts receivable                                                            |       | (2,443,955                     | )          | (1,190,792 | ) |
| Inventories                                                                    |       | 876,157                        |       | (4,952,291 | ) |
| Deposit on purchase of inventories                                             |       | 359,509                        |       | — |   |
| Prepaid expenses and other assets                                              |       | (174,047                       | )          | (96,293 | ) |
| Increase  (Decrease) in:                                                       |       |                           |       |   |   |
| Accounts payable                                                               |       | (2,317,848                     | )          | 248,033 |   |
| Accrued expenses and other liabilities                                         |       | 101,653                        |       | 182,945 |   |
| Accrued restructuring charges                                                  |       | 11,451                         |       | — |   |
| Net cash used in operating activities                                          |       | (4,295,619                     | )          | (5,357,590 | ) |
|                                                                           |       |                           |       |   |   |
| Cash flows from  investing activities:                                         |       |                           |       |   |   |
| Acquisitions of property and equipment                                         |       | (423,700                       | )          | (107,562 | ) |
| Proceeds from sale of equipment                                                |       | 17,300                         |       | — |   |
| Net cash used in investing activities                                          |       | (406,400                       | )          | (107,562 | ) |
|                                                                           |       |                           |       |   |   |
| Cash flows from  financing activities:                                         |       |                           |       |   |   |
| Proceeds from revolving line of credit                                         |       | 34,968,529                     |       | 32,783,331 |   |
| Payments on revolving line of credit                                           |       | (34,297,193                    | )          | (27,079,010 | ) |
| Proceeds from issuance of convertible debt and  warrant                        |       | 4,000,000                      |       | — |   |
| Debt issuance costs                                                            |       | (156,000                       | )          | — |   |
| Payments of long-term debt and capital lease  obligations                      |       | (54,574                        | )          | (74,271 | ) |
| Loan financing costs                                                           |       | —                         |       | (35,654 | ) |
| Net cash provided by financing activities                                      |       | 4,460,762                      |       | 5,594,396 |   |
|                                                                           |       |                           |       |   |   |
| Net Increase  (Decrease) in Cash                                               |       | (241,257                       | )          | 129,244 |   |
| Cash, Beginning                                                                |       | 552,042                        |       | 507,677 |   |
| Cash, Ending                                                                   |       | 310,785                        |       | 636,921 |   |
| Cash Paid During the  Period for:                                              |       |                           |       |   |   |
| Interest expense                                                               |       | $                              | 1,078,327  |   | $ | 604,760 |   |
| Income tax                                                                     |       | $                              | —     |   | $ | 8,000 |   |
| Non-Cash Operating  Activities:                                                |       |                           |       |   |   |
| Inventory acquired through deposit with vendor                                 |       | $                              | 147,237    |   | $ | 73,625 |   |
| Non-Cash Investing and  Financing Activities:                                  |       |                           |       |   |   |
| Acquisition of  property and equipment financed through long-term debt         |       | $                              | —     |   | $ | 53,331 |   |

 

See notes to the consolidated interim financialstatements.

6

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**IWT TESORO CORPORATION ANDSUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Unaudited)SIX MONTHS ENDED JUNE 30, 2006**

**NOTE 1.   SUMMARYOF SIGNIFICANT ACCOUNTING POLICIES**

***Principles of Consolidation***

The consolidatedfinancial statements include IWT Tesoro Corporation and its wholly ownedsubsidiaries International Wholesale Tile, Inc., IWT Tesoro International, Ltd,IWT Tesoro Transport, Inc. and The Tile Club, Inc and The Tile Club, Inc.’swholly owned subsidiary Import Flooring Group, Inc. All significant inter-companybalances and transactions have been eliminated in consolidation. 

***Basis of Presentation***

The interim financial information included herein is unaudited;however, such information reflects all adjustments, which are, in the opinionof management, necessary for a fair presentation of the Company’s financialposition, results of operations, changes in stockholders’ equity and cash flowsfor the interim periods. All such adjustments are of a normal, recurringnature. The results of operations for the first six months of the year are notnecessarily indicative of the results of operations which might be expected forthe entire year.

The accompanyingconsolidated financial statements of the Company have been prepared inaccordance with accounting principles generally accepted in the United Statesof America and with the instructions to Form 10-Q and Rule 10-10 of RegulationS-X of the Securities and Exchange Commission. Accordingly certain informationand footnote disclosure required by accounting principles generally accepted inthe United States of America for complete financial statements have beenomitted. These condensed financial statements should be read in conjunctionwith the Company’s financial statements and notes thereto included in theCompany’s audited financial statements on Form 10-K, for the fiscal year endedDecember 31, 2005.

The Consolidated BalanceSheet at December 31, 2005 has been derived from the audited financialstatements of IWT Tesoro Corporation at that date, but does not include all ofthe information and footnotes required by U.S. generally accepted accountingprinciples for complete financial statements.

***Earnings per Share***

Basic earnings per share (“EPS”) excludes dilution and is calculated bydividing net income (loss) available to common stockholders by theweighted-average number of shares of common stock outstanding during theperiod. Diluted EPS is computed in a manner similar to that of basic EPS exceptthat the weighted-average number of common shares outstanding is increased toinclude the number of incremental common shares (computed using the treasurystock method) that would have been outstanding if all potentially dilutivecommon shares (such as stock options) were issued during the period. DilutedEPS is not presented if the effect of the incremental shares is antidilutive.

7

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*** ***

The following table reflects the calculation of basic and dilutedearnings per share:
| ** **                                                         | ** ** | **The three months ended** | ** ** | **The six months ended** | ** ** |
|--------------------------------------------------------------------|------------|-------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                                         | ** ** | **June 30,**                         | ** ** | **June 30,**                       | ** ** |
| ** **                                                         | ** ** | **2006**                                  | ** ** | **2005**                                | ** ** | **2006** | ** ** | **2005** | ** ** |
| Earnings (loss) per  share — basic                            |       |                                      |       |                                    |       |   |   |   |   |
| Earnings (loss) available to common shareholders                   |       | $                                         | (1,508,201 | )                                       | $          | 164,312 |   | $ | 1,341,941 |   | $ | 215,793 |   |
| Weighted average shares outstanding                                |       | 11,927,146                                |       | 11,698,333                              |       | 11,788,211 |   | 11,697,721 |   |
| Earnings (loss) per share — basic                             |       | $                                         | (0.13)     |                                    | $          | 0.01 |   | $ | 0.11 |   | $ | 0.02 |   |
| Earnings (loss) per  share — diluted                          |       |                                      |       |                                    |       |   |   |   |   |
| Earnings (loss) available to common shareholders                   |       | $                                         | (1,508,201 | )                                       | $          | 164,312 |   | $ | 1,341,941 |   | $ | 215,793 |   |
| Weighted average shares outstanding                                |       | 11,927,146                                |       | 11,698,333                              |       | 11,788,211 |   | 11,697,721 |   |
| Dilutive impact of options outstanding                             |       | 1,170,110                                 |       | 462,748                                 |       | 1,170,110 |   | 462,748 |   |
| Weighted average  shares and potential dilutive shares outstanding |       | 11,927,146                                |       | 12,161,081                              |       | 12,958,321 |   | 12,160,469 |   |
| Earnings (loss)  per share — diluted                          |       | $                                         | (0.13      | )                                       | $          | 0.01 |   | $ | 0.10 |   | $ | 0.02 |   |

 

As of June 30, 2006 and 2005, the following securities, which couldpotentially dilute earnings per share in the future, were not included in thecomputation of earnings per share, because to do so would have been antidilutive:

|               | ** ** | **The three months ended** | ** ** | **The six months ended** | ** ** |
|---------------|------------|-------------------------------------------|------------|-----------------------------------------|------------|
| ** **    | ** ** | **June 30,**                         | ** ** | **June 30,**                       | ** ** |
| ** **    | ** ** | **2006**                                  | ** ** | **2005**                                | ** ** | **2006** | ** ** | **2005** | ** ** |
| Stock Options |       | —                                    |       | —                                  |       | 609,749 |   | 567,749 |   |
| Warrants      |       | 333,333                                   |       | —                                  |       | 1,855,545 |   | 549,500 |   |
|          |       | 333,333                                   |       | —                                  |       | 2,465,294 |   | 1,117,249 |   |

 

***Income Taxes***

The Company recognizesincome taxes under the asset and liability method. Under this method, deferredtax assets and liabilities are recognized for the future tax consequencesattributable to differences between the financial statement carrying amounts ofexisting assets and liabilities and their respective tax bases, and losscarryforwards. Deferred tax assets and liabilities are measured using enactedtax rates expected to apply to taxable income in the years in which thosetemporary differences are expected to be recovered or settled. The effect ondeferred tax assets and liabilities of a change in tax rates is recognized inincome in the period that includes the enactment date. Deferred tax assets arereduced by a valuation allowance when, in the opinion of management, it is morelikely than not that some portion or all of the deferred tax assets will not berealized.

***Segment Information***

The Company has adoptedSFAS No. 131, “Disclosures about Segments of an Enterprise and RelatedInformation.” SFAS No. 131 establishes standards for the way that publicbusiness enterprises report information about operating segments in annualfinancial statements and requires those enterprises to report selectedinformation about operating segments in interim financial reports issued tostockholders. The Company’s revenues are all from floor covering products andservices sold throughout the United States with no single customer accountingfor more than 10% of net sales. There fore the Company operates in one segmentfor management reporting purposes.

8

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***Reclassifications***

Certainamounts in the 2005 financial statements have been reclassified for comparativepurposes to conform to the 2006 presentation. These reclassifications had noeffect on net income.

***Recent AccountingPronouncements***

In December 2004, the FASB issued SFAS No. 123 (revised 2004)(“SFAS No. 123R”), “*Share-Based Payment*,”which requires that the compensation cost relating to share-based paymenttransactions be recognized in the financial statements. SFAS No. 123Rreplaces SFAS No. 123, “Accounting for Stock-Based Compensation,” andsupersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees.”Share-based compensation arrangements include share options, restricted shareplans, performance-based awards, share appreciation rights and employee sharepurchase plans. SFAS No. 123R requires all share-based payments toemployees be valued using a fair value method on the date of grant and expensedbased on that fair value generally over the applicable vesting period. SFAS No. 123Ralso amends SFAS No. 95 “Statement of Cash Flows,” requiring the benefitsof tax deductions in excess of recognized compensation cost be reported asfinancing cash inflow rather than as a reduction of taxes paid. In March 2005,the Securities and Exchange Commission (“SEC”) issued Staff Accounting BulletinNo. 107, (“SAB No. 107”) which expresses the SEC’s views regardingthe interaction between SFAS No. 123R and certain SEC rules andregulations and, accordingly, provides guidance related to share-based paymenttransactions for public companies. The Company adopted SFAS 123R onJanuary 1, 2006 and its adoption did not have a material effect on ourconsolidated results of operations, financial position or cash flows. TheCompany’s compensation expense for the three and six months ended June 30,2006 was approximately $30,400 and $60,100, respectively, as further describedin Note 11. The financial impact of any stock options granted isdetermined using the Black-Scholes option-pricing model with the followingassumptions: option price, dividend yield, expected volatility, risk freeinterest rate and the expected life.

In July 2006, the FASB issued Interpretation No. 48 (“FIN 48”), *Accounting for Uncertainty in Income Taxes*. FIN 48applies to all tax positions related to income taxes subject to SFAS No. 109,Accounting for Income Taxes. This includes tax positions considered to be “routine”as well as those with a high degree of uncertainty. FIN 48 utilizes atwo-step approach for evaluating tax positions. Recognition (step one) occurswhen an enterprise concludes that a tax position, based solely on its technicalmerits, is more-likely-than-not to be sustained upon examination. Measurement(step two) is only addressed if step one has been satisfied (i.e., the positionis more-likely-than-not to be sustained). FIN 48 clarifies the accountingfor income taxes by prescribing the minimum recognition threshold a taxposition must meet before being recognized in the financial statements. FIN 48also provides guidance on derecognition, measurement, classification, interestand penalties, accounting in interim periods, disclosure, and transition. FIN 48is effective for fiscal years beginning after December 15, 2006. Earlieradoption is permitted as of the beginning of an enterprise’s fiscal year,provided the enterprise has not yet issued financial statements, includingfinancial statements for any interim period, for that fiscal year. Managementis currently evaluating the requirements of FIN 48 and has not yetdetermined the impact on the Company’s consolidated financial statements.

9

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**NOTE 2   LIQUIDITYAND PROFITABILITY CONSIDERATIONS**

The Company’s net earnings for the six months ended June 30, 2006are approximately $1,342,000, of which approximately $4,300,000 relates to thechange in the fair value of the derivative liability, as more fully describedin Note 7. This follows net losses of approximately $4,344,000, $1,209,000and $1,865,000 for the years ended December 31, 2005, 2004 and 2003,respectively. As reflected in the consolidated balance sheet as of June 30,2006, the Company a had working capital deficit of approximately $1,055,000, adeterioration of approximately $430,000 from December 31, 2005 at whichtime we had a working capital deficit of approximately $625,000. Thedeterioration in working capital is primarily due to the decline in currentassets of approximately $400,000.

***Profitability***

In January 2006 management implemented a plan to improve profitabilityby reducing projected operating costs in sales and marketing and administrativeoverhead. The Company improved their operations by increasing sales andcontrolling operating expenses. For the six months ended June 30, 2006operating expenses as a percent of sales was 36%, an improvement of 4.8 basispoints from the year ended December 31, 2005, for which operating expensesas a percent of sales was 40.8%. The Company expanded its plan to reduceoperating cost and in June 2006 restructured the operations of itssubsidiary Import Flooring Group, Inc., as more fully described in Note 3.The Company implemented a 3.5% price increase in February 2006, opened a smallwarehouse in Ohio to service existing and new customers in the Midwest andbegan selling products to two additional home center companies.

***Liquidity***

In February 2006, as more fully described in Note 7herein, the Company obtained $2.0 million through the issuance of a three yearsubordinated convertible term note. In May 2006, as more fully described in Note 8herein, the Company obtained $2.0 million through the issuance of a one yearsubordinated term note. These funds will generally be used for the Company’sworking capital requirements.

The Company is currently negotiating the terms of the renewal of itsrevolving line of credit which matures September 10, 2006 with itscommercial lender.

The Company hired a consultant to review purchasing and inventorymanagement procedures. The goal of the study is to determine the optimuminventory necessary to maintain the high levels of customer satisfaction whileimproving working capital. The Company continues to work with the consultant toascertain the optimum inventory levels and has improved inventory turnover andreduced inventory levels 4.3% from December 31, 2005 to June 30,2006.

In December 2005 the Company signed an agreement with a company toprovide market capitalization support services. Additionally, in February 2006the Company signed an agreement with an investment banking firm to providegeneral financial advisory services to develop and implement a plan to raisenew debt and / or equity capital. The Company continues to work with both ofthese companies to improve the Company’s financial structure and raise new debtand / or equity capital.

Summary

Management believes the results of the plan described above willprovide improvements in the Company’s profitability, cash flow and liquidityand to ensure its viability and to sustain its operations.

10

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**NOTE 3   RESTRUCTURING**

IWT Tesoro Corporation has restructured the operations of itssubsidiary Import Flooring Group, Inc. (IFG). Import Flooring Group, Inc.although similar to its sister Company, International Wholesale Tile,Inc.(IWT), in that both company’s major source of revenue is generated throughthe wholesale, distribution and brokering of floor coverings throughout theUnited States. IFG generated revenue from other sources by offering fee basedservices such as “showroom fees”, charged to vendors for allocating a portionof the California Office/Showroom to display the vendor’s products, “conventionfees”, for participating in the annual IFG Floor Covering Convention and “membershipfees” charged to customers for participating in exclusivity agreements. The feebased revenue was anticipated to generate a greater percentage of the totaloverall revenue. However, only 2.7% of the total revenue from July 1, 2005through June 30, 2006 was a result of this fee based revenue source. IWTTesoro Corporation determined that the cost to provide these fee based servicesexceeded the revenue. Therefore, the Company restructured its operationseliminating these services and the associated costs. These costs included theoffice/showroom space located in San Clemente, California and the office andsales staff based out of this office. As a part of this restructuring theCompany entered into an agreement with a former IFG sales person to acquire aportion of the assets and liabilities of IFG related to the fee based revenueactivities. IFG retained a portion of the assets and liabilities related toproduct sales and continue to sell products throughout the United States

In connection with thisrestructuring plan IFG incurred the following costs:

1.               One-TimeTermination Benefits of $30,400 as severance pay to satisfy the employmentcontract of a former IFG sales person.

2.               ContractTermination Costs of $62,272 to terminate the San Clemente office/showroomlease agreement, vendor agency agreements and showroom contracts and customercontracts and customer membership agreements.

3.               Other AssociatedCosts of approximately $493,000, of which $357,035 is the difference betweenthe value of the assets and liabilities surrendered in the agreement with theformer IFG salesperson.to purchase certain assets and liabilities of ImportFlooring Group, Inc. The Company also incurred attorney’s fees of approximately$22,000 and $113,000 related to the write off on a non-refundable deposit forinventory.

The Company accounted forrestructuring costs pursuant to Statement of Financial Accounting Standards(SFAS” No. 146, “Accounting for Costs Associated with Exit or DisposalActivities”. SFAS 146 requires that a liability for a cost associated with anexit or disposal activity be recognized when the liability is incurred, asopposed to when there is a commitment to a restructuring plan. Through thesecond quarter of 2006, the Company recorded a restructuring charge in theamount of approximately $585,700 in connection with the restructuringactivities which includes the recognition of a liability of $11,450 for otherassociated costs incurred, however unpaid as of June 30, 2006. The Companydoes not anticipate incurring any additional costs with respect to thisrestructure. Restructuring charges are reflected in a separate line item in theaccompanying consolidated statements of operations.

11

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**NOTE 4   INVENTORIES**

Inventoriesconsisted of the following:

|                       | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|-----------------------|------------|-------------------|------------|-----------------------|------------|
| ** **            | ** ** | **2006**          | ** ** | **2005**              | ** ** |
| Tiles                 |       | $                 | 29,200,390 |                  | $          | 28,858,620 |   |
| Inventory in  transit |       | 1,621,760         |       | 3,353,387             |       |
|                  |       | $                 | 30,822,150 |                  | $          | 32,212,007 |   |

 

Inventory in transit consists of merchandise purchased overseas, whichis not yet received in the warehouse. The Company obtains legal title at theshipping point.

**NOTE 5   PROPERTYAND EQUIPMENT**

Property and equipment consisted of the following:

|                                | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|--------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                     | ** ** | **2006**          | ** ** | **2005**              | ** ** |
| Furniture and  fixtures        |       | $                 | 319,707    |                  | $          | 423,806 |   |
| Machinery and  equipment       |       | 1,050,127         |       | 859,996               |       |
| Vehicles                       |       | 321,572           |       | 307,195               |       |
| Office and  computer equipment |       | 704,188           |       | 676,304               |       |
| Leasehold  improvements        |       | 627,229           |       | 676,094               |       |
|                           |       | 3,022,823         |       | 2,943,395             |       |
| Less accumulated  depreciation |       | 965,149           |       | 822,973               |       |
|                           |       | $                 | 2,057,674  |                  | $          | 2,120,422 |   |

 

Depreciation expense for the three months ended June 30, 2006 and2005 was approximately $56,800 and $79,200, respectively. Depreciation expensefor the six months ended June 30, 2006 and 2005 was approximately $142,200and $157,300, respectively.

**NOTE 6   NOTESPAYABLE, REVOLVING LINE OF CREDIT**

On December 31, 2004, the Company amended and restated theexisting revolving line of credit agreement providing up to $25,000,000 ofavailable borrowings with interest rates of either (1) LIBOR plus 3.00% or (2)the base rate plus 0.50% (interest rates ranging from 7.97% to 8.75% at June 30,2006) payable monthly. The line of credit is limited by a borrowing base whichis comprised of a percentage of eligible accounts receivable and eligibleinventories, as defined, and is collateralized by substantially all the assetsof the Company. The balance due at June 30, 2006 and December 31,2005 was $23,170,771 and $22,625,500, respectively. The line matures September 10,2006 and contains certain covenants requiring the Company to maintain a certainleverage ratio, a required minimum fixed charge coverage ratio, and certaininventory turnover ratio. At June 30, 2006 the Company was not incompliance with the leverage and fixed charge coverage ratio requirement. TheCompany was granted a waiver of these covenants from its commercial lender.

For the three months ended June 30, 2006 and 2005, interestexpense related to the credit line amounted to $475,990 and $320,676respectively. For the six months ended June 30, 2006 and 2005, interestexpense related to the credit line amounted to $912,063 and $576,301respectively.

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**NOTE 7   NOTESPAYABLE — CONVERTIBLE DEBT**

On February 10, 2006, the Company issued a secured convertible termnote in the amount of $2,000,000 resulting in net proceeds of $1,919,500.Interest accrues on the principal balance of the note at an annual interestrate equal to prime plus 2.0%, payable monthly in arrears commencing on March1, 2006. On June 30, 2006, the interest rate was 10.25%. The note requiresmonthly principal payments of $66,667 commencing on August 1, 2006 andcontinuing until maturity. The note matures on February 10, 2009. The note isconvertible into common stock of the Company at a fixed conversion rate of$2.17 per share. Based upon the closing price per share of the Company’s commonstock on the date of issuance, there was a beneficial conversion feature withan estimated intrinsic value of $553,593, which is presented as a discount onthe note to be amortized into expense over the three year term of the loanusing the effective interest method. In connection with the convertible note,the Company issued to the holder of the note a seven-year warrant to purchase460,829 shares of the Company’s common stock at an exercise price of $2.39 pershare. The Company estimated the fair value of the warrant and allocated$455,943 of the proceeds of the debt to the warrant which is presented as adiscount on the note to be amortized into interest expense over the three-yearterm of the note using the effective interest method. The aggregate discountallocated to the beneficial conversion feature and the options and warrants wasrecorded as additional paid in capital at June 30, 2006. The fair value ofthe warrant was estimated at the date of issuance using the Black-Scholesoption-pricing model using the following assumptions: risk-free rate of 4.59%,dividend yields of 0%, and a volatility factor of the expected market price ofthe Company’s common stock of 58.2%. The Company also issued to the holder, 221,198shares of the Company’s common stock as prepayment of interest in the amount of$486,636, which was calculated based upon the closing price per share of theCompany’s common stock on the date of issuance of $2.20 per share. The prepaidinterest is presented as a discount on the note to be amortized into interestexpense over the three year term using the effective interest method.

On August 25, 2005, the Company issued a secured convertible revolvingnote in the aggregate amount of $5,000,000 resulting in net proceeds of$4,733,000 after debt issuance costs of $267,000. Interest accrues on theprincipal balance of the note at an annual interest rate equal to prime plus1.5%. On June 30, 2006, the interest rate was 9.75%. The note matures onAugust 25, 2008. The note is convertible into common stock of the Company at aninitial conversion rate of $2.74 per share. Because the agreement containscertain non-standard anti-dilution provisions and requirements to settle anyconversion option with registered shares, the Company is required to accountfor the conversion option as an embedded derivative requiring separateaccounting treatment in accordance with *SFAS No. 133 Accountingfor Derivative Instruments and Hedging Activities*. Based upon theclosing price per share of the Company’s common stock on the date of issuance,the Company estimated the fair value of the embedded conversion option andclassified $2,068,317 as a derivative liability that is adjusted to fair valueat each reporting date with changes in fair value reported in earnings. Inconnection with the convertible notes, the Company issued to the holder of thenote a five-year warrant to purchase 511,883 shares of the Company’s commonstock at an exercise price of $3.15 per share and an option to purchase1,170,110 shares of the Company’s common stock at an exercise price of $0.001per share. Based upon the closing price per share of the Company’s common stockon the date of issuance, the Company estimated the fair value of the warrantand option and classified $3,099,835 and $692,334, respectively, as derivativeliabilities that are adjusted to fair value at each reporting date with changesin fair value reflected in operations. The estimated fair value of thederivative liabilities as of June 30, 2006 is $1,607,229. This is adecrease in fair value of $4,347,233 from the value as of December 31,2005. This decrease is primarily due to the decrease in the Company’s closingstock prices as of June 30, 2006 compared to the closing stock price as ofDecember 31, 2005. The Company has recognized this change in fair value asother income in the Consolidated Statement of Operations for the six monthsended June 30, 2006. The fair values of the options, warrants, andembedded conversion option was estimated at the date of issuance using theBlack-Scholes option-pricing model using the following weighted averageassumptions: risk-free rate of 4.06%, dividend yields of 0%, and volatilityfactors of the expected market price of the Company’s common stock of 60.79%.

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On March 31, 2006, the Company issued Amendment #2 to the SecurityAgreement, dated August 25, 2005 and the Convertible Minimum Borrowing Note,dated August 25, 2005. As a result of the Amendment, the Company is no longerrequired to make any modifications to the fixed conversion price, or issueadditional securities in the event the Company issues common stock at a priceless than $2.74 per share.

The balance of the notes, net of unamortized discounts and the embeddedderivative as of June 30, 2006 is as follows:

| Derivative liability at December 31,  2005                 |   | $          | 5,954,462 |   |
|-----------------------------------------------------------------|--------|------------|-----------|--------|
| Change in fair  value                                           |   | (4,347,233 | )         |
| Derivative  liability as of June 30, 2006                  |   | $          | 1,607,229 |   |
|                                                            |   |       |      |
| Principal amount  of notes                                      |   | $          | 7,000,000 |   |
| Fair value - Conversion  feature                                |   | (2,318,222 | )         |
| Fair value -  Warrants and options                              |   | (4,177,950 | )         |
| Accretion of  discount to interest expense                      |   | 1,732,077  |      |
| Balance as of June 30,  2006, net of unamortized discounts |   | $          | 2,235,905 |   |
| Current                                                         |   | 800,007    |      |
| Non-current                                                     |   | 1,435,898  |      |
|                                                            |   | $          | 2,235,905 |   |

 

Interest expense related to the notes amounted to $251,886 for thethree months ended June 30, 2006 and $389,893 for the six months ended June 30,2006.

Amortization of discounts for the conversion features and warrant andoption resulted in charges to interest expense totaling $229,152 for the threemonths ended June 30, 2006 and $421,313 for the six months ended June 30,2006.

Amortization of discounts for the detachable warrants and optionsresulted to charges to interest expense totaling $374,366 for the six monthsended June 30, 2006 and $681,133.

The note is secured by a lien on substantially all the assets of theCompany, subject to a first priority lien of the Company’s primary financiallender.

#### The holder of the note hasagreed that it will not convert the note, or exercise any warrant or option,into common stock in amounts that would cause the holder’s aggregate beneficialownership of the Company’s common stock to exceed 4.99%, without 120 days priornotice, or 19.199%, without stockholder approval.

**NOTE 8   NOTESPAYABLE – OTHER**

On May3, 2006, the Company issued a secured term note in the amount of $2,000,000resulting in net proceeds of $1,924,500. Interest accrues on the principalbalance of the note at an annual interest rate equal to 15%, payable monthly inarrears commencing on June 1, 2006. The note matures on May 3, 2007. Inconnection with the term note, the company issued to the holder of the note aseven-year warrant to purchase 333,333 shares of the Company’s common stock atan exercise price of $1.12 per share. The company estimated the fair value ofthe warrant and allocated $222,809 of the proceeds of the debt to the warrant,which is presented as a discount on the note to be amortized into expense overthe one-year term of the note. The fair value of the warrant was estimated atthe date of issuance using the Black-Scholes option-pricing model using thefollowing assumptions: risk-free rate of 5.06%, dividend yields of 0%, and avolatility factor of the expected market price of the Company’s common stock of59.18%.

14

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The balance of the note as of June 30, 2006, net of unamortizeddiscounts is a follows:

| Principal amount of notes                                  |   | $        | 2,000,000 |   |
|------------------------------------------------------------|--------|----------|-----------|--------|
| Fair value —  Warrants                                |   | (222,809 | )         |
| Accretion of  discount into interest expense               |   | 37,134   |      |
| Balance as of June 30,  2006, net of unamortized discounts |   | $        | 1,814,325 |   |

 

**NOTE 9   STOCKHOLDERS’EQUITY**

**Common Stock**

During the six months ended June 30, 2006, the Company issued 6,300shares of common stock to several employees under the Stock Incentive Plan forservices rendered, based on the closing stock price at the date of issuance,for a total of $12,792, resulting in an equivalent charge to operations.

On February 10, 2006, the Company issued 221,198 shares of common stockto the holder of a secured term note as prepayment of interest in the amount of$486,636, which was calculated based upon the closing price per share of theCompany’s common stock on the date of issuance.

**NOTE 10   INCOMETAXES**

Income tax benefit for the three month period ended June 30, 2006 was$-0- as the benefit for income taxes, computed by applying the Federalstatutory rate to loss before income taxes, was reduced by the increase in thedeferred tax valuation allowance during the period, to adjust deferred taxes tothe amount considered by management more likely than not to be realized.

Income tax benefit for the six month period ended June 30, 2006 was$-0- as the provision for income taxes computed by applying the Federalstatutory rate to income before income taxes, was reduced by the decrease inthe deferred tax valuation allowance during the period, resulting from theutilization of a portion of the Company’s net operating loss carryforward.

Income tax expense for the three and six month period ended June 30,2005 was $-0- as the benefit for income taxes, computed by applying the Federalstatutory rate to loss before income taxes, was reduced by the increase in thedeferred tax valuation allowance during the period, to adjust deferred taxes tothe amount considered by management more likely than not to be realized.

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The significant components of deferred tax assets and deferred taxliabilities at June 30, 2006 and December 31, 2005 are presented below: 

|                                            | ** ** | **June 30,** | ** ** | **December 31** | ** ** |
|--------------------------------------------|------------|-------------------|------------|----------------------|------------|
| ** **                                 | ** ** | **2006**          | ** ** | **2005**             | ** ** |
| Deferred tax asset:                        |       |              |       |                 |       |
| Net operating loss carry forward           |       | $                 | 2,398,290  |                 | $          | 1,302,015 |   |
| Accounts receivable                        |       | 83,965            |       | 52,630               |       |
| Accrued expense                            |       | 30,540            |       | 25,355               |       |
| Deferred compensation — stock options |       | 273,502           |       | 250,867              |       |
| Accumulated depreciation                   |       | 752,945           |       | 822,168              |       |
| Return Reserve                             |       | 62,880            |       | 57,499               |       |
| Derivative liability                       |       | (1,276,700        | )          | 359,164              |       |
| Benefical conversion amortization          |       | (160,448          | )          | —               |       |
| Other                                      |       | 7,124             |       | 24,336               |       |
|                                       |       | 2,172,098         |       | 2,894,034            |       |
| Less: Valuation allowance                  |       | (2,172,098        | )          | (2,894,034           | )          |
|                                       |       | $                 | —     |                 | $          | — |   |

 

The following table summarizes the classification of the deferred taxasset (liability) as of June 30, 2006 and December 31, 2005.

|                                     | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|-------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                          | ** ** | **2006**          | ** ** | **2005**              | ** ** |
|                                |       |              |       |                  |       |
| Current                             |       | $                 | 164,334    |                  | $          | 140,998 |   |
| Non-current                         |       | 2,007,764         |       | 2,753,036             |       |
| Total                               |       | 2,172,098         |       | 2,894,034             |       |
| Valuation  allowance                |       | (2,172,098        | )          | (2,894,034            | )          |
| Net deferred tax  asset (liability) |       | $                 | —     |                  | $          | — |   |

 

At June 30, 2006, the Company had net operating loss carryforwards forfederal income tax purposes of approximately $6,416,000, which are available tooffset future federal taxable income through 2026. Of the $721,936 change inthe valuation allowance, approximately $208,000 was recorded as a reduction tothe deferred tax effect of the beneficial conversion feature recorded inadditional paid in capital.

**NOTE 11   STOCK-BASEDCOMPENSATION**

The Company entered into a Stock Incentive Plan on December 27, 2001.Under the plan, non-qualified stock options, incentive stock options andrestricted stock may be granted to eligible employees, consultants andaffiliates. On June 26, 2006, the Company’s board of directors authorized astock repurchase program to purchase up to 150,000 shares of IWT Tesoro’sstock.

Effective January 1, 2006, the Company adopted the fair valuerecognition provisions of SFAS No. 123R using the modified-prospective-transitionmethod. Prior to the adoption of SFAS No. 123R stock option grants wereaccounted for in accordance with Accounting Principles Board Opinion No. 25, “*Accounting for Stock Issued to Employees*” (APB No. 25), andrelated interpretations, and accordingly the Company recognized no compensationexpense for stock option grants.

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Under the modified-prospective-transition method, SFAS No. 123R appliesto new awards and to awards that were outstanding on January 1, 2006 that aresubsequently modified, repurchased or cancelled. Under themodified-prospective-transition method compensation cost recognized in thethree-month period ended June 30, 2006, includes compensation cost for allshare-based payments granted prior to, but not yet vested as of January 1,2006, based on the grant date fair value estimated in accordance with theoriginal provisions of Statement 123, and compensation cost for all share-basedpayments granted subsequent to January 1, 2006, based on the grant-date fairvalue estimated in accordance with the provisions of SFAS No. 123R. Priorperiods were not restated to reflect the impact of adopting the new standard.

As a result of adopting SFAS No. 123R on January 1, 2006, duringthe three and six month periods ended June 30, 2006, the Company recognizedadditional compensation costs of $30,437 and $29,715, respectively. Theadoption of SFAS No. 123R had no impact on basic and diluted earnings pershare for the six months ended June 30, 2006. 

The following table illustrates the effect on net income and earningsper share if the Company had applied the fair value recognition provisions ofStatement 123(R) to options granted under the Company’s stock option plan forthe three and six month period ended June 30, 2005. For purposes of thisproforma disclosure, the value of the options is estimated using theBlack-Scholes option-pricing model and amortized to expense over the options’vesting periods. 

|                                                                                                                 | ** ** | **For the three** | ** ** | **For the six** | ** ** |
|-----------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|---------------------------|------------|
| ** **                                                                                                      | ** ** | **months ended**       | ** ** | **months ended**     | ** ** |
| ** **                                                                                                      | ** ** | **June 30, 2005** | ** ** |
|                                                                                                            |       |                        |       |                      |       |
| Net income as  reported                                                                                         |       | $                           | 164,312    |                      | $          | 215,793 |   |
| Deduct: Stock-based employee compensation expense  determined under the fair value based method for all options |       | (18,162                     | )          | (37,902                   | )          |
|                                                                                                            |       |                        |       |                      |       |
| Pro forma net  income                                                                                           |       | $                           | 146,150    |                      | $          | 177,891 |   |
|                                                                                                            |       |                        |       |                      |       |
| Earnings per share — As  reported                                                                          |       |                        |       |                      |       |
| Basic                                                                                                           |       | $                           | 0.02       |                      | $          | 0.02 |   |
| Diluted                                                                                                         |       | $                           | 0.02       |                      | $          | 0.02 |   |
|                                                                                                            |       |                        |       |                      |       |
| Earnings per share —  Proforma                                                                             |       |                        |       |                      |       |
| Basic                                                                                                           |       | $                           | 0.02       |                      | $          | 0.02 |   |
| Diluted                                                                                                         |       | $                           | 0.01       |                      | $          | 0.01 |   |

 

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The following assumptions were utilized in the Black-Scholes optionpricing model used to estimate the fair value of stock-based awards.

|                                         | ** ** | **Six Months Ended June 30** | ** ** |
|-----------------------------------------|------------|--------------------------------------------------|------------|
| ** **                              | ** ** | **2006**                                         | ** ** | **2005** | ** ** |
|                                    |       |                                             |       |   |   |
| Dividend yield                          |       | 0                                                | %          | 0 | % |
| Expected  volatility                    |       | 58.8                                             | %          | 75.6 | % |
| Risk-free  interest rate                |       | 4.4                                              | %          | 4.3 | % |
| Expected life of  options (in years)    |       | 5.5                                              |       | 5.5 |   |
| Weighted-average  grant-date fair value |       | $                                                | 1.42       |   | $ | 1.70 |   |
|                                         |            |                                                  |            |  |  |  |  |

 

The assumptions above are based on multiple factors, includinghistorical exercise patterns of employees in relative homogeneous groups withrespect to exercise and post-vesting employment termination behaviors, expectedfuture exercising patterns for these same homogenous groups and the impliedvolatility of our stock price.

At June 30, 2006, there was $210,430 of unrecognized compensation costrelated to share-based payments which is expected to be recognized over aweighted-average period of 1.59 years.

The following table represents employee based stock option activity forthe three months ended June 30, 2006:

|                                             | ** ** | ** **         | ** ** | ** **              | ** ** | **Weighted-Average**        | ** ** |
|---------------------------------------------|------------|--------------------|------------|-------------------------|------------|-----------------------------|------------|
| ** **                                  | ** ** | **Number of** | ** ** | **Weighted-Average**    | ** ** | **Remaining Contract** | ** ** |
| ** **                                  | ** ** | **Shares**         | ** ** | **Exercise Price** | ** ** | **Life in Years** | ** ** |
|                                        |       |               |       |                    |       |                        |       |
| Outstanding  options at beginning of period |       | 609,749            |       | $                       | 3.14       |                        |       |   |
| Granted                                     |       | —             |       | —                  |       |                        |       |
| Exercised                                   |       | —             |       | —                  |       |                        |       |
| Forfeited                                   |       | —             |       | —                  |       |                        |       |
|                                        |       |               |       |                    |       |                        |       |
| Outstanding  options at end of period       |       | 609,749            |       | $                       | 3.14       |                        | 4.42       |   |
|                                        |       |               |       |                    |       |                        |       |
| Options exercisable at  end of period       |       | 458,883            |       | $                       | 3.22       |                        | 4.42       |   |

 

18

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The following table represents employee basedstock option activity for the six months ended June 30, 2006:

|                                             | ** ** | ** **         | ** ** | ** **              | ** ** | **Weighted-Average**        | ** ** |
|---------------------------------------------|------------|--------------------|------------|-------------------------|------------|-----------------------------|------------|
| ** **                                  | ** ** | **Number of** | ** ** | **Weighted-Average**    | ** ** | **Remaining Contract** | ** ** |
| ** **                                  | ** ** | **Shares**         | ** ** | **Exercise Price** | ** ** | **Life in Years** | ** ** |
|                                        |       |               |       |                    |       |                        |       |
| Outstanding  options at beginning of period |       | 567,749            |       | $                       | 3.21       |                        |       |   |
| Granted                                     |       | 50,000             |       | 2.50                    |       |                        |       |
| Exercised                                   |       | —             |       |                    |       |                        |       |
| Forfeited                                   |       | (8,000             | )          | 4.80                    |       |                        |       |
|                                        |       |               |       |                    |       |                        |       |
| Outstanding  options at end of period       |       | 609,749            |       | $                       | 3.14       |                        | 4.42       |   |
|                                        |       |               |       |                    |       |                        |       |
| Options  exercisable at end of period       |       | 458,883            |       | $                       | 3.22       |                        | 4.42       |   |

 

Shares available for future stock option grants to employees anddirectors under the existing plan were 3,243,918 and 3,293,918, respectively,at June 30, 2006 and 2005. At June 30, 2006 the aggregate intrinsic value ofshares outstanding was $1,109,625, and the aggregate intrinsic value of optionsexercisable was 863,005. Total intrinsic value of options exercised was $0 forthe six months ended June 30, 2006.

The following table summarizes our nonvestedemployee based stock option activity for the three months ended June 30,2006:

|                                                 | ** ** | **Number of** | ** ** | **Weighted-Average**                     | ** ** |
|-------------------------------------------------|------------|--------------------|------------|------------------------------------------|------------|
| ** **                                      | ** ** | **Shares**         | ** ** | **Grant Date Fair Value** | ** ** |
|                                            |       |               |       |                                     |       |
| Nonvested stock  options at beginning of period |       | 150,866            |       | $                                        | —     |   |
| Granted                                         |       | —             |       |                                     |       |
| Vested                                          |       | —             |       |                                     |       |
| Forfeited                                       |       | —             |       |                                     |       |
|                                            |       |               |       |                                     |       |
| Nonvested stock options  at end of period       |       | 150,866            |       | $                                        | 1.63       |   |

 

The following table summarizes our nonvestedemployee based stock option activity for the six months ended June 30,2006:

|                                                 | ** ** | **Number of** | ** ** | **Weighted- Average**               | ** ** |
|-------------------------------------------------|------------|--------------------|------------|------------------------------------------|------------|
| ** **                                      | ** ** | **Shares**         | ** ** | **Grant Date Fair Value** | ** ** |
|                                            |       |               |       |                                     |       |
| Nonvested stock  options at beginning of period |       | 158,866            |       | $                                        | —     |   |
| Granted                                         |       | 50,000             |       | 1.42                                     |       |
| Vested                                          |       | (50,000            | )          | 1.56                                     |       |
| Forfeited                                       |       | (8,000             | )          | 0.95                                     |       |
|                                            |       |               |       |                                     |       |
| Nonvested stock options  at end of period       |       | 150,866            |       | $                                        | 1.63       |   |

 

19

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**NOTE 12   SUBSEQUENTEVENT**

On July 28, 2006 Import Flooring Group, Inc. filed anamendment with the State of Delaware to change the name of the corporation toTesoro Direct, Inc.

On August 1, 2006, the Company entered into anagreement to lease an additional 3,900 square feet of warehouse space for aterm of 14 years and two months. This space combined with an existing 9,750square feet of warehouse space under an existing lease for a total of 13,650square feet will be used house the bull nose machine and facilitate theproduction of bull nose and trim pieces.

**ITEM 2:   MANAGEMENT’S DISCUSSION AND ANALYSIS OFFINANCIAL CONDITION AND RESULTS OF OPERATIONS**

IWT Tesoro Corporation (the Company) was organized in Nevada onMay 3rd, 2000, originally under the name “Ponca Acquisition Corporation”.  Effective October 1, 2002, Tesoroacquired all of International Wholesale Tile, Inc.’s (IWT) common stock fromIWT’s three shareholders. IWT was organized in Florida and has been incontinuous operations since 1994. In exchange for the IWT stock, the IWTshareholders each received 3.0 million Tesoro shares, representing 87% ofTesoro’s then outstanding common stock.

In addition to IWT, Tesoro’s primary operating subsidiary, Tesoro hasthree additional wholly owned subsidiaries. These include IWT Tesoro Transport,IWT Tesoro International, Ltd and The Tile Club, Inc. The Tile Club, Inc has awholly owned subsidiary named Import Flooring Group, Inc.

·                  IWT Tesoro Transport, a USDOT licensed commoncarrier, organized to act as our freight carrier outside of Florida and to backhaul non-household goods into Florida to help generate outside revenue, whichhas been insignificant through June 30, 2006; 

·                  IWT Tesoro International, Ltd., a Bermudacorporation to act as a holding company for activities and assets such asagency agreements and investments in foreign operations; and

·                  The Tile Club, Inc., formed in 2004, wasorganized to acquire licensing, manufacturing and distribution rights forhigh-end designer and artistic based decorative tiles and to also act as anagent for foreign manufacturers from whom IWT has acquired exclusivedistribution rights.

·                  Import Flooring Group, Inc., formed in June 2005,was organized to support the Company’s growth strategy with an agent- orientedbusiness model in the floor covering market.

Our principal executive office is located at 191 Post Road West, Suite10, Westport, CT 06880. Our telephone number is (203) 221-2770. Our web sitecan be found at*http://www.iwttesoro.com*.  Information contained on our web site is notpart of this report. 

**RESTRUCTURING**

IWT Tesoro Corporationhas restructured the operations of its subsidiary Import Flooring Group, Inc.(IFG). Import Flooring Group, Inc. although similar to its sister Company,International Wholesale Tile, Inc.(IWT), in that both company’s major source ofrevenue is generated through the wholesale, distribution and brokering of floorcoverings throughout the United States. IFG generated revenue from othersources by offering fee based services such as “showroom fees”, charged to

20

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vendors for allocating aportion of the California Office/Showroom to display the vendor’s products, “conventionfees”, for participating in the annual IFG Floor Covering Convention and “membershipfees” charged to customers for participating in exclusivity agreements. The feebased revenue was anticipated to generate a greater percentage of the totaloverall revenue. However, only 2.7% of the total revenue from July 1, 2005through June 30, 2006 was a result of this fee based revenue source. IWTTesoro Corporation determined that the cost to provide these fee based servicesexceeded the revenue. Therefore, the Company restructured its operationseliminating these services and the associated costs. These costs included theoffice/showroom space located in San Clemente, California and the office andsales staff based out of this office. As a part of this restructuring theCompany entered into an agreement with a former IFG sales person to acquire aportion of the assets and liabilities of IFG related to the fee based revenueactivities. IFG retained a portion of the assets and liabilities related toproduct sales and continue to sell products throughout the United States

The Companyaccounted for restructuring costs pursuant to Statement of Financial AccountingStandards (SFAS” No. 146, “Accounting for Costs Associated with Exit orDisposal Activities”. SFAS 146 requires that a liability for a costassociated with an exit or disposal activity be recognized when the liabilityis incurred, as opposed to when there is a commitment to a restructuring plan.Through the second quarter of 2006, the Company recorded a restructuring chargein the amount of approximately $585,700 in connection with the restructuringactivities which includes the recognition of a liability of $11,450 for otherassociated costs. Of the approximate $585,700 charge approximately $30,400 isattributable to One-Time Termination Benefits in connection with thetermination of the employment contract with a former sales representative.Contract Termination costs of approximately $62,300 is attributable to thetermination of the office/showroom lease agreement and the termination of thevendor agency and showroom agreements and the customer membership agreements.Other Associated Costs of approximately $493,000 is attributable to theagreement entered into with a former sales representative to purchase certainassets and liabilities and $113,000 for a non refundable deposit on material.The Company does not anticipate incurring any additional costs with respect tothis restructure. Restructuring charges are reflected in a separate line itemin the accompanying consolidated statements of operations.

*Results ofOperations for the three months ended June 30, 2006, 2005 and 2004.*

The followingdiscussion and analysis should be read in conjunction with the financialstatements and notes thereto that appear elsewhere in this document. The tablebelow sets forth certain operating data for the periods indicated. Percentages are relative to total revenuefor the periods indicated.

|                          | ** ** | **Quarter ending June 30,** | ** ** |
|--------------------------|------------|--------------------------------------------|------------|
| ** **               | ** ** | **June 30,**                          | ** ** | **June 30,** | ** ** | **June 30,** | ** ** |
| ** **               | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
|                     |       |                                       |       |   |   |   |   |
| Revenues                 |       | $                                          | 16,940,815 |   | $ | 14,317,461 |   | $ | 11,585,016 |   |
| Cost of Goods  Sold      |       | 10,748,471                                 |       | 8,602,396 |   | 7,144,406 |   |
| Gross Margin             |       | 6,192,344                                  |       | 5,715,065 |   | 4,440,610 |   |
| Gross Margin  Percentage |       | 36.55                                      | %          | 39.92 | % | 38.33 | % |
| Operating  Expenses      |       | $                                          | 6,576,878  |   | $ | 5,257,277 |   | $ | 4,392,108 |   |
|                     |       | 38.8                                       | %          | 36.7 | % | 37.9 | % |

 

*Quarter ended June 30,2006 Compared to Quarter June 30, 2005*

Net sales for thethree months ended June 30, 2006 increased $2,623,354 or approximately18.3% over the reported net sales for the three months ended June 30,2005. This growth follows a 23.6% increase in net sales for the three monthsended June 30, 2005 over the three months ended June 30, 2004. Managementbelieves that the lower growth for the three months ended June 30, 2006was due to a general softening in the new home construction and remodelingactivity in the United States. A trend the Company expected. Standard and Poor’sJuly 6, 2006 survey of the home building industry reports that “Data throughApril 2006 suggests that new home sales, though still close to record levels,have begun to trend downward”. However, the report goes on to say “We do notview the United States home building industry as operating with a bubble thatis now expected to burst”. The Company is continuing to increase its marketshare of the $2.86 billion wholesale hard surfaces market by expandinggeographical operations and expects to maintain a strong growth rate. 

Gross profit for thethree months ended June 30, 2006 was $6,192,344 (36.6% of net sales)compared to $5,715,065 (39.9% of net sales) for the three months ended June 30,2005. Gross profit was impacted by higher than expected cost of goods soldrelating to the start up of the Company’s agency based subsidiary, ImportFlooring Group Inc. and a larger volume of truckload sales. The Company hasrestructured the operations of Import Flooring Group and expects to return toan approximate 38 % gross profit sales ratio.

 

21

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Our operating expensesfor the three months ended June 30, 2006 were $6,576,878 (38.8% of net sales)compared to $5,257,277 (36.7% of net sales) for the three months ended June 30,2005. Operating expenses before the restructuring charges of $585,680 were$5,991,198 or 35.4% of net sales. The decrease in operating expenses as apercentage of net sales before the restructuring charges is due to therealization of results from the Company’s expense improvement programs andincreases in sales. Management anticipates future declines in the operatingexpense ratio. 

*Results ofOperations for the Six Months ended June 30, 2006, 2005 and 2004*

The followingdiscussion and analysis should be read in conjunction with the financialstatements and notes thereto that appear elsewhere in this document. The tablebelow sets forth certain operating data for the periods indicated. Percentages are relative to total revenuefor the periods indicated.

|                                | ** ** | **June 30,** | ** ** | **June 30,** | ** ** | **June 30,** | ** ** |
|--------------------------------|------------|-------------------|------------|-------------------|------------|-------------------|------------|
| ** **                     | ** ** | **2006**          | ** ** | **2005**          | ** ** | **2004**          | ** ** |
| Revenues                       |       | $                 | 32,972,034 |              | $          | 27,904,510        |       | $ | 21,119,648 |   |
| Cost of Goods  Sold            |       | 20,966,261        |       | 17,165,389        |       | 12,954,820        |       |
| Gross Margin                   |       | 12,005,773        |       | 10,739,121        |       | 8,164,828         |       |
| Gross Margin  Percentage       |       | 36.41             | %          | 38.49             | %          | 38.66             | %          |
| Operating  Expenses            |       | $                 | 12,451,610 |              | $          | 10,067,253        |       | $ | 8,641,017 |   |
| Income (loss)  from operations |       | $                 | (445,837   | )                 | $          | 671,868           |       | $ | (476,189 | ) |

 

*Six Months ended June 30,2006 Compared to Six Months ended June 20, 2005 and 2004*

Net sales for the sixmonths ended June 30, 2006 increased $5,067,524 or 18.2% over net salesfor the six months ended June 30, 2005. This growth follows a 32.1%increase for the same period ended in 2005 compared with 2004. The Company’sgrowth rate continues to exceed industry growth rates. Management believes thatin addition to the general slow down in construction of new homes in the UnitedStates, the aftermath of the severe weather experienced by the southeastern andgulf coast areas in the later part of 2005 carried over into the beginningmonths of 2006. We expect that we will continue to exceed industry growth ratesas a result of our continued expansion into national markets.

Gross margin for the sixmonths ended June 30, 2006 decrease to 36.4% of net sales compared to38.5% of net sales for the six months ended June 30, 2005. Gross profitwas impacted by higher than expected cost of goods sold relating to the start upof the Company’s agency based subsidiary, Import Flooring Group Inc. and alarger percentage of truckload sales. The Company has restructured theoperations of Import Flooring Group and expects to return to an approximate 38% gross profit sales ratio.

Our operating expensesfor the six months ended June 30, 2006 were $12,451,610 (37.8% of netsales) compared to $10,067,253 (36.1% of net sales) for the six months endedJune 30, 2005. Operating expenses before the restructuring charges of$585,680 were $11,865,930 or 36.0% of net sales. The decrease in operatingexpenses as a percentage of net sales before the restructuring charges is dueto the realization of results from the Company’s expense improvement programsand increases in sales. Management anticipates future declines in the operatingexpense ratio.

Loss from operations forthe six months ended June 30, 2006 were ($445,837) or (1.3%) of salescompared to income of $671,868 or 2.4% of sales for the six months ended June 30,2005. The 3.7% decrease is attributed primarily to the start up costs of ouragency based subsidiary, Import Flooring Group, Inc. and its subsequentrestructuring costs. Management anticipates future declines in the operatingexpense ratio.

**Changes inFinancial Position for the six months ended June 30, 2006 from the yearended December 31, 2005**

Current assets at June 30,2006 are approximately $43.4 million compared to $43.8 million at December 31,2005, a decrease of approximately $0.4 million. The decrease isattributable primarily to the restructure of our subsidiary, Import FlooringGroup., Inc. and our continued efforts to improve our inventory turnover rate.Our receivables have increased approximately

22

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$1.7 millionat June 30, 2006 which is primarily due to our continued sales growth.Inventory decreased $1.4 million at June 30, 2006 from the year endedDecember 31, 2005. The decrease in inventory relates primarily to ourefforts to improve our inventory turnover rate and the restructure of oursubsidiary.

Current liabilitiesremained unchanged at approximately $44.5 million at June 30, 2006compared to December 31, 2005.

Long term liabilities at June 30,2006 are approximately $3.3 million compared to $6.7 million at December 31,2005, a decrease of approximately $3.4 million. The decrease is due to achange in the fair value of the embedded derivative liability relating to aconvertible secured note of approximately $4.3 million and an increase in convertibledebt, net of discounts of approximately $1.0 million, as more fullydescribed in Note 6 of the consolidated financial statements. The decrease inthe embedded derivative liability is primarily attributable to decrease in theinstruments fair market value which is driven by the trading price of theCompany’s common stock.

**Liquidity andCapital Resources**

We had cashbalances of approximately $310,800 at June 30, 2006 and $552,000 at December 31,2005.  We have financed our growth withnew subordinated debt and increased borrowings from our commercial lender.

The cash used inoperations during the six months ended June 30, 2006 were approximately$4.3 million which is primarily due to the net effect of the increase inaccounts receivable, decrease in inventory and decrease in accounts payable.This compares to the $5.4 million used in the six months ended June 30,2005 which was primarily due to the increase in accounts receivable andinventory.

Net cash used ininvesting activities during the six months ended June 30, 2006 wasapproximately $406,400 compared to $107,600 for the six months ended June 30,2005. Capital expenditures consisted of tile finishing equipment to enhance ourbreadth of products offered.

Net cash provided byfinancing activities during the six months ended June 30, 2006 wasapproximately $4.5 million, provided through the issuance of convertibledebt of $2.0 million and the issuance of term debt of $2.0. This comparedto $5.6 million during the six months ended June 30, 2005. Thedecrease is primarily attributable to a slightly slower growth rate. The cashprovided by these financing activities was used to fund our continued salesgrowth and our geographical expansion.

During the six months ended June 30, 2006, weissued a $2,000,000 convertible term note to an institutional investor as morefully described in Note 7 to the consolidated financial statements and a$2,000,000 term note to an institutional investor as more fully described inNote 8 to the consolidated financial statements. The notes are subordinate to arevolving credit line with our commercial lender. The combination of thesenotes and our revolving credit facilities provides us with up to $34 millionof working capital. We expect that this debt will be sufficient to support ournormal growth in accounts receivable and inventory through 2006. However, ourgrowth through geographical expansion and acquisition is expected to continueto require us to seek additional outside capital to supplement earnings and tostrengthen our balance sheet. We expect to raise additional equity through boththe public and private debt and equity markets during 2006. However, we cannotassure anyone that we will be able to obtain outside capital, or if we do, thatit will be on terms beneficial to us.

The balance due atJune 30, 2006 for our subordinated debt was $9 million. The balancedue at June 30, 2006 to our commercial lender for the use of the revolvingline of credit was approximately $23.2 million. The loan and securityagreement contains certain covenants, which include financial covenants thatrequire us to maintain a certain leverage ratio, limit our unfunded capitalexpenditures, a required minimum fixed charge coverage ratio, and a certaininventory turnover ratio. At June 30, 2006 the Company was not incompliance with two of these covenants and obtained a waiver from itscommercial lender.

**CriticalAccounting Policies**

Our financial statementsare prepared in accordance with U.S. generally accepted accounting principles,which require us to make estimates and assumptions about future events andtheir impact on amounts reported in our Financial Statements and related Notes.Since future events and their impact cannot be determined with certainty, theactual results will inevitably differ from our estimates. These differencescould be material to the financial statements.

23

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We believe that ourapplication of accounting policies, and the estimates that are inherentlyrequired by these policies, are reasonable. We believe that significantaccounting policies are described in Note 1 to the consolidated financialstatements included in the Company’s Annual Report on Form 10-K, for the yearended December 31, 2005 and the stock-based compensation expense policyadopted January 1, 2006 may involve a higher degree of judgment and complexity.

***Stock-based compensation expense***

On January 1, 2006,we adopted Statement of Financial Accounting Standards SFAS No. 123R,*Share-Based Payment*, whichrequires us to recognize compensation expense for stock-based compensationbased on the grant date fair value. Stock-based compensation expense is thenrecognized ratably over the service period related to each grant. We used themodified prospective transition method under which financial statements coveringperiods prior to adoption have not been restated. We determine the fair valueof stock-based compensation using the Black-Scholes option pricing model, whichrequires us to make assumptions regarding future dividends, expected volatilityof our stock, and the expected lives of the options. Under SFAS 123R wealso make assumptions regarding the number of options and the number ofrestricted and performance shares that will ultimately vest. The assumptionsand calculations required by SFAS 123R are complex and require a high degree ofjudgment. Assumptions regarding the vesting of grants are accounting estimatesthat must be updated as necessary with any resulting change recognized as anincrease or decrease in compensation expense at the time the estimate ischanged.

**Forward-LookingInformation**

Somestatements made in this Quarterly Report on Form 10-Q, are “forward-lookingstatements” and are not historical facts. For example, statements regarding ourfinancial position, business strategy and other plans and objectives for futureoperations, and assumptions and predictions about future demand for ourservices and products, supply, costs, marketing and pricing factors are allforward-looking statements. When we use words like “intend,” “would”, “anticipate,”“believe,” “estimate,” “plan” or “expect” or the negative of these terms andsimilar expressions, we are making forward- looking statements. Youshould be aware that these forward-looking statements are subject torisks and uncertainties. Additionally, our forward-looking statements speakonly as of the date of this report. Other than as required by law, we undertakeno obligation to update or revise these statements, whether as a result of newinformation, future events or otherwise. New factors emerge from time to time that may cause our business not todevelop as we expect, and it is not possible for us to predict all of them.Factors that may cause our actual results, performance or achievements to bematerially different from the results, performance or achievements expressed orimplied by the forward-looking statements include, among other things arechanges in the industry, energy costs, timing and level of capital expendituresand introduction of new products.

**ITEM 3 —QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS**

**Quantitative and QualitativeDisclosures about Market Risk**

Information about the Company’s exposure tomarket risk was disclosed in its Annual Report on Form 10-K for the year ended December 31,2005, which was filed with the Securities and Exchange Commission on May 19,2006. No material quantitative or qualitative changes in market risk exposurehas occurred since the date of that filings

**ITEM 4 — CONTROLSAND PROCEDURES**

Asof the end of the period covered by this Quarterly Report on Form 10-Q, Tesoro’smanagement, with participation of the Company’s principal executive officer andprincipal financial officer, have performed an evaluation of the Company’sdisclosure controls and procedures, (as defined inRules 13a-15(e) and 15d-15(e) under the Securities Exchange Actof 1934, as amended (“Exchange Act”) to ensure that information required to bedisclosed by Tesoro in the reports that Tesoro files or submits under theExchange Act is recorded, processed, summarized, and reported within the timeperiods specified by the SEC’s rules and forms.

Based on thatevaluation, Tesoro’s principal executive officer and principal financialofficer have concluded that its disclosure controls and procedures areeffective in ensuring that information required to be disclosed by the Companyin the reports that it files or submits under the Exchange Act is recorded,processed, summarized, and reported within the time periods specified by theSEC’s rules and forms. At this time, management has determined that theCompany’s current system of disclosure controls and procedures are sufficienti) to ensure that data errors, control problems, or acts of fraud are detectedand ii) to confirm that appropriate corrective action, including processimprovements, is undertaken in a timely manner.

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Attached as Exhibits 31.1 and 31.2 to thisQuarterly Report are certifications of the CEO and the CFO, which are requiredin accordance with Rule 13a-14 of the Securities Exchange Act of 1934 (theExchange Act). This Controls and Procedures section includes the informationconcerning the controls evaluation referred to in the certifications and itshould be read in conjunction with the certifications.

We are in the process ofimplementing the requirements of Section 404 of the Sarbanes-Oxley Act of2002 which requires our management to assess the effectiveness of our internalcontrol over financial reporting and include an assertion in our 2007 annualreport as to the effectiveness of our internal controls over financialreporting. Subsequently, our independent registered public accounting firm,McGladrey & Pullen LLP, will be required to attest to whether ourassessment of the effectiveness of our internal controls over financialreporting is fairly stated in all material respects and separately report on whetherit believes we maintained, in all material respects, effective internal controlover financial reporting as of December 31, 2007. We are in the process ofperforming the system and process documentation, evaluation and testingrequired for management to make this assessment and for the registered publicaccounting firm to provide its attestation report. We have not completed thisprocess or its assessment, and this process will require significant amounts ofmanagement time and resources. In the course of evaluation and testing,management may identify deficiencies that would need to be addressed andremediated.

**PART II**

**ITEM 1.  LEGAL PROCEEDINGS.**

We are not a partyto any material pending legal proceedings and, to the best of our knowledge, nosuch action by or against us are contemplated, threatened or expected.

**ITEM 2.  UNREGISTERED SALES OF EQUITY SECURITIES ANDUSE OF PROCEEDS**

On May 3, 2006, aspart of the issuance of a $2.0 million private offering of debt securities withLaurus Master Fund, Ltd., IWT Tesoro Corporation issued a secured term note inexchange for $2.0 million. We also issued a warrant that will allow Laurus topurchase up 333,333 shares of our common stock at $1.12 per share through May3, 2013. Of the $2.0 million in proceeds received, $14,500 was paid to Laurus’counsel for legal fees and $56,000 to Laurus Capital Management, LLC formanagement fees in connection with the transaction through closing and $5,000to Laurus for due diligence fees. These offering expenses paid on behalf ofLaurus totaled $75,500 and were paid in cash. After these expenses, we receivednet proceeds of approximately $1,924,500. The net proceeds were used forgeneral corporate purposes.

On April 15, 2006,IWT Tesoro Corporation and Laurus Master Fund, Ltd. Entered into an Amended andRestated Registration Rights Agreement that extends the date that Tesoro mustfile a registration statement for all securities required to be registered byTesoro on behalf of Laurus.

The sale of thesesecurities were deemed to be exempt from registration under the Securities actin reliance on Section 4(2) of the Securities Act, or Regulation D promulgatedthereafter, as transactions by an issuer not involving a public offering.Laurus represented its intention to acquire the securities for investment onlyand not with a view for sale in connection with any distribution thereof andappropriate legends were affixed to the share certificates and instrumentsissued in such transactions. The sales of these securities were made withoutgeneral solicitation or advertising. Laurus is an accredited investor and hadadequate access, through their relationship with the Company, to information,including financial, about the Company. None of these transactions involved anyunderwriters, underwriting discounts or commissions.

**ITEM 3.  DEFAULTS UPON SENIOR SECURITIES.**

None

**ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITYHOLDERS.**

On July 17, 2006, Tesoroheld its 2006 Annual Meeting of Stockholders. All stockholders of recordreceived an Information Statement and a copy of Tesoro’s Form 10-K for the yearended December 31, 2006. No proxies or votes were requested. By a writtenconsent of a majority of the holders of Tesoro’s outstanding capital stockapproved the following:

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Electing the followingindividuals to serve as Tesoro Directors:

Henry J. Boucher, Jr.

Paul F. Boucher

Forrest Jordan

Grey Perna

Carl Anderson, Jr.

James Edwards

Joseph A. Equale

Robert Rogers

Allen Rosenberg

Ratifying theindependent public accounting firm of McGladrey & Pullen, L.P. to serve asTesoro’s auditors for the fiscal year ended December 31, 2006; and

Approving the 2006Employee Stock Purchase Plan., which became effective on July 1, 2006. Tesoroestablished the 2006 Employee Stock Purchase Plan to secure for Tesoro, itsrelated companies and its stockholders the benefits of the incentive inherentin the ownership of common stock by employees. The Plan provides employees theright to withhold a percentage of their compensation to be used to purchaseshares of Tesoro’s common stock.

**ITEM 6: EXHIBITS AND REPORTS ON FORM 10-Q**

(a)  **Exhibits**
| Exhibit  Number | ** ** | **Description**                                                                                                                                                                                                                                                                               |
|-----------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1             |       | Articles of Incorporation (filed as an  Exhibit to the Company’s Form 10-SB, filed with the Securities and  Exchange Commission on August 7, 2000)                                                                                                                        |
| 3.1.1           |       | Articles of Amendment to Articles of Incorporation  dated September 23, 2002 (filed as an Exhibit to the Company’s  Report on Form 8-K, filed with the Securities and Exchange Commission on  October 1, 2002)                                                       |
| 3.2.2           |       | Amended and Restated Bylaws (filed as an  Exhibit to the Company’s Report on Form 8-K, filed with the  Securities and Exchange Commission on February 4, 2003)                                                                                                            |
| 3.3.2           |       | Audit Committee Charter (filed as an Exhibit to  the Company’s Report on Form 8-K, filed with the Securities and Exchange  Commission on February 4, 2003)                                                                                                                |
| 3.3.3           |       | Compensation Committee Charter (filed as an  Exhibit to the Company’s Report on Form 8-K, filed with the                                                                                                                                                                       |
|            |       | Securities and Exchange Commission on  February 4, 2003)                                                                                                                                                                                                                                 |
| 3.3.4           |       | Nominating And Governing Committee Charter (filed as  an Exhibit to the Company’s Report on Form 8-K, filed with the  Securities and Exchange Commission on February 4, 2003)                                                                                             |
| 3.4.1           |       | Code of Ethics for Senior Financial Officers (filed  as an Exhibit to the Company’s Registration Statement, filed with the  Securities and Exchange Commission on April 11, 2003)                                                                                              |
| 4.1.1           |       | Form of Warrant Agreement (filed as an  Exhibit to the Company’s Registration Statement, filed with the  Securities and Exchange Commission on April 11, 2003)                                                                                                            |
| 4.1.2           |       | Form of Stock Certificate (filed as an  Exhibit to the Company’s Registration Statement, filed with the  Securities and Exchange Commission on April 11, 2003)                                                                                                            |
| 10.3            |       | 2001 Ponca Acquisition Corporation Stock Incentive  Plan. (filed as an Exhibit to the Company’s Report on Form 8-K,  filed with the Securities and Exchange Commission on September 11, 2002)                                                                             |
| 10.4            |       | Employment Agreement Between Ponca Acquisition  Corporation And Henry Jr. Boucher, Jr. Dated As Of December 29,  2002 (filed as an Exhibit to the Company’s Report on Form 8-K,  filed with the Securities and Exchange Commission on September 11, 2002)       |
| 10.5            |       | Memorandum Of Understanding Between Ponca  Acquisition Corporation And The Stockholders Of International Wholesale  Tile, Inc. (filed as an Exhibit to the Company’s Report on  Form 8-K, filed with the Securities and Exchange Commission on  September 11, 2002)  |
| 10.6            |       | Stock Purchase Agreement Among The Stockholders Of  International Wholesale Tile, Inc., and Ponca Acquisition Corporation  effective October 1, 2002 (filed as an Exhibit on Form 8-K,  filed with the Securities and Exhibit Commission on October 15,  2002). |
| 10.9            |       | Form of Indemnity Agreement (filed as an  Exhibit to the Company’s Registration Statement, filed with the  Securities and Exchange Commission on April 11, 2003)                                                                                                          |
| 10.10           |       | Employment Agreement between International Wholesale  Tile, Inc. and Forrest Jordan (exhibits omitted) (filed as an  Exhibit to the Company’s Registration Statement, filed with the  Securities and Exchange Commission on May 21, 2003)                                 |
| 10.11           |       | Employment Agreement between International Wholesale  Tile, Inc. and Paul F. Boucher (this document is omitted as it is  substantially similar to Forrest Jordan’s Employment Agreement with the  exception of the employee’s name and address)                                |

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| 10.12 |   | Employment Agreement between International Wholesale  Tile, Inc. and Grey Perna (this document is omitted as it is  substantially similar to Forrest Jordan’s Employment Agreement with the  exception of the employee’s name and address)                                                                                                                                             |
|-------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.13 |   | Subordination Agreement between Congress Financial  Corporation (Florida). and Forrest Jordan (filed as an Exhibit to the  Company’s Registration Statement, filed with the Securities and Exchange  Commission on May 21, 2003)                                                                                                                                                       |
| 10.14 |   | Subordination Agreement between Congress Financial  Corporation (Florida). and Paul F. Boucher (this document is omitted as it is  substantially similar to Forrest Jordan’s Subordination Agreement with the  exception of the employee’s name and address)                                                                                                                                |
| 10.15 |   | Subordination Agreement between Congress Financial  Corporation (Florida). and Grey Perna (this document is omitted as it is  substantially similar to Forrest Jordan’s Subordination Agreement with the  exception of the employee’s name and address)                                                                                                                                     |
| 10.16 |   | Amended and Restated Loan and Security Agreement  between by and between Fleet Capital Corporation, IWT Tesoro Corporation and  International Wholesale Tile, Inc. effective December 31, 2004  (filed as an Exhibit to the Company Annual Report on Form 10-K,  filed with the Securities and Exchange Commission on April 15, 2005).                                       |
| 10.17 |   | Form of Security  Agreement dated as of August 25, 2005, by and between IWT Tesoro  Corporation and International Wholesale Tile, Inc., on the one hand, and  Laurus Master Fund Ltd., on the other hand (without exhibits). (filed as an  exhibit to the Company’s Report on Form 8-K filed with the Securities  and Exchange Commission on August 25, 2005)           |
| 10.18 |   | Form of Secured  Term Note, dated as of August 25, 2005, by Tesoro and IWT in favor of  Laurus Master Fund, Ltd. (filed as an exhibit to the Company’s Report on  Form 8-K filed with the Securities and Exchange Commission on  August 25, 2005)                                                                                                                            |
| 10.19 |   | Form of Subsidiary Guaranty, dated as of  August 25, 2005, by the Tesoro’s subsidiaries in favor of Laurus Master Fund (filed as an exhibit to  the Company’s Report on Form 8-K filed with the Securities and Exchange  Commission on August 25, 2005)                                                                                                                 |
| 10.20 |   | Form of Common Stock Purchase Warrant, by  Tesoro in favor of Laurus Master Fund., Ltd. dated August 25, 2005  (filed as an exhibit to the Company’s Report on Form 8-K filed with the  Securities and Exchange Commission on August 25, 2005)                                                                                                                               |
| 10.21 |   | Form of Funds Escrow Agreement dated  August 25, 2005 (filed as an exhibit to the Company’s Report on  Form 8-K filed with the Securities and Exchange Commission on  August 25, 2005)                                                                                                                                                                                       |
| 10.23 |   | Minimum Borrowing Note in favor of Laurus date  August 25, 2005 (filed as an exhibit to the Company registration  statement on Form S-1, filed with the Securities and Exchange Commission  on September 21, 2005)                                                                                                                                                                     |
| 10.24 |   | Option Agreement to Laurus dated August 25,  2005 (filed as an exhibit to the Company registration statement on  Form S-1, filed with the Securities and Exchange Commission on  September 21, 2005)                                                                                                                                                                                   |
| 10.26 |   | Form of Securities Purchase Agreement dated as  of February 10, 2006, between IWT Tesoro Corporation and Laurus Master  Fund Ltd. (without exhibits) (filed as an exhibit to the Company periodic  report on Form 8-K, filed with the Securities and Exchange Commission on  February 14, 2006).                                                                                  |
| 10.27 |   | Form of Secured Term Note dated as of  February 10, 2006, in favor of Laurus Master Fund Ltd. (filed as an  exhibit to the Company periodic report on Form 8-K, filed with the  Securities and Exchange Commission on February 14, 2006).                                                                                                                                         |
| 10.28 |   | Form of Common Stock Purchase Warrant, by  Tesoro in favor of Laurus Master Fund, Ltd., dated as of February 10,  2006, (filed as an exhibit to the Company periodic report on Form 8-K,  filed with the Securities and Exchange Commission on February 14, 2006).                                                                                                                |
| 10.29 |   | Form of Registration Rights Agreement dated as  of February 10, 2006, between IWT Tesoro Corporation and Laurus Master  Fund Ltd. (filed as an exhibit to the Company periodic report on  Form 8-K, filed with the Securities and Exchange Commission on  February 14, 2006).                                                                                                     |
| 10.30 |   | Ratification and Reaffirmation Agreement by IWT  Tesoro Corporation and each of its subsidiaries dated February 10, 2006,  (filed as an exhibit to the Company periodic report on Form 8-K, filed  with the Securities and Exchange Commission on February 14, 2006).                                                                                                                  |
| 10.31 |   | Form of Registration Rights Agreement dated as  of August 25, 2005, by and between IWT Tesoro Corporation one hand, and  Laurus Master Fund Ltd., as amended December 9, 2005, and as further  amended on April 15, 2006 *(filed as an exhibit to the Company’s  periodic report on Form 8-K/A, filed with the Securities and Exchange  Commission on May 8, 2006) |
| 10.32 |   | Amended and Restated Registration Rights Agreement  dated May 3, 2006 between IWT Tesoro Corporation and Laurus Master  Funds, Ltd. (filed as an exhibit to the Company’s periodic report on  Form 8-K, filed with the Securities and Exchange Commission on  May 8, 2006).                                                                                                       |

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| 10.33 |   | Form of Securities Purchase Agreement dated  May 3, 2006 between Tesoro and Laurus Master Fund dated May 3, 2006  (filed as an exhibit to the Company’s periodic report on Form 8-K, filed  with the Securities and Exchange Commission on May 9, 2006).               |
|-------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.34 |   | Form of Common Stock Purchase Warrant by Tesoro  in favor of Laurus Master Funds., Ltd. (filed as an exhibit to the Company’s  periodic report on Form 8-K, filed with the Securities and Exchange  Commission on May 9, 2006).                                                  |
| 10.35 |   | Amended and Restated Registration Rights Agreement  dated May 3, 2006 between IWT Tesoro Corporation and Laurus Master  Funds, Ltd. (filed as an exhibit to the Company’s periodic report on  Form 8-K, filed with the Securities and Exchange Commission on  May 9, 2006).      |
| 10.36 |   | Reaffirmation and Ratification Agreement dated  May 3, 2006 by Tesoro and its subsidiaries (filed as an exhibit to the  Company’s periodic report on Form 8-K, filed with the Securities and  Exchange Commission on May 9, 2006).                                               |
| 10.37 |   | Second Amended and Restated Senior Subordination  Agreement between Laurus Master Fund, Ltd. and Bank of America, N.A dated  May 3, 2006 (filed as an exhibit to the Company’s periodic report on  Form 8-K, filed with the Securities and Exchange Commission on  May 9, 2006). |
| 10.38 |   | Amendment dated as of March 31, 2006 to the August  25, 2006 $3.0 million Minimum Borrowing Note*                                                                                                                                                                                                    |
| 16    |   | Letter from Kantor Sewell & Oppenheimer,  P.A., concurring with statements concerning their resignation (filed as an  exhibit to the Company Report on Form 8-K filed with the Securities and  Exchange Commission on September 14, 2004).                                        |
| 21    |   | Subsidiaries of Registrant (filed as an  Exhibit to the Company registration statement on Form S-1, filed  with the Securities and Exchange Commission on September 21, 2005                                                                                                          |
| 31.1  |   | Certification of Henry J. Boucher, Jr., Chief  Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act.*                                                                                                                                                                       |
| 31.2  |   | Certification of Forrest Jordan, Chief Financial  Officer pursuant to Section 302 of the Sarbanes-Oxley Act.*                                                                                                                                                                                   |
| 32.1  |   | Certification of Henry J. Boucher, Jr., Chief  Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act.*                                                                                                                                                                       |
| 32.2  |   | Certification of Forrest Jordan, Chief Financial  Officer pursuant to Section 906 of the Sarbanes-Oxley Act.*                                                                                                                                                                                   |

 

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| * |   | Included in this  filing. Exhibits are available without charge, upon request of IWT Tesoro. |
|---|--------|----------------------------------------------------------------------------------------------|

 

(b)   Reports on Form 8-K

Form 8-K, filed on April 4, 2006, regarding entering into material agreements with Laurus Master Fund., Ltd.

Form 8-K, filed on April 24, 2006, regarding non-reliance on previously issued financial statements or a related audit report or completed interim review, as amended on May 2, 2006.

Form 8-K, filed on April 24, 2006, regarding non-reliance on previously issued financial statements or a related audit report or completed interim review.

Form 8-K.A filed on May 8, 2008 to amend certain agreements with Laurus.

Form 8-K, filed on May 9, 2006 regarding entering into material agreements with Laurus.

Form 8-K, filed on June 5, 2006, regarding the potential delisting of the Company’s stock. .

Form 8-K, filed on June 20, 2006, regarding satisfaction of listing requirements.

Form 8-K, filed on June 27, 2006, regarding the Board of Directors adopting a Company Stock Repurchase Agreement.

 

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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.
|            |   |   | IWT TESORO CORPORATION                     |
|-----------------|--------|--------|--------------------------------------------|
|            |   |   |                                       |
|            |   |   |                                       |
| August 11, 2006 |   |   | /s/ Henry J. Boucher, Jr.                  |   |
|            |   |   | Henry J. Boucher, Jr., President           |
|            |   |   |                                       |
| August 11, 2006 |   |   | /s/Forrest P. Jordan                       |   |
|            |   |   | Forrest P. Jordan, Chief Financial Officer |

 

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