**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

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**FORM 10-Q**

**(Mark One)**

**x****                             ****QUARTERLY REPORT PURSUANT TOSECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLYPERIOD ENDED SEPTEMBER 30, 2006**

**o****                                ****TRANSITION REPORT UNDER SECTION13 OR 15(d) OF THE EXCHANGE ACT**

**CommissionFile No. 0-31267**

**IWT TESORO CORPORATION**

(Exactname of registrant as specified in its charter)

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

 

**101 PostRoad West, Suite 10, Westport, CT  06880**

(Address ofprincipal executive offices)

**(203)221-2770**

(Registrant’stelephone number, including area code)

Indicate by check, mark whether the registrant: (1)has filed all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the registrant was required to file such reports), and (2)has been subject to such filing requirements for the past 90 days:

xYes                                     oNo

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer.Large accelerated filer  o                     Acceleratedfiler                     Non-acceleratedfiler.  ý

Indicate by check mark whether the registrant is a shell company (asdefined in Rule 12b-2 of the Exchange Act)

x Yes             o No

Indicate the number ofshares outstanding of each of the issuer’s class of common equity, as ofNovember 14, 2006: 11,928,600 shares

 

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**IWTTESORO CORPORATION AND SUBSIDIARIES**

**FORM10-Q**

**For theNine Months ended September 30, 2006**

**INDEX**
| **PART I**                                                                                                     | **FINANCIAL INFORMATION**                                                                   |   |
|----------------------------------------------------------------------------------------------------------------|---------------------------------------------------------------------------------------------|--------|
| Item I.                                                                                                        | Financial Statements                                                                        |   |
|                                                                                                           |                                                                                        |   |
|                                                                                                           | Consolidated Balance Sheets as of  September 30, 2006 and December 31, 2005                 | 3      |
| Consolidated Statements of  Operations for the Three Months and Nine Months Ended September 30, 2006 and  2005 | 4                                                                                           |
| Consolidated Statements of  Stockholders’ Deficit for the Nine Months Ended September 30, 2006            | 5                                                                                           |
| Consolidated Statements of  Cash Flows for the Nine Months Ended September 30, 2006 and 2005                   | 6                                                                                           |
|                                                                                                           | Notes to the Consolidated  Interim Financial Statements                                     | 8      |
|                                                                                                           |                                                                                        |   |
| Item 2.                                                                                                        | Management’s  Discussion and Analysis of Financial Condition and Results of Operations | 22     |
| Item 3.                                                                                                        | Quantitative  and Qualitative Disclosures About Market Risk                                 | 26     |
| Item 4.                                                                                                        | Controls and  Procedures                                                                    | 26     |
|                                                                                                           |                                                                                        |   |
| **PART II**                                                                                                    | OTHER INFORMATION                                                                           |   |
| ** **                                                                                                     |                                                                                        |   |
| Item 1.                                                                                                        | Legal Proceedings                                                                           | 27     |
| Item 2.                                                                                                        | Unregistered  Sales of Equity Securities and Use of Proceeds                                | 27     |
| Item 3.                                                                                                        | Default Upon  Senior Securities.                                                            | 27     |
| Item 4.                                                                                                        | Submission of  Matters to a vote of Security Holders                                        | 27     |
| Item 6.                                                                                                        | Exhibits                                                                                    | 28     |

2

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PART 1 – FINANCIAL INFORMATION

ITEM 1:  FINANCIAL STATEMENTS

**IWT TESORO CORPORATION AND SUBSIDIARIES**

CONSOLIDATED BALANCE SHEETS
| ** **                                                                                                        | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                                        | ** ** | **2006**               | ** ** | **2005**              | ** ** |
| ** **                                                                                                        | ** ** | **(Unaudited)**        | ** ** | ** **            | ** ** |
| ASSETS                                                                                                            |       |                   |       |                  |       |
| Current Assets:                                                                                                   |       |                   |       |                  |       |
| Cash                                                                                                              |       | $                      | —     |                  | $          | 552,042 |   |
| Accounts receivable,  net of allowance for doubtful accounts and returns of $404,822 and $292,662,  respectively  |       | 11,350,011             |       | 9,910,551             |       |
| Inventories                                                                                                       |       | 33,874,465             |       | 32,212,007            |       |
| Deposit on purchase of  inventories                                                                               |       | 331,278                |       | 860,614               |       |
| Prepaid expenses                                                                                                  |       | 363,255                |       | 293,047               |       |
| Total current assets                                                                                              |       | 45,919,009             |       | 43,828,261            |       |
| Property and equipment,  net                                                                                      |       | 2,143,574              |       | 2,120,422             |       |
|                                                                                                              |       |                   |       |                  |       |
| Other assets                                                                                                      |       | 1,017,857              |       | 1,013,886             |       |
|                                                                                                              |       | $                      | 49,080,440 |                  | $          | 46,962,569 |   |
| LIABILITIES AND  STOCKHOLDERS’ DEFICIT                                                                       |       |                   |       |                  |       |
| Current Liabilities:                                                                                              |       |                   |       |                  |       |
| Accounts payable                                                                                                  |       | $                      | 17,953,390 |                  | $          | 20,165,306 |   |
| Accrued expenses and  other liabilities                                                                           |       | 1,971,733              |       | 1,561,119             |       |
| Current portion of equipment  notes and leases                                                                    |       | 92,055                 |       | 101,415               |       |
| Note payable, revolving  line of credit                                                                           |       | 25,436,522             |       | 22,625,500            |       |
| Current portion of  convertible debt                                                                              |       | 800,007                |       | —                |       |
| Note payable, other  (net of discounts of $129,974)                                                               |       | 1,870,026              |       | —                |       |
| Total current  liabilities                                                                                        |       | 48,123,733             |       | 44,453,340            |       |
|                                                                                                              |       |                   |       |                  |       |
| Long-Term Debt:                                                                                                   |       |                   |       |                  |       |
| Equipment notes and  leases, net of current portion                                                               |       | 106,440                |       | 176,017               |       |
| Note payable, revolving  line of credit (net of discounts of $3,194,456)                                          |       | 1,805,544              |       | —                |       |
| Convertible debt, net  of current portion (net of discounts of $935,929 and $4,444,448,  respectively)            |       | 130,731                |       | 555,552               |       |
| Embedded derivative  liability, at fair value                                                                     |       | —                 |       | 5,954,462             |       |
| Total long-term debt                                                                                              |       | 2,042,715              |       | 6,686,031             |       |
| Total liabilities                                                                                                 |       | 50,166,448             |       | 51,139,371            |       |
| Commitments and  Contingencies                                                                                    |       |                   |       |                  |       |
| Stockholders’ Deficit:                                                                                       |       |                   |       |                  |       |
| 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                |       |
| Treasury stock, 6,000  shares at cost                                                                             |       | (9,894                 | )          | —                |       |
| Additional paid in  capital                                                                                       |       | 7,355,019              |       | 4,189,396             |       |
| Accumulated deficit                                                                                               |       | (8,443,062             | )          | (8,377,899            | )          |
| Total stockholders’  deficit                                                                                 |       | (1,086,008             | )          | (4,176,802            | )          |
|                                                                                                              |       | $                      | 49,080,440 |                  | $          | 46,962,569 |   |

 

See notes to theconsolidated interim financial statements.

3

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**IWT TESORO CORPORATION AND SUBSIDIARIES**

CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)
| ** **                                   | ** ** | **The three months ended** | ** ** | **The nine months ended** | ** ** |
|----------------------------------------------|------------|-------------------------------------------|------------|------------------------------------------|------------|
| ** **                                   | ** ** | **September 30,**                    | ** ** | **September 30,**                   | ** ** |
| ** **                                   | ** ** | **2006**                                  | ** ** | **2005**                                 | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                         |       |                                      |       |                                     |       |   |   |   |   |
| Net Sales                                    |       | $                                         | 15,173,449 |                                     | $          | 14,006,762 |   | $ | 48,145,483 |   | $ | 42,141,461 |   |
| Cost of Goods Sold                           |       | 9,578,329                                 |       | 8,277,926                                |       | 30,544,590 |   | 25,443,315 |   |
| Gross Profit                                 |       | 5,595,120                                 |       | 5,728,836                                |       | 17,600,893 |   | 16,698,146 |   |
| Operating Expenses:                          |       |                                      |       |                                     |       |   |   |   |   |
| Warehouse and  distribution                  |       | 2,579,239                                 |       | 2,206,240                                |       | 7,572,091 |   | 5,817,625 |   |
| Sales and marketing                          |       | 1,333,839                                 |       | 1,923,521                                |       | 4,291,838 |   | 5,381,340 |   |
| General and  administrative                  |       | 1,757,293                                 |       | 1,686,324                                |       | 5,672,372 |   | 4,914,560 |   |
| Restructuring charge                         |       | —                                    |       | —                                   |       | 585,680 |   | — |   |
|                                         |       | 5,670,371                                 |       | 5,816,085                                |       | 18,121,981 |   | 16,113,525 |   |
| Income (Loss) from  Operations               |       | (75,251                                   | )          | (87,249                                  | )          | (521,088 | ) | 584,621 |   |
| Other Expenses:                              |       |                                      |       |                                     |       |   |   |   |   |
| Interest expense                             |       | (1,612,093                                | )          | (554,412                                 | )          | (4,030,140 | ) | (1,159,173 | ) |
| Change in fair value of  derivative          |       | 261,589                                   |       | (910,773                                 | )          | 4,608,822 |   | (910,773 | ) |
| Other                                        |       | 18,651                                    |       | (8,799                                   | )          | (122,757 | ) | 139,883 |   |
|                                         |       | (1,331,853                                | )          | (1,473,984                               | )          | 455,925 |   | (1,930,063 | ) |
| Loss Before Income  Taxes                    |       | (1,407,104                                | )          | (1,561,233                               | )          | (65,163 | ) | (1,345,442 | ) |
|                                         |       |                                      |       |                                     |       |   |   |   |   |
| Income Tax Benefit  (Expense)                |       | —                                    |       | —                                   |       | — |   | — |   |
| Net Loss                                     |       | $                                         | (1,407,104 | )                                        | $          | (1,561,233 | ) | $ | (65,163 | ) | $ | (1,345,442 | ) |
| Loss Per Share:                              |       |                                      |       |                                     |       |   |   |   |   |
| Basic and diluted                            |       | $                                         | (0.12      | )                                        | $          | (0.13 | ) | $ | (0.01 | ) | $ | (0.12 | ) |
|                                         |       |                                      |       |                                     |       |   |   |   |   |
| Weighted Average Common  Shares Outstanding: |       |                                      |       |                                     |       |   |   |   |   |
|                                         |       |                                      |       |                                     |       |   |   |   |   |
| Basic and diluted                            |       | 11,928,600                                |       | 11,701,102                               |       | 11,845,553 |   | 11,698,417 |   |

 

See notes to theconsolidated interim financial statements.

4

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**IWT TESORO CORPORATION AND SUBSIDIARIES**

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ DEFICIT

(Unaudited)
| ** **                                                                                   | ** ** | ** **            | ** ** | ** **   | ** ** | ** **       | ** ** | **Additional** | ** ** | **Accumulated** | ** ** | ** ** | ** ** |
|----------------------------------------------------------------------------------------------|------------|-----------------------|------------|--------------|------------|------------------|------------|----------------|------------|-----------------|------------|------------|------------|
| ** **                                                                                   | ** ** | **Common Stock** | ** ** | **Treasury** | ** ** | **Paid in** | ** ** | **Earnings**   | ** ** | ** **      | ** ** |
| ** **                                                                                   | ** ** | **Shares**            | ** ** | **Amount**   | ** ** | **Stock**        | ** ** | **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                                                           |       | —                |       | —       |       | —           |       | 88,438         |       | —          |       | 88,438     |       |
|                                                                                         |       |                  |       |         |       |             |       |           |       |            |       |       |       |
| 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  |       |
|                                                                                         |       |                  |       |         |       |             |       |           |       |            |       |       |       |
| Reclassification  of fair value of options and warrants in connection with debt modification |       | —                |       | —       |       | —           |       | 1,345,640      |       | —          |       | 1,345,640  |       |
|                                                                                         |       |                  |       |         |       |             |       |           |       |            |       |       |       |
| Treasury  stock at cost                                                                      |       | —                |       | —       |       | (9,894           | )          | —         |       | —          |       | (9,894     | )          |
|                                                                                         |       |                  |       |         |       |             |       |           |       |            |       |       |       |
| Net  loss, nine months ended September 30, 2006                                              |       | —                |       | —       |       | —           |       | —         |       | (65,163         | )          | (65,163    | )          |
|                                                                                         |       |                  |       |         |       |             |       |           |       |            |       |       |       |
| Balance,  September 30, 2006                                                                 |       | 11,928,600            |       | 11,929       |       | $                | (9,894     | )              | $          | 7,355,019       |       | $          | (8,443,062 | ) | $ | (1,086,008 | ) |
|                                                                                              |            |                       |            |              |            |                  |            |                |            |                 |            |            |            |  |  |  |  |  |

 

See notes to theconsolidated interim financial statements.

5

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**IWT TESORO CORPORATION AND SUBSIDIARIES**

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)
| ** **                                                                   | ** ** | **Nine Months Ended** | ** ** |
|------------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                                   | ** ** | **September 30,**          | ** ** | **September 30,** | ** ** |
| ** **                                                                   | ** ** | **2006**                        | ** ** | **2005** | ** ** |
| Cash flows from  operating activities:                                       |       |                            |       |   |   |
| Net loss                                                                     |       | $                               | (65,163    | ) | $ | (1,345,442 | ) |
| Adjustments to  reconcile net loss to net cash used in operating activities: |       |                            |       |   |   |
| Non-cash restructuring  charge                                               |       | 478,794                         |       | — |   |
| Depreciation and  amortization                                               |       | 542,225                         |       | 305,452 |   |
| Amortization of loan  discount                                               |       | 1,903,071                       |       | 138,888 |   |
| Change in fair value of  embedded derivative                                 |       | (4,608,822                      | )          | 910,773 |   |
| Common stock issued for  services and compensation                           |       | 12,792                          |       | 10,600 |   |
| Stock option  compensation expense                                           |       | 88,438                          |       | — |   |
| Provision for doubtful  accounts and reserve for returns                     |       | 112,160                         |       | 53,233 |   |
| Loss on disposal of  property and equipment                                  |       | 80,156                          |       | 16,900 |   |
| Changes in operating  assets and liabilities:                                |       |                            |       |   |   |
| (Increase) Decrease in:                                                      |       |                            |       |   |   |
| Accounts receivable                                                          |       | (2,227,013                      | )          | (1,523,893 | ) |
| Inventories                                                                  |       | (2,176,158                      | )          | (7,455,640 | ) |
| Deposit on purchase of  inventories                                          |       | 415,408                         |       | 82,352 |   |
| Prepaid expenses and  other assets                                           |       | (177,509                        | )          | (614,696 | ) |
| Increase (Decrease) in:                                                      |       |                            |       |   |   |
| Accounts payable                                                             |       | (1,171,372                      | )          | (11,111 | ) |
| Accrued expenses and  other liabilities                                      |       | 233,095                         |       | 255,773 |   |
| Net cash used in  operating activities                                       |       | (6,559,898                      | )          | (9,176,811 | ) |
| Cash flows from  investing activities:                                       |       |                            |       |   |   |
| Acquisitions of  property and equipment                                      |       | (609,261                        | )          | (247,564 | ) |
| Proceeds from sale of  equipment                                             |       | 17,300                          |       | — |   |
| Net cash used in  investing activities                                       |       | (591,961                        | )          | (247,564 | ) |
| Cash flows from  financing activities:                                       |       |                            |       |   |   |
| Proceeds from revolving  line of credit                                      |       | 53,202,232                      |       | 50,813,050 |   |
| Payments on revolving  line of credit                                        |       | (50,224,250                     | )          | (45,399,173 | ) |
| Repayment of notes  payable, subordinated debt                               |       | —                          |       | (338,662 | ) |
| Repayment of  convertible debt                                               |       | (133,334                        | )          | — |   |
| Proceeds from issuance  of convertible debt and warrant                      |       | 4,000,000                       |       | 5,000,000 |   |
| Debt issuance costs                                                          |       | (156,000                        | )          | (267,000 | ) |
| Treasury stock                                                               |       | (9,894                          | )          | — |   |
| Payments of long-term  debt and capital lease obligations                    |       | (78,937                         | )          | (102,421 | ) |
| Loan financing costs                                                         |       | —                          |       | (76,135 | ) |
| Net cash provided by  financing activities                                   |       | 6,599,817                       |       | 9,629,659 |   |
| Net Increase (Decrease)  in Cash                                             |       | (552,042                        | )          | 205,284 |   |
| Cash, Beginning                                                              |       | 552,042                         |       | 507,677 |   |
| Cash, Ending                                                                 |       | $                               | —     |   | $ | 712,961 |   |

 

See notes to theconsolidated interim financial statements.

6

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| ** **                                                                                           | ** ** | **Nine Months Ended** | ** ** |
|------------------------------------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                                                           | ** ** | **September 30,**          | ** ** | **September 30,** | ** ** |
| ** **                                                                                           | ** ** | **2006**                        | ** ** | **2005** | ** ** |
| Cash Paid During the  Period for:                                                                    |       |                            |       |   |   |
| Interest expense                                                                                     |       | $                               | 479,936    |   | $ | 1,020,285 |   |
| Income tax                                                                                           |       | $                               | —     |   | $ | 26,777 |   |
| Non-Cash Operating  Activities:                                                                      |       |                            |       |   |   |
| Inventory acquired  through deposit with vendor                                                      |       | $                               | 243,412    |   | $ | 84,612 |   |
| Non-Cash Investing and  Financing Activities:                                                        |       |                            |       |   |   |
| Acquisition of property  and equipment financed through long-term debt                               |       | $                               | —     |   | $ | 97,155 |   |
| Reclassification of  note payable to embedded derivative liability                                   |       | $                               | —     |   | $ | 5,000,000 |   |
| Payment of interest  expense through issuance of common stock                                        |       | $                               | 181,886    |   | $ | — |   |
| Reclassification of  embedded derivative liability into equity in connection with debt  modification |       | $                               | 1,345,640  |   | $ | — |   |

 

See notes to theconsolidated interim financial statements.

7

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IWT TESORO CORPORATIONAND SUBSIDIARIES

NOTES TOCONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NINE MONTHS ENDEDSEPTEMBER 30, 2006

###### **NOTE 1.                SUMMARYOF SIGNIFICANT ACCOUNTING POLICIES**

#### ***Principlesof Consolidation***

The consolidated financial statements include IWTTesoro Corporation and its wholly owned subsidiaries: International WholesaleTile, Inc., IWT Tesoro International, Ltd, IWT Tesoro Transport, Inc. and TheTile Club, Inc and The Tile Club, Inc.’s wholly owned subsidiary Tesoro Direct,Inc., formerly known as Import Flooring Group, Inc. (TDI) All significantinter-company balances and transactions have been eliminated in consolidation.

#### **B*asis of Presentation***

The interim financial information included herein isunaudited; however, such information reflects all adjustments, which are, inthe opinion of management, necessary for a fair presentation of the Company’sfinancial position, results of operations, changes in stockholders’ deficit andcash flows for the interim periods. All such adjustments are of a normal,recurring nature. The results of operations for the first nine months of theyear are not necessarily indicative of the results of operations which might beexpected for the entire year.

The accompanying consolidated financial statements of the Company havebeen prepared in accordance with accounting principles generally accepted inthe United States of America and with the instructions to Form 10-Q and Rule10-10 of Regulation S-X of the Securities and Exchange Commission. Accordinglycertain information and footnote disclosure required by accounting principlesgenerally accepted in the United States of America for complete financialstatements have been omitted. These condensed financial statements should beread in conjunction with the Company’s financial statements and notes theretoincluded in the Company’s audited financial statements on Form 10-K, for thefiscal year ended December 31, 2005.

The Consolidated Balance Sheet at December 31, 2005 has been derivedfrom the audited financial statements of IWT Tesoro Corporation at that date,but does not include all of the information and footnotes required by U.S.generally accepted accounting principles for complete financial statements.

***Earnings (loss) per Share***

Basic earnings(loss) per share (“EPS”) excludesdilution and is calculated by dividing net income (loss) available to commonstockholders by the weighted-average number of shares of common stockoutstanding during the period. Diluted EPS is computed in a manner similar tothat of basic EPS except that the weighted-average number of common sharesoutstanding is increased to include the number of incremental common shares(computed using the treasury stock method) that would have been outstanding ifall potentially dilutive common shares (such as stock options) were issuedduring the period. Diluted EPS is not presented if the effect of theincremental shares is antidilutive. There is no presentation of diluted lossper share as the effect of convertible debt shares, common stock options andwarrant amounts were antidilutive.

 

8

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## ***Income Taxes***

The Company recognizes income taxes under the asset and liabilitymethod. Under this method, deferred tax assets and liabilities are recognizedfor the future tax consequences attributable to differences between the financialstatement carrying amounts of existing assets and liabilities and theirrespective tax bases, and loss carryforwards. Deferred tax assets andliabilities are measured using enacted tax rates expected to apply to taxableincome in the years in which those temporary differences are expected to berecovered or settled. The effect on deferred tax assets and liabilities of achange in tax rates is recognized in income in the period that includes theenactment date. Deferred tax assets are reduced by a valuation allowance when,in the opinion of management, it is more likely than not that some portion orall of the deferred tax assets will not be realized.

## ***Segment Information***

The Company has adopted SFAS No. 131, “Disclosures about Segmentsof an Enterprise and Related Information.” SFAS No. 131 establishesstandards for the way that public business enterprises report information aboutoperating segments in annual financial statements and requires thoseenterprises to report selected information about operating segments in interimfinancial reports issued to stockholders. The Company’s revenues are all fromfloor covering products and services sold throughout the United States with nosingle customer accounting for more than 10% of net sales. Therefore the Companyoperates in one segment for management reporting purposes.

***Reclassifications***

Certain amounts in the 2005 financial statements have been reclassifiedfor comparative purposes to conform to the 2006 presentation. Thesereclassifications had no effect on net income.

***Recent Accounting Pronouncements***

In December 2004, the FASB issued SFASNo. 123 (revised 2004) (“SFAS No. 123R”), “*Share-BasedPayment*,” which requires that the compensation cost relating toshare-based payment transactions be recognized in the financial statements.SFAS No. 123R replaces SFAS No. 123, “Accounting for Stock-BasedCompensation,” and supersedes APB Opinion No. 25, “Accounting for Stock Issuedto Employees.” Share-based compensation arrangements include share options,restricted share plans, performance-based awards, share appreciation rights andemployee share purchase plans. SFAS No. 123R requires all share-based paymentsto employees be valued using a fair value method on the date of grant andexpensed based on that fair value generally over the applicable vesting period.SFAS No. 123R also amends SFAS No. 95 “Statement of Cash Flows,” requiring thebenefits of tax deductions in excess of recognized compensation cost bereported as financing cash inflow rather than as a reduction of taxes paid. InMarch 2005, the Securities and Exchange Commission (“SEC”) issued StaffAccounting Bulletin No. 107, (“SAB No. 107”) which expresses the SEC’s viewsregarding the interaction between SFAS No. 123R and certain SEC rules andregulations and, accordingly, provides guidance related to share-based paymenttransactions for public companies.  TheCompany adopted SFAS 123R on January 1, 2006 and its adoption did not have amaterial effect on our consolidated results of operations, financial positionor cash flows. The Company’s compensation expense for the three and nine monthsended September 30, 2006 was approximately $28,300 and $88,400, respectively,as further described in Note 11.  Thefinancial impact of any stock options granted is determined using theBlack-Scholes option-pricing model with the following assumptions: optionprice, dividend yield, expected volatility, risk free interest rate and theexpected life.

9

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In July 2006, the FASB issued Interpretation No. 48 (“FIN48”), *Accounting for Uncertainty in Income Taxes*.FIN 48 applies 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 a two-stepapproach for evaluating tax positions. Recognition (step one) occurs when anenterprise concludes that a tax position, based solely on its technical merits,is more-likely-than-not to be sustained upon examination. Measurement (steptwo) is only addressed if step one has been satisfied (i.e., the position ismore-likely-than-not to be sustained). FIN 48 clarifies the accounting forincome taxes by prescribing the minimum recognition threshold a tax positionmust meet before being recognized in the financial statements. FIN 48 alsoprovides guidance on derecognition, measurement, classification, interest andpenalties, accounting in interim periods, disclosure, and transition. FIN 48 iseffective for fiscal years beginning after December 15, 2006. Earlier adoptionis permitted as of the beginning of an enterprise’s fiscal year, provided theenterprise has not yet issued financial statements, including financialstatements for any interim period, for that fiscal year. Management is currentlyevaluating the requirements of FIN 48 and has not yet determined the impact onthe Company’s consolidated financial statements.

In September 2006, the SEC Staff issued StaffAccounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatementswhen Quantifying Misstatements in the Current Year Financial Statements” (“SABNo. 108”), which provides interpretive guidance on the consideration ofthe effects of prior year misstatements for the purpose of materialityassessment. SAB 108 is effective for fiscal years ending after November 15,2006. The Company does not expect the adoption of SAB No. 108 to have materialimpact our consolidated financial statements.

In September 2006, the FASB issued SFAS No. 157, “FairValue Measurements” (FAS 157). FAS 157 defines fair value, establishes theframework for measuring fair value in generally accepted accounting principalsand expands disclosures about fair value measurements. This Statement appliesonly to fair value measurements that are already required or permitted by otheraccounting standards. Accordingly, this Statement does not require any new fairvalue measurements. SFAS No. 157 is effective for fiscal years beginning afterDecember 15, 2007 The Company is currently evaluating the impact, if any, theadoption of SFAS No. 157 will have on its consolidated financial statements.

In September 2006, the FASB issued SFAS No. 158, “Employers’Accounting for Defined Benefit Pension and Other Postretirement Plans” (“SFASNo. 158”). SFAS No. 158 requires companies to recognize in theirstatement of financial position an asset for a plan’s overfunded status or aliability for a plan’s underfunded status and to measure a plan’s assets andits obligations that determine its funded status as of the end of the company’sfiscal year. Additionally, SFAS No. 158 requires companies to recognizechanges in the funded status of a defined benefit postretirement plan in theyear that the changes occur and those changes will be reported in comprehensiveincome. SFAS No. 158 is effective for fiscal years ending afterDecember 31, 2006, and early adoption is encouraged. We do not expect thatthe adoption of SFAS No. 158 will have a material impact on ourconsolidated financial statements.

10

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###### **NOTE 2              LIQUIDITYAND PROFITABILITY CONSIDERATIONS**

***Profitability***

The Company’s net loss for the nine months endedSeptember 30, 2006 is approximately $65,000 which is net of the change in thefair value of the derivative liability of approximately $4,600,000 as morefully described in Note 6. This follows net losses of approximately $4,344,000,$1,209,000 and $1,865,000 for the years ended December 31, 2005, 2004 and 2003,respectively. As reflected in the consolidated balance sheet as of September30, 2006, the Company a had working capital deficit of approximately$2,205,000, a deterioration of approximately $1,580,000 from December 31, 2005at which time we had a working capital deficit of approximately $625,000.

In January 2006 management implemented a plan toimprove profitability by reducing projected operating costs in sales andmarketing and administrative overhead. The Company improved their operations byincreasing sales and controlling operating expenses. For the nine months endedSeptember 30, 2006 operating expenses as a percent of sales was 37.6%, animprovement of 3.2 percentage points from the year ended December 31, 2005, forwhich operating expenses as a percent of sales was 40.8%.  The Company expanded its plan to reduceoperating costs and in June 2006 restructured the operations of its subsidiaryTesoro Direct, Inc., formerly known as Import Flooring Group, Inc. (TDI), asmore fully described in Note 3. The Company implemented a 3.5% price increasein February 2006 and plans to continue to periodically adjust prices to reflectchanges in costs.

Gross margin decreased for the nine months endedSeptember 30, 2006 to 36.6% of net sales compared to 38.3% for the twelvemonths ended December 31, 2005. Gross profit was impacted by higher thanexpected cost of goods sold relating to increase cost to import goods, a largerpercentage of lower margin truckload sales and approximately $1.4 million inTDI sales at or near cost related to actively prior to the restructure. TheCompany has instituted a 6% price increase as of  November 1, 2006 on a majority of itsproducts in order to cover higher shipping and import costs as well as increasemargins.

In August 2006, the Company began installing profilingequipment necessary to produce its own bullnose; finishing pieces for floor andwall tile. The profiling equipment became operational in October 2006 andproduction will replace previously purchased product and potentially increaseprofitability by lowering the cost of sales for this group of products. Theprofiling operation is an integral part of the Company’s strategy to controlthe cost of goods sold by focusing on the production side of our industry’svalue chain.

***Liquidity***

In February 2006, as morefully described in Note 7 herein, the Company obtained $2.0 million through theissuance of a three year subordinated convertible term note. In May 2006, asmore fully described in Note 8 herein, the Company obtained $2.0 millionthrough the issuance of a one year subordinated term note. These funds willgenerally be used for the Company’s working capital requirements.

In December 2005 the Company signed an agreement witha company to provide market capitalization support services. Additionally, inFebruary 2006 the Company signed an agreement with an investment banking firmto provide general financial advisory services to develop and implement a planto raise new debt and / or equity capital. The Company is actively working withits investment bankers to raise additional capital in the near term.

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The Company hired a consultant to review purchasingand inventory management procedures. The goal of the study is to determine theoptimum inventory necessary to maintain high levels of customer satisfactionwhile improving working capital. The Company continues to work with theconsultant’s recommendations to ascertain the optimum inventory levels andimprove inventory turnover. Inventory turnover has improved by 11% to 1.2 times(on an annualized basis) for the nine months ended September 30, 2006 from 1.06times for the twelve months ended December 31, 2005.

As more fully discussed in note 6 the Company received notice ofdefault from its primary lender on November 2, 2006 and the Company hassubsequently entered into a forbearance agreement with its primary lender. TheCompany is in discussions with several banks to restructure and increase itsborrowing base and expects to have this completed in the near future.

The Company’s increase in the accounts receivable balance from $9.9million at December 31, 2005 to $11.4 million at September 30, 2006 is a resultof a $6.0 million increase in sales revenue. The Company has improved the receivable turnover ratio (annualized) to89.2 at September 30, 2006 from 54.9 at December 31, 2005.

As more fully discussed in the results from operations the Company’ssales growth rate is slowing which is increasing cash flow as more is collectedfrom receivables than is sold and subsequently partially financed through theCompany’s revolving credit line. Management believes that its profitimprovement program of increasing margins through price increases, loweringcost of goods, such as the in house bullnose operation and reducing overheadcosts where possible combined with continued focus on improving inventory andaccounts receivable turnover will generate increased cash flow and allow theCompany to meet its debt covenant requirements.

###### **NOTE 3              RESTRUCTURING**

The Company has restructured the operations of itssubsidiary Tesoro Direct, Inc., formerly known as Import Flooring Group, Inc.(TDI). Tesoro Direct, 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. TDI generated revenue from othersources by offering fee based services such as “showroom fees”, charged tovendors for allocating a portion of the California Office/Showroom to displaythe vendor’s products, “convention fees”, for participating in the annual TDIFloor Covering Convention and “membership fees” charged to customers forparticipating in exclusivity agreements. The fee based revenue was anticipatedto generate a greater percentage of the total overall revenue. However, only2.6% of the total revenue from July 1, 2005 through September 30, 2006 was aresult of this fee based revenue source. IWT Tesoro Corporation determined thatthe cost to provide these fee based services exceeded the revenue. Therefore,the Company restructured its operations eliminating these services and theassociated costs. These costs included the office/showroom space located in SanClemente, California and the office and sales staff based out of this office.As a part of this restructuring the Company entered into an agreement with aformer TDI sales person to acquire a portion of the assets and liabilities ofTDI related to the fee based revenue activities.  TDI retained a portion of the assets andliabilities related to product sales and continues to sell products throughoutthe United States.  TDI will facilitateall agency and direct shipment revenue while developing channels for close outlines. TDI recently hired a salesperson dedicated to developing the agency andclose out business.

In connection with this restructuring plan TDI incurred the followingcosts:

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

2.               ContractTermination Costs of $62,272 to terminate the San Clemente office/showroomlease agreement, vendor agency agreements, showroom contracts, 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 TDI salesperson to purchase certain assets and liabilities of TDI. TheCompany also incurred attorney’s fees of approximately $22,000 and $113,000related to the write off on a non-refundable deposit for inventory.

The Company accounted for restructuring costs pursuant to Statement ofFinancial Accounting Standards (SFAS” No. 146, “Accounting for Costs Associatedwith Exit or Disposal 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 third quarter of 2006, the Company recorded a restructuring chargein the amount of approximately $585,700 in connection with the restructuringactivities. The Company does not anticipate incurring any additional costs withrespect to this restructure. Restructuring charges are reflected in a separateline item in the accompanying consolidated statements of operations.

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###### **NOTE 4              INVENTORIES**

Inventoriesconsisted of the following:
|                       | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|-----------------------|------------|------------------------|------------|-----------------------|------------|
| ** **            | ** ** | **2006**               | ** ** | **2005**              | ** ** |
| Tiles                 |       | $                      | 31,524,787 |                  | $          | 28,858,620 |   |
| Inventory in  transit |       | 2,349,678              |       | 3,353,387             |       |
|                  |       | $                      | 33,874,465 |                  | $          | 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:
|                                | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|--------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                     | ** ** | **2006**               | ** ** | **2005**              | ** ** |
|                           |       |                   |       |                  |       |
| Furniture and  fixtures        |       | $                      | 320,475    |                  | $          | 423,806 |   |
| Machinery and  equipment       |       | 1,130,042              |       | 859,996               |       |
| Vehicles                       |       | 321,572                |       | 307,195               |       |
| Office and  computer equipment |       | 714,196                |       | 676,304               |       |
| Leasehold  improvements        |       | 722,097                |       | 676,094               |       |
|                           |       | 3,208,382              |       | 2,943,395             |       |
| Less accumulated  depreciation |       | 1,064,808              |       | 822,973               |       |
|                           |       | $                      | 2,143,574  |                  | $          | 2,120,422 |   |

 

Depreciation expense for the three months ended September 30, 2006 and2005 was approximately $99,700 and $90,200, respectively.  Depreciation expense for the nine monthsended September 30, 2006 and 2005 was approximately $308,600 and $247,500,respectively.

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

On September 5, 2006, the Company amended and restatedthe existing revolving line of credit agreement providing up to $26,500,000 ofavailable borrowings with interest rates of either (1) LIBOR plus 3.00% or (2)the base rate plus 0.50% (interest rates ranging from 8.375% to 8.75% atSeptember 30, 2006) payable monthly.  Theline of credit is limited by a borrowing base which is comprised of apercentage of eligible accounts receivable and eligible inventories, asdefined, and is collateralized by substantially all the assets of the Company.The balance due at September 30, 2006 and December 31, 2005 was $25,436,522 and$22,625,500, respectively. The balance at September 30, 2006 of $25,436,522includes a bank overdraft of $241,229. The line matures December 10, 2006 andcontains certain covenants requiring the Company to maintain a certain minimumadjusted EBITDA, a required minimum fixed charge coverage ratio, and certainadjusted tangible net worth. At September 30, 2006 the Company was not incompliance with the minimum fixed charge coverage ratio and the minimumadjusted EBITDA covenants and received a notice of default from its primarylender on October 25, 2006.On November 2, 2006, the bank and the Company entered into a forbearanceagreement whereby the bank agreed to forbear the exercise of its rights toDecember 10, 2006, provided that the Company is not in default of any of itsother obligations, which it currently is not, and the Company engages amanagement consultant to provide a comprehensive business analysis of theCompany’s operations.

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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 accrued on the principal balance ofthe note at an annual interest rate equal to prime plus 1.5%.  The note matures on August 25, 2008.  The note was convertible into common stock ofthe Company at an initial conversion rate of $2.74 per share.  Because the agreement contained certainnon-standard anti-dilution provisions and requirements to settle any conversionoption with registered shares, the Company was required to account for theconversion option as an embedded derivative requiring separate accountingtreatment in accordance with *SFAS No. 133 Accounting forDerivative Instruments and Hedging Activities*.  Based upon the closing price per share of theCompany’s common stock on the date of issuance, the Company estimated the fairvalue of the embedded conversion option and classified $2,068,317 as a derivativeliability that was adjusted to fair value at each reporting date with changesin 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 priceper share of the Company’s common stock on the date of issuance, the Companyestimated the fair value of the warrant and option and classified $3,099,835and $692,334, respectively, as derivative liabilities that were adjusted tofair value at each reporting date with changes in fair value reflected inoperations. The fair values of the options, warrants, and embedded conversionoption was estimated at the date of issuance using the Black-Scholesoption-pricing model using the following weighted average assumptions:risk-free rate of 4.06%, dividend yields of 0%, and volatility factors of theexpected market price of the Company’s common stock of 60.79%.

On March 31, 2006, the Company issued an Amendment 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

On July 21, 2006, the Company Amended and Restated theSecured Revolving Note dated August 25, 2005 removing all conversion featuresof the original note. In addition the interest rate was modified as follows:August 25, 2006 thru July 20, 2006, annual interest rate equal to prime plus1.5%; July 21, 2006 thru August 25, 2008, annual interest rate equal to8.5%.   The Secured Convertible MinimumBorrowing Note, dated August 25, 2005 was voided.  The Registration Rights Amendment removed allreferences to the convertibility of the Secured Revolving Note, removed allreferences to the Secured Convertible Minimum Borrowing Note and removed theprovision for liquidating damages as a remedy in the event the Company isunable to deliver registered shares.  Asa result, the provisions that required derivative liability classification inaccordance with *SFAS No. 133 – “Accounting for DerivativeInstruments and Hedging Activities:”*no longer exist*.*The holder of the note no longer has the right to convertany portion of principal or interest into common shares of the Company. Theregistration rights agreement was modified to remove all “uneconomical”provisions that previously resulted in the requirement to classify the warrantsand options to purchase common shares covered by the registration rightsagreement as derivative liabilities.  Asamended, the registration rights agreement does not preclude equityclassification of the warrants and options in accordance with EITF 00-19.

Therefore, the fair value of the embedded derivativeliability on July 21, 2006 in the amount of $1,646,269 was eliminated and the$1,345,640 relating to fair value of the options and warrants on the date ofmodification was recorded as additional paid in capital and the remaining$300,629, representing the fair value of the conversion feature was credited tooperations.

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The balance of the note net of unamortized discountsas of September 30, 2006 is as follows:
| Derivative liability at  December 31, 2005                      |   | $          | 5,954,462 |   |
|-----------------------------------------------------------------|--------|------------|-----------|--------|
| Change in fair  value                                           |   | (4,308,193 | )         |
| Balance as of  July 21, 2006, modification date                 |   | 1,646,269  |      |
| Fair value on  date of debt modification                        |   | (1,646,269 | )         |
| Derivative  liability as of September 30, 2006                  |   | $          | —    |   |
|                                                            |   |       |      |
| Principal amount  of notes                                      |   | $          | 5,000,000 |   |
| Fair value - Conversion  feature                                |   | (1,764,629 | )         |
| Fair value -  Warrants and options                              |   | (3,235,371 | )         |
| Accretion of  discount into interest expense                    |   | 1,805,544  |      |
| Balance as of  September 30, 2006, net of unamortized discounts |   | $          | 1,805,544 |   |

 

For the three months ended September 30, 2006 and 2005, interestexpense related to the revolving credit line amounted to $729,270 and $365,011respectively.  For the nine months endedSeptember 30, 2006 and 2005, interest expense related to the credit lineamounted to $1,641,333 and $941,312 respectively.

Interest expense related to the secured revolving noteamounted to $112,541 for the three months ended September 30, 2006 and $342,889for the nine months ended September 30, 2006.

Amortization of discounts for the conversion featureand warrant related to the secured revolving note resulted in charges tointerest expense totaling $147,051 for the three months ended September 30,2006 and $441,153 for the nine months ended September 30, 2006.

Amortization of discounts for the detachable warrantrelated to the secured revolving note resulted to charges to interest expensetotaling $269,613 for the three months ended September 30, 2006 and $808,839for the nine months ended September 30, 2006.

The note is secured by a lien on substantially all theassets of the Company, subject to a first priority lien of the Company’sprimary financial lender.

#### The holder of the note hadagreed 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.

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###### **NOTE 7              NOTESPAYABLE – CONVERTIBLE DEBT**

On February 10, 2006, the Company issued a securedconvertible term note in the amount of $2,000,000 resulting in net proceeds of$1,919,500.  Interest accrues on theprincipal balance of the note at an annual interest rate equal to prime plus2.0%, payable monthly in arrears commencing on March 1, 2006.  On September 30, 2006, the interest rate was10.25%.  The note requires monthlyprincipal payments of $66,667 that commenced on August 1, 2006 and continuinguntil maturity.  The note matures onFebruary 10, 2009.    The note isconvertible into common stock of the Company at a fixed conversion rate of$2.17 per share.  Based upon the closingprice per share of the Company’s common stock on the date of issuance, therewas a beneficial conversion feature with an estimated intrinsic value of$553,593, which is presented as a discount on the note to be amortized intoexpense over the three year term of the loan using the effective interestmethod.  In connection with theconvertible note, the Company issued to the holder of the note a seven-yearwarrant to purchase 460,829 shares of the Company’s common stock at an exerciseprice of $2.39 per share.  The Companyestimated the fair value of the warrant and allocated $455,943 of the proceedsof the debt to the warrant which is presented as a discount on the note to be amortizedinto interest expense over the three-year term of the note using the effectiveinterest method. The aggregate discount allocated to the beneficial conversionfeature and the options and warrants was recorded as additional paid in capitalat the date of issuance. The fair value of the warrant was estimated at thedate of issuance using the Black-Scholes option-pricing model using thefollowing assumptions: risk-free rate of 4.59%, dividend yields of 0%, and avolatility factor of the expected market price of the Company’s common stock of58.2%.  The Company also issued to theholder, 221,198 shares of the Company’s common stock as prepayment of interestin the amount of $486,636, which was calculated based upon the closing priceper share of the Company’s common stock on the date of issuance of $2.20 pershare. The prepaid interest is presented as a discount on the note to beamortized into interest expense over the three year term using the effectiveinterest method.

The balance of the note, net of unamortized discountsas of September 30, 2006 is as follows:
| Principal amount of notes                                       |   | $        | 1,866,667 |   |
|-----------------------------------------------------------------|--------|----------|-----------|--------|
| Fair value -  Conversion feature                                |   | (553,593 | )         |
| Fair value -  Warrants                                          |   | (942,579 | )         |
| Accretion of  discount to interest expense                      |   | 560,243  |      |
| Balance as of  Septebmer 30, 2006, net of unamortized discounts |   | $        | 930,738   |   |
|                                                            |   |     |      |
| Current                                                         |   | 800,007  |      |
| Non-current                                                     |   | 130,731  |      |
|                                                            |   | $        | 930,738   |   |

 

Interest expense related to the note amounted to$70,673 for the three months ended September 30, 2006 and $181,886 for the ninemonths ended September 30, 2006.

Amortization of discounts for the beneficialconversion feature and warrant resulted in charges to interest expense totaling$80,266 for the three months ended September 30, 2006 and $207,476 for the ninemonths ended September 30, 2006.

Amortization of discounts for the detachable warrantresulted to charges to interest expense totaling $66,108 for the three monthsended September 30, 2006 and $170,881 for the nine months ended September 30,2006.

The note is secured by a lien on substantially all theassets of the Company, subject to a first priority lien of the Company’sprimary financial lender.

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#### 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 May 3, 2006, the Company issued a secured term notein the amount of $2,000,000 resulting in net proceeds of $1,924,500.  Interest accrues on the principal balance ofthe note at an annual interest rate equal to 15%, payable monthly in arrearscommencing on June 1, 2006. The note matures on May 3, 2007.  In connection with the term note, the companyissued to the holder of the note a seven-year warrant to purchase 333,333shares of the Company’s common stock at an exercise price of $1.12 pershare.  The company estimated the fairvalue of the warrant and allocated $222,809 of the proceeds of the debt to thewarrant, which is presented as a discount on the note to be amortized intoexpense over the one-year term of the note. The fair value of the warrant was estimated at the date of issuanceusing the Black-Scholes option-pricing model using the following assumptions:risk-free rate of 5.06%, dividend yields of 0%, and a volatility factor of theexpected market price of the Company’s common stock of 59.18%.

The balance of the note as of September 30, 2006, netof unamortized discounts is a follows:
| Principal amount of notes                                  |   | $        | 2,000,000 |   |
|------------------------------------------------------------|--------|----------|-----------|--------|
| Fair value -  Warrants                                     |   | (222,809 | )         |
| Accretion of  discount into interest expense               |   | 92,835   |      |
| Balance as of  June 30, 2006, net of unamortized discounts |   | $        | 1,870,026 |   |

 

Interest expense related to the note amounted to $76,666 for the threemonths ended September 30, 2006 and $124,999 for the nine months endedSeptember 30, 2006.

Amortization of discounts for the detachable warrantresulted in charges to interest expense totaling $55,701 for the three monthsended September 30, 2006 and $92,835 for the nine months ended September 30,2006.

The note is secured by a lien on substantially all theassets of the Company, subject to a first priority lien of the Company’sprimary financial lender.

#### 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 9              STOCKHOLDERS’DEFICIT**

**Common Stock**

During the nine months ended September 30, 2006, the Company issued6,300 shares of common stock to several employees under the Stock IncentivePlan for services rendered, based on the closing stock price at the date ofissuance, for a total of $12,792, resulting in an equivalent charge tooperations.

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.

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**Treasury Stock**

On June 26, 2006, theCompany’s board of directors authorized an employee stock purchase programwhereby The Company would purchase up to 150,000 shares of IWT Tesoro’s stockfor resale to employees participating in the program. During the three monthsended September 30, 2006, the Company purchased 6,000 shares of IWT Tesorocommon stock for a total cost of $9,894, at fair market value in the openmarket.

###### **NOTE 10            INCOMETAXES**

Income tax benefit for the three month period endedSeptember 30, 2006 was $-0- as the benefit for income taxes, computed byapplying the Federal statutory rate to loss before income taxes, was reduced bythe increase in the deferred tax valuation allowance during the period, toadjust deferred taxes to the amount considered by management more likely thannot to be realized.

Income tax benefit for the nine month period endedSeptember 30, 2006 was $-0- as the benefit for income taxes computed byapplying the Federal statutory rate to loss before income taxes, was reduced bythe increase in the deferred tax valuation allowance during the period, toadjust deferred taxes to the amount considered by management more likely thannot to be realized.

Income tax expense for the three and nine month periodended September 30, 2005 was $-0- as the benefit for income taxes, computed byapplying the Federal statutory rate to loss before income taxes, was reduced bythe increase in the deferred tax valuation allowance during the period, toadjust deferred taxes to the amount considered by management more likely thannot to be realized.

At September 30, 2006, the Company had net operatingloss carryforwards for federal income tax purposes of approximately $9,039,000,which are available to offset future federal taxable income through 2026. Ofthe change in the valuation allowance, approximately $506,364 was recorded as areduction to the deferred tax effect of the reclassification of the fair valueof the options and warrants in connection with the debt modification recordedin additional paid in capital.

 

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###### **NOTE 11            STOCK-BASEDCOMPENSATION**

The Company entered intoa 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.

Effective January 1,2006, the Company adopted the fair value recognition provisions of SFAS No.123R using the modified-prospective-transition method.  Prior to the adoption of SFAS No. 123R stockoption grants were accounted for in accordance with Accounting Principles BoardOpinion No. 25,  “*Accounting  for Stock Issued to Employees*”(APB No. 25), and related interpretations, and accordingly the Companyrecognized no compensation expense for stock option grants.

Under themodified-prospective-transition method, SFAS No. 123R applies to new awards andto awards that were outstanding on January 1, 2006 that are subsequentlymodified, repurchased or cancelled. Under the modified-prospective-transitionmethod compensation cost recognized in the nine-month period ended September30, 2006, includes compensation cost for all share-based payments granted priorto, but not yet vested as of January 1, 2006, based on the grant date fairvalue estimated in accordance with the original provisions of Statement 123,and compensation cost for all share-based payments granted subsequent toJanuary 1, 2006, based on the grant-date fair value estimated in accordancewith the provisions of SFAS No. 123R. Prior periods were not restated toreflect the impact of adopting the new standard.

As a result of adoptingSFAS No. 123R on January 1, 2006, during the three and nine month periods endedSeptember 30, 2006, the Company recognized additional compensation costs of$28,286 and $88,438, respectively. The adoption of SFAS No. 123R had no impacton basic and diluted earnings per share for the nine months ended September 30,2006.

The following tableillustrates the effect on net income and earnings per share if the Company hadapplied the fair value recognition provisions of Statement 123(R) to optionsgranted under the Company’s stock option plan for the three and nine month periodended September 30, 2005.  For purposesof this proforma disclosure, the value of the options is estimated using theBlack-Scholes option-pricing model and amortized to expense over the options’vesting periods.

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|                                                                                                                  | ** ** | **For the three**      | ** ** | **For the nine** | ** ** |
|------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|----------------------------|------------|
| ** **                                                                                                       | ** ** | **months ended**            | ** ** | **months ended**      | ** ** |
| ** **                                                                                                       | ** ** | **September 30, 2005** | ** ** |
|                                                                                                             |       |                             |       |                       |       |
| Net loss as  reported                                                                                            |       | $                                | (1,561,233 | )                          | $          | (1,345,442 | ) |
| Deduct:  Stock-based employee compensation expense determined under the fair value  based method for all options |       | —                           |       | (37,902                    | )          |
| Pro forma net  loss                                                                                              |       | $                                | (1,561,233 | )                          | $          | (1,383,344 | ) |
| Loss per share -  As reported                                                                                    |       |                             |       |                       |       |
| Basic and  diluted                                                                                               |       | $                                | (0.13      | )                          | $          | (0.12 | ) |
| Loss per share -  Proforma                                                                                       |       |                             |       |                       |       |
| Basic and  diluted                                                                                               |       | $                                | (0.13      | )                          | $          | (0.12 | ) |

 

The following assumptions were utilized in the Black-Scholes optionpricing model used to estimate the fair value of stock-based awards.
|                                         | ** ** | **Nine Months Ended September 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 with respectto exercise and post-vesting employment termination behaviors, expected futureexercising patterns for these same homogenous groups and the implied volatilityof our stock price.

At September 30, 2006, there was $168,400 of unrecognized compensationcost related to share-based payments which is expected to be recognized over aweighted-average period of 1.32 years.

20

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The following table represents employee based stock option activity forthe three months ended September 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                                   |       | (7,500             | )          | 2.80                       |       |                        |       |
|                                        |       |               |       |                       |       |                        |       |
| Outstanding  options at end of period       |       | 602,249            |       | $                          | 3.14       |                        | 3.59       |   |
|                                        |       |               |       |                       |       |                        |       |
| Options  exercisable at end of period       |       | 458,883            |       | $                          | 3.22       |                        | 3.87       |   |

 

The following table represents employee based stock option activity forthe nine months ended September 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                                   |       | (15,500            | )          | 3.83                       |       |                        |       |
|                                        |       |               |       |                       |       |                        |       |
| Outstanding  options at end of period       |       | 602,249            |       | $                          | 3.14       |                        | 3.59       |   |
|                                        |       |               |       |                       |       |                        |       |
| Options  exercisable at end of period       |       | 458,883            |       | $                          | 3.22       |                        | 3.87       |   |

 

Shares available for future stock option grants to employees anddirectors under the existing plan were 3,243,918 and 3,293,918, respectively,at September 30, 2006 and 2005.  AtSeptember 30, 2006 the aggregate intrinsic value of shares outstanding was$1,095,211, and the aggregate intrinsic value of options exercisable was863,005.   Total intrinsic value ofoptions exercised was $0 for the nine months ended September 30, 2006.

The following table summarizes ournonvested employee based stock option activity for the three months endedSeptember 30, 2006:
|                                                 | ** ** | **Number of** | ** ** | **Weighted- Average**               | ** ** |
|-------------------------------------------------|------------|--------------------|------------|------------------------------------------|------------|
| ** **                                      | ** ** | **Shares**         | ** ** | **Grant Date Fair Value** | ** ** |
|                                            |       |               |       |                                     |       |
| Nonvested stock  options at beginning of period |       | 150,866            |       | $                                        | 1.63       |   |
| Granted                                         |       | —             |       | —                                   |       |
| Vested                                          |       | —             |       | —                                   |       |
| Forfeited                                       |       | (7,500             | )          | 2.80                                     |       |
|                                            |       |               |       |                                     |       |
| Nonvested stock  options at end of period       |       | 143,366            |       | $                                        | 1.62       |   |

 

The following table summarizes our nonvested employee based stockoption activity for the nine months ended September 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                                       |       | (15,500            | )          | 1.42                                     |       |
|                                            |       |               |       |                                     |       |
| Nonvested stock  options at end of period       |       | 143,366            |       | $                                        | 1.62       |   |

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###### **NOTE 12           ****SUBSEQUENTEVENT**

On October 25, 2006, the Company received a letterfrom its senior credit facility, Bank of America, N.A. stating that certainevents of default had occurred and are continuing under its credit facilityagreements including that the Company did not attain its minimum adjustedEBITDA for the months ended August 31, 2006 and September 30, 2006, nor did theCompany reach its minimum fixed charge coverage ratio for the period endedSeptember 30, 2006. 

On November 2, 2006, the Company and its senior creditfacility, Bank of America, N.A. executed a Forbearance Agreement stating thatthe Bank has agreed to forbear the exercise of its rights to December 10, 2006,provided (i) that the Company is not in default of any of its otherobligations, which it currently is not, and (ii) the Company engages amanagement consultant to provide a comprehensive business analysis of theCompany’s operations.

On November 6, 2006 David Whitwell joined IWT Tesoro asits Chief Financial Officer. As part of his agreement he is to be awarded30,000 shares of IWT Tesoro stock at the market price on the date of issuancewhich is expected to be January 6, 2007 which is the next available date forstock to be issued from the IWT Tesoro Employee Stock Incentive Plan.

ITEM 2:   MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTSOF OPERATIONS

IWT Tesoro Corporation (the Company) was organized inNevada on May 3rd, 2000, originally under the name “Ponca AcquisitionCorporation”.   Effective October 1,2002, Tesoro acquired all of International Wholesale Tile, Inc.’s (IWT) commonstock from IWT’s three shareholders. IWT was organized in Florida in 1994 as avalue added reseller and distributor of porcelain and ceramic tile. In exchangefor the IWT stock, the IWT shareholders each received 3.0 million Tesoroshares, representing 87% of Tesoro’s then outstanding common stock.

In addition to IWT, Tesoro’s primary operatingsubsidiary, Tesoro has three additional wholly owned subsidiaries.  These include IWT Tesoro Transport, IWTTesoro International, Ltd and The Tile Club, Inc. The Tile Club, Inc has awholly owned subsidiary named Tesoro Direct, Inc., formerly known as ImportFlooring Group, Inc. (TDI)

·                  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 September 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.

·                  Tesoro Direct, Inc., formerly known as ImportFlooring Group, Inc. (TDI), formed in June 2005, was organized to support theCompany’s growth strategy with an agent- oriented and close-out business modelsin the floor covering market. 

Our principal executive office is located at 191 PostRoad West, Suite 10, Westport, CT 06880. Our telephone number is (203) 221-2770. Our web site can be found at*http://www.iwttesoro.com*.  Information contained on our web site is not part of this report.  

** RESTRUCTURING**

IWT TesoroCorporation has restructured the operations of its subsidiary Tesoro Direct,Inc., (TDI) formerly known as Import Flooring Group, Inc. (IFG). ImportFlooring Group, Inc. although similar to its sister Company, InternationalWholesale Tile, Inc.(IWT), in that both company’s major source of revenue isgenerated through the wholesale, distribution 

22

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and brokering offloor coverings throughout the United States. IFG generated revenue from othersources by offering fee based services such as “showroom fees”, charged tovendors for allocating a portion of the California Office/Showroom to displaythe vendor’s products, “convention fees”, for participating in the annual IFGFloor Covering Convention and “membership fees” charged to customers forparticipating in exclusivity agreements. The fee based revenue was anticipatedto generate a greater percentage of the total overall revenue. However, only2.7% of the total revenue from July 1, 2005 through June 30, 2006 was a resultof this fee based revenue source. IWT Tesoro Corporation determined that thecost to provide these fee based services exceeded the revenue. Therefore, theCompany restructured its operations eliminating these services and theassociated costs. These costs included the office/showroom space located in SanClemente, California and the office and sales staff based out of this office.As a part of this restructuring the Company entered into an agreement with aformer IFG sales person to acquire a portion of the assets and liabilities ofIFG related to the fee based revenue activities.  IFG retained a portion of the assets andliabilities related to product sales and continue to sell products throughoutthe United States

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 thethird quarter of 2006, the Company recorded a restructuring charge in theamount of approximately $585,700 in connection with the restructuringactivities. 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 certain assetsand liabilities and $113,000 for a non refundable deposit on material.  The Company does not anticipate incurring anyadditional costs with respect to this restructure. Restructuring charges arereflected in a separate line item in the accompanying consolidated statementsof operations.

TDI continues tosell products throughout the United States as an agent and through directshipments. TDI is also developing a non-prime close out line of business tobroaden its customer base throughout the United States.

*Results of Operations for thethree months ended September 30, 2006, 2005 and 2004.*

The following discussionand analysis should be read in conjunction with the financial statements andnotes thereto that appear elsewhere in this document. The table below setsforth certain operating data for the periods indicated. Percentages are relative to total revenue for the periods indicated.
|                          | ** ** | **Quarter ending September 30,** | ** ** |
|--------------------------|------------|-------------------------------------------------|------------|
| ** **               | ** ** | **2006**                                        | ** ** | **2005** | ** ** | **2004** | ** ** |
|                     |       |                                            |       |   |   |   |   |
| Revenues                 |       | $                                               | 15,173,449 |   | $ | 14,006,762 |   | $ | 11,052,268 |   |
| Cost of Goods  Sold      |       | 9,578,329                                       |       | 8,277,926 |   | 6,733,909 |   |
| Gross Margin             |       | 5,595,120                                       |       | 5,728,836 |   | 4,318,359 |   |
| Gross Margin  Percentage |       | 36.9                                            | %          | 40.9 | % | 39.1 | % |
| Operating  Expenses      |       | $                                               | 5,670,371  |   | $ | 5,816,085 |   | $ | 4,640,226 |   |
|                     |       | 37.4                                            | %          | 41.5 | % | 42.0 | % |
| Loss from  operations    |       | (75,251                                         | )          | (87,249 | ) | (321,867 | ) |

 

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

Net sales for the threemonths ended September 30, 2006 increased $1,166,687 or approximately 8.3% overthe reported net sales for the three months ended September 30, 2005. Thisgrowth follows a 26.7% increase in net sales for the three months endedSeptember 30, 2005 over the three months ended September 30, 2004. Managementbelieves that the lower growth for the three months ended September 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 

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billion wholesale hardfloor and wall coverings market by expanding geographical operations andexpects to maintain a strong growth rate. 

Gross profit forthe three months ended September 30, 2006 was $5,595,120 (36.9% of net sales)compared to $5,728,836 (40.9% of net sales) for the three months endedSeptember 30, 2005. Gross profit was impacted by higher than expected cost ofgoods sold relating to increased inbound transportation and a larger percentageof lower margin truckload sales.

Our operatingexpenses for the three months ended September 30, 2006 were $5,670,371 (37.4%of net sales) compared to $5,816,085 (41.5% of net sales) for the three monthsended September 30, 2005. The decrease in operating expenses as a percentage ofnet sales is due to the realization of results from the Company’s expenseimprovement programs. Management continues to evaluate cost improvementprograms and anticipates future declines in the operating expense ratio. 

*Resultsof Operations for the Nine Months ended September 30, 2006, 2005 and 2004*

The following discussionand analysis should be read in conjunction with the financial statements andnotes thereto that appear elsewhere in this document. The table below setsforth certain operating data for the periods indicated. Percentages are relative to total revenue for the periods indicated.
|                                | ** ** | **Nine Months Ending September 30,** | ** ** |
|--------------------------------|------------|----------------------------------------------------------|------------|
| ** **                     | ** ** | **2006**                                                 | ** ** | **2005** | ** ** | **2004** | ** ** |
|                           |       |                                                     |       |   |   |   |   |
| Revenues                       |       | $                                                        | 48,145,483 |   | $ | 42,141,461 |   | $ | 32,171,915 |   |
| Cost of Goods  Sold            |       | 30,544,590                                               |       | 25,443,315 |   | 19,688,729 |   |
| Gross Margin                   |       | 17,600,893                                               |       | 16,698,146 |   | 12,483,186 |   |
| Gross Margin  Percentage       |       | 36.6                                                     | %          | 39.6 | % | 38.8 | % |
| Operating  Expenses            |       | $                                                        | 18,121,981 |   | $ | 16,113,525 |   | $ | 13,281,245 |   |
|                           |       | 37.6                                                     | %          | 38.2 | % | 41.3 | % |
| Income (loss)  from operations |       | $                                                        | (521,088   | ) | $ | 584,621 |   | $ | (798,059 | ) |

 

*NineMonths ended September 30, 2006 Compared to Nine Months ended June 20, 2005 and2004*

Net sales for thenine months ended September 30, 2006 increased $6,004,022 or 14.2% over netsales for the nine months ended September 30, 2005. This growth follows a 31.0%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 forthe nine months ended September 30, 2006 decreased to 36.6% of net salescompared to 39.6% of net sales for the nine months ended September 30, 2005.Gross profit was impacted by higher than expected cost of goods sold relatingto increased cost to import goods, a larger percentage of lower margintruckload sales and approximately $1.4 million in TDI sales at or near costprior to the restructure. 

Our operatingexpenses for the nine months ended September 30, 2006 were $18,121,981 (37.6%of net sales) compared to $16,113,525 (38.2% of net sales) for the nine monthsended September 30, 2005. The decrease in operating expenses as a percentage ofnet sales is due to the realization of results from the Company’s expenseimprovement programs. Management continues to evaluate improvement programs andanticipates future declines in the operating expense ratio. 

Loss fromoperations for the nine months ended September 30, 2006 were ($521,088) or(1.1%) of sales compared to income of $584,621 or 1.4% of sales for the ninemonths ended September 30, 2005.  The2.5% decrease is attributed primarily to the 3% or $1.4 million decrease ingross profits partially offset by the improvement in the operating expenseratio. Management continues to evaluate our product price mix and plans toimplement a price increase in December 2006.

**Changesin Financial Position for the Nine Months ended September 30, 2006 from theyear ended December 31, 2005**

Current assets atSeptember 30, 2006 are approximately $45.9 million compared to $43.8 million atDecember 31, 2005, an increase of approximately $2.1 million. The increase isattributable primarily to the increase in our receivables of approximately $1.4million at September 30, 2006 and an increase in inventory of approximately$1.7 million at September 

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30, 2006 from the yearended December 31, 2005. However, our inventory turnover rate increased 11% to1.2 times for the nine months ended September 30, 2006 from 1.06 times for thetwelve months ended December 31, 2005.

Currentliabilities increased approximately $3.7 million at September 30, 2006 comparedto December 31, 2005. The increase is attributable to an increase in ourrevolving line of credit of approximately $2.8 million and additional shortterm financing arrangements of approximately $1.7 million, as more fullydescribed in Note 7 and 8 of the consolidated financial statements. Thesechanges are consistent with our growth strategies.

Long termliabilities at September 30, 2006 are approximately $2.0 million compared to$6.7 million at December 31, 2005, a decrease of approximately $4.7 million.The decrease is primarily due to the elimination of the embedded derivativeliability relating to the amended and restated secured revolving note, as morefully described in Note 6 of the consolidated financial statements. 

# **Liquidityand Capital Resources**

Wehad an overdraft of $241,229 which is reflected in the revolving line of creditbalance at September 30, 2006 and $552,000 at December 31, 2005.   We have financed our growth with newsubordinated debt and increased borrowings from our commercial lender.

The cash used inoperations during the nine months ended September 30, 2006 were approximately$6.6 million which is primarily due to the net effect of the increase inaccounts receivable, and inventory and a decrease in accounts payable. Thiscompares to the $9.2 million used in the nine months ended September 30, 2005which was primarily due to the increase in accounts receivable and inventory.

Net cash used ininvesting activities during the nine months ended September 30, 2006 wasapproximately $592,000 compared to $247,600 for the nine months ended September30, 2005. Capital expenditures consisted of tile finishing equipment purchasedto enhance our breadth of products offered and control our product cost.

Net cash providedby financing activities during the nine months ended September 30, 2006 was approximately$6.6 million, provided through the issuance of convertible debt of $2.0million, the issuance of short-term debt of $2.0 and the increase borrowingsfrom our revolving line of credit. This compared to $9.6 million during thenine months ended September 30, 2005. The decrease is primarily attributable toa slightly slower growth rate. The cash provided by these financing activitieswas used to fund our continued sales growth and our geographical expansion.

During the ninemonths ended September 30, 2006, we issued a $2,000,000 convertible term noteto an institutional investor as more fully described in Note 7 to theconsolidated financial statements and a $2,000,000 term note to aninstitutional investor as more fully described in Note 8 to the consolidatedfinancial statements.  The notes aresubordinate to a revolving credit line with our commercial lender.  The combination of these notes and ourrevolving credit facilities provides us with up to $34 million of workingcapital.  We expect that this debt willbe sufficient to support our current level of sales.

Our growth throughgeographical expansion and acquisition is expected to continue to require us toseek additional outside capital.  Weexpect to raise additional equity through both the public and private debt andequity markets during 2006.  However, wecannot assure anyone that we will be able to obtain outside capital, or if wedo, that it will be on terms beneficial to us.

The balance due atSeptember 30, 2006 for our subordinated debt was $8.9 million. The balance dueat September 30, 2006 to our commercial lender for the use of the revolvingline of credit was approximately $25.4 million. The loan and security agreementcontains certain covenants, which include financial covenants that require usto maintain a minimum adjusted EBITDA, a required minimum fixed charge coverageratio, and a certain adjusted tangible net worth. At September 30, 2006 theCompany was not in compliance with the minimum fixed charge coverage ratio andthe minimum adjusted EBITDA covenants and received a notice of default from itsprimary lender on October 25, 2006. On November 2, 2006, our senior lender and theCompany entered into a forbearance Agreement whereby the bank agreed to forbearthe exercise of its rights to December 10, 2006, provided that the Company isnot in default of any of its other obligations, which it currently is not, andthe Company engages a management consultant to provide a comprehensive businessanalysis of the Company’s operations.

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# **CriticalAccounting Policies**

Our financialstatements are prepared in accordance with U.S. generally accepted accountingprinciples, which require us to make estimates and assumptions about futureevents and their impact on amounts reported in our Financial Statements andrelated Notes. Since future events and their impact cannot be determined withcertainty, the actual results will inevitably differ from our estimates. Thesedifferences could be material to the financial statements.

We believe thatour application 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 policy adoptedJanuary 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 StandardsSFAS No. 123R, *Share-Based Payment*,which requires us to recognize compensation expense for stock-basedcompensation based on the grant date fair value. Stock-based compensationexpense is then recognized ratably over the service period related to eachgrant. We used the modified prospective transition method under which financialstatements covering periods prior to adoption have not been restated. Wedetermine the fair value of stock-based compensation using the Black-Scholesoption pricing model, which requires us to make assumptions regarding futuredividends, expected volatility of our stock, and the expected lives of theoptions. Under SFAS 123R we also make assumptions regarding the number ofoptions and the number of restricted and performance shares that willultimately vest. The assumptions and calculations required by SFAS 123R arecomplex and require a high degree of judgment. Assumptions regarding thevesting of grants are accounting estimates that must be updated as necessarywith any resulting change recognized as an increase or decrease in compensationexpense at the time the estimate is changed.

**Forward-LookingInformation**

Some statements made in this Quarterly Report on Form 10-Q, are “forward-lookingstatements” and are not historical facts. For example, statements regarding our financial position, businessstrategy and other plans and objectives for future operations, and assumptionsand predictions about future demand for our services and products, supply,costs, marketing and pricing factors are all forward-looking statements.When we use words like “intend,” “would”, “anticipate,” “believe,” “estimate,” “plan”or “expect” or the negative of these terms and similar expressions, we aremaking forward- looking statements. You should be aware that these forward-looking statements aresubject to risks and uncertainties. Additionally, our forward-looking statements speak only as of the dateof this report.  Other than as requiredby law, we undertake no obligation to update or revise these statements,whether as a result of new information, future events or otherwise.   New factors emerge from time to time thatmay cause our business not to develop as we expect, and it is not possible forus to predict all of them.  Factors thatmay cause our actual results, performance or achievements to be materiallydifferent from the results, performance or achievements expressed or implied bythe forward-looking statements include, among other things are changes inthe industry, energy costs, timing and level of capital expenditures andintroduction of new products.

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

**Quantitativeand Qualitative Disclosures about Market Risk**

Information about theCompany’s exposure to market risk was disclosed in its Annual Report on Form10-K for the year ended December 31, 2005, which was filed with the Securitiesand 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 – CONTROLS AND 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 

26

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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.

Attached as Exhibits31.1 and 31.2 to this Quarterly Report are certifications of the CEO and theCFO, which are required in accordance with Rule 13a-14 of the SecuritiesExchange Act of 1934 (the Exchange Act). This Controls and Procedures sectionincludes the information concerning the controls evaluation referred to in thecertifications and it should be read in conjunction with the certifications. 

**PART II**

###### **ITEM 1.               LEGALPROCEEDINGS.**

We are not a party to anymaterial pending legal proceedings and, to the best of our knowledge, no suchaction by or against us are contemplated, threatened or expected.

###### **ITEM 2.               UNREGISTEREDSALES OF EQUITY SECURITIES AND USE OF PROCEEDS**

On June 17, 2006, Tesoro’sboard of directors authorized a stock repurchase program of up to 150,000shares of Tesoro stock in open market transactions. Subject to certainconditions, the shares are expected to be purchased through 2006 under Rules10b5-1 and 10b18 under the Securities Act of 1934, as amended. A number of theshares described below were purchased outside those rules, but within thepurview of Tesoro’s Insider Trading Policy. Depending upon prevailing marketconditions and other factors, there can be no assurance that any or allauthorized shares will be purchased pursuant to the plan. Tesoro may terminatethe stock repurchase plan at any time.
| ** **             | ** ** | ** **                             | ** ** | ** **                                | ** ** | ** **                        | ** ** | **(d) Maximum Number**           | ** ** |
|------------------------|------------|----------------------------------------|------------|-------------------------------------------|------------|-----------------------------------|------------|--------------------------------------------|------------|
| ** **             | ** ** | ** **                             | ** ** | ** **                                | ** ** | **(c)Total Number of**  | ** ** | **(or Approximate**                   | ** ** |
| ** **             | ** ** | ** **                             | ** ** | ** **                                | ** ** | **Shares purchased as** | ** ** | **Dollar Value) of Shares** | ** ** |
| ** **             | ** ** | ** **                             | ** ** | ** **                                | ** ** | **Part of Publicly**    | ** ** | **that May Yet Be**         | ** ** |
| ** **             | ** ** | **(a) Total Number of** | ** ** | **(b) Average Price Paid** | ** ** | **Announced Plans or**  | ** ** | **Pruchased Under the**          | ** ** |
| **Period**             | ** ** | **Shares Purchased**              | ** ** | **per Share**                        | ** ** | **Programs**                      | ** ** | **Plans or Program**             | ** ** |
| July 1 - 31, 2006      |       | —                                 |       | $                                         | —     |                              | —     |                                       | 150,000    |   |
| August 1 - 31, 2006    |       | 6,000                                  |       | 1.55                                      |       | 6,000                             |       | 144,000                                    |       |
| September 1 - 30, 2006 |       | —                                 |       | —                                    |       | —                            |       | 144,000                                    |       |
| Total                  |       | 6,000                                  |       | $                                         | 1.55       |                              | 6,000      |                                       | 144,000    |   |

 

###### **ITEM 3.               DEFAULTSUPON SENIOR SECURITIES. **

On October 25,2006, IWT Tesoro Corporation and its subsidiaries received a letter from itssenior credit facility, Bank of America, N.A. stating that certain events ofdefault had occurred and are continuing under its credit facility agreementsincluding that the Company did not attain its minimum EBITDA for the monthsended August 2006 and September 2006, nor did the Company reach its minimumfixed charge coverage ratio for the period ended September 30, 2006. OnNovember 2, 2006 the Company and Bank of America executed a forbearanceagreement, whereby the Bank agreed to forbear the exercise of its rights toDecember 10, 2006 provided (i) that the Company is not in default of any of itsother obligations, and (ii) the Company engages a management consultant toprovide a comprehensive business analysis of the Company’s operations. 

###### **ITEM 4.               SUBMISSIONOF MATTERS TO A VOTE OF SECURITY HOLDERS. **

None

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###### **ITEM 6:              EXHIBITSAND 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)                                                                                                   |
| 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                                                                                                                                                                                                                                                     |

 

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|       |   | 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).                                                                                                      |
| 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  (filed as an exhibit to the Company’s periodic filing on Form 8-K, filed with  the Securities and Exchange Commission on May 9, 2006)                                                                                                                                                         |

 

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| 10.39 |   | Amended and Restated  Securities Agreement effective July 21, 2006 (filed as an exhibit to the  Company’s periodic filing on Form 8-K, filed with the Securities and Exchange  Commission on August 21, 2006).                                                      |
|-------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.40 |   | Amended and Restated  $5.0 million revolving note effective August 25, 2005, as amended and  restated from time to time (filed as an exhibit to the Company’s periodic  filing on Form 8-K, filed with the Securities and Exchange Commission on  August 21, 2006). |
| 10.41 |   | Amended and Amended and  Restated Registration Rights Agreement dated July 21, 2006 (filed as an  exhibit to the Company’s periodic filing on Form 8-K, filed with the  Securities and Exchange Commission on August 21, 2006).                                     |
| 10.42 |   | Fifth Amendment to the  Amended and Restated Loan and Security Agreement dated as of September 5,  2006 (filed as an exhibit to the Company’s periodic filing on Form 8-K, filed  with the Securities and Exchange Commission on September 6, 2006).                |
| 10.43 |   | Form of Amended and  Restated Credit Note in the principal amount $26.5 million dated as of  September 5, 2006 (filed as an exhibit to the Company’s periodic filing on  Form 8-K, filed with the Securities and Exchange Commission on September 5,  2006).        |
| 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.*                                                                                                                                                      |
| *     |   | 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 August 21, 2006, regarding an amendment to the $5.0 million note with Laurus Master Fund., Ltd. 

Form 8-K, filed on August 22, regarding Tesoro’s purchase of common stock for its Stock Repurchase Plan.  .  

Form 8-K, filed on September 6, 2006 amended the credit facility with Bank of America.

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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                     |
|-------------------|--------------------------------------------|
|              |                                       |
|              |                                       |
| November 14, 2006 | /s/ Henry J. Boucher, Jr.                  |   |
|              | Henry J. Boucher, Jr., President           |
|              |                                       |
| November 14, 2006 | /s/Forrest P. Jordan                       |   |
|              | Forrest P. Jordan, Chief Financial Officer |

 

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